TEMA 1

1. Firma LMN i finaneaz operaiunile doar prin credite i profituri

reinvestite. Ea poate s mprumute sume nelimitate la o rat a
dobnzii de 12% atta timp ct se ncadreaz n structura de capital
optim-int, care prevede 45% capital de mprumut i 55% capital
propriu. Ultimul dividend pltit a fost de 2,4 um, iar creterea
constant ateptat a veniturilor i dividendelor este de 5%, iar
aciunile LMN se vnd n prezent cu 24 um/aciune. Impozitul pe
profitul corporativ este de 40%. Firma LMN are la dispoziie
urmtoarele oportuniti investiionale:
Proiect
A
B
C
D

Investiie iniial (mil um)

240
125
200
150

RIR (%)
13
12
11
10

Toate proiectele firmei sunt independente i au un nivel similar de

risc.
a)
b)
c)
d)

Care este costul profiturilor reinvestite pentru firma LMN?

Care este costul capitalului firmei LMN?
Care este bugetul de capital optim al firmei?
Dac presupunem c proiectul A a fost apreciat ca fiind foarte
riscant, n timp ce proiectele C i D au fost evaluate ca avnd
un risc sczut. Proiectul B are un nivel de risc mediu. Dac
firma LMN ajusteaz costul capitalului cu dou puncte
procentuale n plus sau n minus pentru a ine cont de risc. n
acest context care este bugetul de capital optim al firmei.

2. International Associates (IA) is just about to commence

operations as an international trading company. The firm will have
book assets of $10 million, and it expects to earn a 16% return on
the assets before taxes. However, because of certain tax
arrangements with foreign governments, IA will not pay any taxes;
that is, its tax rate will be zero. Management is trying to decide how
to raise the required $10 million. It is known that the capitalization
rate for all-equity firm in this business is 11%, that is k su = 11%.
Further, IA can borrow at a rate k d = 6%. Assume that the MM
assumptions apply.
a) Assuming to MM, what will be the value of IA if it uses no debt? If
it uses $6 million of 6% debt?
b) What are the values of the WACC and k s at debt levels of D = $0,
D = $6 million and D = $10 million? What effect does leverage have
on firm value? Why?
c) Assume the initial facts of the problem (kd = 6%, EBIT = $1.6
million, ksu = 11%), but now assume that a 40% federal-plus-state

corporate tax rate. Find the new market values for IA with zero debt
and with $6 million of debt, using MM formulas.
d) What are the values of the WACC and k s at debt levels of D = $0,
D = $6 million and D = $10 million, assuming a 40% corporate tax
rate?
e) What is the maximum dollar amount of debt financing that can be
used? What is the value of the firm at this debt level? What is the
cost of this debt?
3. The Rivoli Company has no debt outstanding, and it financial position is given by
the following data:
Asstes (book=market)
EBIT
Cost of equity
Stock price
Shares outstanding
Tax rate

$3,000,000
$500,000
10%
$15
200,000
40%

The firm is considering selling bonds and simultaneously

repurchasing some of its stock. If it uses $900,000 of debt, its cost
of equity will increase to 11% to reflect the increased risk. Bonds
can be sold at a cost, before tax, of 7%. Rivoli is a no-growth firm.
Hence, all its earnings are paid out as dividends, and earnings are
expectationally constant over time.
a. What effect would this use of leverage have on the value of
the firm?
b. What would be the price of Rivolis stock?
c. What happens to the firms earnings per share after the
recapitalization?
d. The $500,000 EBIT given previously is actually the expected
value from the following probability distribution:
Probability
10%
20%
40%
20%
10%

EBIT
-$100,000
200,000
500,000
800,000
1,100,000

What is the probability distribution of EPS with zero debt and with
$900,000 of debt? Which EPS distribution is riskier?
4. Pettit Printing Company has a total market value of $100 million,
consisting of 1 million shares selling for $50 per share and $50
million of 10% perpetual bonds now selling at par. The companys
EBIT is $13.24 million and its tax rate is 15%. Pettit can change its
capital structure by either increasing its debt to $70 million or
decreasing it to $30 million. If it decides to increase its use of
leverage, it must call its old bonds and issue new ones with a 12%

coupon. If it decides to decrease its leverage, it will call in its bonds

and replace them with new 8% coupon bonds. The company will sell
or repurchase stock at the new equilibrium price to complete the
capital structure change.
The firm pays out all earnings as dividends; hence, its stock is
a zero growth stock. If it increases leverage, cost of equity will be
16%. If it decreases leverage, cost of equity will be 13%.
a. What is the firms cost of equity at present?
b. Should the firm change its capital structure?
c. Suppose the tax rate is changed to 34%. This would lower
after-tax income and also cause a decline in the price of the
stock and the total value of the equity, other things held
constant. Calculate the new stock price (at $50 million of
debt).
d. Continue the scenario of Part c, but now re-examine the
question of the optimal amount of debt. Does the tax rate
change affect your decision about the optimal use of the
financial leverage?
5. Assume you have just been hired as business manager for
PizzaPlace, a pizza restaurant located adjacent to campus. The
companys EBIT was $500,000 last year, and since the universitys
enrollment is capped, EBIT is expected to remain constant (in real
terms) over time. Since no expansion capital will be required,
PizzaPlace plans to pay out all earnings as dividends. The
management group owns about 50% of the stock, and the stock is
traded in the over-the-counter market.
The firm is currently financed with all equity; it has 100,000
shares outstanding; and the current price $20 per share. When you
took your MBA corporate finance course, your instructor stated that
most firms owners would be financially better off if the firms used
some debt. When you suggested this to your new boss, he
encouraged you to pursue the idea. As a first step, assume that you
obtained form the firms investment banker the following estimated
costs of debt and equity for the firm at different debt levels (in
thousands of dollars):
Amount borrowed
$ 0
250
500
750
1,000

kd
10%
11%
13%
16%

ks
15%
15.5%
16.5%
18.0%
20.0%

If the company were to recapitalize, debt would be issued, and

the funds received would be used to repurchase stock. PizzaPlace is
in the 40% corporate tax bracket.
a. Now, to develop an example that can be presented to
PizzaPlaces management to illustrate the effects of financial
leverage, consider two hypothetical firms: Firm U, which uses

no debt financing, and Firm L, which uses $10,000 of 12%

debt. Both firms have $20,000 in assets, a 40% tax rate, and
an expected EBIT of $3,000.
(1) Construct partial income statements, which start with EBIT,
for the two firms.
(2) Now calculate return on equity (ROE) for the two firms.
(3) What does this example illustrate about the impact of
financial leverage on ROE?
b. (1) What is business risk? What factors influence a firms
business risk?
(2) What is operating leverage, and how does it affect a firms
business risk?
c. (1) What is meant by financial leverage and financial risk?
(2) How does financial risk differ form business risk?
d. Now consider the fact that EBIT is not known with certainty,
but rather has the following probability distribution:
Economic state
Probability
EBIT
Bad
25%
$2,000
Average
50%
3,000
Good
25%
4,000

e.
f.
g.

h.

Redo the Part a) of the analysis for Firms U and L, but add
basic earning power (BEP), return on investment (ROI) defined
as (Net Income + Interest)/(Debt + Equity), and timesinterest-earned (TIE) ratio to the outcome measures. Find the
values for each firm in each state of the economy, and then
calculate the expected values. Finally, calculate the standard
deviation and coefficient of variation of ROE. What does this
example illustrate about the impact of debt financing on risk
and return?
How are financial and business risk measured in a stand-alone
risk framework?
What does capital structure theory attempt to do? What
lessons can be leaned from capital structure theory?
With the above points in mind, now consider the optimal
capital structure for PizzaPlace.
(1)What valuation equations can you use in the analysis?
(2)Could either the MM or the Miller capital structure theories
be applied directly in this analysis based, and if you
presented an analysis based on these theories, how do you
think the owners would respond?
(1) Describe briefly, without using numbers, the sequence of
events that would take place if PizzaPlace does recapitalize.
(2) What would be the new stock price if PizzaPlace
recapitalized and used these amounts of debt: $250,000;
$500,000; $750,000.
(3) How many shares would remain outstanding after
recapitalization under each debt scenario?

(4) Considering only the levels of debt discussed, what is

PizzaPlaces optimal capital structure?
i. It is also useful to determine the effect of any proposed
recapitalization on EPS. Calculate EPS at debt levels of $0,
$250,000, $500,000, $750,000 assuming that the firm begins
with zero debt and recapitalizes to each level of debt in a
single step. Is EPS maximized at the same level that
maximizes stock price?
j. Calculate the firms WACC at each level of debt. What is the
relationship between the WACC and the stock price?
k. Suppose that you discovered the PizzaPlace had more business
risk than you originally estimated. Describe how this would
affect the analysis. What if the firm has less business risk than
originally estimated?