Capital Structure

Q1:

ABC Inc., is an unlevered firm with expected annual earnings before taxes (EBIT) of $30 million
in perpetuity. The required return on the firm’s unlevered equity is 15%, and the firm distributes
all of its earnings as dividends at the end of each year. ABC has 1 million shares of common
stock outstanding.

The firm is planning a recapitalization under which it will issue $50 million of perpetual debt and
use the proceeds to buy back shares. The annual cost of debt is 10%. Assume that there is no
issuing cost and that the firm is operating under perfect capital markets.

Part 1: If there is no corporate tax:

a. Calculate the value of ABC before the recapitalization plan is announced. What is the price
per share?
b. Calculate the value of ABC after the recapitalization plan is announced. What is the price
per share right after the announcement?
c. How many shares will be repurchased (assume shares are perfectly divisible, i.e. can take
fractional shares)?

Part 2: Company is subjected to 35% corporate tax.

d. Redo the a, b, c

Q2:

M&M theory. Star, Inc., a prominent consumer products firm, is debating whether or not to
convert its all-equity capital structure to one that is 50 percent debt. Currently there are 6,000
shares outstanding and the price per share is $58. EBIT is expected to remain at $33,000 per year
forever. The interest rate on new debt is 8 percent, and there are no taxes.

a. Ms. Brown, a shareholder of the firm, owns 1,000 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume
that she keeps all 1,000 of her shares.

c. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to recreate the original capital structure.

d. Using your answer to part (c), explain why Star’s choice of capital structure is irrelevant.
Q3:

Byrd Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a
levered plan (Plan II). Under Plan I, the company would have 365,000 shares of stock
outstanding. Under Plan II, there would be 245,000 shares of stock outstanding and $4.56 million
in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $1.25 million, which plan will result in the higher EPS?
b. If EBIT is $1.75 million, which plan will result in the higher EPS?
c. What is the break-even EBIT?

Q4:

Resurrection Corporation is planning to repurchase part of its common stock by issuing

corporate debt. As a result, the firm’s debt-equity ratio is expected to rise from 35 percent to 50
percent. The firm currently has $2.7 million worth of debt outstanding. The cost of this debt is
6.4 percent per year. The firm expects to have an EBIT of $940,000 per year in perpetuity and
pays no taxes.
a. What is the market value of the firm before and after the repurchase announcement?
b. What is the expected return on the firm’s equity before the announcement of the stock
repurchase plan?
c. What is the expected return on the equity of an otherwise identical all-equity firm? (identical
in terms of business and capital size)
d. What is the expected return on the firm’s equity after the announcement of the stock
repurchase plan?

Capital Budgeting

Q1:

Existing machine was purchased 2 years ago at a cost of $3,200. It is being depreciated straight
line over its 8-year life. It can be sold now for $3,000 or used for 6 more years at which time it
will be sold for an estimated $500. It provides revenue of $5,000 annually and cash operating
costs of $2,000 annually.

A replacement machine can be purchased now for $7,800. It would be used for 6 years, and
depreciated straight line. It will result in additional sales revenue of $1,500 annually, but
because of its increased efficiency it would reduce cash operating costs by $600 per year. The
new machine would require additional inventories of $700, accounts receivable would increase
by $600 and trade payable increase by $300 at the initial. Its expected salvage value in 6 years is
$2,000.
The tax rate is 40% and the required rate of return is 13%. Should the old machine be replaced?

a. Calculate the incremental cash flow at time 0.

b. Calculate the incremental annual operating cash flows that result from the new machine.
c. Calculate the incremental terminal cash flow.
d. Show the incremental CFs.

Year Cash Flow

0 ________
1 ________
2 ________
3 ________
4 ________
………

e. Calculate the NPV for this project.

Q2:
Your firm is considering a project with a five-year life and an initial cost of $120,000. The
discount rate for the project is 12%. The firm expects to sell 2,100 units a year. The cash flow
per unit is $20. The firm will have the option to abandon this project after three years at which
time it expects it could sell the project for $50,000. You are interested in knowing how the
project will perform if the sales forecasts for years four and five of the project are revised such
that there is a 50% chance that the sales will be either 1,400 or 2,500 units a year. What is the net
present value of this project given your sales forecasts?

Q3:
JohnSmith, Inc., manufactures fine furniture. The company is deciding whether to introduce a
new dining room table set. The set will sell for $5,900, including a set of eight chairs. The
company feels that sales will be 1,800, 2,150, 2,600, 2,350, and 2,200 sets per year for the next
five years, respectively. Variable costs will amount to 37 percent of sales and fixed costs are
$2.05 million per year.
The new tables will require inventory amounting to 10 percent of sales, produced and stockpiled
in the year prior to sales.
It is believed that the addition of the new table will cause a loss of 250 tables per year of the oak
tables the company produces. These tables sell for $4,300 and have variable costs of 40 percent
of sales. The inventory for this oak table is also 10 percent of sales. The sales of the oak table
will continue indefinitely.
If the company buys the necessary equipment today, it will cost $16 million. In five years, the
new equipment will have a market value of $2.9 million. The equipment is depreciated on a 7-
year straight-line. The company has a tax rate of 21 percent and the required return for the
project is 11 percent.
a. Calculate the CF0
b. Calculate the OCFs of year 2 and 3 from new dining table only (including the CFs from
NWC)
c. Calculate the CFs effect of the loss of sales of the oak tables every year.

