Capital Structure: the Real World

Question 1

The Caplan Corporation is completely financed by common stock. The beta for Caplan Corp. shares is 1.0. The T-Bill rate is .15 and the expected rate of return on the market portfolio is .30. Assume no taxes, no bankruptcy costs, no agency costs.

a) What is the expected rate of return on Caplan Corp shares?
b) If Caplan Corp issues debt for a sum equal to half the value of the firm’s shares and uses the proceeds to repurchase shares, what is the expected rate of return on Caplan’s shares after this repurchase if the beta of the debt is .5?

Answer 1

a) E(R)= .15 + 1(.30-.15)= .30
b) E(Re)= E(Ra) + (D/E)*(E(Ra)-E(Rd))=.30+1(.30-.225)=.375

where E(Rd)=.15+.5(.30-.15)=.225

Question 2

An all-equity firm is subject to a 30% corporate tax rate, and its equity holders require a 20% return. Its total market value is initially $3,500,000. There are 175,000 shares outstanding. It then issues $1 million of bonds at 10% interest and uses the proceeds to buy back common stock (Assume no change in costs of financial distress). What is the change in the market value of the equity of the firm on a per-share basis?

Answer 2

Initially, the market value of equity on a per share basis is:

    $3.5mm/.175mm shares = $20

The repurchase creates a tax shield worth (0.3)*(1,000,000)= $300,000. This raises firm value to $3,800,000. The resulting increase in firm value accrues to all the existing shareholders, including those who will be selling their shares back to the firm. Thus, letting P be the share price after the repurchase and N the number of shares repurchased:

condition (1): 1,000,000= P*N

condition (2): P=(3,800,000-1,000,000)/(175,000-N)

Solving for P yields P=$21.71 and N=46,061 shares

The per share change in the price of the stock is $1.71

Question 3

Better Bagels Co. has an equity beta of 0.8 and a capital structure with 40% debt (the debt is risk free). The CFO intends to maintain that 40% target leverage ratio indefinitely. What is the firm’s asset beta given that the tax rate is 35%

Answer 3

0.48

asset beta=equity beta(E/V)=0.8.6=0.48
Even though there are taxes, the CFO’s statement about a target debt percentage is the hint that the correct unlevering/relevering formula is the one I called the zero-Monty.

Question 4

Generally, which if the following is true? (e=equity, d=debt, a=assets, R=expected return)

Answer 4

a) Rd>Ra

b) Re

Question 5

TRUE / FALSE A possible consequences of financial distress is that Equity investors would like the company to cut its dividend to conserve cash

Answer 5

FALSE

Question 6

TRUE / FALSE It is better for firms with large accumulated losses to borrow than it is for firms that are tax-paying.

Answer 6

FALSE

[These firms can’t utilize debt tax shields as much as profitable firms.]

Question 7

TRUE / FALSE In an MM world, the expected rate of return on equity is independent of capital structure so long as the probability of default is zero.

Answer 7

FALSE

[the equity beta increase with leverage!]

Question 8

EZ Construction’s balance sheet is as follows (NWC= net working capital; LTA=long-term assets; D=debt; E=equity; V=firm value):

             Market  Values
      \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_
        NWC    200     500       D
        LTA    2800    2500      E
                \_\_\_\_      \_\_\_\_
                3000      3000      V

According to MM’s Proposition I corrected for corporate taxes, what would be the change in company value if EZ Construction issues $200 of equity and uses it to make a permanent reduction in the company’s debt? Assume a 30 percent corporate tax rate.

Answer 8

a) - $60

Retiring $200 of debt creates a negative tax shield of -(200)(Tc)= -$ 60
This valuation method is APV: it assume the debt is permanent and fixed in $ terms.

Question 9

TRUE / FALSE In the Barclay/Smith study of the determinants of capital structure, a statistically significant positive association was discovered between leverage and the book-to-market ratio.

Answer 9

TRUE

Question 10

In an MM world without taxes, which will be more volatile, ROE or ROA?

Answer 10

ROE will be more volatile.

Question 11

EZ Construction’s balance sheet is as follows (NWC= net working capital; LTA=long-term assets; D=debt; E=equity; V=firm value):

             Market  Values
      \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_
        NWC    200     500       D
        LTA    2800    2500      E
                \_\_\_\_      \_\_\_\_
                3000      3000      V

According to MM’s Proposition I corrected for corporate taxes, what would be the change in company value if EZ Construction issues $200 of debt and uses it to make a permanent reduction in the company’s equity? Assume a 30 percent corporate tax rate.

Answer 11

+$60
+$60
+$60
—-
Adding $200 of debt creates a tax shield of (200)(Tc)= $ 60
This valuation method is APV: it assumes the debt is permanent and fixed in $ terms.

Question 12

TRUE / FALSE Assuming that corporate taxes are 35%, but that personal taxes on equity and interest income are the same for all your shareholders and lenders, it would still be very desirable (from a tax perspective) for firms to borrow.

Answer 12

TRUE

Question 13

TRUE / FALSE A plastics manufacturer is afraid of increases in the price of oil (oil is the key raw material used in the production of plastics) and hedges its raw material requirements by buying oil forward at $90 a barrel. If during the next year the average spot price of oil turns out to be $105, then these forward contracts are said to be ‘underwater’.

Answer 13

FALSE