FIN 4610 HW#1

Score: 100 out of 100 points (100%)

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10 out of10.00 points

Pendergast, Inc., has no debt outstanding and a total market value of $117,000. Earnings before interestand taxes, EBIT, are projected to be $8,300 if economic conditions are normal. If there is strong expansionin the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percentlower. Pendergast is considering a $41,700 debt issue with an interest rate of 5 percent. The proceeds willbe used to repurchase shares of stock. There are currently 3,900 shares outstanding. Ignore taxes for thisproblem.

Requirement 1:(a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is

issued. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g.,32.16).)

EPS Recession $ 1.45 Normal $ 2.13 Expansion $ 2.62

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do notround intermediate calculations. Negative amounts should be indicated by a minus sign.Round your answers to 2 decimal places (e.g., 32.16).)

%ΔEPS Recession -32 % Expansion 23 %

Requirement 2:Assume Pendergast goes through with recapitalization.

(a) Calculate earnings per share, EPS, under each of the three economic scenarios after therecapitalization. (Do not round intermediate calculations. Round your answers to 2 decimalplaces (e.g., 32.16).)


(b) Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimalplaces (e.g., 32.16).)

%ΔEPS Recession -43.00 %

Expansion 31.00 %

rev: 11_12_2013_QC_40178

WorksheetLearning Objective: 16-01 Theeffect of financial leverage.

Pendergast, Inc., has no debt outstanding and a total market value of $117,000. Earnings before interestand taxes, EBIT, are projected to be $8,300 if economic conditions are normal. If there is strong expansionin the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percentlower. Pendergast is considering a $41,700 debt issue with an interest rate of 5 percent. The proceeds willbe used to repurchase shares of stock. There are currently 3,900 shares outstanding. Ignore taxes for thisproblem.

Requirement 1:(a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is

issued. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g.,32.16).)

EPS

Recession $ 1.45 ± 1%

Normal $ 2.13 ± 1%

Expansion $ 2.62 ± 1%

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do notround intermediate calculations. Negative amounts should be indicated by a minus sign.Round your answers to 2 decimal places (e.g., 32.16).)

%ΔEPS

Recession -32 ± 1% %

Expansion 23 ± 1% %

Requirement 2:Assume Pendergast goes through with recapitalization.

(a) Calculate earnings per share, EPS, under each of the three economic scenarios after therecapitalization. (Do not round intermediate calculations. Round your answers to 2 decimalplaces (e.g., 32.16).)

EPS


Normal $ 2.48 ± 1%


(b) Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimalplaces (e.g., 32.16).)

%ΔEPS

Recession -42.74 ± 1% %

Expansion 30.72 ± 1% %

rev: 11_12_2013_QC_40178 Explanation:

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1:A table outlining the income statement for the three possible states of the economy is shown below. TheEPS is the net income divided by the 3,900 shares outstanding. The last row shows the percentage changein EPS the company will experience in a recession or an expansion economy.

Recession Normal Expansion EBIT $ 5,644 $ 8,300 $10,209 Interest 0 0 0

NI $ 5,644 $ 8,300 $10,209 EPS $ 1.45 $ 2.13 $ 2.62 %ΔEPS –32% – +23%

2:If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity / Shares outstandingShare price = $117,000 / 3,900Share price = $30

Shares repurchased = Debt issued / Share priceShares repurchased = $41,700 / $30Shares repurchased = 1,390

The interest payment each year under all three scenarios will be:Interest payment = $41,700(0.05)Interest payment = $2,085

The last row shows the percentage change in EPS the company will experience in a recession or anexpansion economy under the proposed recapitalization.

