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Firm U
$10,000
0
?
?
?
0
?
Firm L
$10,000
2,500
16%
?
?
22,500
?
?
Find the missing figures in the above table. Assume that the corporate tax rate is 40% and all cash flows
are perpetual.
Hint: Start by computing the value of the levered firm from the information given in the table.
Exercise 4. Debt/Equity [7]
Firm Z and Y have identical cash flows. Firm Z is 40% debt financed and 60% equity financed, while firm Y
is 0% debt financed and 100% equity financed. The same required rate of return on their debt equals 10%.
(Assume debt is perpetual)
1. Next periods cash flows for each firm are $100. Assume both firms pay out all excess cash in the form
of dividends. What cash flows go to the debt and equity holders of both firms? Assume no corporate
taxes. (Use Dz for the value of firm Zs debt).
2. You own 10% of firm Zs stock. What cash flow will you get in the future? What combination of other
assets will give you the same cash flow?
3. Suppose the value of firm Z is greater than firm Y. How can you become very rich? (You may assume
no transactions costs, or other market imperfections)
4. Now, suppose there is a corporate tax rate of 40%. What should the value of each firm be?
1
Empirical
Solutions
MA 155
PROBLEM SET: Capital Structure
Exercise 1.
The company-wide cost of capital currently is
r = 0.10 + 0.08 1.0 = 18%
If the firm compared the 13% return on the new project to its cost of capital, they would reject the project.
But this would be a mistake since the company-wide cost of capital ignores the risk of the project.
The NPV of the project is
$1, 000, 000 0.13
$1, 000, 000
0.10
= $300, 000
NPV
Note that the appropriate discount rate for this project is rf = 10%.
If the firm issued stock worth $1 mill. to finance the project, the market value of the firms assets would
increase to $5.3 mill and the company-wide cost of capital would decline to 16.04%.
r=
1.3
4
0.18 +
0.10 = 16.04%.
5.3
5.3
Thus, the required rate of return on the firms equity would fall after the investment.
The reason that the required return on the firms equity falls to 16.04% is because the beta of the firms
assets decline to
4
1.3
=
1.0 +
0 = 0.755
5.3
5.3
Exercise 2. Interest tax shields [4]
1. 0.
2.
PV
3.
PV
X
($1, 000 10%) 50%
(1.16)t
t=1
=
=
Firm U
10,000
0
19.05%
19.05%
31,500
0
31,500
Firm L
10,000
2,500
16.0%
20.0%
16.67%
22,500
15,000
37,500
Firm Y
100
100
0.10 100
0.1 (0.10 DZ )
0.1 (100 0.1 DZ )
VY
Cost
VY
VZ DZ
DZ
+ VZ > 0
Next period
100
(100 0.1DZ )
0.1DZ
0
4. New firm values after tax of 40%. Let VY , VZ be the no tax values of Y and Z.
Since Y has no debt, its value goes down by 40%, to 0.60 VY .
For firm Z, its value is adjusted for the tax shelter of debt:
Firm Z goes to
0.6VZ + 0.4DZ
=
0.6VY + 0.4DZ
E
D
rD +
rE
D+E
D+E
Since the equity has a of 1, it has the same return as the market E[rm ]:
E[rm ]
(E[rm ] rf ) + rf
0.08 + 0.12
20%
Hence
rE = 20%
We are also given that the debt is risk-free. Hence
rD = 12%
Thus, we have everything but D in the equation:
r =
0.18 =
E
D
rD +
rE
D+E
D+E
D
12
0.12 +
0.20
D + 12
D + 12
=
=
=
D
E
D +
E
D+E
D+E
4
16
0+
1.5
4 + 16
4 + 16
16
1.5 = 1.2
20
5
Cost of capital:
r
= rf + (E[rm ] rf )
=
840
5,000
Kirkeby
5 mill
5 mill
2 mill
600,000
1,400,000
560,000
840,000
= 16.80%
Bonner
6 mill
4 mill
2 mill
900,000
1,100,000
440,000
660,000
660
=
16.5%
4,000
Kirkeby
5 mill
5 mill
2 mill
600,000
1,400,000
560,000
840,000
16.80%