End-of-Chapter Questions

Q1. Minion, Inc., has no debt outstanding and a total market value of $211,875. (Total market value
refers to the market value of its assets = Market value of equity + Market value of debt. Here since no
debt, we can conclude that market value = value of equity = $211,875)

Earnings before interest and taxes, EBIT, are projected to be $14,300 if economic conditions are
normal (EBIT normal = $14,300). If there is strong expansion in the economy, then EBIT will be 20
percent higher (EBIT expansion = EBIT normal x 1.20 = $14,300 x 1.20 = $17,160).

If there is a recession, then EBIT will be 35 percent lower (EBIT recession = EBIT normal x (1-0.35) =
$9,295).

The company is considering a $33,900 debt issue with an interest rate of 6 percent. The proceeds will
be used to repurchase shares of stock.

(After the capital restructuring, the total value of the firm remains $211,875

The level of debt becomes now= $33,900 and the level of equity becomes = $211,875 - $33,900=
$177,975)

There are currently 7,500 shares outstanding (Market value of equity = Number of shares x price per
share => price per share = $211,875/7,500 = $28.25)

Ignore taxes for this problem.

a. Calculate earnings per share, EPS, under each of the three economic scenarios before any
debt is issued. Also, calculate the percentage changes in EPS when the economy expands or
enters a recession.

Recession Normal Expansion

EBIT $9,295 $14,300 $17,160
Interest 0 0 0
NI $9,295 $14,300 $17,160
EPS $1.24 $1.91 $2.29
%EPS –35% – +20%

Note: Net income = EBIT – Interest

EPS = Net income ($9,295) /number of shares outstanding (7,500) = $1.24

The % change is calculated in reference to the normal scenario:

Under the recession = EPS (recession) – EPS (normal) / EPS (normal) = ($1.24 – $1.91) /$1.91 = -
0.35 or -35%

b. Repeat part (a) assuming that the company goes through with recapitalization (capital restructuring
where the level of debt is increased and the level of equity decreased). What do you observe?
Assume the stock price remains constant.

Note: under the new CS, we do have debt => the firm pays interest = 6% x $33,900 = $2,034

Recession Normal Expansion

EBIT $9,295 $14,300 $17,160
Interest 2,034 2,034 2,034
NI $7,261 $12,266 $15,126
EPS $1.15 $1.95 $2.40
%EPS –40.80% – +23.32%

EPS (new CS) = Net income (new CS)/ number of shares outstanding (new CS)
NOTE:

As we moved to the new capital structure, the firm issued new debt and used the proceeds to
repurchase existing shares ( the number of shares outstanding decreased).

Number of shares still outstanding after the CS = New value of equity/Price per share =
$177,975/$28.25= 6,300 shares)

Q11. Irving Corp. has no debt (D/V =0 => E/V =1- D/V = 1) but can borrow at 6.4 percent (RD= 6.4%).
The firm’s WACC is currently 10.9 percent, and there is no corporate tax.

WACC = Weight of equity x cost of equity + weight of debt x cost of debt

WACC = (E/V) x RE+ (D/V) x RD

a. What is the company’s cost of equity?

RE= WACC since no debt!

b. If the firm converts to 30 percent debt (this is the weight of debt: D/V = 30% and D=30%V =>
E/V= 70%and E=70%V), what will its cost of equity be?

RE = RA + (RA − RD) × (D/E) This is M&M proposition I with no taxes where R A refers to the WACC =
10.9%

RE = 10.9% + (10.90% - 6.40%) x (30% / 70%)

 RE = 12.83%

c. If the firm converts to 60 percent debt (D=60%V and E=40%V), what will its cost of equity be?

RE = 10.9% + (10.90% - 6.40%) x (60% / 40%)

 RE = 17.65%
d. What is the company’s WACC in part (b)? In part (c)?

In part (b): WACC with 30% debt

WACC = (E/V) x RE+ (D/V) x RD

 WACC = (70% x 12.83%) + (30% x 6.40%) = 10.90%

In part (c): WACC with 60% debt

 WACC = (40% x 17.65%) + (60% x 6.40%) = 10.90%

CONCLUSION: M&M Proposition II is validated if no taxes!

The WACC is not affected by firm’s capital structure!

Q16. Horford Co. has no debt. (Current capital structure: D=0 and E=V). Its cost of capital is 8.9
percent (WACC=8.90%). Suppose the company converts to a debt–equity ratio of 1.0 (D/E = 1 it
means that D=E => D/V = E/V = 50%). The interest rate on the debt is 5.7 percent (RD=5.7%). Ignoring
taxes, what is the company’s new cost of equity? What is its new WACC?

RE = RA + (RA − RD) × (D/E) This is M&M proposition I with no taxes where R A refers to the WACC
=8.9%

RE = 8.9% + (8.9% - 5.7%) x 1 = 12.10%

  WACC = (50% x 12.10%) + (50% x 5.7%) = 8.90% This confirms that WACC is not affected by
the capital structure.

Q14. Bird Enterprises has no debt. Its current total value is $47 million. Ignoring taxes, what will the
company’s value be if it sells $18.4 million in debt?

When there are no taxes, the firm value is not affected by its capital structure (M&M case number 1)

 The firm value remains = $47 million

Suppose now that the company’s tax rate is 23 percent (Tc = 23%). What will its overall value be if it
sells $18.4 million in debt? Assume debt proceeds are used to repurchase equity.

Levered firm value > unlevered firm value

VL = VU + PV of the tax shield

VL = VU + D X Tc = $47,000,000 + (18,400,000 x 23%) = $51,232,000

Q15. In the previous question, what is the debt – equity ratio in both cases?

No debt, D/E = 0

With debt, D/E =? D= $18.4 m => E = VL – D = $51,232,000 - 18,400,000 = $32,832,000

 D/E = 18,400,000/32,832,000 =0.56