Chapter 14: 1, 3, 23

1. EBIT and Leverage:

Beckett, Inc., has no debt outstanding and a total market
value of $250,000. Earnings before interest and taxes, EBIT, are projected to be
$13,000 if economic conditions are normal. If there is strong expansion in the
economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will
be 40 percent lower. Beckett is considering an $80,000 debt issue with a 6 percent
interest rate. The proceeds will be used to repurchase shares of stock. There are
currently 4,000 shares outstanding. Ignore taxes for this problem.
a.
Calculate earnings per share, EPS, under each of the three economic
scenarios before any debt is issued. Also, calculate the percentage changes in EPS
when the economy expands or enters a recession.
A table outlining the income statement for three possible states of the economy is
show below. The EPS is the net income divided by the 2500 shares outstanding. The
last row shows the percentage change in EPS.
EBIT
Interest
NI
EPS
EPS

Recession
7800
0
7800
1.95
-40

Normal
13000
0
13000
3.25
-

Expansion
17550
0
17550
4.39
+35

b.
Repeat part (a) assuming that Beckett goes through with recapitalization.
What do you observe?
If the company undergoes the proposed recapitalization it will repurchase:
share price = Equity / share outstanding
= 250000 / 4000
= 62.50
Show repurchase = Debt issued / share rice
= 80000/ 62.50
=1280
the interest payment each years under all three scenarios will be:
interest payment= 80000(.06) = 4800

EBIT
Interest
NI
EPS
EPS

Recession
7800
4800
3000
1.10
-63.41

Normal
13000
4800
8200
3.01
-

Expansion
17550
4800
12750
4.69
+55.49

3. ROE and Leverage: Suppose the company in Problem 1 has a market-to-book

ratio of 1.0.
a.
Calculate return on equity, ROE, under each of the three economic scenarios
before any debt is issued. Also, calculate the percentage changes in ROE for
economic expansion and recession, assuming no taxes.
Since the company has market- to- book ratio of 1.0 the total equity of firm is equal
to the market value of equity. Using the equation for ROE:
ROE = NI / 225000
The ROE for each state of the economy under the current capital structure and no
taxes is:
Recession
Normal
Expansion
ROE
3.38%
8.44%
10.98%
- 60
+30
%ROE
The second row shows the percentage change ROE from the normal economy.

b.
Repeat part (a) assuming the firm goes through with the proposed
recapitalization.
If the company undertakes the proposed recapitalization the new equity value will
be:
Equity = 225000 - 90000
= 135000
so the ROE for each state of the company is:
ROE = NI / 135000

ROE
%ROE

Recession
0.30%
- 96.61

Normal
8.74%
-

Expansion
12.96%
+48.31

c.
Repeat parts (a) and (b) of this problem assuming the firm as a tax rate of 35
percent.
If there corporate taxes and the company maintains its current capital structure the
ROE is :
ROE
%ROE

2.20%
- 60

5.49%
-

7.14%
+30

If the company undertakes the proposed recapitalization the new equity value will
be:
ROE
%ROE

0.14%
- 96.61

5.68%
-

8.43%
+48.31

notice that the percentage change in ROE is the same as percentage change in EPS.
The percentage change in ROE is the same with or without taxes.

23. MM Propositions: Garnett Corporation is planning to repurchase part of its

common stock by issuing corporate debt. As a result, the firms debt-to-equity ratio
is expected to rise from 30 percent to 45 percent. The firm currently has $5.8
million worth of debt outstanding. The cost of this debt is 8 percent per year.
Garnett expects to have an EBIT of $2.75 million per year in perpetuity. Garnett
pays no taxes.
a.
What is the market value of Garnett Corporation before and after the
repurchase announcement?
Before the announcement of the stock repurchase plan the market value of the
outstanding debt is 5800000. Using the debit equity ratio we can find the value of
outstanding ratio by:
debit - equity ratio = B/S
30 = 5800000 /S
S= 19333333

The value of levered firm is equal to the sum of market value of the firms debt and
market value of the firm's equity so:
VL= B+S
VL= 5800000 + 19333333
VL= 25133333
According to MM proposition without taxes change in firm's capital structure have
no effect on the overall value. Therefore, the value will not change.

