DUKE UNIVERSITY

Fuqua School of Business

FINANCE 351 - CORPORATE FINANCE
Problem Set #4
Prof. Simon Gervais Fall 2011 Term 2
Questions
1. Suppose the corporate tax rate is 40%. Consider a rm that earns $1,000 before interest
and taxes each year (in perpetuity) with no risk. The rms capital expenditures equal its
depreciation expenses each year, and it will have no changes to its net working capital. The
riskfree interest rate is 5%.
(a) Suppose the rm has no debt and pays out its net income as a dividend each year. What
is the value of the rms equity?
(b) Suppose instead the rm makes interest payments of $500 per year. What is the value
of equity? What is the value of debt?
(c) What is the dierence between the total value of the rm with leverage and without
leverage?
(d) The dierence in part (c) is equal to what percentage of the value of the debt?
2. Western Lumber Company expects to have a free cash ow of $4.25 million in the coming
year. Free cash ows are expected to grow at a rate of 4% per year thereafter. Western
Lumber has an equity cost of capital of 10% and a debt cost of capital of 6%. The corporate
tax rate is 35%. If Western Lumber maintains a (constantly rebalanced) debt-equity ratio of
0.50, what is the present value of its interest tax shield?
3. Suppose that the Drazil Susej Corporation (DSC) has an equity cost of capital of 8.5%, a
debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio
of 2.6. Suppose that Goodyear does not plan to rebalance its debt, i.e., its current debt is
perpetual.
(a) What is DSCs WACC?
(b) What is DSCs unlevered cost of capital?
4. Kurz Manufacturing is currently an all-equity rm with 20 million shares outstanding and
stock price of $7.50 per share. Although investors currently expect Kurz to remain an all-
equity rm, Kurz plans to announce that it will borrow $50 million and use the funds to
repurchase shares (i.e., Kurzs announcement is not anticipated by investors and thus not
reected in the current stock price). Kurz will pay interest only on this debt, and it has no
further plans to increase or decrease the amount of debt. Kurz is subject to a 40% corporate
tax rate.
(a) What is the market value of Kurzs existing assets before the announcement?
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(b) What is the market value of Kurzs assets (including any tax shields) just after the debt
is issued, but before the shares are repurchased?
(c) What is Kurzs share price just before the share repurchase? How many shares will Kurz
repurchase?
(d) What are Kurzs market value balance sheet and share price after the share repurchase?
5. Mercks simplied balance sheets (using book and market values) are currently as follows:
Balance Sheet (book values in millions)
Net working capital 1,473 Long-term debt 5,269
Long-term assets 14,935 Equity 11,139
Total assets 16,408 Total liabilities 16,408
Balance Sheet (market values in millions)
Net working capital 1,473 Long-term debt 5,269
Market value of long-term assets 51,212 Equity 47,416
Total assets 52,685 Total liabilities 52,685
Suppose that Merck decides to move to a 50% book debt-to-value ratio by issuing debt
and using the proceeds to repurchase shares. The corporate tax rate is 40%; consider only
corporate taxes. Now construct Mercks balance sheet (with market values only) to reect
the new capital structure, making sure to add an item called PV(additional tax shields) on
the asset side of the balance sheet. Before it changes its capital structure, Merck has 1,248
million shares outstanding. What is the stock price before and after the change?
6. Hula Enterprises is considering a new project to produce solar water heaters. The nance
manager wishes to nd an appropriate risk adjusted discount rate for the project. The (equity)
beta of Hot Water, a rm currently producing solar water heaters, is 1.3. Hot Water has a
debt to total value ratio of 0.4. The expected return on the market is 14% and the risk-free
rate is 8%. Throughout this problem, assume that the debt is risk-free and that it is constant
(i.e., the debt is never rebalanced).
(a) Suppose the corporate tax rate is 30%. What is the asset (or unlevered) beta for the
solar water heater project?
(b) If Hula is an equity nanced rm, what is the weighted average cost of capital for the
project?
(c) If Hula has a debt to equity ratio of 2, what is the weighted average cost of capital for
the project?
(d) Hulas chairman wishes to know why the cost of capital for Hot Water cannot be used
directly. Explain why.
(e) The nance manager believes that the solar water heater project can only support
30 cents of debt for every dollar of asset value, i.e., the debt capacity is 30 cents for
every dollar of asset value. This is lower than the 66.67 cents to every dollar of asset
value (debt to equity ratio of 2) that current projects can support. Current projects
have higher collateral value than the assets of the new solar heater project. Hence she
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is not sure that the debt to equity ratio of 2 used in the weighted average cost of capi-
tal calculation is valid. What is the appropriate capital structure to use? What is the
weighted average cost of capital that you will arrive at with this capital structure?
7. Company XYZ is currently nanced with 40% debt (a 40% debt-to-value ratio). The average
current yield on government securities is 10%. The expected return on the S&P500 portfolio
is 20%. The corporate tax rate is 20% and XYZs stock has a beta of 1.6. XYZ can borrow
at 200 basis points above the prevailing government rate.
(a) What is XYZs weighted average cost of capital under the current capital structure?
(b) What is XYZs cost of capital if it decides to pursue a policy of always using 100% equity
nancing instead?
(i) First, solve this under the assumption that XYZs debt will never be rebalanced.
(ii) Now, solve this under the assumption that XYZs debt will be constantly rebalanced.
8. If it were unlevered, the overall rm beta for Wild Widgets Inc. (WWI) would be 0.9. WWI
has a target debt/equity ratio of 1/2 and plans to constantly rebalance its debt in order
to maintain it. The expected return on the market is 16%, and Treasury bills are currently
selling to yield 8%. WWI one-year bonds (with a face value of $1,000) carry an annual coupon
of 7% and are selling for $972.72. The corporate tax rate is 34%.
(a) What is WWIs cost of debt?
(b) What is WWIs weighted average cost of capital?
(c) What is WWIs cost of equity?
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Solutions
1. Because the rms cash ows are riskless, we have r
E
= r
D
= 5%.
(a) If the rm has no debt and pays out its net income (of $600 = $1,000(1 0.40)) as a
dividend each year, the rms equity is worth
E
U
=
$600
0.05
= $12,000.
(b) If the rm makes (riskless) interest payments of $500 per year, then the equity-holders
will receive an annual dividend of $300 = ($1,000$500)(10.40). Their equity is then
worth
E
L
=
$300
0.05
= $6,000.
The bondholders receive $500 every year. Their debt is worth
D
L
=
$500
0.05
= $10,000.
(c) The levered value of the rm is
V
L
= E
L
+D
L
= $6,000 + $10,000 = $16,000.
The dierence between the levered value and the unlevered value is V
L
V
U
= $16,000
$12,000 = $4,000.
(d) This dierence is the present value of the interest tax shield, which is a fraction t
c
of the
debt D
L
:
PV (interest tax shield) = t
c
D
L
= (0.40)($10,000) = $4,000.
2. We can calculate the value of Western Lumbers interest tax shield by comparing its value
with and without leverage. The expected return on Western Lumbers unlevered assets is
given by
r
A
=

