I = Total capital investment d = CCA tax rate PV (OCF) after-tax savings = 900K (1.5M)(1-0.4) Lease or buy scanner?

Tc = Corporate tax rate r = Discount rate
Sn = Salvage value in year n n = Number of periods
The SML Approach Advantages
1.Explicitly adjusts for systematic risk
2. Applicable to all companies, as long as we can compute beta
Disadvantages
1. Have to estimate expected market risk, which varies over time
d. Have to estimate beta, which also varies over time
e. We are relying on the past to predict the future, which is not
always reliable
DGM Approach
Advantage – easy to understand and use
Disadvantages
1. Only applicable to companies currently paying dividends
2. Not applicable if divs aren’t growing at reasonably constant rate
3. Extremely sensitive to estimated growth rate
4. Does not explicitly consider risk
UNLEVERED FIRM = NO DEBT
LEASING
NAL = Initial Cost – PV(ATLP) – PV(CCATS) – PV (Salvage)
1. Find RD* = RD (1- Tc) = 15%(1-0.4) = 9% (dis S PV(CCATS)=[(950,000)(0.3)(0.4)/(0.3+0.072)]*[(1+0.5(0.072))/(1.
count rate w tax)
2. Find ATLP = LP (1-Tc) = (1,750,000)(1-0.4) = 1,050,000
3. Find PV(ATLP) = PVAD = [PMT, N, I, FV = 0]
4. Find PV(CCATS) use RD*
5. Find PV(salvage) salvage / (1+RD*)n
6. Solve for NAL
Indiff L.P: Set NAL = 0 and solve for LP
PV(ATLP) = 0 + initial cost - PV(CCATS) - PV(Salvage)
Solve for ATLP using calculator ATLP (PMT) = [ PV = ATLP, N,
I, FV=0]
BTLP = ATLP / (1-TC)
Types of Leases
1. Finacial = Longer-term, Lessee is responsible, not cancelable
2. Operating = Shorter-term, Lessor is responsible for
insurance, taxes and maintenance, Often cancelable.
Criteria For Capital Lease (One of the following must be met)
Lease transfers ownership by the end of lease term
Lessee can purchase asset at below market price
Lease term is for 75% or more of the life of the asset
PV lease pmt at least 90% of fair mkt value at the start of the lease
Relevant CFs Include
The saved cash outflow from purchase
Direct cash outflows (lease payments) from leasing,
Indirect costs such as loss of CCA tax deductions and salvage value
*BUYING VS LEASING* NAL < 0 = BUY NAL > 0 = LEASE
Reasons to Lease = Tax Differences, Agency & Transaction Costs
Good Reasons to Lease = Taxes may be reduced May reduce some
uncertainty May have lower transaction costs May require fewer
restrictive covenants May encumber fewer assets than borrowing
CAPITAL STRUCTURE
Capital restructuring involves changing the amount of leverage
a firm has without changing the firm’s assets
1. Increase leverage by issuing debt & repurchasing o/s shares
2. Decrease leverage by issuing new shares and retiring o/s debt
What is the primary goal of financial managers?
1. Choose capital structure that will maximize stockholder wealth
2. Maximize stockholder wealth by max. firm value or min. WACC
How does leverage affect the EPS and ROE of a firm?
When amount of debt financing increases, so does fixed interest
expense. If we have good year, then we pay fixed cost and have
more left over for stockholders If we have bad year, we still have to
pay our fixed costs and we have less left over for our stockholders
The effect of financial leverage depends upon EBIT?
EBIT = High, EPS & ROE raises If EBIT > break-even = good
EBIT = Low, EPS & ROE lowers If EBIT < break-even = bad
Modigliani and Miller (M&M) Theory of Capital Structure
Proposition I – firm value & Proposition II – WACC
Changing firm value = Change the CFs or risks of CFS
Assumptions Underlying M&M Model
There are no taxes, tax differentials, costs of financial distress &
transaction costs. Investors can diversify and seek debt at the same
rate/cost as firms.
Pecking Order Theory
Firms will use internal financing first, They will issue debt if
necessary, Equity is sold as a last resort.
DIVIDEND POLICY
Regular cash div. = Cash pmts made to stockholders each quarter
Extra cash dividend = Indication that extra amount may not repeat
Liquidating dividend = Some or all of the business has been sold
Ex-dividend date = Occurs 2 business days before date of record If
you buy stock on or after this date, you will not receive dividend
Stock price generally drops by about the amount of the dividend
Homemade Divs = Dividend policy is irrelevant when there are no
taxes or other market imperfections
P0 = D1 / (1+R) + D2 / (1+R)2 ….. R = discount rate
Shareholder who receives a div. greater than desired can
reinvest excess. Those who receives a div. smaller than desired
can sell extra shares of stock
Capital Budgeting – CHP 9,10,14 (Approx. 5-6 Questions)
ABC inc a new production system that will initially cost $5M .It
will save the firm $1.5M/yr in inventory and receivables
management costs.The system is expected to last for 5yrs and will
be depreciated at a CCA rate of 25%.The system is expected to
have a salvage value of $250K at the end of yr 5.The project
requires 50K of NWC which will be recovered at the end of the
project. Marginal tax rate = 40%. The required return = 8%.
