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T16.1 Chapter Outline

CLICK MOUSE OR HIT SPACEBAR TO ADVANCE T16.1 Chapter Outline Chapter 13 Financial Leverage and Capital Structure Policy Chapter Organization 13.1 The Capital Structure Question 13.2 The Effect of Financial Leverage 13.3 Capital Structure and the Cost of Equity Capital

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T16.1 Chapter Outline

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  1. CLICK MOUSE OR HIT SPACEBAR TO ADVANCE T16.1 Chapter Outline Chapter 13Financial Leverage and Capital Structure Policy Chapter Organization • 13.1 The Capital Structure Question • 13.2 The Effect of Financial Leverage • 13.3 Capital Structure and the Cost of Equity Capital • 13.4 Corporate Taxes and Capital Taxes • 13.5 Bankruptcy Costs • 13.6 Optimal Capital Structure • 13.7 Observed Capital Structures • 13.8 A Quick Look at the Bankruptcy Process Summary and Conclusions Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc. 2000

  2. T16.2 What’s Your Financing I.Q.? 6. How do you handle financial controls? a. Formally b. Some formally, some informally c. There are no official controls in this area 7. What is your company’s ratio of assets to liabilities, compared to your competitors? a. Higher b. Equal c. Lower 8. For how many of these functions do you have yourself: marketing, production, human resources, office management, finance? a. Almost all of them b. Half of them c. Two or less of them 1. What do you need funding for? a. To expand the business b. To assist with business operations c. To start the business 2. Describe your company’s profit history. a. A steady upward climb b. Even or flat, but steady c. Inconsistent, or downward-sloping 3. How old is the business? a. Three or more years b. One to three years c. Less than one year 4. How well known are you within your market? a. Very well known b. Somewhat known c. Not known at all 5. Describe your company’s business plan. a. Formal, complete, and current b. Informal, but current c. We have no formal business plan

  3. T16.2 What’s Your Financing I.Q.? (concluded) • Scoring your business: For each A answer, give yourself 10 points, 5 points for each B, and 0 points for each C. 60 points or above: It won’t take much to convince a lender that you’re worthy of financing. 50 - 59 points: You’re on the right track. Seek out lenders who are familiar with firms of your size and industry. 35 - 49 points: Obtain funds from government-subsidized programs such as the Small Business Administration (SBA). Below 35: Take a close look at your company and consider making adjustments before you seriously consider seeking external financing. Source: Adapted from : “What’s Your Financing I.Q?” Datamerge Corporation

  4. T16.3 Capital Structure, Cost of Capital, and the Value of the Firm • Key issues: • What is the relationship between capital structure and firm value? • What is the optimal capital structure? • Preliminaries: • Capital structure is flexible D/E can be varied • Capital restructuringsThe act of varying D/E • Optimal capital structure: firm value vs. stock valueD/E that maximizes firm value • Optimal capital structure: firm value vs. WACCFirm value is just E(NPV) of all firm’s projects. WACC is just average discount rate for all firm’s projects. Given E(CFs), lowest WACC is associated with highest firm value.

  5. Table 16.1 Possible firm values: No debt versus debt plus dividend Debt Plus Dividend No Debt I II III Debt $ 0 $ 500 $ 500 $ 500Equity 1,000 750 500 250Firm Value $1,000 $1,250 $1,000 $ 750 Table 16.2 Possible payoffs to shareholders: Debt plus dividend Debt Plus Dividend I II IIIEquity value reduction* - $ 250 - $ 500 - $ 750Dividends 500 500 500Net Effect + $ 250 $ 0 - $ 250* Original E(=1,000) – E left after dividend value of the firm as result of restructuring (here, borrowing $500) [ E(NPV) of restructuring “project”).= Net effect on shareholders Due to ↑ L = 500 on B/S