Recession Normal Expansion EBIT $ 5,644 $ 8,300 $10,209 Interest 2,085 2,085 2,085

NI $ 3,559 $ 6,215 $ 8,124

EPS $ 1.42 $ 2.48 $ 3.24 %ΔEPS –42.74% – +30.72%

Pendergast, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interestand taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strongexpansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25percent lower. Pendergast is considering a $95,000 debt issue with an interest rate of 8 percent. Theproceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding.Pendergast has a tax rate of 35 percent.

a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))

EPS

Recession $ 2.93 Normal $ 3.90 Expansion $ 4.49

a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

Percentage changes in EPS Recession -25 % Expansion 15 %

b-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS)under each of the three economic scenarios assuming the company goes through with recapitalization.(Round your answers to 2 decimal places. (e.g., 32.16))


b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands orenters a recession. (Negative amounts should be indicated by a minus sign. Round youranswers to 2 decimal places. (e.g., 32.16))

Percentage changes in EPS Recession -32.00 % Expansion 19.00 %

WorksheetLearning Objective: 16-02 Theimpact of taxes and bankruptcy oncapital structure choice.

Pendergast, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interestand taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strongexpansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25percent lower. Pendergast is considering a $95,000 debt issue with an interest rate of 8 percent. Theproceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding.Pendergast has a tax rate of 35 percent.

a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))

EPS


Normal $ 3.90 ± 1%


a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

Percentage changes in EPS



b-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS)under each of the three economic scenarios assuming the company goes through with recapitalization.(Round your answers to 2 decimal places. (e.g., 32.16))

EPS


Normal $ 8.39 ± 1%


b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands orenters a recession. (Negative amounts should be indicated by a minus sign. Round youranswers to 2 decimal places. (e.g., 32.16))

Percentage changes in EPS

Recession -31.69 ± 1% %


Explanation:

a.

A table outlining the income statement with taxes for the three possible states of the economy is shownbelow. The share price is $25, and there are 6,000 shares outstanding. The last row shows the percentagechange in EPS the company will experience in a recession or an expansion economy.

Recession Normal Expansion EBIT $ 27,000 $ 36,000 $ 41,400 Interest 0 0 0 9,450 12,600 14,490 NI $ 17,550 $ 23,400 $ 26,910 EPS $ 2.92 $ 3.90 $ 4.48 %ΔEPS – 25 — + 15

b.

If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstandingShare price = $150,000/6,000Share price = $25 Shares repurchased = Debt issued / Share priceShares repurchased = $95,000/$25Shares repurchased = 3,800 The interest payment each year under all three scenarios will be: Interest payment = $95,000(0.08) = $7,600

A table outlining the income statement with taxes for the three possible states of the economy andassuming the company undertakes the proposed capitalization is shown below. The last row shows the percentage change in EPS the company will experience in a recession or anexpansion economy under the proposed recapitalization.

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Recession Normal Expansion EBIT $ 27,000 $ 36,000 $ 41,400 Interest 7,600 7,600 7,600 6,790 9,940 11,830 NI $ 12,610 $ 18,460 $ 21,970 EPS $ 5.73 $ 8.39 $ 9.99 %ΔEPS – 31.69 — + 19.01

Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interestand taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strongexpansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. Theproceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignoretaxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))

ROE Recession 12.27 % Normal 16.36 % Expansion 19.31 %

a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

% change in ROE Recession -25 % Expansion 18 %

Assume the firm goes through with the proposed recapitalization.

b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Round youranswers to 2 decimal places. (e.g., 32.16))


b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimalplaces. (e.g., 32.16))

% change in ROE Recession -34.63 % Expansion 24.92 %

Assume the firm has a tax rate of 35 percent.

c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))


c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

% change in ROE Recession -25 % Expansion 18 %

c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firmgoes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16))

ROE Recession 11.63 %

Normal 17.79 %

Expansion 22.22 %

c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands orenters a recession. (Negative amounts should be indicated by a minus sign. Round youranswers to 2 decimal places. (e.g., 32.16))

% change in ROE Recession -34.63 % Expansion 24.92 %


Learning Objective: 16-02 Theimpact of taxes and bankruptcy oncapital structure choice.

Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interestand taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strongexpansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. Theproceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignoretaxes for questions a and b. Assume the company has a market-to-book ratio of 1.0.

a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))

ROE

Recession 12.27 ± 1% %

Normal 16.36 ± 1% %


a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

% change in ROE



Assume the firm goes through with the proposed recapitalization.

b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Round youranswers to 2 decimal places. (e.g., 32.16))

ROE


Normal 27.37 ± 1% %


b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimalplaces. (e.g., 32.16))

% change in ROE

Recession -34.62 ± 1% %


Assume the firm has a tax rate of 35 percent.

c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt isissued. (Round your answers to 2 decimal places. (e.g., 32.16))

ROE


Normal 10.64 ± 1% %


c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign.)

% change in ROE



c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firmgoes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16))

ROE


Normal 17.79 ± 1% %


c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands orenters a recession. (Negative amounts should be indicated by a minus sign. Round youranswers to 2 decimal places. (e.g., 32.16))

% change in ROE

Recession -34.62 ± 1% %

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Explanation:

a.

Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the marketvalue of equity. Using the equation for ROE: ROE = NI/$220,000 The ROE for each state of the economy under the current capital structure and no taxes is:

Recession Normal Expansion ROE 0.1227 0.1636 0.1931 %ΔROE – 25 — + 18

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 = $220,000 – 125,000Equity = $95,000 So, the ROE for each state of the economy is: ROE = NI/$95,000

Recession Normal Expansion ROE 0.1789 0.2737 0.3419 %ΔROE – 34.62 — + 24.92

c.

If there are corporate taxes and the company maintains its current capital structure, the ROE is:

ROE 0.0798 0.1064 0.1255 %ΔROE – 25 — + 18

If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for eachstate of the economy is:

ROE 0.1163 0.1779 0.2222 %ΔROE – 34.62 — + 24.92

The percentage change in ROE is the same with or without taxes.

Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and alevered plan (Plan II). Under Plan I, the company would have 150,000 shares of stock outstanding. UnderPlan II, there would be 100,000 shares of stock outstanding and $1.20 million in debt outstanding. The

interest rate on the debt is 5 percent, and there are no taxes.

a. If EBIT is $300,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS Plan I $ 2.00 Plan II $ 2.40

b. If EBIT is $550,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS Plan I $ 3.67 Plan II $ 4.90

c. What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer indollars, not millions of dollars, i.e. 1,234,567.)

Break-even EBIT $ 180,000


Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and alevered plan (Plan II). Under Plan I, the company would have 150,000 shares of stock outstanding. UnderPlan II, there would be 100,000 shares of stock outstanding and $1.20 million in debt outstanding. Theinterest rate on the debt is 5 percent, and there are no taxes.

a. If EBIT is $300,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS

Plan I $ 2.00 ± 1%

Plan II $ 2.40 ± 1%

b. If EBIT is $550,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS

Plan I $ 3.67 ± 1%

Plan II $ 4.90 ± 1%

c. What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer indollars, not millions of dollars, i.e. 1,234,567.)

Break-even EBIT$

180,000 ± 0.1%

Explanation:

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a.

Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPSunder this capitalization will be: EPS = $300,000/150,000 sharesEPS = $2.00 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment isthe amount of debt times the interest rate, so: NI = $300,000 – 0.05($1,200,000)NI = $240,000 And the EPS will be: EPS = $240,000/100,000 sharesEPS = $2.40 Plan II has the higher EPS when EBIT is $300,000. b.

Under Plan I, the net income is $550,000 and the EPS is: EPS = $550,000/150,000 sharesEPS = $3.67 Under Plan II, the net income is: NI = $550,000 – 0.05($1,200,000)NI = $490,000 And the EPS is: EPS = $490,000/100,000 sharesEPS = $4.90 Plan II has the higher EPS when EBIT is $550,000. c.

To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal toeach other and solve for EBIT. The breakeven EBIT is: EBIT/150,000 = [EBIT – 0.05($1,200,000)]/100,000EBIT = $180,000

Rise Against Corporation is comparing two different capital structures, an all-equity plan (Plan I) and alevered plan (Plan II). Under Plan I, the company would have 190,000 shares of stock outstanding. UnderPlan II, there would be 140,000 shares of stock outstanding and $1.95 million in debt outstanding. Theinterest rate on the debt is 8 percent and there are no taxes.

