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    Caluclation of Void

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    فتىالصحراءفتىالصحراء
    The document discusses capital structure decisions and their impact on return on equity (ROE) and earnings per share (EPS) under different economic scenarios for a company called Beckett, Inc. Key points: - Beckett is considering issuing $80,000 in debt to repurchase shares. - With no debt, EPS ranges from $1.95 to $4.39 depending on the economy. ROE ranges from 3.38% to 10.98%. - If debt is issued, EPS declines in a recession but increases more in an expansion. The same is true for ROE. - Leverage increases volatility but does not change the expected returns according to MM propositions.

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    Caluclation of Void

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    فتىالصحراءفتىالصحراء
    243 views8 pages
    The document discusses capital structure decisions and their impact on return on equity (ROE) and earnings per share (EPS) under different economic scenarios for a company called Beckett, Inc. Key points: - Beckett is considering issuing $80,000 in debt to repurchase shares. - With no debt, EPS ranges from $1.95 to $4.39 depending on the economy. ROE ranges from 3.38% to 10.98%. - If debt is issued, EPS declines in a recession but increases more in an expansion. The same is true for ROE. - Leverage increases volatility but does not change the expected returns according to MM propositions.

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    caluclation of void

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    The document discusses capital structure decisions and their impact on return on equity (ROE) and earnings per share (EPS) under different economic scenarios for a company called Beckett, Inc. Key points: - Beckett is considering issuing $80,000 in debt to repurchase shares. - With no debt, EPS ranges from $1.95 to $4.39 depending on the economy. ROE ranges from 3.38% to 10.98%. - If debt is issued, EPS declines in a recession but increases more in an expansion. The same is true for ROE. - Leverage increases volatility but does not change the expected returns according to MM propositions.

    Copyright:

    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    243 views8 pages

    Caluclation of Void

    Uploaded by

    فتىالصحراءفتىالصحراء
    The document discusses capital structure decisions and their impact on return on equity (ROE) and earnings per share (EPS) under different economic scenarios for a company called Beckett, Inc. Key points: - Beckett is considering issuing $80,000 in debt to repurchase shares. - With no debt, EPS ranges from $1.95 to $4.39 depending on the economy. ROE ranges from 3.38% to 10.98%. - If debt is issued, EPS declines in a recession but increases more in an expansion. The same is true for ROE. - Leverage increases volatility but does not change the expected returns according to MM propositions.

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    You are on page 1of 8

    Chapter 14: 1, 3, 23

    1. EBIT and Leverage:


    Beckett, Inc., has no debt outstanding and a total market
    value of $250,000. Earnings before interest and taxes, EBIT, are projected to be
    $13,000 if economic conditions are normal. If there is strong expansion in the
    economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will
    be 40 percent lower. Beckett is considering an $80,000 debt issue with a 6 percent
    interest rate. The proceeds will be used to repurchase shares of stock. There are
    currently 4,000 shares outstanding. 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.
    A table outlining the income statement for three possible states of the economy is
    show below. The EPS is the net income divided by the 2500 shares outstanding. The
    last row shows the percentage change in EPS.
    EBIT
    Interest
    NI
    EPS
    EPS

    Recession
    7800
    0
    7800
    1.95
    -40

    Normal
    13000
    0
    13000
    3.25
    -

    Expansion
    17550
    0
    17550
    4.39
    +35

    b.
    Repeat part (a) assuming that Beckett goes through with recapitalization.
    What do you observe?
    If the company undergoes the proposed recapitalization it will repurchase:
    share price = Equity / share outstanding
    = 250000 / 4000
    = 62.50
    Show repurchase = Debt issued / share rice
    = 80000/ 62.50
    =1280
    the interest payment each years under all three scenarios will be:
    interest payment= 80000(.06) = 4800

