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Problem Set III Solutions - Capital Structure, Financing, and Financial Distress

# Problem Set III Solutions - Capital Structure, Financing, and Financial Distress

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Problem Set III Solutions Capital Structure, Financing, and Financial Distress 1. Let number of shares before repurchase be x. Thus earnings of the firm are thus \$6x and the market value of the firm is \$40x. After repurchase, the market value of the firm remains at \$40x. However to repurchase 0.25x of shares (leaving 0.75x shares outstanding), \$10x (25% of firm) of debt is issued. The yield on that debt is 6%. Thus annual interest is 0.06*10x = 0.6x. Hence earnings of the firm after interest payments at the new capital structure = 6x – 0.6x = 5.4x. Now earnings per share = 5.4x/0.75x = \$7.20. 2. Since the company is reducing the scale, WACC is the appropriate discount rate. To calculate WACC, first determine the cost of equity with CAPM = .06 + 1.2(.14 - .06) = 0.156. The cost of debt (after tax) = .08*(1 - .3) = 0.056. The debt-to-equity ratio is 2/3. That is the proportion of debt of total assets is 0.4 and that of equity is 0.6. Thus WACC = 0.4*.056 + 0.6*0.156 = .116 or 11.6%. The amount at which you can sell the P&E (after tax) = \$5 million – (\$5 - \$4)*0.3 million = \$4.7 Million. Annual sales reduce by \$1.5 million, costs reduce by \$1 million, and depreciation reduces by \$0.2 million (\$4 million/20). Thus CFAT = (-1.5 – (-1) – (-0.2))(1-0.3) + (-0.2) = -\$0.41 million NPV of selling = 4.7 –0.41* 20 116 . A = \$1,559,105.36 Hence reduce the production. 3. All numbers in this problem are in millions. Step 1: Assuming all equity The debt-to-equity ratio of the industry (a proxy for the pure play firm) is .5 and industry equity beta is 1.5. Beta of assets: 1.09 .75 * .5 1 1.5 ) T 1 ( * E D 1 E A = + = - + β = β Using CAPM E(R) for project = .06 + 1.09 *(.12 - .06) = 12.55% The incremental annual cash flows

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