  6. Financial Leverage, EPS, and ROE: An Example Current ProposedAssets $5,000,000 $5,000,000Debt $ 0 $2,500,000Equity $5,000,000 $2,500,000 Debt/Equity Ratio 0 1Share Price * $ 10 $ 10Shares Outstanding 500,000 250,000Interest Rate n/a 10% * For now, assume restructuring has no influence on share price. Later we’ll show how it generally will. Also, ignore taxes for now. EPS and ROE under current capital structure; no debt Recession Expected Expansion EBIT $300,000 $650,000 $800,000Interest $ 0 $ 0 $ 0Net Income $300,000 $650,000 $800,000 EPS (=NI/Q of shares) $0.60 $1.30 $1.60ROE (= NI/ E; 6% 13% 16%(divide numerator + denominator by Q) = EPS/ Price per share

  7. Financial Leverage, EPS, and ROE: An Example (continued) EPS and ROE under proposed capital structure; D/E = 1: interest rate 10% Recession Expected Expansion EBIT $300,000 $650,000 $800,000Interest $250,000 $250,000 $250,000Net Income $ 50,000 $400,000 $550,000 EPS $0.60 (<0.60) $1.30 (>1.30) $2.20(>1.60)ROE 2% (< 6%) 16%(>13%) 22% (>16%) Intuition for why ↑ D/E  ↑ variability of EPS (+ ROE):D/E produces 2 changes:1. ↑ interest payments, a fixed cost (here $250,000)2. ↓ Q of shares (here, from 500,000 to 250,000) At low levels of EBIT, the % ↓ in NI (here, the $250,000 interest cost) > ↓ shares  EPS ↓. At high levels of EBIT, the % ↓ in NI (here, the $250,000 interest cost) < ↓ shares  EPS ↑.

  8. T16.4 Example: Computing Break-Even EBIT – A Quick Note • Ignoring taxes: A. With no debt: EPS = EBIT/500,000 (shares) B. With $2,500,000 in debt at 10%: EPS = (EBIT - $250,000)/250,000 (shares) EPS (no debt) = EPS (with debt), i.e. C. These are equal when: EPSBE = EBITBE/500,000 = (EBITBE - $250,000)/250,000 D. With a little algebra: EBITBE = $500,000 So EPSBE = $1/shareAlternatively: ROEBE = EPSBE/price per share = $1/$10 = 10%So at EPSBE, share holders are earning the same return as bondholders.At EPSBE, shareholders are indifferent between the 2 capitals structures.When EPS < EPSBE, ROE < i  shareholders prefer no leverage.When EPS > EPSBE,, ROE > i  shareholders prefer leverage

  9. T16.5 Financial Leverage, EPS and EBIT EPS ($) With debt D/E = 1 Slope =  EPS/EBIT = $0.40/$100,000 3 2.5 2 1.5 1 0.5 0 – 0.5 – 1 Advantages to debt No debt D/E = 0 Slope = EPS/  EBIT = $0.20/$100,000 Disadvantages to debt EBIT ($ millions, no taxes) 0 0.2 0.3 0.4 0.5 0.6 0.650 0.8 1 Recession (B/E) Expected Expansion

  10. Conclusions About Financial Leverage 1. The effect of financial leverage depends upon the company’s EBIT. When EBIT is high, leverage is beneficial (in the sense that EPS is higher than without leverage). 2. Under the expected scenario (in the example above), leverage increases the returns to share holders, as measured by both ROE and EPS (This occurs because the expected scenario occurs at higher than B/E EBIT + EPS. Alternatively, ROE > borrowing rate). 3. Shareholders are exposed to more risk under the proposed capital structure (i.e., ↑ D/E from 0 to 1) since the EPS and ROE are much more sensitive to changes in EBIT in this case. (The above three conclusions are valid.* From these, a fourth conclusion seems reasonable): 4. Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important consideration. Surprisingly the 4th conclusion is not valid! The reason is that stockholders can adjust the amount of financial leverage in their portfolio by borrowing or lending on their own (This is a.k.a. creating homemade leverage). As a consequence investors can make their personal leverage more or less than the leverage of the company who’s stocks they own. * As long as we ignore the effect of ↑ D/E on financial risk to shareholders. We’ll see later that, as D/E ↑, shareholders will require ↑ RE.