Use M&M Proposition I to find the price per share. (Round your answer to 2 decimal places. (e.g.,32.16))

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Share price $ 39.00 per share

What is the value of the firm under each of the two proposed plans? (Do not round intermediatecalculations and round your final answers to the nearest whole dollar amount. (e.g., 32))

All equity plan $ 7,410,000

Levered plan $ 7,410,000


Rise Against Corporation is comparing two different capital structures, an all-equity plan (Plan I) and alevered plan (Plan II). Under Plan I, the company would have 190,000 shares of stock outstanding. UnderPlan II, there would be 140,000 shares of stock outstanding and $1.95 million in debt outstanding. Theinterest rate on the debt is 8 percent and there are no taxes.

Use M&M Proposition I to find the price per share. (Round your answer to 2 decimal places. (e.g.,32.16))

Share price $ 39.00 ± 1% per share

What is the value of the firm under each of the two proposed plans? (Do not round intermediatecalculations and round your final answers to the nearest whole dollar amount. (e.g., 32))

All equity plan $ 7,410,000 ± 0.01%

Levered plan $ 7,410,000 ± 0.01%

Explanation:

We can find the price per share by dividing the amount of debt used to repurchase shares by the number ofshares repurchased. Doing so, we find the share price is: Share price = $1,950,000/(190,000 – 140,000)Share price = $39.00 per share

The value of the company under the all-equity plan is: V= $39.00(190,000 shares) = $7,410,000 And the value of the company under the levered plan is: V = $39.00(140,000 shares) + $1,950,000 debt = $7,410,000

Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and$100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on

the debt is 8 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $90,000.The all-equity plan would result in 18,000 shares of stock outstanding. What is the EPS for each ofthese plans? (Round your answers to 2 decimal places. (e.g., 32.16))

EPS Plan I $ 5.91 Plan II $ 7.00 All equity $ 5.00

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equityplan?

EBIT Plan I and all-equity $ 36,000 Plan II and all-equity $ 36,000

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II?

EBIT $ 36,000

d-1 Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round youranswers to 2 decimal places. (e.g., 32.16))

EPS Plan I $ 3.51 Plan II $ 4.20 All equity $ 3.00

d-2 Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for eachplan as compared to that for an all-equity plan?

EBIT Plan I and all-equity $ 36,000 Plan II and all-equity $ 36,000

d-3 Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II?

EBIT $ 36,000


Learning Objective: 16-02 The

impact of taxes and bankruptcy oncapital structure choice.

Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and$100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate onthe debt is 8 percent.

a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $90,000.The all-equity plan would result in 18,000 shares of stock outstanding. What is the EPS for each ofthese plans? (Round your answers to 2 decimal places. (e.g., 32.16))

EPS

Plan I $ 5.86 ± 1%

Plan II $ 7.00 ± 1%

All equity $ 5.00 ± 1%

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equityplan?

EBIT

Plan I and all-equity $ 36,000 ± 0.1%

Plan II and all-equity $ 36,000 ± 0.1%

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II?

EBIT $ 36,000 ± 0.1%

d-1 Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round youranswers to 2 decimal places. (e.g., 32.16))

EPS

Plan I $ 3.51 ± 1%

Plan II $ 4.20 ± 1%

All equity $ 3.00 ± 1%

d-2 Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for eachplan as compared to that for an all-equity plan?

EBIT

Plan I and all-equity$ 36,000 ± 0.1%

Plan II and all-equity$ 36,000 ± 0.1%

d-3 Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II?

EBIT $ 36,000 ± 1%

Explanation:

a.

The income statement for each capitalization plan is:

I II All-

equity

EBIT $ 90,000 $ 90,000 $ 90,000 Interest 8,000 14,400 0 NI $ 82,000 $ 36,000 $ 90,000 EPS $ 5.86 $ 7.00 $ 5.00

The Plan II has the highest EPS; All equity has the lowest EPS.

b.