D
V

r
D
+

E
V

r
E
=

0.5
0.5 + 1

(0.06) +

1
0.5 + 1

(0.10) = 8.67%.
If Western Lumber was all-equity nanced, then its value would be
V
U
=
$4.25M
0.0867 0.04
= $91.07M.
To calculate Western Lumbers levered value, we rst need to calculate its weighted-average
cost of capital:
WACC =
D
D +E
(1 t
c
)r
D
+
E
D +E
r
E
=
0.5
0.5 + 1
(1 0.35)(0.06) +
1
0.5 + 1
(0.10) = 7.97%.
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The levered value of Western Lumber is therefore
V
L
=
$4.25M
0.0797 0.04
= $107.14M.
This levered value exceeds the unlevered value by the present value of the interest tax shield,
that is, by
PV (interest tax shield) = V
L
V
U
= $107.14M$91.07M = $16.07M.
3. We have r
E
= 8.5%, r
D
= 7%, t
c
= 0.35, and D/E = 2.6 (which corresponds to D/V =
2.6
2.6+1
= 0.722).
(a) DSCs weighted average cost of capital is
WACC =
D
V
(1 t
c
)r
D
+
E
V
r
E
= (0.722)(1 0.35)(0.07) + (0.278)(0.085) = 5.65%.
(b) We know that the weighted average cost of capital satises
WACC =