  11. T16.6 Example: Homemade Leverage and ROE Firm does not adopt proposed capital structure; given $500 of investor wealth. Instead, investor puts up $500 and borrows $500 to buy 100 shares at $10/share. This makes your total assets consist of ½ equity and ½ debt  personal D/E =1, same as firm’s proposed D/E. RecessionExpectedExpansion EPS ofunlevered firm $0.60 $1.30 $1.60 Earnings for100 shares $60.00 $130.00 $160.00 less interest on$500 at 10% $50.00 $50.00 $50.00 Net earnings $10.00 $80.00 $110.00 ROE = 2% 16% 22% Yet, the ROE is the same as that of the levered firm.

  12. T16.6 Homemade Leverage: An Example (concluded) Firm adopts proposed capital structure; given $500 of investor wealth. Instead, investor puts up $500, $250 in stock and $250 in bonds. For each $250 of equity in the firm, there is also $250 in debt. So if you lend $250 more, your net asset position is $250 in equity*  personal D/E = 0, same as for unlevered firm. EPS oflevered firm $0.20 $1.60 $2.20 Earnings for25 shares $5.00 $40.00 $55.00 plus interest on$250 at 10% $25.00 $25.00 $25.00 Net earnings $30.00 $65.00 $80.00 ROE 6% 13% 16% Yet, the ROE is the same as that of the unlevered firm. * in effect you’re lending to yourself

  13. T16.7 The Modigilani & Miller (M&M) Propositions • Case I: No Taxes Proposition I: Financial leverage and firm value If investors can offset firm leverage to create their own desired (“homemade”) leverage costlessly, then the value of the firm is unaffected by its capital structure. In symbols, VL= VU, where L is levered and U is unlevered. (Note: by definition, VU = EU and VL = EL + DL). Thus, capital restructuring by themselves don’t create value.

  14. T16.7 The Modigilani & Miller (M&M) Propositions • Proposition II: The WACC, the cost of equity and financial leverage A. Because of Prop I, the WACC must be constant. Recall from the previous chapter that, without taxes, WACC = RA = (E/V)(RE) + (D/V)(RD), where RA is the required return on the firm’s assets. B. Solve for RE to get MM Prop II: RE = RA + (RA – RD)(D/E) There are 2 important implications: 1. RE must ↑ with ↑ in D/E, so as to keep WACC constant. 2. The cost of equity has 2 parts. Each is related to systematic risk. a. RA, related to “business risk” (the risk inherent in CF’s from the firm’s assets, i.e., the firm’s operating activities; recall: b. (RA – RD)D/E, related to “financial risk” (the part of the equity risk attributable to capital structure)

  15. T16.7 Milestones in Finance: The M&M Propositions • The pie model “homemade leverage” argument and Proposition I. If investors can offset firm leverage to create their own desired (homemade) leverage costlessly (remember, taxes are ignored here). Implications (VL = VU) : 1. In the absence of taxes and other unpleasantries, the value of the firm is unaffected by its financial policy. 2. Alternatively, WACCL = WACCU (i.e., RE) • Corollary #1: There is no “magic” in finance - you can’t get something for nothing. • Corollary #2: Capital restructurings don’t create value, in and of themselves. (Why is the last part of the statement so important? Stay tuned.)

  16. T16.7 Milestones in Finance: The M&M Propositions (concluded) The cost of equity and financial leverage: Proposition II • A. Because of Prop. I, the WACC must be constant. With no taxes, WACC = RA = (E/V)  RE + (D/V)  RD where RA is the required return on the firm’s assets • B. Solve for RE to get MM Prop. II RE = RA + (RA - RD)  (D/E) Implications: 1. RE must ↑ with ↑ in D/E, so as to keep WACC constant.* 2. () Cost of equity has two parts: 1. RA and “business” risk, i.e. systematic risk inherent in CF’s from firm’s assets, i.e. its operating activities (βA) Recall: DOL (Chapter 11) 2. D/E and “financial” risk, i.e., the part of the equity risk attributable to capital structure. Total systematic risk of firm (βE) * Intuition: The more debt relative to equity, the greater the risk that earnings will be paid to bondholders at the expense of stockholders. So stockholders require higher RE to compensate for this risk (This is true even if bondholders face no default risk).

