Question 1

Solution

a. The income statement for each capitalization plan is:

I II All-equity
EBIT $70,000 $70,000 $70,000
Interest 10,005 22,620 0
NI $59,995 $47,380 $70,000
EPS $4.72 $4.83 $4.67

Plan II has the highest EPS; the all-equity plan has the lowest EPS.
b. The break-even level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is
calculated as:

EPS = (EBIT – RDD)/Shares outstanding

This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which results in the net
income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest
term is zero. To find the break-even EBIT for two different capital structures, we set the equations equal to
each other and solve for EBIT. The break-even EBIT between the all-equity capital structure and Plan I is:

EBIT/15,000 = [EBIT – .10($100,050)]/12,700

EBIT = $65,250

And the break-even EBIT between the all-equity capital structure and Plan II is:

EBIT/15,000 = [EBIT – .10($226,200)]/9,800

EBIT = $65,250

The break-even levels of EBIT are the same because of M&M Proposition I.
c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for
EBIT, we get:

[EBIT – .10($100,050)]/12,700 = [EBIT – .10($226,200)]/9,800

EBIT = $65,250

This break-even level of EBIT is the same as in part b again because of M&M Proposition I.
d. The income statement for each capitalization plan with corporate income taxes is:

I II All-equity
EBIT $70,000 $70,000 $70,000
Interest 10,005 22,620 0
Taxes 12,599 9,950 14,700
NI $47,396 $37,430 $55,300
EPS $3.73 $3.82 $3.69

Plan II still has the highest EPS; the all-equity plan still has the lowest EPS.
We can calculate the EPS as:
EPS = [(EBIT – RDD)(1 – TC)]/Shares outstanding

This is similar to the equation we used before, except now we need to account for taxes. Again, the interest expense term is zero in the all-
equity capital structure. So, the break-even EBIT between the all-equity plan and Plan I is:

EBIT(1 – .21)/15,000 = [EBIT – .10($100,050)](1 – .21)/12,700

EBIT = $65,250

The break-even EBIT between the all-equity plan and Plan II is:
EBIT(1 – .21)/15,000 = [EBIT – .10($226,200)](1 – .21)/9,800
EBIT = $65,250

And the break-even between Plan I and Plan II is:

[EBIT – .10($100,050)](1 – .21)/12,700 = [EBIT – .10($226,200)](1 – .21)/9,800
EBIT = $65,250

The break-even levels of EBIT do not change because the addition of taxes reduces the income of all three plans by the same percentage;
therefore, they do not change relative to one another.
Question 2
Solution
a. The earnings per share are:

EPS = $41,000/6,500 shares

EPS = $6.31

So, the cash flow for the investor is:

Cash flow = $6.31(100 shares)

Cash flow = $630.77
b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed
capital structure. The market value of the firm is:
V = $51(6,500)
V = $331,500
Under the proposed capital structure, the firm will raise new debt in the amount of:
D = .30($331,500)
D = $99,450
This means the number of shares repurchased will be:
Shares repurchased = $99,450/$51
Shares repurchased = 1,950

Under the new capital structure, the company will have to make an interest payment on the new debt. The net
income with the interest payment will be:
NI = $41,000 – .08($99,450)
NI = $33,044

This means the EPS under the new capital structure will be:
EPS = $33,044/(6,500 – 1,950 shares)
EPS = $7.26
Since all earnings are paid as dividends, the shareholder will receive:

Shareholder cash flow = $7.26(100 shares)

Shareholder cash flow = $726.24
c. To replicate the proposed capital structure, the shareholder should sell 30 percent of their shares, or 30
shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of:

Interest cash flow = 30($51)(.08)

Interest cash flow = $122.40

The shareholder will receive dividend payments on the remaining 70 shares, so the dividends received
will be:

Dividends received = $7.26(70 shares)

Dividends received = $508.37

The total cash flow for the shareholder under these assumptions will be:
Total cash flow = $122.40 + 508.37
Total cash flow = $630.77

