Lecture 13: Capital Structure Theory Exercises

Question 1
Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both
companies expect to earn $150 million in perpetuity, and both distribute all of their earnings as
dividends. Levereds perpetual debt has a market value of $300 million and the required return
on its debt is 7%. Levereds stock sells for $100 per share, and there are 5 million shares
outstanding. Unlevered has 8 million shares outstanding worth $90 each. Unlevered has no
debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take
advantage of this scenario?

Question 2
Consider the problem of estimating the cost of equity for Crab Inc., a non-listed chain of
restaurants specializing in crab meals. Crab has a debt-to-equity ratio of 2 and pays an interest
rate of 5% on its debt. Crabs operations are highly similar to those of the publicly traded
Lobster Inc. and Shrimp Inc., which specialize in lobster meals and shrimp meals, respectively.
Assume that none of these companies pays taxes. The risk free rate is 2% and the expected
return on the market is 10%. Lobster has a debt-to equity ratio of 1, an equity beta of 2, and a
cost of debt of 3.6%. Shrimp has a debt-to-equity ratio of 1.5, an equity beta of 3, and a cost of
debt of 4.4%.
a. Are the debts of Crab, Lobster, and Shrimp risk free? What does this imply for their debt
betas?
b. Estimate Crabs cost of equity. Be careful to do it using the information you have
efficiently to avoid approximation errors.
c. Suppose now that Crabs debt beta is .375, Lobsters debt beta is .2 and Shrimps debt
beta is .3. Estimate Crabs cost of equity using the levering/de-levering formulas for
betas we derived in class. You should get the same answer you obtained in b).
Note: I gave you the cost of debt for each firm, the risk free, and the expected return on the
market. Since the cost of debt must satisfy the CAPM equation, you could have inferred these
debt betas yourself.
d. Suppose now that you only know the following information. Crab has a debt-to-equity
ratio of 2. Crabs operations are highly similar to those of the publicly traded Lobster Inc.
and Shrimp Inc., which specialize in lobster meals and shrimp meals, respectively. None
of these companies pays taxes. The risk free rate is 2% and the expected return on the
market is 10%. Lobster has a debt-to equity ratio of 1 and an equity beta of 2. Shrimp
has a debt-to-equity ratio of 1.5 and an equity beta of 3. How would you estimate Crabs
cost of equity using this information? Carefully explain how you approach and quality of
estimates would differ from those you did in b) and c).

Question 3
Seashell has 100 million shares worth $12 per share and no debt. Its cost of capital is 10%. It has
a perpetual (before tax) random CF with mean $200 million and it pays taxes at a 40% tax rate.
Seashell plans a leveraged recapitalization, in which it will issue $600 million in perpetual debt
at an interest rate of 5% per year and use the proceeds to repurchase shares. The firm operates
in the Modigliani-Miller world with taxes.
a. What are Seashells firm value, cost of equity, and WACC before the recapitalization?
b. What are Seashells firm value, equity value, debt value, cost of equity, and WACC after
the recapitalization? Compare you results to those in a) and interpret the differences.
c. What happens with Seashells equity values and share price at the time of the
announcement but before the recapitalization is executed?
d. How many shares can Seashell repurchase and how many shares outstanding are left
after the transaction? Check that shareholders would be indifferent between selling
their shares in the recapitalization and keeping them.