This document provides solutions to capital structure and leverage assignment problems.
Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value.
Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable.
Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.
This document provides solutions to capital structure and leverage assignment problems.
Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value.
Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable.
Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.
This document provides solutions to capital structure and leverage assignment problems.
Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value.
Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable.
Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.
This document provides solutions to capital structure and leverage assignment problems.
Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value.
Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable.
Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.
e. The relevant before-tax cost of debt is now 9.5% and the cost of equity is 14.13%. WACC = wdrd(1 – T) + wcrs = (0.4)(9.5%)(1 – 0.4) + (0.6)(14.13%) = 10.76%.
f. The firm should be advised to proceed with the recapitalization as it causes the WACC to decrease from 10.96% to 10.76%. As a result, the recapitalization would lead to an increase in firm value.
Q2) Without new investment:
Sales $12,960,000 VC 10,200,000 FC 1,560,000 EBIT $ 1,200,000 Interest 384,000* EBT $ 816,000 Tax (40%) 326,400 Net income $ 489,600
*Interest = 0.08($4,800,000) = $384,000.
EPSOld = $489,600/240,000 = $2.04.
With new investment: Debt Stock Sales $12,960,000 $12,960,000 VC (0.8)($10,200,000) 8,160,000 8,160,000 FC 1,800,000 1,800,000 EBIT $ 3,000,000 $ 3,000,000 Interest 1,104,000** 384,000 EBT $ 1,896,000 $ 2,616,000 Tax (40%) 758,400 1,046,400 Net income $ 1,137,600 $ 1,569,600
EPS should improve, but expected EPS is significantly higher if financial leverage is used.
Examples Q1) a) Market value of equity = Market price of share x Number of shares outstanding = $2 x 190,000 = $380,000 Debt = $95,000 Total Assets = 95,000 + 380,000 = $475,000
b) WACC will change after recapitalization due to change in weights as well as cost of capital.
Increase in debt = $95,000
New debt level = 95000 + 95000 = $190,000
Decrease in equity = $95,000
New equity level = 380,000 – 95000 = $285,000
Number of shares repurchased = Decrease in equity/Price of share = 95000/2 = 47,500
New number of shares outstanding = 190,000 – 47,500 = 142,500
New wd = 190000/475000 = 0.4 new ws = 285000/475000 = 0.6
New rd = 10% To calculate new rs, the new levered beta is needed. To calculate the new levered beta, the unlevered beta has to be calculated first at existing D/E using Hamada’s equation.
