Topic 6 - Capital Structure Part 1 Flashcards
Problem 1 - Home Made Leverage - Context
Firm A considers converting all-equity cap structure to 40% debt 60% equity.
200 shares outstanding, £10 share price. Market Cap of £2,000.
EBIT constantly £500
New Debt I.R = 10% (no tax)
I own 20 shares (10% ownership)
Assume all earnings are paid in dividends in both alternatives.
Problem 1 - Home Made Leverage - Show how to unlever shares to recreate the original all-equity cap structure (Step 1)
Let’s figure out the Current All-Equity Capital Structure
Earnings per Share = EBIT / Shares
= £500 / 200 shares = £2.5
My cashflow/earnings from this ownership = EPS (2.5) * my shares (20) = £50
Problem 1 - Home Made Leverage - Show how to unlever shares to recreate the original all-equity cap structure (Step 2) - Part 1
Now, the Proposed 40% Debt Capital Structure
Market value of the firm = 2,000
We want 40% of this to be debt.
We want 0.4*2000 = £800 of debt
The firm, obviously, repurchases these shares.
£800 debt / £10 per share = 80 shares
200 shares – 80 shares =
120 number of shares after repurchase.
Problem 1 - Home Made Leverage - Show how to unlever shares to recreate the original all-equity cap structure (Step 2) - Part 2
Under the new cap structure, we pay interest on new debt.
EBIT – Interest Payments
= 500 – 0.1 (£800)
= £420 (new earnings)
EPS under new cap structure =
£420 / 120 shares = £3.5
Problem 1 - Home Made Leverage - Show how to unlever shares to recreate the original all-equity cap structure (Step 3)
My cashflow/earnings from this ownership = EPS 3.5 * my shares (20) = £70
To replicate the original capital structure, I should sell 40% / 8 of my shares and lend the proceeds at 10% (the I.R of the debt) because I previously had 10% ownership (20 / 200) and must replicate (12 / 120)
8 shares * £10 per share * 10% interest = £8 cashflow I get for lending
I receive dividends on the rest of the shares.
£3.5 * 12 shares = £42
My total cashflow is then £8 + £42 = £50
Good for me, this is the same cash flow calculated for the current all-equity structure.
This proves M&M’s proposition 1 without taxes completely right, as the capital structure is therefore irrelevant. This is because shareholders like me can create their own leverage or unlever the equity to create the payoff I want.
Problem 2 - Leverage Changes and Cost of Capital - Context
Consider a firm with a D/V of 0.1. Debt / Market Value = 0.1
Market Value of Equity = £9000
Expected Return on Debt = 5%
Expected Return on Equity = 10%
100 outstanding shares
No tax, no distress.
Problem 2 - Leverage Changes and Cost of Capital - Step 1 - Firm’s WACC, RoA and EV
A) What’s the firm’s WACC, return on assets and enterprise value?
WACC =
(D/V * Expected Return on Debt) + (E/V * Expected Return on Equity)
(0.1 * 5%) + (0.9 * 10%) = 9.5%
Return on Asset is the same.
E/V = 0.9
* V = 9000 (market value of equity)
V = 10000
Problem 2 - Leverage Changes and Cost of Capital - Step 2 - D/V becomes 0.3. Levers up, and the cost of debt increases to 6% through recapitalization (increase in debt, proceeds distributed to shareholders as special dividends) What’s the new return on equity and WACC?
Return on Equity =
Return on Asset (9.5%) + (Debt/Equity (0.3 / 0.7)) * (Return on Asset (9.5%) – Return on Debt (6%)) =
9.5% + (0.3 / 0.7) * (9.5 - 6) = 11%
WACC =
(D/V * Expected Return on Debt) + (E/V * Expected Return on Equity)
(0.3 * 6%) + (0.7 * 11%) = 0.095 or 9.5%
Problem 2 - Leverage Changes and Cost of Capital - Step 3 - What happens to stock price at announcement of change in cap structure
Well, from MM 1 we know no value is created or destroyed. Thus, price will not move at the announcement of the recapitalisation.
Problem 2 - Leverage Changes and Cost of Capital - Step 4 - What happens to Market Value of Equity post recapitalisation - and what’s the impact on shareholders?
Post recap,
E/V = 0.7 * V = 7,000
However, shareholders are equally well off as they receive dividends.
The increase in debt from 1000 to 3000 is distributed to them as dividends, as mentioned in question B.