The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is

calculated as: EPS = (EBIT – RDD)/Shares outstanding

This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which results in the net

income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, theinterest term is zero. To find the breakeven EBIT for two different capital structures, we simply set theequations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capitalstructure and Plan I is: EBIT/18,000 = [EBIT – 0.08($100,000)]/14,000EBIT = $36,000 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT/18,000 = [EBIT – 0.08($180,000)]/10,800EBIT = $36,000 The break-even levels of EBIT are the same because of M&M Proposition I. c.

Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: [EBIT – 0.08($100,000]/14,000 = [EBIT – 0.08($180,000)]/10,800EBIT = $36,000 This break-even level of EBIT is the same as in part b again because of M&M Proposition I.

d.

The income statement for each capitalization plan with corporate income taxes is:

I II All-

equity

EBIT $ 90,000 $ 90,000 $ 90,000 Interest 8,000 14,400 0 Taxes 32,800 30,240 45,360 NI $ 49,200 $ 45,360 $ 54,000

EPS $ 3.51 $ 4.20 $ 3.00

The Plan II still has the highest EPS; all-equity plan still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT – RDD)(1 – T)]/Shares outstanding

This is similar to the equation we used before, except now we need to account for taxes. Again, the interestexpense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all-equity planand Plan I is:

EBIT(1 – 0.40)/18,000 = [EBIT – 0.08($100,000)](1 – 0.40)/14,000

EBIT = $36,000

The break-even EBIT between the all-equity plan and Plan II is:

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EBIT(1 – 0.40)/18,000 = [EBIT – 0.08($180,000)](1 – 0.40)/10,800

EBIT = $36,000

And the breakeven between Plan I and Plan II is:

[EBIT – 0.10($100,000)](1 –0.40)/14,000 = [EBIT – 0.08($180,000)](1 – 0.40)/10,800

EBIT = $36,000

Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capitalstructure to one that is 25 percent debt. Currently, there are 12,000 shares outstanding, and the price pershare is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9percent, and there are no taxes.

a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the currentcapital structure, assuming the firm has a dividend payout rate of 100 percent? (Round your answer to2 decimal places. (e.g., 32.16))

Cash flow $ 300.00

b. What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all100 of her shares. (Do not round intermediate calculations and round your final answer to 2decimal places. (e.g., 32.16))

Cash flow $ 232.00

c. Assume that Allison unlevers her shares and re-creates the original capital structure. What is her cashflow now? (Do not round intermediate calculations and round your final answer to 2 decimalplaces. (e.g., 32.16))

Total Cash flow $ 300.00


Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capitalstructure to one that is 25 percent debt. Currently, there are 12,000 shares outstanding, and the price pershare is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9percent, and there are no taxes.

a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the currentcapital structure, assuming the firm has a dividend payout rate of 100 percent? (Round your answer to2 decimal places. (e.g., 32.16))

Cash flow $ 300.00 ± 0.1%

b. What will Allison’s cash flow be under the proposed capital structure of the firm? Assume she keeps all100 of her shares. (Do not round intermediate calculations and round your final answer to 2decimal places. (e.g., 32.16))

Cash flow $ 232.00 ± 0.1%

c. Assume that Allison unlevers her shares and re-creates the original capital structure. What is her cashflow now? (Do not round intermediate calculations and round your final answer to 2 decimalplaces. (e.g., 32.16))

Total Cash flow $ 300.00 ± 0.1%

Explanation:

a.

The earnings per share are: EPS = $36,000/12,000 sharesEPS = $3.00 So, the cash flow for the investor is: Cash flow = $3.00(100 shares)Cash flow = $300.00 b.