Merger and Acquisition

Q1:

Consider the following premerger information about a bidding firm (firm B) and a target firm
(firm T). Assume that both firms have no debt outstanding.
Firm B Firm T
Share outstanding 2,900 1,400
Price per share $39 $26
Firm B has estimated that the value of the synergistic benefits from acquiring firm T is $550 per
year indefinitely. The appropriate discount rate for the incremental cash flows is 10 percent.

a. If firm T is willing to be acquired for $29 per share in cash. What is the merger premium,
what is the NPV of the firm B?
b. What will the price per share of the merged firm be assuming the condition in (a)?
c. Suppose firm T is agreeable to a merger by an exchange of stock. If B offers three of its
shares for every five of T’s shares, what will the price per share of the merged firm be?
What is the merger premium, what is the NPV of the firm B?
d. Should the shareholders of firm T choose the cash offer or the stock offer? At what
exchange ratio of B shares to T shares would the shareholders in T be indifferent between
the two offers?
Q2:

Your company has earnings per share of $4. It has 1.6 million shares outstanding, each of which
has a price of $56. You are thinking of buying TargetCo, which has earnings per share of $1, 1.3
million shares outstanding, and a price per share of $24. You will pay for TargetCo by issuing
new shares. There are no expected synergies from the transaction.
a. If you pay no premium to buy TargetCo, what will your earnings per share be after the
merger? Given that the EPS of the combined firm is equal to sum of EPS of acquirer and
acquiring firms.
b. Suppose you offer an exchange ratio such that, the offer represents a 20% premium to
buy TargetCo. What will your earnings per share be after the merger?
c. What will your price-earnings ratio be after the merger (if you pay no premium)? How
does this compare to your and TargetCo’s P/E ratio before the merger.

Q3:
Consider the following premerger information about a bidding firm (Firm B) and a target firm
(Firm T). Assume that both firms have no debt outstanding.
Firm B Firm T
Shares outstanding 8,700 3,600
 Share price $47 $19
Firm B has estimated that the value of the synergistic benefits from acquiring Firm T is $16,700.
a. If Firm T is willing to be acquired for $21 per share in cash, what is the Premium and NPV of
the merger?
b. What will the price per share of the merged firm be assuming the conditions in (a)?
c. Suppose Firm T is agreeable to a merger by an exchange of stock. If B offers one of its shares
for every two of T’s shares, what will the price per share of the merged firm be?
d. What is the Premium and NPV of the merger assuming the conditions in (d)?

Dividend Policy (20 marks)

a. A U.S. company’s annual earnings are $300, and the corporate tax rate is 35%. Assume
that the company pays out 100% of its earnings as dividends. Calculate the effective tax
rate on a dollar of corporate earnings paid out as dividends assuming a 15% tax rate on
dividend income. (5 marks)
b. Suppose that the Larson Company has $1,000 in earnings and $900 in planned capital
spending (representing positive NPV projects). Larson has a target debt-to-equity ratio
of 0.5. Calculate the company’s dividend under a residual dividend policy. (5 marks)
c. JetFun Inc. has 10 million shares outstanding and has just reported net income of $50
million. Because the company has $100 million of excess cash currently earning no
return, JetFun’s directors are considering repurchasing shares at a premium of 25% over
the current market price of $40. Calculate the effect of repurchase on EPS when the
repurchase is financed using the existing surplus cash. (5 marks)
d. It is sometimes suggested that firms should follow a “residual” dividend policy. With
such a policy, the main idea is that a firm should focus on meeting its investment needs
and maintaining its desired debt−equity ratio. Having done so, a firm pays out any
leftover, or residual, income as dividends. What do you think would be the chief
drawback to a residual dividend policy? (5 marks)
Leasing

Quartz Corporation is a relatively new firm. Quartz has experienced enough losses during its
early years to provide it with at least eight years of tax loss carryforwards. Thus, Quartz’s
effective tax rate is zero. Quartz plans to lease equipment from New Leasing Company. The term
of the lease is five years. The purchase cost of the equipment is $840,000. New Leasing
Company is in the 35 percent tax bracket. There are no transaction costs to the lease. Each firm
can borrow at 10 percent. Assume that: leasing payments are paid at the beginning of the
period but the tax benefits are received at the end of the period.

a. What is Quartz’s reservation price?

b. What is New Leasing Company’s reservation price?
c. Explain why these reservation prices determine the negotiating range of the lease.
Short term Finance

Anne Teak, the financial manager of a furniture manufacturer, is considering operating a lockbox
system. She forecasts that 300 payments a day will be made to lockboxes, with an average
payment size of $1,600. The bank’s charge for operating the lockboxes is either $.40 a check or
compensating balances of $800,000.
a. If the interest rate is 9%, which method of payment is cheaper? (use 360-day basis)
b. What reduction in the time to collect and process each check is needed to justify use of
the lockbox system?