Corporate Finance - Chapter 16 and 17

Assignment Print View

2 of 21

http://ezto.mhecloud.mcgraw-hill.com/hm_finance.tpx

award:

10.00 points Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem. a-1.Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Recession

$

EPS 2.52 ± 1%

Normal

$

4.20 ± 1%

Expansion

$

5.25 ± 1%

a-2.Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.) Percentage changes in EPS Recession -40 ± 1% % 25 ± 1% %

Expansion

b-1.Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios. (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Recession

$

EPS 1.46 ± 1%

Normal

$

4.09 ± 1%

Expansion

$

5.73 ± 1%

b-2.Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) Percentage changes in EPS Recession -64.22 ± 1% % Expansion

40.14 ± 1% %

Explanation: a.

A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest

Recession $ 12,600 0

$

Normal 21,000 0

NI

$

12,600

$

21,000

EPS %∆EPS

$

2.52 – 40

$

4.20 —

Expansion $ 26,250 0 $ 26,250 $

5.25 + 25

b.

If the company undergoes the proposed recapitalization, it will repurchase:

3/19/2014 3:53 PM


3 of 21


Share price = Equity / Shares outstanding Share price = $275,000 / 5,000 Share price = $55 Shares repurchased = Debt issued / Share price Shares repurchased = $99,000 / $55 Shares repurchased = 1,800 The interest payment each year under all three scenarios will be: Interest payment = $99,000(.08) = $7,920 The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. EBIT Interest

Recession $ 12,600 7,920

Normal $ 21,000 7,920

Expansion $ 26,250 7,920

NI

$ 4,680

$ 13,080

$ 18,330

EPS %∆EPS

$

$

$

1.46 – 64.22

4.09 —

5.73 + 40.14

View Hint #1

Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


4 of 21


award:

10.00 points Money, Inc., has no debt outstanding and a total market value of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Money has a tax rate of 35 percent. a-1.Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Recession

$

EPS 1.64 ± 1%

Normal

$

2.73 ± 1%

Expansion

$

3.41 ± 1%

a-2.Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.) Percentage changes in EPS Recession -40 ± 1% % 25 ± 1% %

Expansion

b-1.Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios. (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Recession

EPS .95 ± 0.01

$

Normal

$

2.66 ± 1%

Expansion

$

3.72 ± 1%

b-2.Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) Percentage changes in EPS Recession -64.22 ± 1% % Expansion

40.14 ± 1% %

Explanation: a.

A table outlining the income statement with taxes for the three possible states of the economy is shown below. The share price is $55, and there are 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest Taxes

Recession Normal $ 12,600 $ 21,000 0 0 4,410 7,350

Expansion $ 26,250 0 9,188

NI

$ 8,190

$ 13,650

$ 17,063

EPS %∆EPS

$

$

$

1.64 – 40

2.73 —

3.41 + 25

b.

3/19/2014 3:53 PM


5 of 21


If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = $275,000 / 5,000 Share price = $55 Shares repurchased = Debt issued / Share price Shares repurchased = $99,000 / $55 Shares repurchased = $1,800 The interest payment each year under all three scenarios will be: Interest payment = $99,000(.08) = $7,920 A table outlining the income statement with taxes for the three possible states of the economy and assuming the company undertakes the proposed capitalization is shown below. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. EBIT Interest Taxes

Recession Normal $ 12,600 $ 21,000 7,920 7,920 1,638 4,578

Expansion $ 26,250 7,920 6,416

NI

$ 3,042

$ 8,502

$ 11,915

EPS %∆EPS

$

$

$

.95 – 64.22

2.66 —

3.72 +40.14

Notice that the percentage change in EPS is the same both with and without taxes. Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


6 of 21


award:

10.00 points Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outstanding and $2.8 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. a. If EBIT is $750,000, what is the EPS for each plan? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I

$

EPS 2.83 ± 1%

Plan II

$

2.54 ± 1%

b. If EBIT is $1,500,000, what is the EPS for each plan? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I

$

EPS 5.66 ± 1%

Plan II

$

6.59 ± 1%

c. What is the break-even EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.) Break-even EBIT

$

927,500 ± 0.1%

Explanation: a.

Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: EPS = $750,000 / 265,000 shares EPS = $2.83 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: NI = $750,000 – .10($2,800,000) NI = $470,000 And the EPS will be: EPS = $470,000 / 185,000 shares EPS = $2.54 Plan I has the higher EPS when EBIT is $750,000. b.

Under Plan I, the net income is $1,500,000 and the EPS is: EPS = $1,500,000 / 265,000 shares EPS = $5.66 Under Plan II, the net income is: NI = $1,500,000 – .10($2,800,000) NI = $1,220,000 And the EPS is: EPS = $1,220,000 / 185,000 shares

3/19/2014 3:53 PM


7 of 21


EPS = $6.59 Plan II has the higher EPS when EBIT is $1,500,000. c.

To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: EBIT / 265,000 = [EBIT – .10($2,800,000)] / 185,000 EBIT = $927,500 View Hint #1

Difficulty: Basic

Worksheet

award:

10.00 points Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would be 185,000 shares of stock outstanding and $2.8 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. Use MM Proposition I to find the price per share. (Do not round intermediate calculations.) Share price

$

35.00 ± 1% per share

What is the value of the firm under each of the two proposed plans? (Do not round intermediate calculations. Enter your answers in dollars, not millions of dollars, i.e. 1,234,567.)

All equity plan

Value of the firm $ 9,275,000 ± 0.01%

Levered plan

$ 9,275,000 ± 0.01%

Explanation:

We can find the price per share by dividing the amount of debt used to repurchase shares by the number of shares repurchased. Doing so, we find the share price is: Share price = $2,800,000 / (265,000 – 185,000) Share price = $35.00 per share The value of the company under the all-equity plan is: V= $35(265,000 shares) = $9,275,000 And the value of the company under the levered plan is: V = $35(185,000 shares) + $2,800,000 debt = $9,275,000 View Hint #1

Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


8 of 21


award:

10.00 points Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $8,500. The all-equity plan would result in 2,700 shares of stock outstanding. What is the EPS for each of these plans? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

$

EPS 2.14 ± 1%

Plan II

$

2.94 ± 1%

All equity

$

3.15 ± 1%

Plan I

b. In part (a) what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I and all-equity

$

EBIT 9,855 ± 0.1%

Plan II and all-equity

$

9,855 ± 0.1%

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) EBIT

$

9,855 ± 0.1%

d-1.Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm for each of these plans? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I

$

EPS 1.29 ± 1%

Plan II

$

1.76 ± 1%

All equity

$

1.89 ± 1%

d-2.Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I and all-equity

$

EBIT 9,855 ± 0.1%

Plan II and all-equity

$

9,855 ± 0.1%

d-3.Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) EBIT

$

9,855 ± 0.1%

Explanation: a.

The income statement for each capitalization plan is: EBIT Interest

I II All-equity $ 8,500 $ 8,500 $ 8,500 6,570 2,920 0

3/19/2014 3:53 PM


9 of 21


NI

$ 1,930 $ 5,580 $ 8,500

EPS

$

2.14 $

2.94 $

3.15

The all-equity plan has the highest EPS; Plan I has the lowest EPS. b.