    EBIT
    Interest
    NI
    EPS
    EPS

    Recession
    7800
    4800
    3000
    1.10
    -63.41

    Normal
    13000
    4800
    8200
    3.01
    -

    Expansion
    17550
    4800
    12750
    4.69
    +55.49

    3. ROE and Leverage: Suppose the company in Problem 1 has a market-to-book


    ratio of 1.0.
    a.
    Calculate return on equity, ROE, under each of the three economic scenarios
    before any debt is issued. Also, calculate the percentage changes in ROE for
    economic expansion and recession, assuming no taxes.
    Since the company has market- to- book ratio of 1.0 the total equity of firm is equal
    to the market value of equity. Using the equation for ROE:
    ROE = NI / 225000
    The ROE for each state of the economy under the current capital structure and no
    taxes is:
    Recession
    Normal
    Expansion
    ROE
    3.38%
    8.44%
    10.98%
    - 60
    +30
    %ROE
    The second row shows the percentage change ROE from the normal economy.

    b.
    Repeat part (a) assuming the firm goes through with the proposed
    recapitalization.
    If the company undertakes the proposed recapitalization the new equity value will
    be:
    Equity = 225000 - 90000
    = 135000
    so the ROE for each state of the company is:
    ROE = NI / 135000

    ROE
    %ROE

    Recession
    0.30%
    - 96.61

    Normal
    8.74%
    -

    Expansion
    12.96%
    +48.31

    c.
    Repeat parts (a) and (b) of this problem assuming the firm as a tax rate of 35
    percent.
    If there corporate taxes and the company maintains its current capital structure the
    ROE is :
    ROE
    %ROE

    2.20%
    - 60

    5.49%
    -

    7.14%
    +30

    If the company undertakes the proposed recapitalization the new equity value will
    be:
    ROE
    %ROE

    0.14%
    - 96.61

    5.68%
    -

    8.43%
    +48.31

    notice that the percentage change in ROE is the same as percentage change in EPS.
    The percentage change in ROE is the same with or without taxes.

    23. MM Propositions: Garnett Corporation is planning to repurchase part of its


    common stock by issuing corporate debt. As a result, the firms debt-to-equity ratio
    is expected to rise from 30 percent to 45 percent. The firm currently has $5.8
    million worth of debt outstanding. The cost of this debt is 8 percent per year.
    Garnett expects to have an EBIT of $2.75 million per year in perpetuity. Garnett
    pays no taxes.
    a.
    What is the market value of Garnett Corporation before and after the
    repurchase announcement?
    Before the announcement of the stock repurchase plan the market value of the
    outstanding debt is 5800000. Using the debit equity ratio we can find the value of
    outstanding ratio by:
    debit - equity ratio = B/S
    30 = 5800000 /S
    S= 19333333

    The value of levered firm is equal to the sum of market value of the firms debt and
    market value of the firm's equity so:
    VL= B+S
    VL= 5800000 + 19333333
    VL= 25133333
    According to MM proposition without taxes change in firm's capital structure have
    no effect on the overall value. Therefore, the value will not change.

    b.
    What is the expected return on the firms equity before the announcement of
    the stock repurchase plan?
    The expected return on firm's equity is the ratio of annual earning to the market
    value of the firm's equity or return on equity
    we calculate first interest payment:
    Interest payment= .08(5800000)= 454000
    return on equity will be:
    ROE= RS =(2750000 - 464000) / 19333333
    RS= .1182 or 11.82%
    c.
    What is the expected return on the equity of an otherwise identical all-equity
    firm?
    According to Modigliani Miller proposition II with no taxes:
    Rs = R0 + (B/S)(R0 -Rb)
    .1182 = R0 + (.30)(R0 - .08)
    R0= .1094 or 10.94%
    This problem can also solve as:
    R0 = Earnings before interest / Vu
    R0 = 2750000/25133333
    =.1094 or 10.49%

    d.
    What is the expected return on the firms equity after the announcement of
    the stock repurchase plan?
    We will calculate cost of equity under the stock:
    RS= R0 +(B/S)(R0-Rb)
    RS= .1094 + (.45)(.1094 - .08)
    Rs = .1227 or 12.27%

    3. Capital Structure and Growth: Edwards Construction currently has debt


    outstanding with a market value of $170,000 and a cost of 8 percent. The company
    has an EBIT of $13,600 that is expected to continue in perpetuity. Assume there are
    no taxes.
    a.

