18 CHAPTER Does Debt Policy Matter? Answers to Practice Questions 9. a. The two firms have equal value; let V represent the total value of the firm. Rosencrantz could buy one percent of Company Bs equity and borrow an amount equal to: 0.01 (DA - DB) = 0.002V This investment requires a net cash outlay of (0.007V) and provides a net cash return of: (0.01 Profits) (0.003 rf V) where rf is the risk-free rate of interest on debt. Thus, the two investments are identical. b. Guildenstern could buy two percent of Company As equity and lend an amount equal to: 0.02 (DA - DB) = 0.004V This investment requires a net cash outlay of (0.018V) and provides a net cash return of: (0.02 Profits) (0.002 rf V) Thus the two investments are identical. c. The expected dollar return to Rosencrantz original investment in A is: (0.01 C) (0.003 rf VA) where C is the expected profit (cash flow) generated by the firms assets. Since the firms are the same except for capital structure, C must also be the expected cash flow for Firm B. The dollar return to Rosencrantz alternative strategy is: (0.01 C) (0.003 rf VB) Also, the cost of the original strategy is (0.007VA) while the cost of the alternative strategy is (0.007VB). If VA is less than VB, then the original strategy of investing in Company A would provide a larger dollar return at the same time that it would cost less than the alternative. Thus, no rational investor would invest in Company B if the value of Company A were less than that of Company B.
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10.
When a firm issues debt, it shifts its cash flow into two streams. MMs Proposition I states that this does not affect firm value if the investor can reconstitute a firms cash flow stream by creating personal leverage or by undoing the effect of the firms leverage by investing in both debt and equity. It is similar with Carruthers cows. If the cream and skim milk go into the same pail, the cows have no special value. (If an investor holds both the debt and equity, the firm does not add value by splitting the cash flows into the two streams.) In the same vein, the cows have no special value if a dairy can costlessly split up whole milk into cream and skim milk. (Firm borrowing does not add value if investors can borrow on their own account.) Carruthers cows will have extra value if consumers want cream and skim milk and if the dairy cannot split up whole milk, or if it is costly to do so.
11.
a. b.
The market price of the stock is not affected by the announcement. Since the market price of the shares is $10, the company can buy back: $160 million/$10 = 16 million shares
c.
After the change in capital structure, the market value of the firm is unchanged: Equity + Debt = (9 million $10) + $160 million = $250 million
d.
After the change in structure, the debt ratio is: Debt/(Debt + Equity) = $160 million/$250 million = 0.64
e. 12. a.
No one gains or loses. (See the answer to the next question.) The market value of the firms equity increases by $30 million, the amount of the decrease in the market value of the firms existing debt. Therefore, the price of the stock increases to: ($150 million + $30 million)/15 million shares = $12
b.
Since the market price of the shares is $12, the company can buy back: $60 million/$12 = 5 million shares
c.
After the change in capital structure, the market value of the firm is unchanged: Equity + Debt = (10 million $12) + $130 million = $250 million
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d.
After the change in structure, the debt ratio is: Debt/(Debt + Equity) = $130 million/$250 million = 0.52
e.
The investors in the existing debt lose $30 million while the shareholders gain this $30 million. The value of each share increases by: $30 million/15 million shares = $2
13.
The company cost of capital is: rA = (0.8 0.12) + (0.2 0.06) = 0.108 = 10.8% Under Proposition I, this is unaffected by capital structure changes. With the bonds remaining at the 6% default-risk free rate, we have: Debt-Equity Ratio 0.00 0.10 0.50 1.00 2.00 3.00 rE 0.108 0.113 0.132 0.156 0.204 0.252 rA 0.108 0.108 0.108 0.108 0.108 0.108
See figure on next page. 14. This is not a valid objection. MMs Proposition II explicitly allows for the rates of return for both debt and equity to increase as the proportion of debt in the capital structure increases. The rate for debt increases because the debt-holders are taking on more of the risk of the firm; the rate for common stock increases because of increasing financial leverage. See Figure 18.2 and the accompanying discussion.
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Rates of Return
.250
rE
.200 .150 rA rD
.108
.060
1
2
3
Debt / Equity
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15.
a.
Under Proposition I, the firms cost of capital (rA) is not affected by the choice of capital structure. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller proportion of the firm is financed by equity. The overall effect is to leave the firms cost of capital unchanged. Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average return to stockholders. If the opportunity were the firms only asset, this would be a good deal. Stockholders would put up no money and, therefore, would have nothing to lose. However, rational lenders will not advance 100% of the assets value for an 8% promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for a particular investment. Such investments do not support all of the additional debt; lenders are protected by the firms other assets too. In any case, if firm value is independent of leverage, then any assets contribution to firm value must be independent of how it is financed. Note also that the statement ignores the effect on the stockholders of an increase in financial leverage.
b.
16.
a.
b.
This is not an important reason for conservative debt levels. So long as MMs Proposition I holds, the companys overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increasing probability of financial distressand that can be important.)
17.
Examples of such securities are given the in text and include unbundled stock units, preferred equity redemption cumulative stock and floating-rate notes. Note that, in order to succeed, such securities must both meet regulatory requirements and appeal to an unsatisfied clientele.
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18.
a.