  17. T16.8 The Cost of Equity and the WACC (Figure 16.3) – No Taxes RE = RA+ (RA – RD) x (D/E) RA ↓ ↑ ↑ Alternatively, as D/E ↑, WACC  RA  (E/V) x RE + (D/V) x RD and RD < RE.So, won’t firm ↓ WACC by ↑ D/V and ↓ E/V? No; WACC  RA is determined by financial markets as the appropriate return for projects of the same systematic risk as the firm’s average project. This has nothing to do with where the firm gets the finances for the project. Thus, if D/V ↑ and E/V ↓, RE must ↑ just enough to keep WACC  RA unchanged.

  18. T16.9 More on Business and Financial Risk (not in text) The SML and MM Proposition II:Proposition II: RE = RA + (RA - RD)  (D/E) CAPM: RE = RF + (RM - RF) βERA = RF + (RM - RF) βAwhere βA is the “asset” beta. Systematic risk and financial leverage Assume the debt is riskless, so that RD = RF, and substitute for RA in Proposition II: RE = RF +[(RM - RF) βA x (1 + D/E)]Setting this above equation for RE = CAPM equation for RE () βE = βA x (1 + D/E) = βA + βA x D/E() Systematic risk for the firm’s stock has two parts:1. βA and “business” risk2. D/E and “financial” risk

  19. T16.10 Case II: The M&M Proposition with Taxes • The interest tax shield and firm value For simplicity: (1) perpetual cash flows (2) no depreciation (3) no fixed asset or NWC spending A firm is considering going from zero debt to $400 at 10% borrowing rate: Firm U Firm L (unleveraged) (leveraged) EBIT $200 $200 Interest 0 $40 Tax (40%) $80 $64 Net income $120 $96 Cash flowfrom assets (EBIT-Taxes) $120 $136 Tax saving = $16 = 0.40  $40 = TC(RD D)*

  20. T16.10 Case II: The M&M Proposition with Taxes (Continued) • Thus, for same EBIT, firm L paid $16 less in taxes  firm L had $16 more in CF from assets to distribute to stockholders. • PV (tax savings) = $16/0.10 = $160 = (TC x RD x D)/RD = TC x D Proposition I:VL = VU = (TC x D)The value of the leveraged firm is equal to the value of the unleveraged firm plus the interest tax shield. Note: VU = (EBIT c [1-TC])/RU Implication: since the value of the firm ↑ with leverage, we have: Proposition II:A. The WACC ↓ with leverage. WACC = RA = RL= (E/V)(RE) + (D/V)(RD)(1-TC) Thus, the optimal capital structure is all debt.

  21. T16.10 Case II: The M&M Proposition with Taxes (Continued) Note: this peculiarity – the interest tax shield – is due to our tax system allowing pre-tax distribution of CF to creditors (even though interest payments aren’t an operating cost), versus after-tax distribution of CF to owners. B. Solve for RE to get MM Prop II: RE = RU + (RU – RD) x (D/E x [1-TC]) Thus, RE↑ with ↑ in D/E, just as in the no-tax case. But in the present case of taxes, RE doesn’t ↑ by as much as in the no-tax case. (Why? Compare the above equation for RE to the corresponding equation with no taxes).

  22. T16.12 M&M Proposition I with Taxes (Figure 16.4)

  23. T16.13 Example: Debt, Taxes, and the WACC • Taxes and firm value: an example • EBIT = $100 • TC = 30% • RU = 12.5% Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E? VU = EBIT x (1-TC)/RU1. Here, VU = $100  (______)/.125 = $560 VL = VU + TC x D2. Here, VL = $560 + .30  $_____ = $590, so E = $_____ .

  24. T16.13 Example: Debt, Taxes, and the WACC • Taxes and firm value: an example • EBIT = $100 • TC = 30% • RU = 12.5% Q. Suppose debt goes from $0 to $100 at 10%, what happens to equity value, E? VU = $100  (1 - .30)/.125 = $560 VL = $560 + .30  $100 = $590, so E = $490 .