Should the firm purchase the equipment?
PV (OCF) = PVA [900K=PMT, 5=N, I=8%] CMP PV = 3,593,439
PV(NCS) = -5m + 250,000/(1.08)^5 = -4,829,854
PV(CCATS) = [(5m)(0.25)(0.4)/(0.25+.08)]x(1.04/1.08) –
[(250,000)(0.25)(0.4)/(0.25+.08)]x(1/(1.08)^5) = 1,407,475
PV (NWC) = -50K + 50K/((1.08)^5) = -15,971
NPV = 3,593,439– 4,829,854 + 1,407,475 – 15,971 = $155,089
Original Machine = 200k initial cost, purchased 5y ago, salvage
today = 140k, salvage in 5y, = 20k New Machine =350k initial
cost, 5yr life, salvage in 5y = 5k, cost savings = 55k/yr, both have
CCA of 20%, req. rate = 10%, Tax Rate = 40% do you replace?
PV(OCF)= PVA [55K=PMT, N=5, I=10%] CMP PV = 208, 493
PV(NCS*)= -(350K-140K)+(5K-20K/(1.1)^5) = - 219,314
PV(CCATS) = [(210K)(0.2)(0.4)/(0.2+0.1)]x(1.05/1.1) –
[(-15K )(0.2)(0.4)/(0.2+0.1]x(1/(1.1)^5) = 55,938
NPV Replacement = 208,493 – 219, 413 + 55,938 = 45,117 YES
Machine A = 30K initial cost, 13K pre-tax operating cost, 5yr life.
Machine B = 20K initial cost, 15K pre-tax operating cost, 7yr life.
No change in NWC is required. Required return is 10%, CCA rate
is 20%, and tax rate is 40%. Which machine do you buy?(EAC)
NPV(A) = PVA[(13K)(1-0.4), 5yrs, 10%] +(30K+0)
+[(30K)(0.2)(0.4)/(0.2+0.1)x(1.05/1.1)-0] = -51,932
Do the same for machine B and put each NPVs as PV in calc. Use
respective Ns & 10% for I and compute PMT. Choose lowest EAC
ABC to pay a dividend of $5/share next year. There has been steady
growth in dividends of 3.95%/year and the market expects that to
continue. Current stock price is $25. What is cost of equity?
DGM: Re =5/25 + 0.0395 =
free rate is 4%. The market believes dividends will grow 5%/year
and our last dividend was $3. Our stock is currently selling for
$27.50. What is our cost of equity?
CAPM=4+(1.75)(7%)=16.25%
DGM = (3x1.05)/27.50 + 0.05 = 16.45%
Therefore cost of equity is between 16.25-16.45%
Bond issue currently outstanding that has 30 years left to maturity.
Coupon rate is 8% and coupons are paid semi-annually. Bond is
currently selling for $904.50 per $1K bond. What is cost of debt?
N= 60(30x2) PMT= 40(1K)(.08)/2 FV= 1K PV = -904.50
CMPT I = 4.459 x 2 = 8.92% is the cost of debt
Your company has preferred stock that has an annual dividend of
$6. If the current price is $50, what is the cost of preferred stock?
Rp = D/Po = 6/50 = 12%
You have a market value of equity equal to $100 million and a
market value of debt = $95 million. What cap. structure weights?
WE = E/V = 100/95 = 51.28% WD = D/V = 95/195 = 48.72%
Equity Info = 500K shares, $25/share, Beta = 1.25, market risk
premium = 9%, risk free rate = 5%. Debt Info = $10M o/s debt,
current quote = 95, coupon rate = 8% (semi), 20 YTM, tax = 40%.
A) what is cost of equity?
Re = 5% + (1.25)(9) = 16.25%
B) what is the cost of debt?
N=40(20x2) FV=1K PMT= 40 (8%)(1K)/2 PV= -950
CMP I = 4.263 x 2 = 8.53%
C) what are capital structure weights?
MVE = (500K)(25) = 12.5M MVD = (0.95)(10M) = 9.5M
V = 12.5M + 9.5M = 22M
WE = 12.5M/22M = 56.82% WD = 9.5M/22M = 43.18%
D) What is the WACC?
WACC = (0.5682)(16.25) + (0.4318)(8.53)(1-0.4) = 11.44%
ABC considering project that will cost $150K. Project will generate
after-tax cash flows of $46.5K/year for 5 yrs. Firm’s WACC = 15%
target D/E ratio is 0.75. Floatation cost for equity is 6% and 4% for
debt. What is NPV for project after adjusting flotation costs?
