Leverage Policy

8. a. The earnings per share are:

EPS = $43,600/5,000 shares

EPS = $8.72

So, the cash flow for the shareholder is:

Cash flow = $8.72(100 shares)

Cash flow = $872

b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm
under the proposed capital structure. The market value of the firm is:

V = $49(5,000)
V = $245,000

Under the proposed capital structure, the firm will raise new debt in the amount of:

B = .35($245,000)
B = $85,750
 This means the number of shares repurchased will be:

Shares repurchased = $85,750/$49

Shares repurchased = 1,750

Under the new capital structure, the company will have to make an interest payment on the
new debt. The net income with the interest payment will be:

NI = $43,600 – .07($85,750)
NI = $37,598

This means the EPS under the new capital structure will be:

EPS = $37,598/(5,000 – 1,750 shares)

EPS = $11.57

Since all earnings are paid as dividends, the shareholder will receive:

Shareholder cash flow = $11.57(100 shares)

Shareholder cash flow = $1,156.85

c. To replicate the proposed capital structure, the shareholder should sell 35 percent of their
shares, or 35 shares, and lend the proceeds at 7 percent. The shareholder will have an interest
cash flow of:

Interest cash flow = 35($49)(.07)

Interest cash flow = $120.05

The shareholder will receive dividend payments on the remaining 65 shares, so the dividends
received will be:

Dividends received = $11.57(65 shares)

Dividends received = $751.95

The total cash flow for the shareholder under these assumptions will be:

Total cash flow = $120.05 + 751.95

Total cash flow = $872

This is the same cash flow we calculated in part a.

d. The capital structure is irrelevant because shareholders can create their own leverage or
unlever the stock to create the payoff they desire, regardless of the capital structure the firm
actually chooses.
9. a. The rate of return earned will be the dividend yield. The company has debt, so it must make
an interest payment. The net income for the company is:

NI = $61,000 – .08($270,000)
NI = $39,400

The investor will receive dividends in proportion to the percentage of the company’s shares
he owns. The total dividends received by the shareholder will be:

Dividends received = $39,400($30,000/$270,000)

Dividends received = $4,378

So the return the shareholder expects is:

R = $4,378/$30,000
R = .1459, or 14.59%

b. To generate exactly the same cash flows in the other company, the shareholder needs to match
the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net
$30,000. The shareholder should then borrow $30,000. This will create an interest cash flow
of:

Interest cash flow = .08(–$30,000)

Interest cash flow = –$2,400

The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC.
The investor will receive dividends in proportion to the percentage of the company’s share
he owns. The total dividends received by the shareholder will be:

Dividends received = $61,000($60,000/$540,000)

Dividends received = $6,778

The total cash flow for the shareholder will be:

Total cash flow = $6,778 – 2,400

Total cash flow = $4,378

The shareholder’s return in this case will be:

R = $4,378/$30,000
R = .1459, or 14.59%
c. ABC is an all equity company, so:

RS = RA = $61,000/$540,000
RS = .1130, or 11.30%

To find the cost of equity for XYZ, we need to use M&M Proposition II, so:

RS = RA + (RA – RB)(B/S)(1 – TC)

RS = .1130 + (.1130 – .08)(1)(1)
RS = .1459, or 14.59%
 d. To find the WACC for each company, we need to use the WACC equation:

WACC = (S/V)RS + (B/V)RB(1 – TC)

So, for ABC, the WACC is:

WACC = (1)(.1130) + (0)(.08)

WACC = .1130, or 11.30%

And for XYZ, the WACC is:

WACC = (1/2)(.1459) + (1/2)(.08)

WACC = .1130, or 11.30%

When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital
structure; this is M&M Proposition I without taxes.