This is the same cash flow we calculated in part a.

d. The capital structure is irrelevant because shareholders can create their own leverage or unlever the
stock to create the payoff they desire, regardless of the capital structure the firm actually chooses.
Question 3
 Solution

Since Unlevered is an all-equity firm, its value is equal to the market value of its outstanding shares.
Unlevered has 3.4 million shares of common stock outstanding, worth $72 per share. Therefore, the value
of Unlevered:

VU = 3,400,000($72)
VU = $244,800,000

Modigliani-Miller Proposition I states that, in the absence of taxes, the value of a levered firm equals the
value of an otherwise identical unlevered firm. Since Levered is identical to Unlevered in every way
except its capital structure and neither firm pays taxes, the value of the two firms should be equal.
Therefore, the market value of Levered, Inc., should also be $244.8 million. Since Levered has 1.8 million
outstanding shares, worth $101 per share, the market value of Levered’s equity is:
SL = 1,800,000($101)
SL = $181,800,000

The market value of Levered’s debt is $60 million. The value of a levered firm equals the market value of its debt
plus the market value of its equity. Therefore, the current market value of Levered is:

VL = B + S
VL = $60,000,000 + 181,800,000
VL = $241,800,000

The market value of Levered’s equity needs to be $184.8 million, $3 million higher than its current market value
of $181.8 million, for MM Proposition I to hold. Since Levered’s market value is less than Unlevered’s market
value, Levered is relatively underpriced and an investor should buy shares of the firm’s stock.
Solution

To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value of the
unlevered firm is:

VU = EBIT(1 – TC)/RU
VU = ($57,000)(1 – .21)/.103
VU = $437,184.47

Now we can find the value of the levered firm as:

VL = VU + TCD
VL = $437,184.47 + .21($134,000)
VL = $465,324.47
Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as
M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company should
continue to increase its debt-equity ratio to maximize the value of the firm.
Question 4
a. Before the announcement of the stock repurchase plan, the market value of the outstanding debt is
$2,500,000. Using the debt-equity ratio, we can find that the value of the outstanding equity must be:

Debt-equity ratio = B/S

.35 = $2,500,000/S
S = $7,142,857

The value of a levered firm is equal to the sum of the market value of the firm’s debt and the market
value of the firm’s equity, so:
VL = B + S
VL = $2,500,000 + 7,142,857
VL = $9,642,857

According to MM Proposition I without taxes, changes in a firm’s capital structure have no effect on the
overall value of the firm. Therefore, the value of the firm will not change after the announcement of the
stock repurchase plan.
b. The expected return on a firm’s equity is the ratio of annual earnings to the market value of the
firm’s equity, or return on equity. Before the restructuring, the company was expected to pay
interest in the amount of:

Interest payment = .051($2,500,000)

Interest payment = $127,500

The return on equity, which is equal to RS, will be:

ROE = RS = ($920,000 – 127,500)/$7,142,857

RS = .1110, or 11.10%
c. According to Modigliani-Miller Proposition II with no taxes:

RS = R0 + (B/S)(R0 – RB)
.1110 = R0 + (.35)(R0 – .051)
R0 = .0954, or 9.54%

This problem can also be solved in the following way:

R0 = Earnings before interest/VU

According to Modigliani-Miller Proposition I, in a world with no taxes, the value of a levered
firm equals the value of an otherwise-identical unlevered firm. Since the value of the company as a
levered firm is $9,642,857 (= $2,500,000 + 7,142,857) and since the firm pays no taxes, the value of
the company as an unlevered firm is also $9,642,857. So:

R0 = $920,000/$9,642,857
R0 = .0954, or 9.54%
d. In part c, we calculated the cost of an all-equity firm. We can use
Modigliani-Miller Proposition II with no taxes again to find the cost of equity for
the firm with the new leverage ratio. The cost of equity under the stock
repurchase plan will be:

RS = R0 + (B/S)(R0 – RB)
RS = .0954 + (.50)(.0954 – .051)
RS = .1176, or 11.76%