    What is the value of the companys equity? What is the debt to value ratio?

    Interest payment = .08(170000)= 13600


    This is exactly equal to the EBIT so no cash is available for shareholders and the
    value of equity will be ZERO since shareholders will never receive any payment
    The total value of company is market value of debt. This implies the debt to value
    ratio is 1 (one).
    b.
    What is the equity value and debt to value ratio if the companys growth rate
    is 5 percent?
    At 5 % growth rate the earnings next year will be:
    Earning next year = 13600(1.05)= 14280
    so the cash available for shareholders is :
    payment to shareholders= 1280 - 13600= 680
    Since there is no risk the required return for shareholders is the same with debt
    the payments to stockholders will increase at their growth ratio of 5 %
    And debt to value ratio now will be:
    Debt/ value ratio = 170000/(170000 +22666.67)
    = 0.882

    c.
    What is the equity value and debt to value ratio if the companys growth rate
    is 7 percent?
    At 7 % growth rate the earnings next year will be:
    Earning next year = 13600(1.07)= 14552
    so the cash available for shareholders is :
    payment to shareholders= 14552 - 13600= 95200
    Since there is no risk the required return for shareholders is the same with debt
    the payments to stockholders will increase at their growth ratio of 7 %
    And debt to value ratio now will be:
    Debt/ value ratio = 170000/(170000 +95200)
    = 0.641

    7. Agency Costs
    Sheaves Corporation economists estimate that a good business
    environment and a bad business environment are equally likely for the coming year.
    The managers of Sheaves must choose between two mutually exclusive projects.
    Assume that the project Sheaves chooses will be the firms only activity and that
    the firm will close one year from today. Sheaves is ob- ligated to make a $4,000
    payment to bondholders at the end of the year. The projects have the same
    systematic risk, but different volatilities. Consider the following information
    pertaining to the two projects:
    ECONOMY

    PROBABILITY

    Bad
    Good

    .50
    .50

    LOW-VOLATILITY
    PROJECT PAYOFF
    $4,000
    4,300

    HIGH-VOLATILITY
    PROJECT PAYOFF
    $3,600
    4,600

    a.
    What is the expected value of the firm if the low-volatility project is
    undertaken? What if the high-volatility project is undertaken? Which of the two
    strategies maximizes the expected value of the firm?
    The expected value of each project is the sum of each state of the economy so:
    low-volatility project value = .50(4000) + .50(4300) = 4150
    high-volatility project value = .50(3600) + .50(4600) = 4100
    The low-volatility project value maximizes the expected value of firm

    b.
    What is the expected value of the firms equity if the low-volatility project is
    undertaken? What is it if the high-volatility project is undertaken?
    The value of the equity is the residual value of company after bondholders are paid
    off
    The expected value of the firm's equity is:
    Expected value of equity with low-volatility project= .50(0) + .50(300)= 150
    Expected value of equity with High-volatility project = .50(0) + .50(600) = 300

    c.

    Which project would the firms stockholders prefer? Explain.

    risk neutral investors prefer the strategy with the highest expected value thus, the
    company's stockholders prefer the high-volatility project since it's maximizes the
    expected value of the company's equity.

    d. Supposebondholdersarefullyawarethatstockholdersmightchoosetomaximizeequity
    value rather than total firm value and opt for the high-volatility project. To minimize
    this agency cost, the firms bondholders decide to use a bond covenant to stipulate
    that the bondholders can demand a higher payment if the firm chooses to take on
    the high-volatility project. What payment to bondholders would make stockholders
    indifferent between the two projects?

    In order to make stock holders indifferent between the low- volatility project and
    high- volatility project the bond holders will need to raise their required debt
    payment. So, the expected value of equity if the high- volatility project is under
    taken is equal to expected value of equity.
    The value of firm will be 3600 if economy is bad and 4600 if economy is good.
    If it's bad the entire of 3600 will go to bondholders and stock holders will receive no
    thing. If it's good the stock holders will receive the different between 600 the total
    value of the firm and required debt payment.
    Expected value of equity = 4150= .05(0) + .50(4600 - X)
    X= 4300

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