D/E = 0.75 = 0.75(debt)/1(equity) V = D+E = .75+1 = 1.75
Wd = 0.75/1.75= 42.86% We =1/1.75 = 57.14%
Weighted FC = (0.4268)(4%) + (0.5714)(6%) = 5.143%
Amt to raise = 150K/(1-0.05143) = $158, 133
NPV FC = -158,133 + PVA [PMT 45.6K, N=5, 15%] = -2,258
Leasing – CHP 22 (Approx. 5-6 Questions)
ABC needs new printer. The press would cost $950K if purchased
and would depreciate at CCA rate of 30%. After its 5-year life, the
press could be sold for $75K. You can lease press for 5yrs at
$220K/year and payments are due at the beginning of the year. Tax
rate 40% and firms cost of debt = 12%. Should you buy or lease?
After-tax RD= (12%)(1-0.4) = 7.2%
After-tax LP = ($220,000)(1-0.4) = 132,000
PV(ATLP) = PVAD($132,000, 5 years, 7.2%) = $577,101
072)] –[(75,000)(0.3)(0.4)/(0.3+0.072)]*[1/(1.072)5]= $279,071
PV(Salvage) = 75,000/(1.072)5= 52,977
NAL for lessee = 950,000 –577,101–279,071–52,977= $40,851
ABC is thinking about leasing a scanner costing $33.6M if
purchased. CCA rate = 35%, tax rate = 40%. Salvage value of
scanner after 4yrs = $4M. The firm can lease scanner for $9.35M/yr
(at start of year) for 4yrs. Pre-tax cost of borrowing is 10%.
After-tax RD= (10%)(1-0.4) = 6%
After-tax LP = ($9.35m)(1-0.4) = 5.61M
PV(ATLP) = PVAD($5.61m, 4years, 6%) = $20,605,597
PV(CCATS)=[(33.6m)(0.35)(0.4)/(0.35+0.06)]*[(1+0.5(0.06))/(1.0
6)] –[(4m)(0.35)(0.4)/(0.35+0.06)]*[1/(1.06)4]= $10,066,574
PV(Salvage) = $4m/(1.06)4= $3,168,375
NAL = 33.6m –20,605,597–10,066,574 –3,168,375
= $240,546 > 0 therefore buy the scanner
B) What are CFs from lessor’s point of view, with 40% tax rate?
Lessor nal = -33.6m+20,605,597+10,066,574+3,168,375 = 240,546
C)What would the lease payment have to be for both the lessor and
lessee to be indifferent to the lease?
Set NAL = 0 and solve for LP:
NAL for lessee = 33.6m –PV(ATLP)–10,066,574 –3,168,375
PV(ATLP) = 20,365,05
PV(ATLP) = 20,365,051 as PV in calc, n = 4, I = 6%, BGN mode
Compute PMT = ATLP = $5,544,510
BTLP = ATLP/(1-TC) = $5,544,510/(1-0.4) = $9,240,850
D) What is the NAL if the lessee does not pay taxes?
PV(BTLP) = PVAD[9.35m, 4 yrs, 10%] = $32,602,066
New PV(Salvage) = 4m/(1.1)4= $2,732,054
NAL = 33.6m –32,602,066–2,732,054 = -$1,734,120 buy scanner
What is the NAL of the computer from ABCs point of view?
PV(ATLP) = $7,769,284
PV(CCATS) =
[(12M)(0.4)(0.35)/(0.35+0.06))(1+(0.5)(0.06))/(1.06)] –
[(600K)(0.4)(0.35)/(0.35+0.06))(1/(1.06)^5] = $3,828,495
PV(Salvage) = 600K/(1.06)^5 = 448,355 Cost of printer = 12M
NAL == 12,000,000 – 7,769,284 – 3,828,495 – 448,355 = -$46,134
Suppose ABC tax rate is 0% (not 40%). What is maximum amount
per year that ABC would be willing to pay for the lease?
PV(Salvage) = 600,000/1.10^5 = 372,553
NAL = Cost – PV(BTLP) – PV(Salvage) 0 = 12,000,000 –
PV(BTLP) – 372,553 PV(BTLP) = $11,627,447
PV = 11,627,447, N = 5, I = 10%, compute PMT = 2,788,447
Suppose annual cost to maintain equipment is $2,500. Assuming
ABCs tax rate is still 0% and the maintenance cost would be
covered by the lease payment, how would the NAL be affected?
Annual maintenance cost = $2,500 N = 5, I = 10%, PMT = 2,500,
compute PV = $9,477 is the amount that would be increased
Capital Structure – CHP 16 (Approx. 11-12 Questions)
ABC has no debt outstanding and total market value of $8M. EBIT
is $900K next year. They consider debt issue of $5M with 10%
interest rate and will use the funds to buy back shares in the firm.
There are currently 200K shares outstanding and no taxes in the
economy. What is breakeven level of EBIT between the two capital
structures?
