Unformatted text preview: sh flow for the company is: Cash flow = $7.50(100 shares) Cash flow = $750 b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is: V = $65(5,000) V = $325,000 Under the proposed capital structure, the firm will raise new debt in the amount of: D = 0.40($325,000) D = $130,000 349 This means the number of shares repurchased will be: Shares repurchased = $130,000/$65 Shares repurchased = 2,000 Under the new capital structure, the company will have to make an interest payment on the new debt. The net income with the interest payment will be: NI = $37,500 – .08($130,000) NI = $27,100 This means the EPS under the new capital structure will be: EPS = $27,100 / 3,000 shares EPS = $9.03 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $9.03(100 shares) Shareholder cash flow = $903.33 c. To replicate the proposed capital structure, the shareholder should sell 40 percent of their shares, or 40 shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of: Interest cash flow = 40($65)(.08) Interest cash flow = $208.00 The shareholder will receive dividend payments on the remaining 60 shares, so the dividends received will be: Dividends received = $9.03(60 shares) Dividends received = $542.00 The total cash flow for the shareholder under these assumptions will be: Total cash flow = $208 + 542 Total cash flow = $750 This is the same cash flow we calculated in part a. d. The capital structure is irrelevant because shareholders can create their own leverage or unlever the stock to create the payoff they desire, regardless of the capital structure the firm actually chooses. The rate of return earned will be the dividend yield. The company has debt, so it must make an interest payment. The net income for the company is: NI = $95,000 – .10($400,000) NI = $55,000 9. a. 350 The investor will receive dividends in proportion to the percentage of the company’s shares they own. The total dividends received by the shareholder will be: Dividends received = $55,000($30,000/$400,000) Dividends received = $4,125 So the return the shareholder expects is: R = $4,125/$30,000 R = .1375 or 13.75% b. To generate exactly the same cash flows in the other company, the shareholder needs to match the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net $30,000. The shareholder should then borrow $30,000. This will create an interest cash flow of: Interest cash flow = .10(–$30,000) Interest cash flow = –$3,000 The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive dividends in proportion to the percentage of the company’s share they own. The total dividends received by the shareholder will be: Dividends received = $95,000($60,000/$800,000) Dividends received = $7,125 The total cash flow for the shareholder will be: Total cash flow = $7,300 – 3,000 Total cash flow = $4,125 The shareholders return in this case will be: R = $4,125/$30,000 R = .1375 or 13.75% c. ABC is an all equity company, so: RE = RA = $95,000/$800,000 RE = .1188 or 11.88% To find the cost of equity for XYZ, we need to use M&M Proposition II, so: RE = RA + (RA – RD)(D/E)(1 – tC) RE = .1188 + (.1188 – .10)(1)(1) RE = .1375 or 13.75% 351 d. To find the WACC for each company, we need to use the WACC equation: WACC = (E/V)RE + (D/V)RD(1 – tC) So, for ABC, the WACC is: WACC = (1)(.1188) + (0)(.10) WACC = .1188 or 11.88% And for XYZ, the WACC is: WACC = (1/2)(.1375) + (1/2)(.10) WACC = .1188 or 11.88% When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital structure; this is M&M Proposition I without taxes. 10. With no taxes, the value of an unlevered firm is the interest rate divided by the unlevered cost of equity, so: V = EBIT/WACC $43,000,000 = EBIT/.11 EBIT = .11($43,000,000) EBIT = $4,730,000 11. If there are corporate taxes, the value of an unlevered firm is: VU = EBIT(1 – tC)/RU Using this relationship, we can find EBIT as: $43,000,000 = EBIT(1 – .35)/.11 EBIT = $7,276,923.08 The WACC remains at 11 percent. Due to taxes, EBIT for an allequity firm would have to be higher for the firm to still be worth $43 million. 12. a. With the information provided, we can use the equation for calculating WACC to find the cost of equity. The equation for WACC is: WACC = (E/V)RE + (D/V)RD(1 – tC) The company has a debtequity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and the weight of equity is 1/2.5, so WACC = .12 = (1/2.5)RE + (1.5/2.5)(.09)(1 – .35) RE = .2123 or 21.23% 352 b. To find the unlevered cost of equity, we need to use M&M Proposition II with taxes, so: RE = R0 + (R0 – RD)(D/E)(1 – tC) .2123 = R0 + (R0 – .09)(1.5)(1 – .35) RO = .1519 or 15.19% c. To find the cost of equity under different capital structures, we can again use M&M Proposition II with taxes. With a debtequity ratio of 2, the cost of...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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