The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is calculated as: EPS = (EBIT – R B) / Shares outstanding B

This equation calculates the interest payment (R B) and subtracts it from the EBIT, which results in the B

net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest paid is zero. To find the breakeven EBIT for two different capital structures, we simply set the equations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capital structure and Plan I is: EBIT / 2,700 = [EBIT – .10($65,700)] / 900 EBIT = $9,855 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT / 2,700 = [EBIT – .10($29,200)] / 1,900 EBIT = $9,855 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($65,700)] / 900 = [EBIT – .10($29,200)] / 1,900 EBIT = $9,855 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: EBIT Interest Taxes

I II All-equity $ 8,500 $ 8,500 $ 8,500 6,570 2,920 0 772 2,232 3,400

NI

$ 1,158 $ 3,348 $ 5,100

EPS

$

1.29 $

1.76 $

1.89

The all-equity plan still has the highest EPS; Plan I still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT – R D)(1 – t )] / Shares outstanding B

C

This is similar to the equation we used before, except that now we need to account for taxes. Again, the interest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all-equity plan and Plan I is: EBIT(1 – .40) / 2,700 = [EBIT – .10($65,700)](1 – .40) / 900 EBIT = $9,855

3/19/2014 3:53 PM


10 of 21


The breakeven EBIT between the all-equity plan and Plan II is: EBIT(1 – .40) / 2,700 = [EBIT – .10($29,200)](1 – .40) / 1,900 EBIT = $9,855 And the breakeven between Plan I and Plan II is: [EBIT – .10($65,700)](1 – .40) / 900 = [EBIT – .10($29,200)](1 – .40) / 1,900 EBIT = $9,855 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. Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


11 of 21


award:

10.00 points Kolby Corp. is comparing two different capital structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the debt is 10 percent. Assume that EBIT will be $8,500. An all-equity plan would result in 2,700 shares of stock outstanding. Ignore taxes. What is the price per share of equity under Plan I? Plan II? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Plan I Plan II

Price per share of equity $ 36.50 ± 1% per share $

36.50 ± 1% per share

Explanation:

To find the value per share of the stock under each capitalization plan, we can calculate the price as the value of shares repurchased divided by the number of shares repurchased. The dollar value of the shares repurchased is the increase in the value of the debt used to repurchase shares, or: Dollar value of repurchase = $65,700 – 29,200 = $36,500 The number of shares repurchased is the decrease in shares outstanding, or: Number of shares repurchased = 1,900 – 900 = 1,000 So, under Plan I, the value per share is: P = $36,500 / 1,000 shares P = $36.50 per share And under Plan II, the number of shares repurchased from the all equity plan by the $29,200 in debt are: Shares repurchased = 2,700 – 1,900 = 800 So the share price is: P = $29,200 / 800 shares P = $36.50 per share This shows that when there are no corporate taxes, the stockholder does not care about the capital structure decision of the firm. This is M&M Proposition I without taxes. Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


12 of 21


award:

10.00 points Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 35 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 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cash flow

$

550.00 ± 1%

b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cash flow

$

596.31 ± 1%

c. Assume that Ms. Brown unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Total Cash flow

$

550.00 ± 1%

Explanation: a.

The earnings per share are: EPS = $33,000 / 6,000 shares EPS = $5.50 So, the cash flow for the investor is: Cash flow = $5.50(100 shares) Cash flow = $550 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 = $58(6,000) V = $348,000 Under the proposed capital structure, the firm will raise new debt in the amount of: B = .35($348,000) B = $121,800 This means the number of shares repurchased will be: Shares repurchased = $121,800 / $58 Shares repurchased = 2,100 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 = $33,000 – .08($121,800) NI = $23,256 This means the EPS under the new capital structure will be:

3/19/2014 3:53 PM


13 of 21


EPS = $23,256 / (6,000 – 2,100) shares EPS = $5.96 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $5.96(100 shares) Shareholder cash flow = $596.31 c.