To determine the cash flow to the shareholder, we need to determine the EPS of the firm under theproposed capital structure. The market value of the firm is: V = $56(12,000)V = $672,000 Under the proposed capital structure, the firm will raise new debt in the amount of: D = 0.25($672,000)D = $168,000 in debt. This means the number of shares repurchased will be:

Shares repurchased = $168,000/$56Shares repurchased = 3,000 Under the new capital structure, the company will have to make an interest payment on the new debt. Thenet income with the interest payment will be: NI = $36,000 – 0.090($168,000)NI = $20,880.00 This means the EPS under the new capital structure will be: EPS = $20,880.00/(12,000 – 3,000) sharesEPS = $2.3200 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $2.3200(100 shares)Shareholder cash flow = $232.00 c.

To replicate the proposed capital structure, the shareholder should sell 25 percent of her shares, or 25

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shares, and lend the proceeds at 9 percent. The shareholder will have an interest cash flow of: Interest cash flow = 25($56)(0.090)Interest cash flow = $126.00 The shareholder will receive dividend payments on the remaining 75 shares, so the dividends received willbe: Dividends received = $2.3200(75 shares)Dividends received = $174.00 The total cash flow for the shareholder under these assumptions will be: Total cash flow = $126.00 + 174.00Total cash flow = $300.00 This is the same cash flow we calculated in part a.

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equityfinanced with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 andthe interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes.

a. Rico owns $39,000 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to2 decimal places. (e.g., 32.16))

Rate of return 15.35 %

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate ofreturn. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

Total cash flow $ 5,985 Rate of return 15.35 %

c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g.,32.16))

Cost of equity ABC 10.92 % XYZ 15.35 %

d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

WACC ABC 10.92 % XYZ 10.92 %


ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equityfinanced with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 andthe interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes.

a. Rico owns $39,000 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to2 decimal places. (e.g., 32.16))

Rate of return 15.35 ± 1% %

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate ofreturn. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

Total cash flow $ 5,985 ± 0.1%

Rate of return 15.35 ± 1% %

c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g.,32.16))

Cost of equity

ABC 10.92 ± 1% %

XYZ 15.35 ± 1% %

d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

WACC

ABC 10.92 ± 1% %

XYZ 10.92 ± 1% %

Explanation:

a.

The rate of return earned will be the dividend yield. The company has debt, so it must make an interestpayment. The net income for the company is: NI = $71,000 – 0.065($325,000)NI = $49,875 The investor will receive dividends in proportion to the percentage of the company’s shares they own. Thetotal dividends received by the shareholder will be: Dividends received = $49,875($39,000/$325,000)Dividends received = $5,985 So the return the shareholder expects is: R = $5,985/$39,000R = 0.1535, or 15.35% b.

To generate exactly the same cash flows in the other company, the shareholder needs to match the capitalstructure of ABC. The shareholder should sell all shares in XYZ. This will net $39,000. The shareholdershould then borrow $39,000. This will create an interest cash flow of: Interest cash flow = 0.065(–$39,000)

Interest cash flow = –$2,535 The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. Theinvestor will receive dividends in proportion to the percentage of the company’s shares they own. The totaldividends received by the shareholder will be: Dividends received = $71,000[($39,000 + 39,000)/$650,000]Dividends received = $8,520 The total cash flow for the shareholder will be: Total cash flow = $8,520 – 2,535Total cash flow = $5,985 The shareholder's return in this case will be: R = $5,985/$39,000R = 0.1535, or 15.35%

c.

ABC is an all equity company, so: RE= RA = $71,000/$650,000

RE= 0.1092, or 10.92%

To find the cost of equity for XYZ we need to use M&M Proposition II, so: RE = RA + (RA – RD)(D/E)(1 – T)

RE = 0.1092 + (0.1092 – 0.065)(1)(1)

RE = 0.1535, or 15.35%

d.

To find the WACC for each company we need to use the WACC equation:

WACC = (E/V)RE + (D/V)RD(1 – T)

So, for ABC, the WACC is: WACC = (1)(0.1092) + (0)(0.065)WACC = 0.1092, or 10.92%

And for XYZ, the WACC is:

WACC = (1/2)(0.1535) + (1/2)(0.065)WACC = 0.1092, or 10.92% When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital structure; thisis M&M Proposition II without taxes.