New shares = old # - shares repurchase = 200K–5M/$40(8M/200K)
= 200K – 125K = 75K Now need to find breakeven of EBIT
EBIT – 0 / 200K = EBIT – (5M)(0.1) /75K
750K(EBIT) = 200K (EBIT-500K) * Divide both by 10K *
7.5(EBIT) = 20 (EBIT-500K) or 7.5(EBIT) -20(EBIT) = -10M
-12.5(EBIT) = -10M EBIT = $800,000
(Homemade Leverage) ABC in above example DOES NOT
change its capital structure. An investor can replicate returns of the
proposed borrowing by making D/E ratio equal to that of the firm
under the proposed capital structure. If a shareholder owns 900
shares but prefers the CFs she gets under the proposed capital
structure: A) What strategy could she use to achieve those cash
flows? B) What would be her CF? C)What would be her ROE?
A) D/E = 5M/8M-5M = 5/3 Her equity = (900)(40) = 36K
To create 5/3 she must borrow (5/3)(36K) = 60K @ 10%
Shares bought = 60K/40 = 1,500 shares
Therefore, she must borrow 60K and buy 1500 shares
B) Her CF = (shares owned)(EPS) – interest
Her CF = (900+1500) x (900K/200K) – (60K)(0.1) = 4800
C) Her ROE = Her CF/Her Equity = 4800/36K = 13.33%
Suppose ABC DOES change its capital structure. An investor can
replicate the returns of the original capital structure by selling
shares in the ratio at which the firm is buying back and putting the
proceeds in the bank at the firm’s cost of borrowing. If a
shareholder with 800 shares before the change prefers the cash
flows she would have received under the all-equity capital
structure: A) What strategy could she use to achieve those cash
flows? B) What would be her CF? C)What would be her ROE?
A) To undo recap, investor sells same % of shares that firm is
buying back = use % debt added
% of debt = 5M/8M = 62.5% = she must sell 62.5% of shares
Shares to sell = (0.625)(800) = 500 shares
She will put (500)(40) = 20K into account paying 10% interest
Her strategy = Sell 500 shares & put proceeds in bank @ 10%
B) Her CF = (800-500) x (900K-500K/75K) + (20K)(0.1) = 3600
C) Her ROE = 3600/[(300)(40)+20K] = 11.25%
ABC debating whether to convert its all-equity capital structure to
one that is 30% debt. There are 15K shares outstanding, price per
share = $70. EBIT is $135K per year forever. The interest rate on
new debt is 6% and there are no taxes. DEF, a potential shareholder
of the firm, has $49K to invest in the company. Suppose the firm
does not convert but prefers the proposed capital structure with
debt. If DEF replicates the proposed structure using homemade
leverage, what will be there total cash flow?
D/E = 3/7 Old V = 1.05M (15K)(70) D = 315K (0.3)(1.05M)
To Create 3/7 we must borrow (3/7)(49K) = 21k @ 6%
The total 49K+21K= 70K will buy shares 70K/70 = 1000 shares
CFs = (1000)(135K/15K) – (21K)(0.06) = $7,740
OPA Inc. has a required return on assets of 16%, cost of debt of
10%, and is 45% financed with debt. What is cost of equity?
Re= 0.16 + (0.16 – 0.10) x (0.45/(1-0.45)) = 20.91%
Suppose cost of equity is 25%. What is the debt-to-equity ratio?
25% = 0.16 + (0.16 – 0.10) x (D/E)
9% = (0.06)(D/E) D/E =1.5
What would be the weight of equity in OPA?
D/E = 1.5/1 D = 1.5 E = 1 V = 1.5+1 = 2.5
We = 1/2.5 = 40%
ABC has a debt/equity ratio of 5/3. WACC is 12%, and cost of debt
is 7.8%. There are no taxes. What is cost of equity capital?
D/E = 5/3 V=5+3=8 We = 3/8 = 37.5% Wd= 5/8 =62.5%
12% = (0.375)(Re) + (0.625) (7.8)
(0.375)Re = 7.12 Re = 19%
What is the company's unlevered cost of equity capital?
19 = RA+(RA-7.8)(5/3)  19 = RA+(5/3)(RA) -13
32 = 8/3 RA  RA = 12%
What would the cost of equity be if the debt/equity ratio were 2?
If D = 2  We = 1/3 Wd = 2/3
12 = (1/3)(RE)+(2/3)(7.8)  1/3(RE) = 6.8 RE = 20.40%
(M&M Case II) 2 firms are identical except capital structure of
one is all-equity and other has a mix of debt/equity. Both firms
have annual EBIT of $100K per year forever and 40% tax rate. The
levered firm has $125K in 8% debt. What are annual CF for both?
NI (unlevered) = (100,000 –0)(1 –0.4) = $60,000
NI (levered) = [100,000 –(125,000)(0.08)](1 –0.4) = $54,000
CF from assets (unlevered) = CF to shareholders = $60,000
CF from assets (levered) = $54,000 + 10,000 = $64,000
Annual debt tax shield = (0.4)(10,000) = $4,000
PV(debt tax shield) = $4,000/0.08 = $50K OR
PV(debt tax shield) = D(RD)(TC)/RD= DTC= $125K(0.4) = $50K
5Step Corp. expects an EBIT of $180,000 every year forever. The
firm currently has no debt, and its cost of equity is 15%. The firm
can borrow $600,000 at 12% and buy back shares. The corporate
tax rate is 40%. What would be the value of the levered firm?
