Practice_problems_capital_structure2-KEY.pdf - Finance 550...

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Finance 550 Practice Problems Capital Structure 2 Questions 1-6: WAS IT AN ACCIDENT OR DID JILL WACC JACK? Jack and Jill Corporation is a leading producer of hydroelectric power. The firm currently has $900 in perpetual risk-free debt outstanding which has a coupon rate of 10% and sells at par. Last year the firm had $1,000 in revenue and that is expected to be the same this year. Over the last 5 years, SG&A expenses had been increasing at a rate of 3% per year, and are expected to be $100 next year. It is expected that the firm’s EBIT this year is $270 and their EBIT is expected to be constant through time. The firm has 40 shares of stock outstanding which trade on the Nasdaq under the symbol PAIL at $13.50 each. The firm faces a 40% tax rate. Assume that the firm’s cash flows are perpetual and that corporations and investors can borrow and lend at the same rate. The firm will pay out all its earnings as dividends. Today is February 25 th and the firm has just decided to retire its debt by issuing $900 in additional equity. No one except the insiders of the firm knows that the restructuring will occur. The firm plans on publicly announcing the restructuring on March 1 st and the actual issuance of equity and retirement of debt will occur on March 15 th . Assume that markets are semi-strong form efficient (in other words, prices will fully react as soon as the news is released). 1. Prior to the restructuring (i.e today), what is the EPS for Jack and Jill?
2. Prior to the restructuring (i.e today), what is the WACC for Jack and Jill?
1
2 We know that there is $900 in debt outstanding and the debt trades at par value which means the market value of the debt is also $900. Thus, D=900. We know that there are 40 shares of stock each trading at $13.50 which means that E=13.50*40 = 540. Because V=D+E, V=1,440. Knowing that the bonds trade at par value means that the cost of the debt (i.e. the YTM) is the same as the coupon rate so r d =0.10. (Remember from Fin I that when a bond trades at par, coupon rate=YTM). Lastly, we know that the tax rate is 40% so τ=0.40. Plugging in what we know, we have: e r 440 , 1 540 ) 4 . 0 1 ( 10 . 0 440 , 1 900 WACC The only thing we don’t know is R e . We could use MM proposition II to determine R e , but in order to do that, we would need to know R a , the return on the equity of an unlevered firm. Since we don’t know (yet) the return on equity of an equivalent unlevered firm, this method won’t help. However, we know that the firm’s EPS is $2.70 per share and that this value is expected to remain constant forever. This suggests a perpetuity. The present value

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