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STP Corp. uses no debt. The weighted average cost of capital is 7.6 percent. The current market value ofthe equity is $14 million and the corporate tax rate is 35 percent.

What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Round youranswer to 2 decimal places. (e.g., 32.16))

EBIT $ 1,636,923.08


STP Corp. uses no debt. The weighted average cost of capital is 7.6 percent. The current market value ofthe equity is $14 million and the corporate tax rate is 35 percent.

What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Round youranswer to 2 decimal places. (e.g., 32.16))

EBIT $ 1,636,923.08 ± 0.01%

Explanation:

If there are corporate taxes, the value of an unlevered firm is: VU = EBIT(1 – T)/RU

Using this relationship, we can find EBIT as: $14,000,000 = EBIT(1 – 0.35)/0.076EBIT = $1,636,923.08

Skillet Industries has a debt–equity ratio of 1.5. Its WACC is 9.2 percent, and its cost of debt is 6.0percent. The corporate tax rate is 35 percent.

a. What is the company’s cost of equity capital? (Round your answer to 2 decimal places. (e.g.,32.16))

Cost of equity capital 17.15 %

b. What is the company’s unlevered cost of equity capital? (Round your answer to 2 decimal places.(e.g., 32.16))

Unlevered cost of equity capital 11.65 %

c-1 What would the cost of equity be if the debt–equity ratio were 2? (Round your answer to 2 decimalplaces. (e.g., 32.16))

Cost of equity 18.99 %

c-2 What would the cost of equity be if the debt–equity ratio were 1.0? (Round your answer to 2 decimalplaces. (e.g., 32.16))


c-3 What would the cost of equity be if the debt–equity ratio were zero? (Round your answer to 2decimal places. (e.g., 32.16))



Skillet Industries has a debt–equity ratio of 1.5. Its WACC is 9.2 percent, and its cost of debt is 6.0percent. The corporate tax rate is 35 percent.

a. What is the company’s cost of equity capital? (Round your answer to 2 decimal places. (e.g.,32.16))

Cost of equity capital 17.15 ± 1% %

b. What is the company’s unlevered cost of equity capital? (Round your answer to 2 decimal places.(e.g., 32.16))

Unlevered cost of equity capital 11.65 ± 1% %

c-1 What would the cost of equity be if the debt–equity ratio were 2? (Round your answer to 2 decimalplaces. (e.g., 32.16))

Cost of equity 18.98 ± 1% %

c-2 What would the cost of equity be if the debt–equity ratio were 1.0? (Round your answer to 2 decimalplaces. (e.g., 32.16))


c-3 What would the cost of equity be if the debt–equity ratio were zero? (Round your answer to 2decimal places. (e.g., 32.16))


Explanation:

a.

With the information provided, we can use the equation for calculating WACC to find the cost of equity. Theequation for WACC is: WACC = (E/V)RE + (D/V)RD(1 – T)

The company has a debt-equity 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 = 0.092 = (1/2.5)RE + (1.5/2.5)(0.060)(1 – 0.35)

RE = 0.17150, or 17.15%

b.

To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so: RE = RU + (RU – RD)(D/E)(1 – T)

0.17150 = RU + (RU – 0.060)(1.5)(1 – 0.35)

RU = 0.1165, or 11.65%

c.

To find the cost of equity under different capital structures, we can again use M&M Proposition II withtaxes. With a debt-equity ratio of 2, the cost of equity is: RE = RU + (RU – RD)(D/E)(1 – T)

RE = 0.1165 + (0.1165 – 0.060)(2)(1 – 0.35)

RE = 0.1898, or 18.98%

With a debt-equity ratio of 1.0, the cost of equity is: RE = 0.1165 + (0.1165 – 0.060)(1)(1 – 0.35)

RE = 0.1532, or 15.32%

And with a debt-equity ratio of 0, the cost of equity is: RE = 0.1165 + (0.1165 – 0.060)(0)(1 – 0.35)

RE = RU = 0.1165, or 11.65%

FIN 4610 HW#1

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