VU= EBIT * (1-Tc)/r= $180,000(1 –0.4)/0.15 = $720,000
VL= VU + (TC*D) = 720,000+ 600,000(0.4) = $960,000
What would be the value of the equity?
E = VL–D = 960,000 –600,000 = 360,000
What would be the cost of equity and WACC after the
recapitalization?
RE= = 15%+ (15% –12%)(600/360)(1–0.4) = 18%
WACC = (360/960)(18%) + (600/960)(12%)(1–0.4) = 11.25%
EBIT = $50 million; tax rate = 40% Debt = $150 million; cost of
debt = 9% Unlevered cost of capital = 12% What is firm’s equity?
VU= 50m(1 –0.4)/0.12 = $250M VL= 250m+ (150m)(0.4) =$310M
E = 310m–150m= $160 million
What is the firm’s cost of equity?
RE= 12%+ (12% –9%)(150/160)(1–0.4) = 13.69%
What is the firm’s WACC?
WACC = (160/310)(13.69%) + (150/310)(9%)(1–0.4) = 9.68%
Suppose the firm changes its capital structure so that the D/E ratio
becomes 1.5. What will happen to the cost of equity and WACC
under this new capital structure?
RE= 12 + (12 –9)(1.5)(1–0.4) = 14.7%
WACC = (0.4)(14.7) + (0.6)(9)(1–0.4) = 9.12%
ABC expects its EBIT to be $450K every year forever. The firm
currently has no debt, and can borrow funds at 10%. The firm is
thinking of borrowing $1.5M and using the proceeds to buy back
shares. Cost of equity is 15%. Tax rate is 40%. What would be the
cost of equity and WACC for this firm after the recapitalization?
VU= 450,000(1–0.4)/0.15 = $1,800,000
VL= 1,800,000 + (1,500,000)(0.4) = $2,400,000
E = 2.4M –1.5M = $900,000
RE= 15 + (15–10)(1500/900)(1–0.4)= 20%
WACC = (900/2400)(20) + (1500/2400)(10)(1–0.4) = 11.25%
ABC currently an all-equity firm with 2,800 shares outstanding, is
thinking of changing its capital structure. Two other options it is
considering are as follows: Plan I = 2.2K shares of stock & $33K in
debt. Plan II = 1.8K shares of stock & $55K in debt. The interest
rate on the debt is 10%. ignoring taxes, what are the break-even
levels of EBIT for each plan?
Plan 1: EBIT/2,800 = [EBIT –(0.10)($33,000)]/2,200
EBIT/2,800= [EBIT –3,300]/2,200
2,200(EBIT)= (2,800)(EBIT –3,300)
600EBIT = -92,400  EBIT = $15,400
Plan 2: EBIT/2,800 = [EBIT –(0.10)($55,000)]/1,800
EBIT/2,800= [EBIT –5,500]/1,800
1,800(EBIT)= (2,800)(EBIT –5,500)
1,000EBIT = -15.4m  EBIT = $15,400
Ignoring taxes, when will EPS be identical for plans I & II?
Set EPS from Plan I and Plan II equal to each other & solve EBIT,
[EBIT –3,300]/2,200 = [EBIT –5,500]/1,800
(1,800)(EBIT –3,300)= (2,200)(EBIT –5,500)
400EBIT = -6.16m  EBIT = $15,400
Assuming corporate tax rate is 40%. What happened to the break-
even levels of EBIT?
EBIT(1 –0.4)/2,800 = [EBIT –(0.10)($33,000)](1 –0.4)/2,200
0.6EBIT/2,800 = (0.6)[EBIT –3,300]/2,200
0.6(2,200)EBIT = (0.6)(2,800)[EBIT –3,300]
1,320EBIT = 1,680[EBIT –3,300] -
360EBIT =-5,544,000  EBIT = $15,400
Dividend Policy – CHP 17 (Approx. 6-7 Questions)
A $1 dividend declared on Aug 23 has a date of record of Sept 16
and will be paid on Oc 27. What is ex-dividend date?
ex-div. date is 2 biz days before date of record = September 14th
Will a shareholder who purchases the stock on September 13th
receive the dividend? September 14th?
Purchase stock on 13th = Yes 14th = No
Firm can either pay out dividends of $100K per year for next 2
years or can pay $90K in 1 year, reinvest the other $10K into the
firm and then pay $111.2K in 2 years. Require a 12% return.
Assume that the dividend in the second year will be a liquidating
dividend. What is the value of the firm in each case?