b.
What is the expected return on the firms equity before the announcement of
the stock repurchase plan?
The expected return on firm's equity is the ratio of annual earning to the market
value of the firm's equity or return on equity
we calculate first interest payment:
Interest payment= .08(5800000)= 454000
return on equity will be:
ROE= RS =(2750000 - 464000) / 19333333
RS= .1182 or 11.82%
c.
What is the expected return on the equity of an otherwise identical all-equity
firm?
According to Modigliani Miller proposition II with no taxes:
Rs = R0 + (B/S)(R0 -Rb)
.1182 = R0 + (.30)(R0 - .08)
R0= .1094 or 10.94%
This problem can also solve as:
R0 = Earnings before interest / Vu
R0 = 2750000/25133333
=.1094 or 10.49%

d.
What is the expected return on the firms equity after the announcement of
the stock repurchase plan?
We will calculate cost of equity under the stock:
RS= R0 +(B/S)(R0-Rb)
RS= .1094 + (.45)(.1094 - .08)
Rs = .1227 or 12.27%

3. Capital Structure and Growth: Edwards Construction currently has debt

outstanding with a market value of $170,000 and a cost of 8 percent. The company
has an EBIT of $13,600 that is expected to continue in perpetuity. Assume there are
no taxes.
a.

What is the value of the companys equity? What is the debt to value ratio?

Interest payment = .08(170000)= 13600

This is exactly equal to the EBIT so no cash is available for shareholders and the
value of equity will be ZERO since shareholders will never receive any payment
The total value of company is market value of debt. This implies the debt to value
ratio is 1 (one).
b.
What is the equity value and debt to value ratio if the companys growth rate
is 5 percent?
At 5 % growth rate the earnings next year will be:
Earning next year = 13600(1.05)= 14280
so the cash available for shareholders is :
payment to shareholders= 1280 - 13600= 680
Since there is no risk the required return for shareholders is the same with debt
the payments to stockholders will increase at their growth ratio of 5 %
And debt to value ratio now will be:
Debt/ value ratio = 170000/(170000 +22666.67)
= 0.882

c.
What is the equity value and debt to value ratio if the companys growth rate
is 7 percent?
At 7 % growth rate the earnings next year will be:
Earning next year = 13600(1.07)= 14552
so the cash available for shareholders is :
payment to shareholders= 14552 - 13600= 95200
Since there is no risk the required return for shareholders is the same with debt
the payments to stockholders will increase at their growth ratio of 7 %
And debt to value ratio now will be:
Debt/ value ratio = 170000/(170000 +95200)
= 0.641

7. Agency Costs
Sheaves Corporation economists estimate that a good business
environment and a bad business environment are equally likely for the coming year.
The managers of Sheaves must choose between two mutually exclusive projects.
Assume that the project Sheaves chooses will be the firms only activity and that
the firm will close one year from today. Sheaves is ob- ligated to make a $4,000
payment to bondholders at the end of the year. The projects have the same
systematic risk, but different volatilities. Consider the following information
pertaining to the two projects:
ECONOMY

PROBABILITY

Bad
Good

.50
.50

LOW-VOLATILITY
PROJECT PAYOFF
$4,000
4,300

HIGH-VOLATILITY
PROJECT PAYOFF
$3,600
4,600

a.
What is the expected value of the firm if the low-volatility project is
undertaken? What if the high-volatility project is undertaken? Which of the two
strategies maximizes the expected value of the firm?
The expected value of each project is the sum of each state of the economy so:
low-volatility project value = .50(4000) + .50(4300) = 4150
high-volatility project value = .50(3600) + .50(4600) = 4100
The low-volatility project value maximizes the expected value of firm

b.
What is the expected value of the firms equity if the low-volatility project is
undertaken? What is it if the high-volatility project is undertaken?
The value of the equity is the residual value of company after bondholders are paid
off
The expected value of the firm's equity is:
Expected value of equity with low-volatility project= .50(0) + .50(300)= 150
Expected value of equity with High-volatility project = .50(0) + .50(600) = 300

c.

Which project would the firms stockholders prefer? Explain.

risk neutral investors prefer the strategy with the highest expected value thus, the
company's stockholders prefer the high-volatility project since it's maximizes the
expected value of the company's equity.

d. Supposebondholdersarefullyawarethatstockholdersmightchoosetomaximizeequity
value rather than total firm value and opt for the high-volatility project. To minimize
this agency cost, the firms bondholders decide to use a bond covenant to stipulate
that the bondholders can demand a higher payment if the firm chooses to take on
the high-volatility project. What payment to bondholders would make stockholders
indifferent between the two projects?

In order to make stock holders indifferent between the low- volatility project and
high- volatility project the bond holders will need to raise their required debt
payment. So, the expected value of equity if the high- volatility project is under
taken is equal to expected value of equity.
The value of firm will be 3600 if economy is bad and 4600 if economy is good.
If it's bad the entire of 3600 will go to bondholders and stock holders will receive no
thing. If it's good the stock holders will receive the different between 600 the total
value of the firm and required debt payment.
Expected value of equity = 4150= .05(0) + .50(4600 - X)
X= 4300