To replicate the proposed capital structure, the shareholder should sell 35 percent of her shares, or 35 shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of: Interest cash flow = 35($58)(.08) Interest cash flow = $162.40 The shareholder will receive dividend payments on the remaining 65 shares, so the dividends received will be: Dividends received = $5.96(65 shares) Dividends received = $387.60 The total cash flow for the shareholder under these assumptions will be: Total cash flow = $162.40 + 387.60 Total cash flow = $550 This is the same cash flow we calculated in part a. View Hint #1

Difficulty: Basic

Worksheet

award:

10.00 points Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If the current market value of the equity is $37 million and there are no taxes, what is EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) EBIT

$ 3,330,000 ± 0.01%

Explanation:

With no taxes, the value of an unlevered firm is the interest rate divided by the unlevered cost of equity, so: V = EBIT / WACC $37,000,000 = EBIT / .09 EBIT = .09($37,000,000) EBIT = $3,330,000 View Hint #1

Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


14 of 21


award:

10.00 points Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. The current market value of the equity is $37 million and the corporate tax rate is 35 percent. What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations. Round your EBIT answer to 2 decimal places.) EBIT

$ 5,123,076.92 ± 0.01%

What is the WACC? WACC

9 %

Explanation:

If there are corporate taxes, the value of an unlevered firm is: V = EBIT(1 – t ) / R U

C

U

Using this relationship, we can find EBIT as: $37,000,000 = EBIT(1 – .35) / .09 EBIT = $5,123,076.92 The WACC remains at 9 percent. Due to taxes, EBIT for an all-equity firm would have to be higher for the firm to still be worth $37 million. View Hint #1

Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


15 of 21


award:

10.00 points Bruce & Co. expects its EBIT to be $185,000 every year forever. The firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity is 16 percent. If the tax rate is 35 percent, what is the value of the firm? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16)) Value of the firm

$ 751,562.50 ± 0.1%

What will the value be if Bruce borrows $135,000 and uses the proceeds to repurchase shares? (Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16)) Value of the firm

$ 798,812.50 ± 0.1%

Explanation:

The value of the unlevered firm is: V = EBIT(1 – t ) / R C

0

V = $185,000(1 − .35) / .16 V = $751,562.50 The value of the levered firm is: V=V +t B U

C

V = $751,562.50 + .35($135,000) V = $798,812.50 Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


16 of 21


award:

10.00 points Tool Manufacturing has an expected EBIT of $57,000 in perpetuity and a tax rate of 35 percent. The firm has $90,000 in outstanding debt at an interest rate of 8 percent, and its unlevered cost of capital is 15 percent. What is the value of the firm according to MM Proposition I with taxes? (Do not round intermediate calculations.) Value of the firm

$

278,500 ± 0.1%

Explanation:

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: V = EBIT(1 – t ) / R U

C

0

V = ($57,000)(1 – .35) / .15 U

V = $247,000 U

Now we can find the value of the levered firm as: V =V +t B L

U

C

V = $247,000 + .35($90,000) L

V = $278,500 L

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. View Hint #1

Worksheet

Difficulty: Intermediate

3/19/2014 3:53 PM


17 of 21


award:

10.00 points Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent. The company also has a perpetual bond issue outstanding with a market value of $1.9 million. What is the value of the company? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places. (e.g., 32.16)) Value of the company

$ 5,191,785.71 ± 0.01%

Explanation:

Using M&M Proposition I with taxes, the value of a levered firm is: V = [EBIT(1 − t ) / R ] + t B L

C

0

C

V = [$975,000(1 − .35) / .14] + .35($1,900,000) L

V = $5,191,785.71 L

Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


18 of 21


award:

10.00 points Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company's profits are driven by the amount of work Tom does. If he works 40 hours each week, the company's EBIT will be $550,000 per year; if he works a 50-hour week, the company's EBIT will be $625,000 per year. The company is currently worth $3.2 million. The company needs a cash infusion of $1.3 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are no corporate taxes. a. What are the cash flows to Tom under each scenario? (Enter your answers in whole dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32)) Scenario-1 Debt issue:

40-hour week

$

Cash flows 446,000 ± 0.1%

50-hour week

$

521,000 ± 0.1%

40-hour week

$

Cash flows 391,111 ± 0.1%

50-hour week

$

444,444 ± 0.1%

Scenario-2 Equity issue:

b. Under which form of financing is Tom likely to work harder? Debt issue Equity issue

Explanation: a.