Option I: PV = 100,000/1.12 + 100,000/(1.12)2= 169,005.10
Option II: PV = 90,000/1.12 + 111,200 /(1.12)2= 169,005.10
ABC is all-equity that will pay div. of $24/share next year and
liquid div. of $18 at end of 2nd year. Current stock price
$36.69/share. No tax, discount rate =10%. If investor with 1K
shares used homemade divs. to generate equal divs. each period,
how many shares need to be bought/sold at end of the 1st year?
PV=36.69, N=2, FV = 0, I = 10%, Solve PMT= $21.14
Investor wants 1K * 21.14= $21,140 but gets 1K * 24= $24,000.
Investor has $2,860 extra = buys $2,860 worth of shares at T1.
P1= 18/1.1= $16.36  $2,860/16.36= 174.82 shares
Instead, investor wants first div. to double the size of second div.
what would size of the first div. and how would it be achieved?
$36.69= 2D/1.1+ D/(1.1)^2  Solve for D:
36.69(1.1)^2 = 2D(1.1)+ D
3.2D = 44.39  D= $13.87  D1= 2D2= (2)(13.87) = 27.7
Investor wants 1K * 27.74= $27,740 but gets 1K * 24= $24K.
Investor is short $3,740 and will sell shares
P1= 18/1.1= $16.36  $3,740/16.36= 228.61 shares
ABC is all-equity firm that will pay a div. of $10/share next year
and a liquidating div. of $18.50 at the end of the 2nd year. Current
stock price = $23.68/share. No tax and discount rate of 12%. If
investor w/ 500 shares wants to generate equal divs. in each period,
how many shares need to be bought or sold next year (year 1)?
N = 2, I = 12%, PV = $23.68 PMT = $14.01
Investor wants: $7,005 (500)(14.01) Investor gets: (500)(10) = 5K
Difference = 7,005–5,000 = $2,005 SHORT
Investor has to sell shares at time 1. P1 = $18.50/(1.12) = $16.52
# Shares sold = 2,005/16.52= 121.37 shares
Another investor with 500 shares wants exactly $3,500 (in total) at
year 1, how many shares would need to be bought or sold at year 1?
Investor wants: $3,500 Investor gets: (500)($10) = $5,000
Difference = 1,500 EXTRA! Investor buy shares at time 1.
P1 = $18.50/(1.12) = $16.52
# Shares bought = 1,500/16.52 = 90.8 shares
Firm needs $20 million for new investments. D/E ratio is 2/3. Net
Income this year will be $16M If firm follows a residual div.
policy, what would be amount of the dividend?
D/E = 2/3, V = 2 + 3 = 5, so D/V = 2/5 = 40% E/V = 3/5 = 60%
Finding div.:40% financed w/ debt: Debt need = 0.4 x $20m = 8M
60% financed with equity: Equity need = 0.6 x $20m = 12M
Dividend = max(Earnings–Equity need, 0)
= max($16million -$12million, 0)= $4M
Firm needs $14M for new investments. D/E ratio is 1.5. Its net
income this year will be $4M. If the firm follows a residual
dividend policy, what would be the amount of the dividend?
D = 1.5, E = 1 V = 2.5 wD= 1.5/2.5 = 60%, wE= 1/2.5 = 40%
Equity need= ($14m)(0.4) = $5.6m
Dividend = max($4m –5.6m, 0) = max(-$1.6m, 0)= 0
The balance sheet for ABC. as of Sept. 30th, 2017 is Cash=1M,
Assets=400K, Debt=200K, Equity=1.2M a day before the ex-
dividend day. On Sept. 12th, firm declared a 20% stock div. Firm
has 50K shares o/s before the payment of the stock dividend. A
shareholder currently (at Sept. 30th) owns 3K shares of ABC. How
many shares will he own after stock dividend has been paid?
- S/H will own 3,000(1.2)= 3,600 shares
What will be the price of Inbox Inc. shares on the ex-dividend day?
Total equity = $1.2m, total number of shares = (50K*(1.2)) = 60K
Price = $1.2m/ 60,000= $20
- Past Midterm Questions
KeeBored Inc. is deciding to lease or buy a new keyboard system
for its business. The system will generate $500K in annual pre-tax
cost savings. The system costs $2.5 million and qualifies for a 40%
CCA rate. The system will have a salvage value of $200K in 4
- years. Tax rate is 40%, and firm can borrow at 10%. AAA Corp.
has offered to lease system for payments of $600K/year. AAA
policy requires that its lessees make payments at 30 of year
What is the PV of the after-tax lease payments?
After-tax cost of debt = 10% x (1 – 0.4) = 6%
After-tax lease payment = $600,000 x (1 – 0.4) = $360,000
BGN mode: N = 4, I = 6%, PMT = 360L CMPT PV = $1,322,284
Suppose now that the total present value of all of the after-tax lease
payments is $1,600,000 (it’s not). What would be the NAL from
Acme Leasing Corp.’s point of view? AAA also faces a 40% tax
rate. PV(ATLP) = $1,600,000
PV(CCATS) = [((2.5m)(0.4)(0.4)/(0.46))(1+(0.5)(0.06))/(1.06)] –
[(200,000)(0.4)(0.4)/(0.46))(1/(1.06)^4] = $789,853
PV(Salvage) = 200,000/(1.06)^4 = 158,419 Cost of System = 2.5m
NAL = -2,500,000 + 1,600,000 + 789,853 + 158,419 = $48,271
Assume that KeeBored has a corporate tax rate of 0%. What is the
lease payment indifferent between leasing and buying?
