Problem solving assignment - Module 4
Instructions:
1. Please answer the following problems (from the book Essentials of Financial Management
(Philippine Edition - 4th Edition)
by E.F. Brigham, et. al :
a) Page 573 - Problems 15-7; 15-8; 15-9;
b) Page 574 - Problems 15-11; 15-12
2. Submit your answers by uploading using word, excel, pdf or image of your clear handwritten
output.
3. Due April 10, 2021 at 8pm
4. This is a graded activity
PROBLEM 15-7
Case-1: When the debt value is zero and the equity value is $14,000,000
Expected ROE = $2,520,000 / $14,000,000
= 0.18
Net income under state-2: Here the debt portion is 0% and the equity portion is 100% and the
Cost of debt is 0%
Expected ROE = $1,680,000 / $14,000,000
= 0.12
Net income under state-3: Here the debt portion is 0% and the equity portion is 100% and the
Cost of debt is 0%
Expected ROE = $420,000 / $14,000,000
= 0.03
Therefore, from the table
Column-7 is calculated as 0.2*(0.18-0.105)^2 = 0.00113
Similarly calculating for other states.
Variance = 0.00293
Standard deviation = Square root of variance
PROBLEM 15-8
Cost of Equity = Riskfree rate + (Market Risk Premium) (Leveraged Beta)
14 = 5% + (6%)(Beta leveraged at 25% Debt)
Beta leveraged for 25% Debt = 1.5
Unleveraged Beta = (Leveraged Beta)/[1+(1-T)(D/E)]
= 1.5/[1+(1-40%)(25%/75%)]
= 1.25
Beta leveraged at 50% Debt = 1.25x[1+(1-40%)(50%/50%)]
=2
Cost of equity, rs= Riskfree rate + (Market Risk Premium)(Beta leveraged at 50% Debt)
= 5% + (6%)(2)
= 17%
PROBLEM 15-9
Tapley Inc. currently has total capital of $5 million, has zero debt, is in the 40% federalplus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings
as dividends. Net income is expected to grow at a constant rate of 5% per year, 200,000
shares of stock are outstanding, and the current WACC is 13.40%. The company is
considering a recapitalization where it will issue $1 million in debt and use the proceeds
to repurchase stock. Investment bankers have estimated that if the company goes through
with the recapitalization, its before-tax cost of debt will be 11%, and its cost of equity will
rise to 14.5%.
a. What is the stock’s current price per share (before the recapitalization)?
The current stock price can be determined using the DCF (dividend growth model) approach:
Dividend per share (D0) = (0.40)($1,000,000) / 200,000 = $2.00
D1 = $2.00(1.05) = $2.10
P0 = D1 / (rS – g) = $2.10 / (0.134 – 0.05) = $25.00
Note that the cost of equity (rS) is the same as the WACC of 13.40% as the firm currently has
no debt.
b. Assuming that the company maintains the same payout ratio, what will be its stock
price following the recapitalization? Assume that shares are repurchased at the price
calculated in Part a.
The first step is to calculate the earnings before interest and tax (EBIT) for the firm:
EBIT = $1,000,000 / (1 – T) = $1,000,000 / (0.60) = $1,666,667
Net income after recapitalization = [$1,666,667 – (0.11)($1,000,000)](0.60) = $934,000
Number of issued shares after recapitalization = 200,000 – ($1,000,000 / $25.00) = 160,000
Current dividend per share after the recapitalization (D0) = (0.4)($934,000 / 160,000) =
$2.335
D1 = $2.335(1.05) = $2.45175
P0 = $2.45175 / (0.145 - 0.050) = $25.8079
Thus, the stock price increases as the interest tax-shield benefits more than offset the increase
in the cost of equity. This is consistent with the underlying message of the static theory of capital
structure determination.
PROBLEM 15-11
Currently, Bloom Flowers Inc. has a capital structure consisting of 20% debt and 80% equity. Bloom’s
debt currently has an 8% yield to maturity. The risk-free rate (rRF) is 5%, and the market risk premium
(rM – rRF) is 6%. Using the CAPM, Bloom estimates that its cost of equity is currently 12.5%. The
company has a 40% tax rate.
a.
What is Bloom’s current WACC?
WACC = wDrD(1 – T) + wCrS
WACC = (0.20)(0.08)(0.60) + (0.80)(0.125) = 0.1096 or 10.96%
b.
What is the current beta on Bloom’s common stock?
The levered beta coefficient can be found using the CAPM:
rS = rRF + (rM – rRF)bL 0.125 = 0.05 + (0.06)bL
– 0.05) / 0.06 = 1.25
c.
What would Bloom’s beta be if the company had no debt in its capital structure? (That is, what is
Bloom’s unlevered beta, bU?)
The Hamada equation can be used to unlever the firm’s beta:
bU = bL / [1 + (1 – T)(D/E)]
bU = 1.25 / [1 + (1 - 0.40)(0.20/0.80)] = 1.25 / 1.15 = 1.0870
Bloom’s financial staff is considering changing its capital structure to 40% debt and 60% equity. If the
company went ahead with the proposed change, the yield to maturity on the company’s bonds would rise
to 9.5%. The proposed change will have no effect on the company’s tax rate.
d.
What would be the company’s new cost of equity if it adopted the proposed change in capital
structure?
– T)(D/E)]
- 0.40)(0.40/0
The CAPM can now be used to calculate the firm’s new cost of equity: rS = rRF + (rM – rRF)bL
rS = 0.05 + (0.06)(1.5218) = 0.1413 or 14.13%
e.
What would be the company’s new WACC if it adopted the proposed change in capital structure?
WACC = wDrD(1 – T) + wCrS
WACC = (0.40)(0.095)(0.60) + (0.60)(0.1413) = 0.1076 or 10.76%
f.
Based on your answer to Part e, would you advise Bloom to adopt the proposed change in capital
structure? Explain.
Yes, the firm should be encouraged to move to the proposed capital structure as it would reduce
the firm’s WACC from 10.96% to 10.76%. As a result, the recapitalization would lead to an increase in
firm value and the firm’s stock price.
PROBLEM 15-12
(1) Under the old production process
Sales
$12,960,000 =$288´45,000
Variable costs (10,200,000)
Fixed costs
(1,560,000)
EBIT
$1,200,000
Interest expense (384,000)**
EBT
816,000
Tax (40%)
(326,400)
Net income
$ 489,600
** Interest expense = $4,800,000 ´ 0.08
= $384,000
EPS = $489,600 ¸ 240,000
= $2.04