Optimal Capital Structure

Question 1

Winfield case

Which of the following assumptions of the Modigliani-Miller theorem are violated in the Winfield case? (Choose all that apply, then explain why each assumption is or is not violated in maximum 100 words total).

• a. No agency problems
• b. No taxes
• c. No transaction costs
• d. No distress costs

Question 2

In determining Winfield’s cost of debt financing, should debt principal repayments be counted?

What if by “cost” we mean “pressure on the firm’s cash flows”?

Explain in maximum 50 words.

Question 3

Capital restructuring and share price Dividendi & Governanza (D&G) is currently an unlevered firm.

The firm expects to generate an EBIT of $2,500 in perpetuity.

The tax rate is 25%.

There are no net working capital, depreciation, or capital expenditures.

The firm has 1,000 shares outstanding, and it pays out all net income as a dividend.

The industry-average cost of unlevered equity capital is 15%.

a. Calculate total firm value, equity value, and stock price.

Draw a stylized balance sheet with only the market values of assets (V) and equity (E)

Answer 3

EBIAT = $2,500(1-.25)= $1,875

NO NWC/DEP/CAPEX

FCF = 1,875

GGM = FCF/(r-g) = $1,875/(.15-.0) = $12,500

Total Value: $12,500 (UNLEVERED)
Equity Value: $12,500

Stock Price: $12,500/1000 = $12.50

Question 4

• Capital restructuring and share price Dividendi & Governanza (D&G) is currently an unlevered firm.*
• The firm expects to generate an EBIT of $2,500 in perpetuity.*
• The tax rate is 25%.*
• There are no net working capital, depreciation, or capital expenditures.*
• The firm has 1,000 shares outstanding, and it pays out all net income as a dividend.*
• The industry-average cost of unlevered equity capital is 15%.*

The CEO of D&G is considering a capital restructuring:

issue $5000 of perpetual debt and use that to repurchase stock.

Its cost of debt capital is 10%.

The CEO would like to do the deal in secret (i.e., first repurchase, then announce).

Draw a sequence of balance sheets to show what happens to the firm upon:

1. borrowing
2. repurchase
3. announcement

Calculate the new firm value, equity value, number of shares, and stock price.

Answer 4

Repurchase $5,000 @ 12.5 = 400 Shares : 600 Shares Outstanding Remain

WACC = Rd * (1-tax) * (D/V) + Re * ((E/V) = .1 * .75 * (.4)) + (.15 * .6) = .12

GGM = 1875/.12 = $15,625

Enterprise (Total) Value = $15,625

Equity Value = Enterprise Value - Debt = $15,625 - $5,000 = $10,625

Stock Price = Eq Val / Sh Outstanding = $10,625/600 = $17.71