Assignment 4: Corporate Finance

Capital Structure & Dividend Policy

Due Thursday, July 19, 2018 at the beginning of class sharp! Late assignments are not acceptable.

1. Textbook: Chapter 1, Problem 5; Prove Corollary 1 page 33; that is, show that the M-M de…nition
of the WACC given in (1) is consistent with the standard de…nition given in (2) below:

B
W ACCM M = 1 c (1)
B+S

B S
W ACCCAP M = (1 c )kb + ks : (2)
B+S B+S
State clearly any assumption(s) you have to make.
2. Textbook: Chapter 1, Problem 4; Consider the Modigliani-Miller model discussed in class. The
model assumes that the …rm has only two classes of securities, perpetual debt and equity. Suppose
that the …rm under consideration has issued a third class of securities–preferred stock– and that X%
of preferred dividends may be written o¤ as an expense, where 0 < X < 1: Let kp be the rate of return
on Preferred Shares, Fp be the face value of the Preferred Share, Dp = kp Fp be the …xed dividend
on the Preferred Share, and everything else is de…ned as in the Modigliani-Miller model. Answer the
following question.

(a) Derive an expression for the value of the unlevered …rm VU

(b) Derive an expression for the value of the levered …rm VL and show that

VL = VU + c (B + P ) ;

where B = kkdbD be the market value of Debt, where kd is the after-tax cost of debt, kb is the
before-tax cost of debt and D is the total debt, and P is the market value of Preferred Share.

3. Textbook: Chapter 1, Problem 6; Prove the following corollary: Suppose that the environment
is that of problem 4. Assume that the following assumptions hold: (1) Shareholders require a rate
of return on new projects that exceeds the opportunity of cost of funds supplied by them and by
bondholders. (2) Debt is assumed to be risk free. (3) New projects are assumed to be no riskier than
outstanding ones. (4) New projects must be …nanced either by new debt or new equity or both. (5) A
steady state equilibrium is assumed; that is, the …rm’s current debt ratio is equal to its long-run target
ratio VB , so that the change in debt due to new investment 4I is consistent with the long-run target,
i.e.,
4B B B
= = ;
4I V V
where V = B + S is the current value of the …rm. (6) Fp and X are una¤ected by the new investment.
Then
4B 4P
W ACCM M = 1 c c :
4I 4I

4. Textbook: Chapter 5, Problem 13; AU Construction Company currently has a market value
capital structure of 20% debt to total assets. The company’s treasurer believes that more debt can be
taken on, up to a limit of 35% debt, without losing the …rm’s ability to borrow at 7%, the prime rate,
which could also be taken to be the risk-free rate. Suppose that the corporate tax rate is 50%, the
expected rate of return on the market next year is estimated to be 17%, and the systematic risk of the
company’s equity, L , is estimated to be 0.5.

(a) What is the company’s current weighted average cost of capital. (Hint: use the CAPM to compute
the current cost of equity …rst)

1
 (b) Demonstrate that the current cost of equity that you computed in part (a) is consistent with
M-M de…nition. (Hint: No need for a formal proof here, you just to compute ks from the M-M
de…nition and verify that it is indeed consistent with its CAPM counterpart. It might be useful
to …nd …rst from the M-M de…nition of the WACC)
(c) Now, suppose that the company seeks to …nance more assets through debt, i.e., more …nancial
leverage. One would expect that the cost of equity to increase with the increase in leverage. The
reason is that shareholders will face more risk with higher …nancial leverage, and thus, they will
require higher return to compensate them for it. Assume that the company is planning to reach
its debt limit and that the …rm’s business risk remains unchanged and, hence, its unlevered cost
of equity capital, , remains also unchanged. Compute the cost of equity under the new capital
structure. (Hint: you should use the M-M de…nition here rather than the CAPM).
(d) Using the M-M de…nition, compute the company’s weighted average cost of capital under the
new capital structure. If the new project has an expected rate of return of 9%, do you think the
company should take on this project under the new capital structure? Explain why or why not.

5. Textook: Chapter 1, Problem 7; The XYZ company has a current market value of $1,000,000, half
of which is debt. Assuming M-M theorems hold, its current weighted average cost of capital is 9%, and
the corporate tax rate is 40%. The treasurer proposes to undertake a new project, which costs $500,000
and which can be …nanced completely with debt. The project is expected to have the same operating
risk as the company and to earn 9.5% on its levered after-tax cash ‡ows. The treasurer argues that
the project is desirable because it earns more than 5%, which is the before-tax marginal cost of the
debt used to …nance it. Do you agree with the treasurer’s argument to justify the acceptance of this
project? Explain in detail and show the calculations supporting your argument. You can assume the
M-M theorems holds. (Hint: What is the WACC for the project before and after the change in capital
structure?). We need to know the appropriate weighted average cost of capital for the project. One
should be immediately suspect that 100 percent debt …nancing is unrealistic. Consequently, a better
approach is to calculate the new WACC for the …rm after the addition of $500,000 of debt to the …rm’s
capital structure.