  25. T16.13 Example: Debt, Taxes, and the WACC (concluded) • WACC and the cost of equity (MM Proposition II with taxes) With taxes: WACC = [(E/V) x RE] + [(D/V) x RD x (1-TC)]Solving for RE: RE = RU + (RU - RD)  (D/E)  (1 - TC ) RE = _____+ (_____- .10)  ($____/____)  (1 - .30) = 12.86% WACC = ($____/____)  .1286 + (100/590)  .10  (1 - .30) = 11.86% Implication: Even though RE↑ with ↑ D/E (just as in no-tax case) () the WACC decreases as more debt financing is used. Optimal capital structure is all debt!

  26. T16.13 Example: Debt, Taxes, and the WACC (concluded) • WACC and the cost of equity (MM Proposition II with taxes) With taxes: RE = RU + (RU - RD)  (D/E)  (1 - TC ) RE = .125 + (.125 - .10)  ($100/490)  (1 - .30) = 12.86% WACC = ($490/590)  .1286 + (100/590)  .10  (1 - .30) = 11.86%

  27. T16.11 Case II: The M&M Proposition with Taxes (An Example) Assume EBIT = $100, TC = 30%, RU = 12.5%, RD = 10%. If debt goes from $0 to $100, what happens to equity value (E), RE, and WACC? 1a. VU = (EBIT x [1-TC])/ RU = $100 x (0.7)/0.125 = $560 1b. MM Prop I says: VL = VU + (TC x D) = $560 + (0.30 x $100) = $590 Thus, E = VL – D = $590 - $100 = $490 2. MM Prop II says: RE = RU + (RU –RD) x (D/E x [1-TC]) = 0.125 + (0.125 – 0.10) x (100/490) x (1-0.30) = 12.86% 3. WACC = RA = RU = (E/V)(RE) + (D/V)(RD)(1-TC) = ($490/$590)(0.1286) + ($100/$590)(0.10)(1-0.30) = 11.86%

  28. T16.14 Taxes, the WACC, and Proposition II Cost of capital (%) RE 2. RE = 0.1286 givenRU = 0.125 WACC = 0.1186 RU WACC 3. (given)RD x (1-TC)= 0.10 x (1-0.30)= 0.07 RD (1 – TC) Debt-equity ratio, D/E D/E = (100/490) = 0.204

  29. T16.17 The Static Theory* of Capital Structure : The Optimal Capital Structure and the Value of the Firm (continued) (Figure 16.6) (MMI with taxes)  agency** (Static Theory) (MMI: no taxes) A+D, + VL/D=0, i.e. ↑ PV of tax shield on debt = ↓ PV due to ↑ probability of fin. distress ** Fin. Distress costs include: 1. Direct bankruptcy costs. Legal and administrative expenses associated with bankruptcy proceedings2. Indirect bankruptcy costs. Costs of avoiding a bankruptcy filing; incurred by financially distressed firm (especially diversion of resources from normal operatings. Note: Conflict between stockholders who control firm and bondholders, who are creditors  bondholders want firm to file for bankruptcy to preserve the firm’s ability to repay bond value. Stockholders want to avoid bankruptcy proceedings, since paying off bondholders technically leaves little or no equity.

  30. T16.18 The Static Theory of Capital Structure: The Optimal Capital Structure and the Cost of Capital (Figure 16.7) The D/E that maximizes firm value (VL) is alsothe D/E that minimizes the firm’s WACC Managerial recommendations on capital structure:Given that your firm is currently at the optimal D/E ratio (D*/E*), what, if any, changes in capital structure would you recommend in each of the following 2 scenarios? 1. ↓ TC, relative to TP (personal tax rate); 2. ↓ in some component of expected financial distress costs. Can you illustrate the changes

  31. T16.19 The Capital Structure Question (Figure 16.8) Note: Can’t show upward-sloping RE in lower panel because it is different in each of the 3 cases: RE ↑ fastest with ↑D/E when WACC is ↑ (part of static theory); next fastest when WACC is constant (MM – no taxes) and slowest when WACC is ↓ (either MM; taxes; or part of static theory).

