You are managing an unleveraged firm that pays

Info icon This preview shows pages 10–12. Sign up to view the full content.

View Full Document Right Arrow Icon
56. You are managing an unleveraged firm that pays corporate taxes on its net income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. You issue debt causing a $40 annual coupon payment (CPN). Your cost of debt (r d ) is 8%. The leverage would increase the shareholders' required return (r L ) to 16%. What was your firm worth when all-equity financed (V U ), and what is it now worth with leverage (V L )? a. V U = $500 and V L = $912.50 b. V U = $750 and V L = $912.50 c. V U = $750 and V L = $1,162.50 d. V U = $1,000 and V L = $1,162.50 [ ANSWER: Before issuing debt, your net worth is: V U = (1 – T) / r = (1 – 0.4)$150 = $90 / 0.12 = $750 . Under the proposed leveraging, D = CPN / r d = $40 / 0.08 = $500 and the value of the levered firm is: E L = (1 – T)( – CPN) / r L = (1 – 0.4)($150 – $40) / 0.16 = $66 / 0.16 = $412.50 . The total value is V L = D + E L = $500 + $412.50 = $912.50 .] d 57. You are managing an unleveraged firm that pays corporate taxes on its net income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. Now suppose your firm borrows money. Your coupon payment (CPN) is $48. Your cost of debt (r d ) is 8% per year and gives the $600 to the shareholders. The leverage would increase the shareholders' required return (r L ) to 15%. What is the gain in leverage (G L )? [ $90 / 0.12 = $750 . Under the proposed leveraging, D = CPN / r d = $48 / 0.08 = $600 and the value of the levered firm is: E L = (1 – T)( – CPN) / r L = (1 – 0.4)($150 – $48) / 0.16 = $61.2 / 0.15 = $408 . The total value is V L = D + E L = $600 + $408 = $1,008 . Thus, in this environment, the proposed leveraging increases shareholder value by: G L = V L – V U = $1,008 – $750 = $258 .] d 58. You are managing an unleveraged firm that pays corporate taxes on its net income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. Now suppose your firm borrows $500 at r d = 8% per year. The leverage would increase the shareholders' required return (r L ) to 16%. Which of the following is true? shareholders each year is $66 basis) [ net worth is: V U = (1 – T) / r = (1 – 0.4)$150 = $90 / 0.12 = $750 , compared to V U = (1 – T) / r = (1 – 0)$150 / 0.12 = $1,250 value without corporate taxes. This debt will require r d CPN = 0.08($500) = $40 per year in interest payments. Because the interest payments are made
Image of page 10

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
before corporate taxes are assessed, they cost only r d (1 – T)CPN = 0.08(1 – 0.4)$500 = $24 on an after-tax basis. After the capital structure change, the residual expected future cash flow to be paid out to shareholders each year is (given = $150 and CPN = $40): (1 – T)( – CPN) = (1 – 0.4)($150 – $40) = $66 . Therefore, under the proposed leveraging, shareholders would get D = CPN / r d = $40 / 0.08 = $500 from the debtholders in cash to invest as they wish and have a
Image of page 11
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern