Corporate_Finance_9th_edition_Solutions_Manual_FINAL0

# C setting the equations for eps from plan i and plan

This preview shows page 1. Sign up to view the full content.

This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: e equity risk that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage. No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise. 2. 3. 4. 5. 6. 7. Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it is practically impossible to determine the precise debt/equity ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more expensive, it’s probably true that the firm is too highly leveraged. It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses. Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level. 8. 9. 10. The basic goal is to minimize the value of non-marketed claims. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest NI EPS %∆ EP S b. Recession \$7,600 0 \$7,600 \$ 1.52 –60 Normal \$19,000 0 \$19,000 \$ 3.80 ––– Expansion \$24,700 0 \$24,700 \$ 4.94 +30 If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = \$225,000/5,000 Share price = \$45 Shares repurchased = Debt issued / Share price Shares repurchased =\$90,000/\$45 Shares repurchased = 2,000 The interest payment each year under all three scenarios will be: Interest payment = \$90,000(.08) = \$7,200 342 The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. EBIT Interest NI EPS %∆ EP S 2. a. Recession \$7,600 7,200 \$ 400 \$0.13 –96.61 Normal \$19,000 7,200 \$11,800 \$ 3.93 ––– Expansion \$24,700 7,200 \$17,500 \$ 5.83 +48.31 A table outlining the income statement with taxes for the three possible states of the economy is shown below. The share price is \$45, and there are 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest Taxes NI EPS %∆ EP S Recession \$7,600 0 2,660 \$4,940 \$0.99 –60 Normal \$19,000 0 6,650 \$12,350 \$2.47 ––– Expansion \$24,700 0 8,645 \$16,055 \$3.21 +30 b. A table outlining the income statement with taxes for the three possible states of the economy and assuming the company undertakes the proposed capitalization is shown below. The interest payment and shares repurchased are the same as in part b of Problem 1. EBIT Interest Taxes NI EPS %∆ EP S Recession \$7,600 7,200 140 \$ 260 \$0.09 –96.91 Normal \$19,000 7,200 4,130 \$7,670 \$2.56 ––– Expansion \$24,700 7,200 6,125 \$11,375 \$3.79 +48.31 Notice that the percentage change in EPS is the same both with and without taxes. 3. a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE: ROE = NI/\$225,000 343 The ROE for each state of the economy under the current capital structure and no taxes is: ROE %∆ RO E Recession 3.38% –60 Normal 8.44% ––– Expansion 10.98% +30 The second row shows the percentage change in ROE from the normal economy. b. If the company undertakes the proposed recapitalization, the new equity value will be: Equity = \$225,000 – 90,000 Equity = \$135,000 So, the ROE for each state of the economy is: ROE = NI/\$135,000 ROE %∆ RO E c. Recession 0.30% –96.61 Normal 8.74% ––– Expansion 12.96% +48.31 If there are corporate taxes and the company maintains its current capital structure, the ROE is: ROE %∆ RO E 2.20% –60 5.49% ––– 7.14% +30 If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is: ROE %∆ RO E 0.19% –96.61 5.68% ––– 8.43% +48.31 Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes. 4. a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS...
View Full Document

## 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 Texas-Tyler.

Ask a homework question - tutors are online