Business: Weighted Average Cost of Capital and Market Value Essay

Submitted By jennifer1992116
Words: 6072
Pages: 25

CHAPTER 15
CAPITAL STRUCTURE
Basic Concepts

1. In a world with no taxes, distress costs, or transaction costs, the choice of debt or equity is irrelevant to the value of the firm. In this scenario, the firm is like a pizza. It doesn’t matter how you slice it, you still have a pizza – no more, no less.

2. Section 15.2 goes into this in detail. However, in a world with no taxes, transaction costs or distress costs, any change in capital structure that increases the value of the firm will have a direct impact on the shareholders. Similarly, when the value of the firm decreases, this will hurt both debt holders and shareholders. In a world with frictions (taxes, distress costs, transaction costs), this is not necessarily true.

3. False. A reduction in leverage will decrease both the risk of the equity and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the share price and the overall value of the firm unchanged.

4. False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm’s equity is positively related to the firm’s debt-equity ratio [RS = R0 + (B/S)(R0 – RB)]. Therefore, any increase in the amount of debt in a firm’s capital structure will increase the required return on the firm’s equity.

5. Section 15.5 covers this in detail. The main impact is that taxes make debt valuable because of the tax shield that comes with debt. In addition, the risk of equity increases as debt increases in the capital structure. These are Propositions I and II of Modigliani & Miller’s theorem.

6. This is covered in Section 15.6. A firm is indifferent between equity and debt when:

7. The question requires the student to develop their own example. The relevant sections in the chapter that this question refers to are 15.3 and 15.4.

8. If the total asset value is £120,000 before the restructuring, the debt and equity values after the restructuring are £60,000 each. The debt to equity ratio is 1 and the debt to assets ratio is 0.5.

9. The table below outlines the income statement for the three states:

State
1
2
3
EBIT
£8,000
£10,000
£12,000
Interest
£6,000
£6,000
£6,000
NI
£2,000
£4,000
£6,000
ROE
3.33%
6.67%
10.00%

10. 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 1 billion shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy.

Recession
Normal
Expansion
EBIT
1.024
€ 2.56
€ 3.33
Interest
€ 0
€ 0
€ 0
Taxes
€ 0
€ 0
€ 0
NI
€ 1.024
€ 2.560
€ 3.328
EPS
€ 1.024
€ 2.560
€ 3.328
%EPS
-60.00%
–––
30.00%

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

Share price = Equity / Shares outstanding Share price = 12.68/1 Share price = €12.68

Shares repurchased = Debt issued / Share price Shares repurchased =€2 billion/€12.68 Shares repurchased = 157,728,707 The interest payment each year under all three scenarios will be:

Interest payment = €2 billion(.05) = €100 million

The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization.

Recession
Normal
Expansion
EBIT
1.024
2.560
3.328
Interest
€ 0.1
€ 0.1
€ 0.1
Taxes
€ 0
€ 0
€ 0
NI
€ 0.924
€ 2.460
€ 3.228
EPS
€ 1.097
€ 2.921
€ 3.832
%EPS
-62.44%
–––
31.22%

11. a. A table outlining the income statement with taxes for the three possible states of the economy is shown below. The EPS is the net income divided by the 1 billion shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy.

Recession
Normal
Expansion
EBIT
1.024
2.560
3.328
Interest…