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Capital Structure and Firm Value Capital structure decisions determine how firms are financed in the long-run.

Capital Structure and Firm Value

Capital structure decisions determine how firms are financed in the long-run. Depending on the circumstances, a firm's capital structure decision may increase its total value. In this section, you will be analyzing Activision Blizzard Inc's capital structure decision. Suppose you are working for Activision, currently an all-equity firm, and have been asked by your boss to analyze a potential debt issuance to repurchase shares. Complete the following tasks and present your answers in an easy to read format with all calculations rounded to 4 decimal places. There are two parts in this section.

Part I

For the first part, assume Activision pays no taxes. If you are troubled by why companies may pay no taxes, you can imagine that Activision has been granted a special exemption such that all of its income is not taxable. This is actually not at all that uncommon - General Electric paid no federal corporate income tax at all despite making a pro t of $5.1 billion from its US operations in 2010.

A.     Calculate WACC. Following the same steps as section 1, calculate Activision's WACC using a market risk premium of 7.6% and the risk-free rate that you obtained. Activision Blizzard Inc's ticker symbol on NASDAQ is ATVI. For this section, collect also the current stock price and number of shares outstanding. Hint: Activision is currently an all-equity firm, so there is no debt outstanding.

B.     Obtain cost of debt. Activision announces its intention to issue debt to repurchase equity. In particular, it will issue $2 billion of 10-year bonds at par to repurchase shares at market price. Assume Activision's bonds will be rated at A by rating agencies. Go to http://finance.yahoo.com/bonds/composite_bond_rates?bypass=true and find the yield to maturity for ten-year A-rated corporate bond.

C.     Activision plans to keep the bonds in perpetuity, i.e. it plans to roll over and reissue the bonds again at the same amount when the current bonds come due. Determine new market value of equity after the announcement. Activision will buy back shares at the market price after announcement. 3 What is the stock price after the announcement? How many shares will Activision buy back, and how many shares will Activision have after the buy back? What is the market value of equity after the buy back? What is the stock price after the shares are repurchased?

D.     What is the market value D/E ratio? Calculate Activision's required return on equity using


E.      Calculate Activision's new WACC after debt issuance and share repurchase.

F.      Explain the relationship between capital structure and WACC in this part.

Part II

For this part, assume Activision is subject to corporate tax rate of 35%. Go all the way back to step 1 of last part. We will redo the calculations of the first part, but now in the presence of taxes.

A.     Activision will issue $2 billion of 10-year bonds at par to repurchase shares at market price. Assume again that Activision plans to keep the bonds in perpetuity and they will be rated at A by rating agencies. Determine the present value of tax shield.

B.     Determine new market value of equity after the announcement. Activision will buy back shares at the market price after announcement. What is the stock price after the announcement? How many shares will Activision buy back, and how many shares will Activision have after the buy back? What is the market value of equity after the buy back? What is the stock price after the shares are repurchased? Hint: Use APV to value the levered firm.

C.     What is the market value D/E ratio? Calculate Activision's required return on equity using


D.     Calculate Activision's new WACC after debt issuance and share repurchase. Compare this WACC to the previous one without taxes and explain why they are the same or different.

E.      Based on the stock price, does the debt increase and share repurchase appear to be a good idea? Do you think Activision's executives should issue more debt than the $2 billion suggested in this case? What issues might the executives raise that are not considered in your analysis?

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