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a. Suppose Merck increases its long-term debt to $10 billion. It uses the additional debt
to repurchase shares. Reconstruct the above table with the new capital structure.
b. How much additional value is added for Merck shareholders if the table’s
assumptions are correct?
c. What operating problems might Merck encounter in the event of financial distress?
How well would the assets keep their value?
Solution
The following table shows a simplified balance sheet for Rensselaer Felt.
Cash and marketable $ 1,500 $ 75,600 Short-term debt
securities
Accounts receivable 120,000 62,000 Accounts payable
Inventories 125,000 137,600 Current liabilities
Current assets $246,500 $208,600 Long-term debt
Property, plant and $ 302,000 $ 45,000 Deferred taxes
equipment
Other assets 89,000 246,300 Shareholders’ equity
Total $637,500 $637,500 Total
Calculate this company’s weighted-average cost of capital. The debt has been refinanced at an
interest rate of 6% (short-term) and 8% (long-term). The expected rate of return on the
company’s shares is 15%. There are 7.46 million shares outstanding, and the shares are trading at
$46. The tax rate is 35%.
(Hint: Make three adjustments to the balance sheet:
Ignore deferred taxes; this is an accounting entry and represents neither a liability nor a source of funds
‘Net out’ accounts payable against current assets
Use book value (the table value that is already given) for short-term and long-term debt.
Use the market value of equity (7.46 million x $46)
Since Total = Short-term debt, Long-term debt and Shareholders’ equity, you can have the weights for the WACC
equation).
Solution
We make three adjustments to the balance sheet:
Ignore deferred taxes; this is an accounting entry and represents neither a liability nor
a source of funds
‘Net out’ accounts payable against current assets
Use the market value of equity (7.46 million x $46)
Now the right-hand side of the balance sheet (in thousands) is:
funding, is: