Name: ____________________________
ID: ____________________________
9.348 — Corporate Finance Theory and Practice
Assignment 3
Dr. D.A. Stangeland
Due Wednesday, March 25, 1998 at 11:30 a.m. Remember that this assignment is to be done on an individual
basis. Do not consult your peers. Any suspected breaches of the Faculty’s code of academic integrity will be
sent to the Dean’s office. Only selected parts will be marked.
Use the following information to answer the questions below.
Morton Downey Corporation (MDC) is currently 100% equity financed. There are 300 million shares
outstanding. Analysts agree that the expected yearly pre-tax cash flows produced by MDC will be
$1,000,000,000. No growth in these cash flows is expected as all after-tax amounts are paid out to security
holders. Given the systematic risk of MDC, its assets and equity currently yield 15% (before personal tax) per
year. MDC is subject to corporate tax at a rate (combined federal and provincial) of 46%.
1. The after-corporate-tax cash flow available to equity holders each year is
_______________________.
2. The total value of MDC’s equity is
_______________________.
3. The per-share value of MDC’s equity is
_______________________.
4. The total value of MDC is
_______________________.
5. If the marginal investor has a personal tax rate on equity income of 15%, then the after-all-tax cash flow to
equity holders is
_______________________.
New Capital Structure: Consider changing the capital structure of MDC such that there will be $2,000,000,000
of debt outstanding. Whenever some debt is retired, new debt with the same market value will be issued. The
debt will be composed of 2 million bonds each paying annual coupons of $90. The marginal investor is taxed at
a rate of 45% on debt income and 15% on equity income. Answer questions 6-14 given the new capital
structure information.
6. The total amount of interest paid on the debt per year is
_______________________.
7. The debt yield expressed as an effective rate per year (before tax) is
_______________________.
8. The total value of MDC is
_______________________.
9. The total value of MDC’s equity is
_______________________.
10. The number of shares outstanding after the debt is issued is
_______________________.
(Hint 1: with a change in capital structure, the money raised by issuing debt is used to repurchase shares.
Investors will anticipate a higher price per share due to the capital structure change. Hence, the repurchased
shares must be bought at the new higher price. You need to set up two equations with two unknowns —
solving for the new number of shares and the new price per share simultaneously.
11. The new price per share after the capital structure change is
_______________________.
New pre-tax cash flows: Suppose the new capital structure described above will result in MDC’s expected pretax cash flows rising to $1,050,000,000 per year. Answer questions 12-14 given the new pre-tax cash flows.
12. The total value of MDC is
_______________________.
(Hint 2: first recalculate VU as though pre-tax cash flows were $1.05 billion, then do the remaining
calculations.)
13. The new price per share of MDC’s equity is
(Hint: see hint 1.)
_______________________.
14. Why might a hostile takeover be necessary to force the capital structure change that results in the share price
calculated in question 13?
TC=0% case: Suppose MDC has the new capital structure. Assume the original capital structure will result in
the original pre-tax cash flows and the new capital structure results in the new pre-tax cash flows. Answer
questions 15-18 given MDC’s corporate tax rate of 0%.
15. The total value of MDC with the original capital structure is
_______________________.
16. The price per share of MDC’s equity with the original capital structure is
(Hint: see hint 1.)
_______________________.
17. The total value of MDC with the new capital structure is
(Hint: see hint 2)
_______________________.
18. The price per share of MDC’s equity with the new capital structure is
(Hint: see hint 1.)
_______________________.
19. Using the above examples and your knowledge of capital structure theory, explain why most hostile
takeovers are associated with increases in leverage and few are associated with decreases in leverage (in
fact, managers are usually willing to decrease leverage without external market forces).