PV(Salvage) = 200,000/(1.10)^4 = 136,603
NAL = Cost – PV(BTLP) – PV(Salvage)
0 = 2.5m – PV(BTLP) – 136,603
PV(BTLP) = $2,363,397
N = 4, I = 10%, PV = $2,363,397, compute PMT = $677,803(BGN)
How are the cost savings mentioned in the problem dealt with in
the NAL calculation for KeeBored Inc.?
The cost savings are irrelevant to KeeBored’s lease vs buy decision.
ABC is a firm that generates a perpetual EBIT of $1.5M per year.
Firm has no debt and has 250K shares outstanding. The cost of
capital is 12% and the beta of firm is 1.25. Firm is thinking of
issuing $6M in debt and using the proceeds to repurchase equity.
Firm borrows funds @ 7%. If there are no corporate taxes and
M&M Proposition I holds, what would be the market value of
Vyolin Corp. if it issues the debt and repurchases shares?
According to Proposition I (no-tax), the value of the firm will
remain unchanged. VU = 1.5m/0.12 = 12.5m VL = 12.5m
Assume now that ABCs corporate tax rate is 40%. If the firm does
the planned recapitalization, what would be the required return on
equity and its overall weighted average cost of capital?
VU = (1.5m)(1-0.4)/0.12 = 7.5m VL = 7.5m + (6m)(0.4) = 9.9m
D/E ratio = 6m/(9.9m-6m) = 1.5385
RE = 12 + (12 – 7)(1.5385)(1-0.4) = 16.62%
WACC = (3.9/9.9m)(16.62) + (6m/9.9m)(7)(1-0.4) = 9.09%
What would be the beta of the firm after it does the
recapitalization? ABC faces a tax rate of 40%.
Beta = (unlevered beta)(1 + D/E) = (1.25)(1+6m/3.9m) = 3.17
You own 1,000 shares in CuppaJoe. If you were to use homemade
dividends to generate equal dividends over the next two years, how
many shares would you need to buy or sell at end of first year?
PV = 110, N = 2, I = 8%, compute PMT = $61.68
The investor wants 1000 x 61.68 = 61,680
The investor gets 1000 x 10.80 = 10,800.
The investor is $50,880 short, and so will sell shares.
Price at time 1 = 116.64/1.08 = $108
Investor will sell 50,880/108 = 471.11 shares.
Suppose instead that you, as a very picky holder of 1K shares, want
the second dividend to be 12 times the size of the 1st dividend.
How many shares would you be buying or selling to do this?
110 = D/1.08 + 12D/(1.08)^2 = 110(1.08)^2 = 1.08D + 12D
13.08D = 128.3040 D = 9.81
The investor wants (1,000)(9.81) = 9,810
The investor gets (1,000)(10.80) = 10,800.
The investor has $990 extra, so they will buy shares.
Price at time 1 = 116.64/1.08 = $108
Investor will buy 990/108 = 9.17 shares.
A 10-for-4 stock split is equivalent to a ___stock dividend
10-4 stock split is equivalent to (10 – 4)/4 = 150% stock dividend.
Computer costs $4.25M has a depreciation rate of 25% per year,
and would be worth $1,200,000 in five years. The new monitor
would save the firm $1,540,000 per year before taxes on operating
costs. There is no impact on net working capital. The firm’s
weighted average cost of capital is 12% and the corporate tax rate is
40%. What would be the total PV of the after-tax cost?
After-tax cost savings = 1.54m(1 – 0.4) = 924,000
PV(OCF) = PVA[924,000, 5yrs, 12%] = $3,330,813
Pretend that your answer to the previous question was $3,500,000.
What would be the NPV of purchasing this system?
PV(OCF) = $3.5m PV(NCS) = -4.25m + 1.2m/(1.12)^5 = -4.25m +
680,912 = -3,569,088 PV(CCATS) = [(4.25m)(0.25)(0.4)/(0.37)]
(1.06/1.12) – [(1.2m)(0.25)(0.4)/(0.37)](1/(1.12)^5) = 903,084
NPV = 3.5m – 3,569,088 + 903,084 = $833,996
In the previous question, suppose the new monitor also requires
(NWC) by $15K when we buy it, and this investment will be
recovered at the end of year 5. What would happen to the NPV?
PV(NWC) = -155,000 + 155,000/(1.12)^5 = -155,000 + 87,951 = -
67,049 NPV declines by = $67,049
Plate Inc has 12K bonds outstanding with par value of $1K. Bonds
have a semi-annual coupon rate of 11%, mature in 11 years, and are
trading at $805 each. Common shares sell for $58 and there are
250K shares outstanding. The most recent dividend (paid
yesterday) was $7.50, this dividend is expected to grow 6% a year
in perpetuity. ABC beta is 2.1 and the firm’s corporate tax rate is
40%. What is cost of equity capital?