1 t
c
D
V

r
A
5.65% =

1 (0.35)(0.722)

r
A
.
This implies that r
A
= 7.56%.
4. (a) Because Kurz Manufacturing is initially all-equity nanced, its value is the value of its
equity:
V
U
= E
U
= 20 million $7.50 = $150 million.
(b) Right after the debt is issued, Kurzs value increases by the amount of debt it raised
($50 million), and by the tax shield that this debt creates (0.40$50 million = $20 million).
That is, its value increases by $70 million.
(c) Before the debt is repurchased, the total value of the rm is $150 million+$70 million =
$220 million. Since the debt is worth $50 million (i.e., the debtholders get what they pay
for), the equity must be worth $220 million $50 million = $170 million. This implies
that Kurzs share price is $170 million 20 million = $8.50. This in turn implies that
the $50 million raised through the debt issue will allow Kurz to buy back $50 million
$8.50 = 5.882 million shares.
(d) After the share repurchase, the total market value of Kurz Manufacturing is $220 million
$50 million = $170 million. On the asset side of the balance sheet, Kurzs unlevered as-
sets are worth $150 million, as before, and the debt tax shield is $20 million. On the
liability side of the balance sheet, the debt is worth $50 million, and the equity is worth
$120 million (20 million 5.882 million = 14.118 million shares trading at $8.50 each).
5. The long-term debt is increased from $5,269 to
50% of book = 50%$16,408 = $8,204,
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that is it is increased by $8,204 $5,269 = $2,935. This implies that the debt tax shield is
increased by 0.40$2,935 = $1,174, and the market value of the rm is now $52,685+$1,174 =
$53,859. The new balance sheet (with market values) will look as follows:
Balance Sheet (market values in millions)
Net working capital 1,473 Long-term debt 8,204
Mkt value of long-term assets 51,212 Equity 45,655
PV(additional tax shields) 1,174
Total assets 53,859 Total liabilities 53,859
Before the change, the equity is worth $47,416, and 1,248 shares are outstanding, so that the
stock price is
P =
47,416
1,248
= 37.99.
Upon the rms announcement of its plans to repurchase shares, the rms value should
go up by the extra debt tax shield that this will generate. That is, the equity goes up to
$47,416 + $1,174 = $48,590, and each share is then worth
P

=
48,590
1,248
= 38.93.
The amount raised from the new debt, $2,935, is therefore used to repurchase
2,935
38.93
= 75.38 shares.
6. (a) When the tax rate is 30%, the asset beta (unlevered beta) of the solar heater project is

A
=

E
1 + (1 t
c
)
D
E
=
1.3
1 + (1 0.30)
2
3
= 0.8863.
Notice that the debt-to-equity ratio is
0.4
0.6
=
2
3
when the debt-to-value ratio is 0.4.
(b) If Hula is an all-equity nanced rm, the weighted average cost of capital for the project
is just the unlevered cost of equity. The unlevered cost of equity is given by the CAPM:
r
A
= r
unlevered
E
= r
f
+
A
(r
m
r
f
) = 0.08 + (0.8863)(0.14 0.08) = 13.32%.
(c) The levered beta corresponding to a debt-to-equity ratio of 2 is

levered
E
=

1 + (1 t
c
)
D
E

A
= [1 + (1 0.30)(2)] (0.8863) = 2.13.
Hence the return on equity corresponding to the leverage of 2 is given by the CAPM:
r
levered
E
= 0.08 + (2.13)(0.14 0.08) = 20.8%.
Thus the weighted average cost of capital for the project is
WACC =