12. a. With the information provided, we can use the equation for calculating WACC to find the
cost of equity. The equation for WACC is:

WACC = (S/V)RS + (B/V)RB(1 – TC)

The company has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and
the weight of equity is 1/2.5, so

WACC = .098 = (1/2.5)RS + (1.5/2.5)(.06)(1 – .21)

RS = .1739, or 17.39%
 b. To find the unlevered cost of equity, we need to use M&M Proposition II with taxes, so:

RS = R0 + (R0 – RB)(B/S)(1 – TC)

.1739 = R0 + (R0 – .06)(1.5)(1 – .21)
R0 = .1121, or 11.21%

c. To find the cost of equity under different capital structures, we can again use M&M
Proposition II with taxes. With a debt-equity ratio of 2, the cost of equity is:

RS = R0 + (R0 – RB)(B/S)(1 – TC)

RS = .1121 + (.1121 – .06)(2)(1 – .21)
RS = .1945, or 19.45%

With a debt-equity ratio of 1.0, the cost of equity is:

RS = .1121 + (.1121 – .06)(1)(1 – .21)

RS = .1533, or 15.33%

And with a debt-equity ratio of 0, the cost of equity is:

RS = .1121 + (.1121 – .06)(0)(1 – .21)

RS = R0 = .1121, or 11.21%

13. a. For an all-equity financed company:

WACC = R0 = RS = .091, or 9.1%

b. To find the cost of equity for the company with leverage, we need to use M&M Proposition
II with taxes, so:

RS = R0 + (R0 – RB)(B/S)(1 – TC)

RS = .091 + (.091 – .058)(.25/.75)(1 – .22)
RS = .0996, or 9.96%

c. Using M&M Proposition II with taxes again, we get:

RS = R0 + (R0 – RB)(B/S)(1 – TC)

RS = .091 + (.091 – .058)(.50/.50)(1 – .22)
RS = .1167, or 11.67%

d. The WACC with 25 percent debt is:

WACC = (S/V)RS + (B/V)RB(1 – TC)

WACC = .75(.0996) + .25(.058)(1 – .22)
WACC = .0860, or 8.60%
 And the WACC with 50 percent debt is:

WACC = (S/V)RS + (B/V)RD(1 – TC)

WACC = .50(.1167) + .50(.058)(1 – .22)
WACC = .0810, or 8.10%

18. a. With no debt, we are finding the value of an unlevered firm, so:

V = EBIT(1 – TC)/R0

V = $31,480(1 – .21)/.14

V = $177,637.14

b. The general expression for the value of a leveraged firm is:

VL = VU + TCB

If debt is 50 percent of VU, then D = (.50)VU, and we have:

VL = VU + TC[(.50)VU]

VL = $177,637.14 + .21(.50)($177,637.14)

VL = $196,289.04
 And if debt is 100 percent of VU , then D = (1.0)VU, and we have:

VL = VU + TC[(1.0)VU]

VL = $177,637.14 + .21(1.0)($177,637.14)

VL = $214,940.94

c. According to M&M Proposition I with taxes:

VL = VU + TCB

With debt being 50 percent of the value of the levered firm, D must equal (.50)VL, so:

VL = VU + T[(.50)VL]

VL = $177,637.14 + .21(.50)(VL)

VL = $198,477.25

If the debt is 100 percent of the levered value, D must equal VL, so:

VL = VU + T[(1.0)(VL]

VL = $177,637.14 + .21(1.0)(VL)

VL = $224,857.14
20. a. Since Alpha Corporation is an all-equity firm, its value is equal to the market value of its
outstanding shares. Alpha has 18,000 shares of common stock outstanding, worth $35 per
share, so the value of Alpha Corporation is:

VAlpha = 18,000($35)

VAlpha = $630,000

b. Modigliani-Miller Proposition I states that in the absence of taxes, the value of a levered firm
equals the value of an otherwise identical unlevered firm. Since Beta Corporation is identical
to Alpha Corporation in every way except its capital structure and neither firm pays taxes,
the value of the two firms should be equal. So, the value of Beta Corporation is $630,000 as
well.

c. The value of a levered firm equals the market value of its debt plus the market value of its
equity. So, the value of Beta’s equity is:

VL = B + S

$630,000 = $85,000 + S

S = $545,000

d. The investor would need to invest 20 percent of the total market value of Alpha’s equity,
which is:
 Amount to invest in Alpha = .20($630,000)

Amount to invest in Alpha = $126,000

Beta has less equity outstanding, so to purchase 20 percent of Beta’s equity, the investor
would need:

Amount to invest in Beta = .20($545,000)

Amount to invest in Beta = $109,000

e. Alpha has no interest payments, so the dollar return to an investor who owns 20 percent of
the company’s equity would be:

Dollar return on Alpha investment = .20($93,000)

Dollar return on Alpha investment = $18,600

Beta Corporation has an interest payment due on its debt in the amount of:

Interest on Beta’s debt = .09($85,000)

Interest on Beta’s debt = $7,650

So, the investor who owns 20 percent of the company would receive 20 percent of EBIT
minus the interest expense, or:

Dollar return on Beta investment = .20($93,000 – 7,650)

Dollar return on Beta investment = $17,070

f. From part d, we know the initial cost of purchasing 20 percent of Alpha Corporation’s equity
is $126,000, but the cost to an investor of purchasing 20 percent of Beta Corporation’s equity
is only $109,000. In order to purchase $126,000 worth of Alpha’s equity using only $109,000
of his own money, the investor must borrow $17,000 to cover the difference. The investor
will receive the same dollar return from the Alpha investment, but will pay interest on the
amount borrowed, so the net dollar return to the investment is:

Net dollar return = $18,600 – .09($17,000)

 Net dollar return = $17,070

Notice that this amount exactly matches the dollar return to an investor who purchases 20
percent of Beta’s equity.

g. The equity of Beta Corporation is riskier. Beta must pay off its debt holders before its equity
holders receive any of the firm’s earnings. If the firm does not do particularly well, all of the
firm’s earnings may be needed to repay its debt holders, and equity holders will receive
nothing.

24. a. The expected return on a firm’s equity is the ratio of annual aftertax earnings to the market
value of the firm’s equity. The amount the firm must pay each year in taxes will be:

Taxes = .21($1,450,000)

Taxes = $304,500

So, the return on the unlevered equity will be:

R0 = ($1,450,000 – 304,500)/$6,100,000

R0 = .1878, or 18.78%

Notice that perpetual aftertax annual earnings of $1,145,500, discounted at 18.78 percent,
yields the market value of the firm’s equity.
b. The company’s market value balance sheet before the announcement of the debt issue is:

Debt 0

Assets $6,100,000 Equity $6,100,000

Total assets $6,100,000 Total D&E $6,100,000

The price per share is the total market value of the stock divided by the shares outstanding,
or:

Price per share = $6,100,000/280,000

Price per share = $21.79

c. Modigliani-Miller Proposition I states that in a world with corporate taxes:

VL = VU + TCB

When the company announces the debt issue, the value of the firm will increase by the
present value of the tax shield on the debt. The present value of the tax shield is:

PV(Tax Shield) = TCB

PV(Tax Shield) = .21($1,600,000)

PV(Tax Shield) = $336,000

Therefore, the value of the company will increase by $336,000 as a result of the debt issue.
The value after the repurchase announcement is:

VL = VU + TCB

VL = $6,100,000 + .21($1,600,000)

VL = $6,436,000
 Since the firm has not yet issued any debt, its equity is also worth $6,436,000.

The company’s market value balance sheet after the announcement of the debt issue is:

Old assets $6,100,000 Debt 0

PV(tax shield) 336,000 Equity $6,436,000

Total assets $6,436,000 Total D&E $6,436,000

d. The share price immediately after the announcement of the debt issue will be:

New share price = $6,436,000/280,000

New share price = $22.99

e. The number of shares repurchased will be the amount of the debt issue divided by the
new share price, or:

Shares repurchased = $1,600,000/$22.99

Shares repurchased = 69,608.45

The number of shares outstanding will be the current number of shares minus the number
of shares repurchased, or:

New shares outstanding = 280,000 – 69,608.45

New shares outstanding = 210,391.55

f. The share price will remain the same after restructuring takes place. The total market value
of the outstanding equity in the company will be:

Market value of equity = $22.99(210,391.55)

Market value of equity = $4,836,000

The market-value balance sheet after the restructuring is:

 Old assets $6,100,000 Debt $1,600,000

PV(tax shield) 336,000 Equity 4,836,000

Total assets $6,436,000 Total D&E $6,436,000

g. According to Modigliani-Miller Proposition II with corporate taxes:

RS = R0 + (B/S)(R0 – RB)(1 – TC)

RS = .1878 + ($1,600,000/$4,836,000)(.1878 – .06)(1 – .21)

RS = .2212, or 22.12%