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Strictly for course AB1201 internal circulation only.

Nanyang Business School


AB1201 Financial Management
Tutorial 10: Capital Structure and Leverage
(Common Questions)
Questions 1 to 3 will be presented by students while Question 4 will be presented by instructors.

1) A firm is about to double its assets to serve its rapidly growing market. It must choose between a
highly automated production process and a less automated one. It also must choose a capital
structure for financing the expansion. Should the asset investment and financing decisions be
jointly determined, or should each decision be made separately? How would these decisions
affect one another?

2) How does each of the following affect a firms optimal capital structure? Explain.
a) Business risk
b) Liquidity of the firms assets
c) Investment in plant and equipment
d) Volatility of sales of the firm

3) Financial leverage effects. Firm HL and LL are identical except for their debt-to-capital ratios
and the interest rates they pay on debt. Each has $20 million in capital, has $4 million of EBIT,
and is in the 40% federal plus-tax bracket. Firm HL however, has a debt-to-capital ratio of 50%
and pays 12 % interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 10%
interest on its debt.
a) Calculate the rate of return on equity (ROE) for each firm.
b) Observing that HL has a higher ROE, LLs treasurer is thinking of raising the debt-to-capital
ratio from 30% to 60% even though that would increase LLs interest rate on all debt to 15%.
Calculate the new ROE for LL.

4) Recapitalization. Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent
debt and 80 percent equity. Blooms debt currently has an 8 percent yield to maturity. The risk-
free rate (rRF) is 5 percent, and the market risk premium (rM rRF) is 6 percent. Using the CAPM,
Bloom estimates that its cost of equity is currently 12.5 percent. The company has a 40 percent
tax rate.
a) What is Blooms current WACC?
b) What is the current beta on Blooms common stock?
c) What would Blooms beta be if the company had no debt in its capital structure? (That is, what
is Blooms unlevered beta, bU?)
Blooms financial staff is considering changing its capital structure to 40 percent debt and 60
percent equity. If the company went ahead with the proposed change, the yield to maturity on
the companys bonds would rise to 9.5 percent. The proposed change will have no effect on the
companys tax rate.
d) What would be the companys new cost of equity if it adopted the proposed change in capital
structure?
e) What would be the companys new WACC if it adopted the proposed change in capital
structure?
f) Based on your answer to part e, would you advise Bloom to adopt the proposed change in
capital structure? Explain.

Page 1 of 4
Strictly for course AB1201 internal circulation only.
Self-Practice Questions

Question 1

Pretty Women Company currently uses no debt, but its new CFO is considering changing the
capital structure to 65.0% debt by issuing bonds and using the proceeds to repurchase some
common stock at the market price. If risk-free rate is 5.5%, market risk premium is 4%, companys
tax rate is 35% and current beta is 1.22, by how much would this recapitalization change the firm's
cost of equity?

Question 2

Last year Matrix Tech had a debt-to-equity ratio of 1/2 and its beta was 1.40. Now Matrix Tech has
a debt-to-equity ratio of 2/3. Risk-free rate is 3%. The market return is 8%. Tax rate is 20%. Matrix
Techs dividend per share just paid last year was $4 and is expected to decrease by 15% per year
for the next 2 years and then grow at a rate of 10% per year in perpetuity. Determine the current
value of Matrixs stock.

Question 3

Mighty Corporation currently has total assets of $10 million and 1,000,000 common shares
outstanding. Its current capital structure is 20% debt and 80% equity. EBIT is $720,000, cost of
debt (before tax) is 6%, and corporate tax rate is 30%.

(a) What is the companys earnings per share (EPS)?

(b) The company wants to achieve an EPS of $0.50 by changing its capital structure. It plans to
taking up more debt (at the same 6% before-tax interest cost) to repurchase its common shares at $8
per share in the open market. How many shares must be repurchased (round up to the nearest
number of shares)?

Question 4

Junius Corporations current capital structure consists of 50% debt and 50% equity, and the
following information on company have been gathered:

Intrinsic value of share = $15


Expected earnings per share (12 months from now), EPS1 = $4
Dividend payout ratio = 30%
Perpetual annual dividend growth rate = 4%
Risk-free rate = 3%, market risk premium = 6% and tax rate = 30%

(i) What is the unlevered beta of Junius shares?

(ii) The company intends to change its capital structure to 60% debt and 40% equity. It also
expects its share price to increase if it increases the dividend payout ratio, but this
would reduce the perpetual annual dividend growth rate to 3%. If EPS1 remains
unchanged at $4, what dividend payout ratio will cause the companys share price to
reach $18?

Page 2 of 4
Strictly for course AB1201 internal circulation only.
Answers to self-practice questions:

Question 1
Given

Risk-free rate, rRF 5.50% Current beta, bU 1.22


Market risk premium, RPM 4.00% Current debt ratio 0%
Tax rate, T 35% Target debt ratio 65%

Target D/E = Debt% / (1- Debt%)


= 0.65 / (1-0.65)
= 1.8571

bL = bU [(1 + (D/E)(1 - T)] = 1.22[(1 + (1.8571)(1-0.35)) = 2.6927

rsU = rRF + bU(RPM ) = 5.5 + 1.22(4) = 10.38%

rsL = rRF + bL(RPM ) = 5.5 + 2.6927(4) = 16.2708%

Change in the firms cost of equity = 16.2708 10.38 = 5.8908%

Question 2
Using the Hamada equation:
BL = BU[1+(1-T)(D/E)] 1.4 = BU[1+(1-0.2)(0.5)] BU = 1.0
New BL = 1[1+(1-0.2)(2/3)] = 1.53

Therefore, discount rate = 3+1.53*(8-3) = 10.65%


Value of stock =
4*(1-0.15)/(1+0.1065) + 4*(1-0.15)2/(1+0.1065)2 +
[4*(1-0.15)2(1+0.10)]/(0.1065-0.10)}/(1+0.1065)2 = $404.89

Question 3
a) Debt = (0.2)10 million = $2 million
Annual interest = 2,000,000(6%) = $120,000
Net income = (EBIT Interest)(1 T) = (720,000 120,000)(1 30%) = $420,000
EPS = Net income / No. of shares = 420,000 / 1,000,000 = $0.42

b) Number of shares to repurchase = x


Number of common shares after repurchase = 1,000,000 x
Total dollar of debt raised for repurchase = $8x
New level of total debt = 2,000,000 + 8x
New total annual interest = (2,000,000 + 8x)(6%) = 120,000 + 0.48x
New net income = (EBIT Interest)(1 T)
= (720,000 120,000 0.48x)(1 30%)
= 420,000 0.336x
0.5 = (420,000 0.336x) / (1,000,000 x)
Solving for x = 487,804.88 487,805

Question 4
(i) D1 = 0.3($4) = $1.20
P = D1/(rS g)
15 = 1.20/(rS 4%) rS = 12%
Page 3 of 4
Strictly for course AB1201 internal circulation only.
rS = rRF + RPM(bL)
12% = 3% + 6%(b) b = 1.5
Hamada Equation: bL = bU[1 + (1 T)(D/E)]
1.5 = bU[1 + (1 0.3)(50/50)] bU = 0.8823

(ii) Find the new levered beta using Hamada Equation:

bL = bU[1 + (1 T)(D/E)]
bL = 0.8823[1 + (1 0.3)(60/40)] bL = 1.8088
rS = rRF + RPM(bL) = 3% + 6%(1.8088) = 13.8529%
Assume payout ratio is p, so D1 = 4p.
P = D1/(rS g)
18 = 4p/(13.8529% 3%) p = 48.84%

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