ANSWER FOR EXERCISES CHAPTER 8

QUESTION 1

a. Common equity = .65 × $3 million = $1,950,000

Debt = .35 × $3 million = $1,050,000
b. Dividends = $2,200,000 - $1,950,000 = $250,000

QUESTION 2

i.(15% x 1,000,000 shares) + 1,000,000 shares = 1,150,000 shares outstanding

ii. $10,000,000 / 1,150,000 = $8.70

QUESTION 3

a) EPS= 4,000,000/ 320,000 = $12.50 per share

P/E = $50/ $12.50 = $4

b) 320,000 shares x $4 per share = $1,280,000

Shares that can be repurchased $1,280,000/ $54 =23,704shares

c) After proposed repurchased:

Shares outstanding = 320,000 – 23,704 = 296,296 shares
EPS = $4,000,000/ 296,296 = $13.50 per share

QUESTION 4

ANSWER:
a. .40($900,000)/500,000 = $0.72
.40($1,200,000)/500,000 = $0.96
.40($850,000)/500,000 = $0.68
.40($1,350,000)/500,000 = $1.08

b. .40($1,075,000) = $430,000/500,000 = $0.86

QUESTION 5

i.

Equity Structure of Srikandi Berhad as at 30 November 2016

____________________________________________________________

Common Stock (RM1 par, 1,100,000 shares) 1,100,000

Contributed Capital in excess of par 1,000,000
Retained earnings 200,000
_________
Total Common Stockholders’ Equity 2,300,000
=========

# a total of RM500,000 is transferred from retained earnings to the other stockholders’

equity account of this RM500,000, RM100,000 is added to the common stock account
and the remaining RM400,000 is added to the Contributed Capital in Excess of Par
account.

ii. If the company decided to split the shares 2:1, what is the new structure of
equity of Srikandi Berhad?

Equity Structure of Srikandi Berhad as at 30 November 2016

____________________________________________________________

Common Stock (RM0.50 par, 2,000,000 shares) 1,000,000

Contributed Capital in excess of par 600,000
Retained earnings 700,000
_________
Total Common Stockholders’ Equity 2,300,000
=========
Answer for Individual Assignment (ONLY FOR CALCULATION PART)

a.

The net income for the company is:

NI = $80,000 – .08($300,000)
NI = $56,000

The total dividends received by the shareholder will be:

Dividends received = $56,000($30,000/$300,000)
Dividends received = $5,600

So the return the shareholder expects is:

R = $5,600/$30,000
R = .1867 or 18.67%

b.
To generate exactly the same cash flows in the other company, the shareholder needs to match the
capital structure of ABC. The shareholder should sell all shares in DEF. This will net $30,000.
The shareholder should then borrow $30,000. This will create an interest cash flow of:
Interest cash flow = .08(–$30,000)
Interest cash flow = –$2,400

The total dividends received by the shareholder will be:

Dividends received = $80,000($60,000/$600,000)
Dividends received = $8,000

The total cash flow for the shareholder will be:

Total cash flow = $8,000 – 2,400
Total cash flow = $5,600
The shareholders return in this case will be:
R = $5,600/$30,000
R = .1867 or 18.67%

c. ABC is an all equity company, so:

RE = RA = $80,000/$600,000
RE= .1333 or 13.33%

To find the cost of equity for DEF we need to use M&M Proposition II, so:
RE= RA + (RA – RD)(D/E)(1 – tC)
RE= .1333 + (.1333 – .08)(1)(1)
RE= .1867 or 18.67%

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

WACC = (E/V)RE + (D/V)RD(1 – tC)

So, for ABC, the WACC is:

WACC = (1)(.1333) + (0)(.08)
WACC = .1333 or 13.33%

And for DEF,

WACC = (1/2)(.1867) + (1/2)(.08)
WACC = .1333 or 13.33%

When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital
structure; this is M&M Proposition II without taxes.

3
. a. With the information provided, we can use the equation for calculating WACC to find the cost of
equity. The equation for WACC is:
WACC = (E/V)RE + (D/V)RD(1 – tC)

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 = .10 = (1/2.5)RE + (1.5/2.5)(.07)(1 – .35)

RE= .1818 or 18.18%

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 – tC)
.1818 = RU + (RU – .07)(1.5)(1 – .35)
RU= .1266 or 12.66%

c. To find the cost of equity under different capital structures, we can again use M&M Proposition II
with taxes.
With a debt-equity ratio of 2, the cost of equity is:
RE= RU + (RU – RD)(D/E)(1 – tC)
RE= .1266 + (.1266 – .07)(2)(1 – .35)
RE= .2001 or 20.01%