  32. T16.20 The Extended Pie Model (Figure 16.9) Value of claims to the firm’s cash flows Marketable Claims Non-marketable Claims Q: Is the value of the firm larger with higher financial leverage (in this example)?“In the extended pie model, the value of all the claims against the firm’s CF’s is not affected by capital structure, but the relative value of claims changes as the amount of debt financing is increases.” (Can you explain why the size of each claimant’s slice changes with higher financial leverage?)

  33. T 16.16 Notes on Observed Capital Structures • Especially in US, corporations appear to use relatively low proportions of debt financing on average, D/E  ⅓. Do financial distress costs ↑ that rapidly (to offset tax shield of debt) or are there other explanations? Note: D↑ by 70% in US non-financial corps between 1983 and 1988. Now D is↓. • The static theory of capital structure suggests that firms with similar systematic risk (due to similar asset types and EBIT volatility) ought to have similar capital structures. An implication is that capital structures should be less variable within an industry than between industries, even when these industries are in different countries. A study of U.S. and Japanese firms confirms this. For example: There is relatively little difference in average D/E between U.S. and Japanese steel firms, but a big difference in average D/E between U.S. steel firms and U.S. pharmaceutical firms.

  34. Factors Results Example I. General Economic Conditions Demand and supply of funds in the economy Inflation in the economy Riskless rate Of return 5% II. Market Conditions Marketability of the firm’s securities + Risk premium 7% III. Firm’s operating and financing decisions Business Risk Financial Risk = (Systematic Components) Cost of capital IV. Financing level 12% Dollar amount of financing needed for investments

  35. Asset Side Liability and Equity Side The discount or hurdle rate input to “correct” capital-budget models:1. internal rate of return (IRR)2. Net Present Value (NPV)3. Profitability Index (PI) The financial structure affects the level and variability of the cash flows after taxes available to the common shareholders. (or EPS). Financial Risk Cost of Capital Directly influences the determination of the asset structure of the firm through the project evaluation process The decision to employ financial leverage affects the determination of the financial structure of the firm. The asset structure affects the level and variability of the firm’s net operating income (EBIT) ( or OCF = EBIT + D – T). Business Risk This is an input to choosing the amount of financial leverage the firm should employ (Figure 12.1 Cost of Capital as a link between firm’s asset structure and financial structure)

  36. Solution to Problem 15.2 Duosys is comparing two plans: Plan I Plan IIDebt 0 $5,000 at 12%Equity 200 shares 100 shares A. If EBIT = $1,000, which plan will result in the higher EPS? EBIT $1,000 $1,000- INT. - 0- 600NI (no tax) $1,000 $ 400EPS $5 $4 B. If EBIT = $2,000, which plan will result in the higher EPS? EBIT $2,000 $2,000- INT. - 0- 600NI (no tax) $2,000 $ 1,400EPS $10 $14

  37. Solution to Problem 15.2 (Continued) C. What is the break-even EPS? EPS(Plan I) = EPS(Plan II) EBIT = $1,200

  38. Solution to Problem 15.10 McGowan has no debt and its WACC is currently 12%. McGowan has a 34% tax rate and can borrow at 9%. a. What is McGowan’s current cost of equity? WACC = 100% x RE + 0 x RD x (1 – TC) 0.12 = 100% x RE RE = ______ b. What is McGowan’s new cost of equity if it converts to 25% debt? RE = RU + (RU – RD) x (D/E) x (1 – TC) = 0.12 = (0.12 – 0.09) x (_____) x 0.66 = 0.1266 c. What is McGowan’s new cost of equity if it converts to 50% debt? RE = 0.12 + (0.12 – 0.09) x (1/1) x 0.66 = 0.1398 d. Compute the WACC under each option 25% debt: WACC = 0.75 x 0.1266 + 0.25 x ____ x _____ = 0.1098 50% debt: WACC = 0.50 x ______ + 0.50 x 0.1398 x 0.66 = 0.0996