As leverage is increased, the cost of equity capital rises. This is the same as saying that, as leverage is increased, the ratio of the income after interest (which is the cash flow stockholders are entitled to) to the value of equity increases. Thus, as leverage increases, the ratio of the market value of the equity to income after interest decreases. (i) Assume MM are correct. The market value of the firm is determined by the income of the firm, not how it is divided among the firms security holders. Also, the firms income before interest is independent of the firms financing. Thus, both the value of the firm and the value of the firms income before interest remain constant as leverage is increased. Hence, the ratio is a constant. (ii) Assume the traditionalists are correct. The firms income before interest is independent of leverage. As leverage increases, the firms cost of capital first decreases and then increases; as a result, the market value of the firm first increases and then decreases. Thus, the ratio of the market value of the firm to firm income before interest first increases and then decreases, as leverage increases.
b.
19.
We begin with rE and the capital asset pricing model: rE = rf + E (rm rf) = 0.10 + 1.5 (0.18 0.10) = 0.22 = 22.0% Similarly for debt: rD = rf + D (rm rf) 0.12 = 0.10 + D (0.18 0.10) D = 0.25 Also, we know that:
r
A
=
D
E r + D + E rE = (0.5 0.12) + (0.5 0.22) = 0.17 = 17.0% D D + E
To solve for A, use the following: D E A = D + E D + D + E E = (0.5 0.25) + (0.5 1.5) = 0.875
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20.
We know from Proposition I that the value of the firm will not change. Also, because the expected operating income is unaffected by changes in leverage, the firms overall cost of capital will not change. In other words, rA remains equal to 17% and A remains equal to 0.875. However, risk and, hence, the expected return for equity and for debt, will change. We know that rD is 11%, so that, for debt: rD = rf + D (rm rf) 0.11 = 0.10 + D (0.18 0.10) D = 0.125 For equity:
r
A
=
E r + D + E rE D D + E
D
0.17 = (0.3 0.11) + (0.7 rE) rE = 0.196 = 19.6% Also: rE = rf + E (rm rf) 0.196 = 0.10 + E (0.18 0.10) E = 1.20 21. [Note: In the following solution, we have assumed that $200 million of long-term bonds have been issued.] a. E = $55 10 million = $550 million V = D + E = $200 million + $550 million = $750 million D $200millio n = = 0.267 V $750millio n E $550millio n = = 0.733 V $750millio n After-tax WACC = r (1 T )
D C
D E +r EV V
= 0.07 (1 0.35) 0.267 + (0.12 0.733) = 0.1001 = 10.01%
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b.
The after-tax WACC would increase to the extent of the loss of the tax deductibility of the interest on debt. Therefore, the after-tax WACC would equal the opportunity cost of capital, computed from the WACC formula without the tax-deductibility of interest: WACC = r
D
D E +r = (0.07 0.267) + (0.12 0.733) = 0.1067 = 10.67% EV V
22.
We make use of the basic relationship:
r = r (1 T )
A D C
D E + rE V V
Since overall beta ( A) is not affected by capital structure or taxes, then: rA = rf + A (rm rf) = 0.06 + (1.5 0.08) = 0.18 The following table shows the value of rE for various values of D/E (and the corresponding values of D/V), derived from the above formula. The graph is on the next page.
D/E 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 D/V 0.00000 0.04762 0.09091 0.13043 0.16667 0.20000 0.23077 0.25926 0.28571 0.31034 0.33333 0.35484 0.37500 0.39394 0.41176 0.42857 0.44444 0.45946 0.47368 0.48718 0.50000 rA 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 0.18 rD 0.0600 0.0600 0.0600 0.0600 0.0600 0.0600 0.0610 0.0620 0.0630 0.0640 0.0650 0.0660 0.0670 0.0680 0.0690 0.0690 0.0700 0.0725 0.0750 0.0775 0.0800 rE 0.1800 0.1871 0.1941 0.2012 0.2082 0.2153 0.2221 0.2289 0.2356 0.2423 0.2489 0.2554 0.2619 0.2683 0.2746 0.2814 0.2876 0.2929 0.2981 0.3031 0.3080
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0.35000 0.30000 0.25000 Return 0.20000 0.15000 0.10000 0.05000 0.00000 0.00 0.20 0.40 D/E 0.60 0.80 1.00
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Challenge Questions 23. Assume the election is near so that we can safely ignore the time value of money. Because one, and only one, of three events will occur, the guaranteed payoff from holding all three tickets is $10. Thus, the three tickets, taken together, could never sell for less than $10. This is true whether they are bundled into one composite security or unbundled into three separate securities. However, unbundled they may sell for more than $10. This will occur if the separate tickets fill a need for some currently unsatisfied clientele. If this is indeed the case, then Proposition I fails. The sum of the parts is worth more than the whole. 24. Some shoppers may want only the chicken drumstick. They could buy a whole chicken, cut it up, and sell off the other parts in the supermarket parking lot. This is costly. It is far more efficient for the store to cut up the chicken and sell the pieces separately. But this also has some cost, hence the observation that supermarkets charge more for chickens after they have been cut. The same considerations affect financial products, but: a. The proportionate costs to companies of repackaging the cash flow stream are generally small. b. Investors can also repackage cash flows cheaply for themselves. In fact, specialist financial institutions can often do so more cheaply than the companies can do it themselves. 25. Firms that are able to identify an unsatisfied clientele and then design a financial service or instrument that satisfies the demands of this clientele can, in violation of MMs capital-structure irrelevance theory, enhance firm value. However, if this is done successfully by one financial innovator, others will follow, eventually restoring the validity of the MM irrelevance theory. If the financial innovation can be patented, the creator of the innovation can restrict the use of the innovation by other financial managers and thereby continue to use the innovation to create value. Consequently, MMs capitalstructure irrelevance theory would potentially be violated during the life of the patent.
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