RE = D1/P0 + g = (7.50)(1.06)/58 + 0.06 = 19.71%
What is Plate’s after-tax cost of debt?
N=22, PMT = $55, FV = 1K PV = -805, compute I = 7.308%
cost debt = 14.616% after-tax cost debt =(14.616)(1–0.4) = 8.77%
Beleaf Inc. is considering an investment in new hardware
technology that would cost $8M, and would be financed with only
equity. Flotation costs are 5.5% of the amount of common stock
issued and Beleaf’s WACC is 12%. How much equity would
Beleaf have to issue so that, after flotation costs are paid?
Amt to issue = 8m/(1-0.055) = $8,465,608
Eminem Corp., produces candy files for bankruptcy. Eminem can
either (1) pay a cost of $100K today to reorganize, after which the
firm will earn annual cash flows of $187.5K forever, or (2)
liquidate all assets today for $1.8M What would discount rate have
to be to make firm indifferent between reorganizing & liquidating?
-100,000 + 187,500/r = 1.8m  187,500/r = 1.9m
R = 187,500/1.9m R = 9.87%
A firm is 100% equity financed and generates operating cash flows
of $3M per year. The corporate tax rate is 40%, and unlevered cost
of equity (RU) is 20%. firm raises $4.5M of debt at an interest rate
of 10% and using the proceeds to repurchase shares.
W(bond/unlev) Y(share/unlev) X(bond/lev) Z(share/lev)
What is the value of all? W = 0 X= 4.5M(0.10) = 450K
Z = [3m – (4.5m)(0.1)](1 – 0.4) = $1.53M
Soil Corp., an all-equity firm, generates EBIT of $570K/year in
perpetuity. There are currently 100K shares o/s and firm’s cost of
capital is 15%. The firm wants to recapitalize, where it would issue
$1.5M in debt and use the proceeds to repurchase equity. Soil Corp.
can issue the debt at a 7.5% What is Plate’s cost of equity capital?
If there no corporate taxes, no bankruptcy costs, or any other
market frictions, what would be the market value of Soil Corp. if it
issues the debt and repurchases shares? (Hint: MM Case I)
VU = 570,000/0.15 = $3.8m  VL = $3.8 million
Assume corp. tax is 40%. What is req. return of equity?
VU = (570K)(1-0.4)/0.15 = 2.28m VL = 2.28m + (1.5m)(0.4) =
2.88m E = 2.88m – 1.5m = 1.38m D/E ratio = 1.5m/1.38m
RE = 15 + (15 – 7.5)(1.5/1.38)(1-0.4) = 19.89%
What is required return on equity is 21%. What is WACC?
WACC = (1.38/2.88)(21) + (1.5/2.88)(7.5)(1-0.4) = 12.41%
Snarcos Inc. is an unlevered firm with 350K shares o/s trading at
$64. The firm changes cap. structure & issues $8.96 of debt at 8%
and using the proceeds to repurchase shares. No corp. tax or market
frictions. EPS of $10. Indifference EBIT between cap structures?
shares repur. = 8.96m/64 = 140K shares o/s = 350K–140K = 210K
EBIT/350K = (EBIT – 716.8K)/210K
210K EBIT = (350K)(EBIT – 716.8K)  -14EBIT = -25,088,000
EBIT = 1.792 million
Dexter owns 1,200 shares. Firm remains all-equity, but Dexter
prefers the CFs he would have received under the proposed capital
structure. Using HM leverage what would is his value of cash flow?
D/E = $8.96m/[(350K)(64) – 8.96m] = 2/3.
He needs to borrow 2/3X = (2/3)($64)(1200) = $51,200.
He takes 51.2K and buy 51,200/64 = 800 more shares in the firm.
His CF = ($10)(1200+800) – (51,200)(0.08) = $15,904.
Switch Inc. is an all-equity firm worth $6M w/ 100K shares o/s.
corporate tax rate is 40%. They decided to issue $2.5M of debt at
7% intrest and will use the proceeds to repurchase shares. What
would be the stock price of Switch Inc. after it has announced the
debt issue to the market but before it repurchases the shares?
Debt Issue = $2,500,000; debt tax shield = (2.5M)(0.4) = 1M
Old price = $6,000,000/100,000 = $60
New stock price = = $60 + 1m/100K = $70
Theory Accept IRR > Req R, HM Leverage = Case 1
when tax rates are same, the NAL = 0 for both (False)
operating lease on balance sheet (False), Increase Lev by selling
shares/paying debt, No structure = Case I, Structure Offset = P2,C1
the after-tax cost of debt(correct) Fin distress = place covenants,
increase # shares by payin div. and 2-1, GMA buy shares w high
div. Bonus = If on line A right of X, decr debt to lower fin distress