  39. Solution to Problem 15.14 Kau currently has no debt. EBIT is expected to be $6,000 forever, and the cost of capital is currently 12%. The tax rate is 40%. A. VU = EBIT x (1-TC)/RU = $6,000 x 0.60/0.12 = $30,000 B. Suppose Kau sells $20,000 in debt and uses the proceeds to repurchase stock. The interest rate is 8%. What is the new total value for Kau? The new equity value? VL = VU + TC x D = $30,000 + 0.40 x $20,000 = $38,000 E = VL – D = $38,000 - $20,000 = $18,000

  40. T16.21 Chapter 16 Quick Quiz 1. Why does the firm’s cost of equity increase with leverage? All else equal, as the D/E ratio increases, the riskiness of the remaining equity increases. 2. What are direct bankruptcy costs? Direct bankruptcy costs are generally observable and, therefore, measurable. Examples: legal fees, accounting fees, administrative expenses. 3. What kinds of firms would be most likely to suffer indirect bankruptcy costs? Firms most likely to lose customers and/or sales as the likelihood of distress increases. 4. Name three types of financial distress. Business failure; legal bankruptcy; technical insolvency

  41. T16.22 Solution to Problem 16.1 • Big Apple, Inc. has no debt and a total market value of $80,000. EBIT is projected to be $4,000 if economic conditions are normal. EBIT is expected to be 30% higher if the economy is strong, or 60% lower if a recession occurs. Big Apple is considering a $35,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase outstanding stock. There are now 2,000 shares outstanding. Ignore taxes for this problem. a. Calculate 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. b. Repeat part (a) assuming that Big Apple goes through with the recapitalization. What do you observe?

  42. T16.22 Solution to Problem 16.1 (continued) a. EBIT: $1,600 $4,000 $_____ Interest: 0 0 0 Taxes: 0 0 0 NI: $_____ $4,000 $_____ EPS: $ .80 $2.00 $____ EPS: -60% --- +30%

  43. T16.22 Solution to Problem 16.1 (continued) a. EBIT: $1,600 $4,000 $5,200 Interest: 0 0 0 Taxes: 0 0 0 NI: $1,600 $4,000 $5,200 EPS: $ .80 $2.00 $2.60 EPS: -60% --- +30%

  44. T16.22 Solution to Problem 16.1 (concluded) b. $80,000/2,000 shares = $40 per share $35,000/$40 = 875 shares bought back 2,000 - 875 = 1,125 shares left outstanding EBIT: $1,600 $4,000 $5,200 Interest: 1,750 1,750 1,750 Taxes: 0 0 0 NI: -$150 $2,250 $3,450 EPS: -$0.13 $2.00 $3.07  EPS: -106.50% --- +53.50%

  45. T16.23 Solution to Problem 16.11 • Chelsea Corp. uses no debt. The weighted average cost of capital (WACC) is 12 percent. If the current market value of the equity is $25 million, and the corporate tax rate is 34 percent, what is the EBIT? What is the WACC? Explain. According to M&M, V = VU + TCD. In this case, V = $25M, WACC = 12%, and D = 0. So, V = $25M = EBIT(1 - .34)/.12 + 0 EBIT = $4.545M

  46. T16.24 Solution to Problem 16.12 • Fordebtful Industries has a debt/equity ratio of 2.5. Its WACC is 12 percent, and its cost of debt is 12 percent. The corporate tax rate is 35 percent. a. What is Fordebtful’s cost of equity capital? b. What is Fordebtful’s unlevered cost of equity capital? c. What would the cost of equity be in part (a) if the debt/equity ratio were 1.5? What if it were 1.0? What if it were zero?

  47. T16.24 Solution to Problem 16.12 (concluded) a. Since WACC = (E/V)(RE) + (D/V)(RD)(1 - TC),WACC = .12 = (.2857)RE + (.7143)(.12)(.65),Solving, RE = .2250 b. .2250 = RU + (RU - .12)(2.5)(.65) Solving, RU = .16 c. .12 = (.40)RE + (.60)(.12)(.65)Solving, RE = .1830 .12 = (.50)RE + (.50)(.12)(.65)Solving, RE = .1620 .12 = (1.0)RE + (0)(.12)(.65)Solving, RE = RU = WACC = .12

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