Debt issue: The company needs a cash infusion of $1.3 million. If the company issues debt, the annual interest payments will be: Interest = $1,300,000(.08) = $104,000 The cash flow to the owner will be the EBIT minus the interest payments, or: 40-hour week cash flow = $550,000 − 104,000 = $446,000 50-hour week cash flow = $625,000 − 104,000 = $521,000 Equity issue: If the company issues equity, the company value will increase by the amount of the issue. So, the current owner's equity interest in the company will decrease to: Tom's ownership percentage = $3,200,000 / ($3,200,000 + 1,300,000) = .71 So, Tom's cash flow under an equity issue will be 71 percent of EBIT, or: 40-hour week cash flow = .71($550,000) = $391,111 50-hour week cash flow = .71($625,000) = $444,444 b.

Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more under

3/19/2014 3:53 PM


19 of 21


this form of financing since the payments to bondholders are fixed. Under an equity issue, new investors share proportionally in his hard work, which will reduce his propensity for this additional work. Worksheet

Difficulty: Basic

3/19/2014 3:53 PM


20 of 21


award:

10.00 points Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 80 percent for the next year, and the probability of a recession is 20 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent. a-1. What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

Equity value Debt value

Steinberg's $ 1,309,735 ± 0.01% $

796,460 ± 0.1%

a-2. What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

b.

Equity value

Dietrich's $ 1,061,947 ± 0.01%

Debt value

$ 1,044,248 ± 0.01%

Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement? Agree Disagree

Explanation: a.

The total value of a firm's equity is the discounted expected cash flow to the firm's stockholders. If the expansion continues, each firm will generate earnings before interest and taxes of $2,700,000. If there is a recession, each firm will generate earnings before interest and taxes of only $1,100,000. Since Steinberg owes its bondholders $900,000 at the end of the year, its stockholders will receive $1,800,000 (= $2,700,000 − 900,000) if the expansion continues. If there is a recession, its stockholders will only receive $200,000 (= $1,100,000 − 900,000). So, assuming a discount rate of 13 percent, the market value of Steinberg's equity is: S

Steinberg

= [.80($1,800,000) + .20($200,000)] / 1.13 = $1,309,735

Steinberg's bondholders will receive $900,000 whether there is a recession or a continuation of the expansion. So, the market value of Steinberg's debt is: B

Steinberg

= [.80($900,000) + .20($900,000)] / 1.13 = $796,460

Since Dietrich owes its bondholders $1,200,000 at the end of the year, its stockholders will receive $1,500,000 (= $2,700,000 − 1,200,000) if the expansion continues. If there is a recession, its stockholders will receive nothing since the firm’s bondholders have a more senior claim on all $1,100,000 of the firm’s earnings. So, the market value of Dietrich's equity is: S

Dietrich

= [.80($1,500,000) + .20($0)] / 1.13 = $1,061,947

Dietrich's bondholders will receive $1,200,000 if the expansion continues and $1,100,000 if there is a recession. So, the market value of Dietrich's debt is:

3/19/2014 3:53 PM


21 of 21


B

Dietrich

= [.80($1,200,000) + .20($1,100,000)] / 1.13 = $1,044,248

b.

The value of the company is the sum of the value of the firm's debt and equity. So, the value of Steinberg is: V

=B+S

V

= $796,460 + 1,309,735

V

= $2,106,195

Steinberg Steinberg Steinberg

And value of Dietrich is: V

=B+S

V

= $1,044,248 + 1,061,947

V

= $2,106,195

Dietrich Dietrich Dietrich

You should disagree with the CEO's statement. The risk of bankruptcy per se does not affect a firm's value. It is the actual costs of bankruptcy that decrease the value of a firm. Note that this problem assumes that there are no bankruptcy costs Worksheet

Difficulty: Intermediate

3/19/2014 3:53 PM

Corporate Finance - Chapter 16 and 17

Recommend Documents