D
V

p
(1 t
c
)r
p
D
+

E
V

p
r
p
E
= 0.667(1 0.30)(0.08) + 0.333(0.208) = 10.7%.
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(d) Hot Water may have a dierent capital structure and thus its weighted average cost of
capital is not applicable. Even though the business risk is the same, the dierence in
capital structure implies a dierent weighted average cost of capital.
(e) You are explicitly told that the new project has a lower debt capacity. Thus it can only
support 30 cents of debt for every dollar of asset value. Existing assets can support
66.67 cents. Thus the long run debt capacity of the new project is dierent. Hence we
need to account for this while doing our capital budgeting. The appropriate leverage
adjustment is the debt to value ratio of 0.3. First, the levered beta corresponding to the
debt to total value ratio of 0.3 is calculated as follows:

levered
E
=

1 + (1 t
c
)
D
E

A
=

1 + (1 0.30)
0.3
0.7

(0.8863) = 1.15.
The corresponding return on equity, as given by the CAPM, is
r
E
= 0.08 + 1.15(0.14 0.08) = 14.9%,
and the weighted average cost of capital is then
WACC =

D
V

p
(1 t
c
)r
p
D
+

E
V

p
r
p
E
= 0.3(1 0.30)(0.08) + 0.7(0.149) = 12.1%.
Hence 12.1% rather than 10.7% is the right answer.
7. (a) With a debt-to-value ratio of 40%, we have
D
E
=
40%
60%
= 2/3. We use the CAPM to
compute the cost of equity:
r
E
= r
f
+
E
(r
m
r
f
) = 0.10 + 1.6(0.20 0.10) = 26%.
Noticing that r
D
= 10% + 2% = 12%, we have
WACC =

D
V

(1 t
c
)r
D
+

E
V

r
E
= 0.40(1 0.20)(0.12) + 0.60(0.26) = 19.44%.
(b) The risk premium on XYZs debt is 0.02 =
D
(0.20 0.10), for a
D
of 0.2.
(i) When the debt is permanent, we can unlever the equity beta to get an (unlevered)
asset beta as follows:

A
=

E
+

D
E

(1 t
c
)
D
1 +

D
E

(1 t
c
)
=
1.6 +
2
3
(1 0.20)(0.2)
1 +
2
3
(1 0.20)
= 1.113.
Using CAPM, we nd
r
A
= r
f
+
A
(r
m
r
f
) = 0.10 + 1.113(0.20 0.10) = 21.13%.
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(ii) When the debt is constantly rebalanced, we can unlever the equity beta to get an
(unlevered) asset beta as follows:

A
=

D
V

D
+

E
V

E
= (0.40)(0.2) + (0.60)(1.6) = 1.040.
Using CAPM, we nd
r
A
= r
f
+
A
(r
m
r
f
) = 0.10 + 1.040(0.20 0.10) = 20.40%.
8. From the data we have r
m
= 0.16, r
f
= 0.08, D/V = 1/3, and E/V = 2/3. Also the beta of
an otherwise identical but unlevered rm is 0.9. This means that
r
A
= r
f
+ (r
m
r
f
)
A
= 0.08 + (0.16 0.08)(0.9) = 15.2%.
(a) WWI one-year coupon bonds have a face value of $1,000. One year from now, they will
pay the face value and the 7% coupon, i.e. 1,000(1 +0.07) = 1,070. Since WWIs bonds
are now selling for $972.72, we can deduct the value for WWIs (pre-tax) cost of debt:
r
D
=
1,070
972.72
1 = 10%.
(b) The weighted average cost of capital for a levered rm can be calculated as follows:
WACC
L
= r
A

D
V
t
c
r
D
= 0.152
1
3
(0.34)(0.10) = 14.06667%.
(c) Since
WACC
L
= r
D
(1 t
c
)
D
V
+r
E
E
V
,
we have
0.1406667 = 0.10(1 0.34)
1
3
+r
E
2
3
,
which implies r
E
= 17.80%.
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