Score: 100

out of 100 points (100%)

1.

aw ard:

10 out of 10.00 points Pendergast, Inc., has no debt outstanding and a total market value of $117,000. Earnings before interest and taxes, EBIT, are projected to be $8,300 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percent lower. Pendergast is considering a $41,700 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,900 shares outstanding. Ignore taxes for this problem. Requirement 1: (a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).) Recession Normal Expansion EPS $ 1.45 $ 2.13 $ 2.62

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).) %EPS Recession Expansion -32 23 % %

Requirement 2: Assume Pendergast goes through with recapitalization. (a) Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).) Recession Normal Expansion EPS $ 1.42 $ 2.48 $ 3.24

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).) Recession Expansion %EPS -43.00 31.00 % %

rev: 11_12_2013_QC_40178

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Pendergast, Inc., has no debt outstanding and a total market value of $117,000. Earnings before interest and taxes, EBIT, are projected to be $8,300 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 23 percent higher. If there is a recession, then EBIT will be 32 percent lower. Pendergast is considering a $41,700 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 3,900 shares outstanding. Ignore taxes for this problem. Requirement 1: (a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).) EPS 1.45 1% 2.13 1% 2.62 1%

Recession Normal Expansion

$ $ $

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).) %EPS -32 1% % 23 1% %

Recession Expansion

Requirement 2: Assume Pendergast goes through with recapitalization. (a) Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).) EPS $ 1.42 1% $ $ 2.48 1% 3.24 1%

Recession Normal Expansion

(b) Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).) %EPS -42.74 1% % 30.72 1% %

Recession Expansion
rev: 11_12_2013_QC_40178 Explanation:

1: A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 3,900 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest NI EPS %EPS Recession $ 5,644 0 $ 5,644 $ 1.45 32% Normal $ 8,300 0 $ 8,300 $ 2.13 Expansion $10,209 0 $10,209 $ 2.62 +23%

2: If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = $117,000 / 3,900 Share price = $30 Shares repurchased = Debt issued / Share price Shares repurchased = $41,700 / $30 Shares repurchased = 1,390 The interest payment each year under all three scenarios will be: Interest payment = $41,700(0.05) Interest payment = $2,085 The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. EBIT Interest NI EPS %EPS Recession $ 5,644 2,085 $ 3,559 $ 1.42 42.74% Normal $ 8,300 2,085 $ 6,215 $ 2.48 Expansion $10,209 2,085 $ 8,124 $ 3.24 +30.72%

2.

aw ard:

10 out of 10.00 points Pendergast, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $95,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Pendergast has a tax rate of 35 percent. a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) EPS

Recession Normal Expansion

$ 2.93 $ 3.90 $ 4.49

a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.) Percentage changes in EPS Recession -25 Expansion 15 % %

b-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16)) Recession Normal Expansion EPS $ 5.73 $ 8.39 $ 9.99

b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) Percentage changes in EPS Recession -32.00 Expansion 19.00 % %

Worksheet

Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.

Pendergast, Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $95,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 6,000 shares outstanding. Pendergast has a tax rate of 35 percent. a-1 Calculate earnings per share (EPS) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) EPS 2.92 1% 3.90 1% 4.48 1%

Recession Normal Expansion

$ $ $

a-2 Calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.) Percentage changes in EPS Recession -25 1% % Expansion 15 1% %

b-1 Assume that the company goes through with recapitalization. Calculate earnings per share (EPS) under each of the three economic scenarios assuming the company goes through with recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16)) EPS 5.73 1% 8.39 1% 9.99 1%

Recession Normal Expansion

$ $ $

b-2 Given the recapitalization, calculate the percentage changes in EPS when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) Percentage changes in EPS Recession -31.69 1% % Expansion 19.01 1% %

Explanation: a.

A table outlining the income statement with taxes for the three possible states of the economy is shown below. The share price is $25, and there are 6,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. EBIT Interest Recession $ 27,000 0 9,450 $ 17,550 $ 2.92 25 Normal $ 36,000 0 12,600 $ 23,400 $ 3.90 Expansion $ 41,400 0 14,490 $ 26,910 $ + 4.48 15

NI EPS %EPS
b.

If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = $150,000/6,000 Share price = $25 Shares repurchased = Debt issued / Share price Shares repurchased = $95,000/$25 Shares repurchased = 3,800 The interest payment each year under all three scenarios will be: Interest payment = $95,000(0.08) = $7,600 A table outlining the income statement with taxes for the three possible states of the economy and assuming the company undertakes the proposed capitalization is shown below. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization.

EBIT Interest

Recession $ 27,000 7,600 6,790 $ 12,610 $ 5.73 31.69

Normal $ 36,000 7,600 9,940 $ 18,460 $ 8.39

Expansion $ 41,400 7,600 11,830 $ 21,970 $ + 9.99 19.01

NI EPS %EPS

3.

aw ard:

10 out of 10.00 points Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) Recession Normal Expansion ROE 12.27 16.36 19.31 % % %

a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.) Recession Expansion % change in ROE -25 % 18 %

Assume the firm goes through with the proposed recapitalization. b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Round your answers to 2 decimal places. (e.g., 32.16)) Recession Normal Expansion ROE 17.89 27.37 34.19 % % %

b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE -34.63 % 24.92 %

Recession Expansion

Assume the firm has a tax rate of 35 percent.

c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) Recession Normal Expansion ROE 7.98 10.64 12.55 % % %

c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.) Recession Expansion % change in ROE -25 % 18 %

c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16)) Recession Normal Expansion ROE 11.63 17.79 22.22 % % %

c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) Recession Expansion % change in ROE -34.63 % 24.92 %

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.

Pendergast, Inc., has no debt outstanding and a total market value of $220,000. Earnings before interest and taxes, EBIT, are projected to be $36,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 18 percent higher. If there is a recession, then EBIT will be 25 percent lower. Pendergast is considering a $125,000 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares of stock. There are currently 11,000 shares outstanding. Ignore taxes for questions a and b. Assume the company has a market-to-book ratio of 1.0. a-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) ROE 12.27 1% % 16.36 1% % 19.31 1% %

Recession Normal Expansion

a-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.)

Recession Expansion

% change in ROE -25 1% % 18 1% %

Assume the firm goes through with the proposed recapitalization. b-1 Calculate the return on equity (ROE) under each of the three economic scenarios. (Round your answers to 2 decimal places. (e.g., 32.16)) ROE 17.89 1% % 27.37 1% % 34.19 1% %

Recession Normal Expansion

b-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE -34.62 1% % 24.92 1% %

Recession Expansion

Assume the firm has a tax rate of 35 percent. c-1 Calculate return on equity (ROE) under each of the three economic scenarios before any debt is issued. (Round your answers to 2 decimal places. (e.g., 32.16)) ROE 7.98 1% % 10.64 1% % 12.55 1% %

Recession Normal Expansion

c-2 Calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign.) % change in ROE -25 1% % 18 1% %

Recession Expansion

c-3 Calculate the return on equity (ROE) under each of the three economic scenarios assuming the firm goes through with the recapitalization. (Round your answers to 2 decimal places. (e.g., 32.16)) ROE 11.63 1% % 17.79 1% % 22.22 1% %

Recession Normal Expansion

c-4 Given the recapitalization, calculate the percentage changes in ROE when the economy expands or enters a recession. (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places. (e.g., 32.16)) % change in ROE -34.62 1% %

Recession

Expansion

24.92 1% %

Explanation: a.

Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE: ROE = NI/$220,000 The ROE for each state of the economy under the current capital structure and no taxes is: ROE %ROE Recession 0.1227 25 Normal Expansion 0.1636 0.1931 + 18

The second row shows the percentage change in ROE from the normal economy.
b.

If the company undertakes the proposed recapitalization, the new equity value will be: Equity = $220,000 125,000 Equity = $95,000 So, the ROE for each state of the economy is: ROE = NI/$95,000 ROE %ROE
c.

Recession 0.1789 34.62

Normal Expansion 0.2737 0.3419 + 24.92

If there are corporate taxes and the company maintains its current capital structure, the ROE is: ROE %ROE 0.0798 25 0.1064 0.1255 + 18

If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is: ROE %ROE 0.1163 34.62 0.1779 0.2222 + 24.92

The percentage change in ROE is the same with or without taxes.

4.

aw ard:

10 out of 10.00 points Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 150,000 shares of stock outstanding. Under Plan II, there would be 100,000 shares of stock outstanding and $1.20 million in debt outstanding. The

interest rate on the debt is 5 percent, and there are no taxes. a. If EBIT is $300,000, what is the EPS for each plan? (Round your answers to 2 decimal places. (e.g., 32.16)) Plan I Plan II EPS $ 2.00 $ 2.40

b. If EBIT is $550,000, what is the EPS for each plan? (Round your answers to 2 decimal places. (e.g., 32.16)) Plan I Plan II EPS $ 3.67 $ 4.90

c. What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Break-even EBIT $ 180,000

Worksheet

Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.

Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 150,000 shares of stock outstanding. Under Plan II, there would be 100,000 shares of stock outstanding and $1.20 million in debt outstanding. The interest rate on the debt is 5 percent, and there are no taxes. a. If EBIT is $300,000, what is the EPS for each plan? (Round your answers to 2 decimal places. (e.g., 32.16)) EPS 2.00 1% 2.40 1%

Plan I Plan II

$ $

b. If EBIT is $550,000, what is the EPS for each plan? (Round your answers to 2 decimal places. (e.g., 32.16)) EPS Plan I Plan II $ $ 3.67 1% 4.90 1%

c. What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Break-even EBIT $ 180,000 0.1%

Explanation:

a.

Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: EPS = $300,000/150,000 shares EPS = $2.00 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: NI = $300,000 0.05($1,200,000) NI = $240,000 And the EPS will be: EPS = $240,000/100,000 shares EPS = $2.40 Plan II has the higher EPS when EBIT is $300,000.
b.

Under Plan I, the net income is $550,000 and the EPS is: EPS = $550,000/150,000 shares EPS = $3.67 Under Plan II, the net income is: NI = $550,000 0.05($1,200,000) NI = $490,000 And the EPS is: EPS = $490,000/100,000 shares EPS = $4.90 Plan II has the higher EPS when EBIT is $550,000.
c.

To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: EBIT/150,000 = [EBIT 0.05($1,200,000)]/100,000 EBIT = $180,000

5.

aw ard:

10 out of 10.00 points Rise Against Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 190,000 shares of stock outstanding. Under Plan II, there would be 140,000 shares of stock outstanding and $1.95 million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes. Use M&M Proposition I to find the price per share. (Round your answer to 2 decimal places. (e.g., 32.16))

Share price

$ 39.00

per share

What is the value of the firm under each of the two proposed plans? (Do not round intermediate calculations and round your final answers to the nearest whole dollar amount. (e.g., 32))

All equity plan Levered plan

$ 7,410,000 $ 7,410,000

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Rise Against Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 190,000 shares of stock outstanding. Under Plan II, there would be 140,000 shares of stock outstanding and $1.95 million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes. Use M&M Proposition I to find the price per share. (Round your answer to 2 decimal places. (e.g., 32.16)) Share price $ 39.00 1% per share

What is the value of the firm under each of the two proposed plans? (Do not round intermediate calculations and round your final answers to the nearest whole dollar amount. (e.g., 32))

All equity plan Levered plan

$ $

7,410,000 0.01% 7,410,000 0.01%

Explanation:

We can find the price per share by dividing the amount of debt used to repurchase shares by the number of shares repurchased. Doing so, we find the share price is: Share price = $1,950,000/(190,000 140,000) Share price = $39.00 per share The value of the company under the all-equity plan is: V= $39.00(190,000 shares) = $7,410,000 And the value of the company under the levered plan is: V = $39.00(140,000 shares) + $1,950,000 debt = $7,410,000

6.

aw ard:

10 out of 10.00 points Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and $100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on

the debt is 8 percent. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $90,000. The all-equity plan would result in 18,000 shares of stock outstanding. What is the EPS for each of these plans? (Round your answers to 2 decimal places. (e.g., 32.16)) Plan I Plan II All equity EPS $ 5.91 $ 7.00 $ 5.00

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Plan I and all-equity Plan II and all-equity EBIT $ 36,000 $ 36,000

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? EBIT $ 36,000

d-1 Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round your answers to 2 decimal places. (e.g., 32.16)) Plan I Plan II All equity EPS $ 3.51 $ 4.20 $ 3.00

d-2 Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? Plan I and all-equity Plan II and all-equity EBIT $ 36,000 $ 36,000

d-3 Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II? EBIT $ 36,000

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.

Destin Corp. is comparing two different capital structures. Plan I would result in 14,000 shares of stock and $100,000 in debt. Plan II would result in 10,800 shares of stock and $180,000 in debt. The interest rate on the debt is 8 percent. a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $90,000. The all-equity plan would result in 18,000 shares of stock outstanding. What is the EPS for each of these plans? (Round your answers to 2 decimal places. (e.g., 32.16)) EPS

Plan I Plan II All equity

$ $ $

5.86 1% 7.00 1% 5.00 1%

b. In part (a), what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? EBIT 36,000 0.1% 36,000 0.1%

Plan I and all-equity Plan II and all-equity

$ $

c. Ignoring taxes, at what level of EBIT will EPS be identical for Plans I and II? EBIT $ 36,000 0.1%

d-1 Assuming that the corporate tax rate is 40 percent, what is the EPS of the firm? (Round your answers to 2 decimal places. (e.g., 32.16)) EPS 3.51 1% 4.20 1% 3.00 1%

Plan I Plan II All equity

$ $ $

d-2 Assuming that the corporate tax rate is 40 percent, what are the break-even levels of EBIT for each plan as compared to that for an all-equity plan? EBIT 36,000 0.1% 36,000 0.1%

Plan I and all-equity Plan II and all-equity

$ $

d-3 Assuming that the corporate tax rate is 40 percent, when will EPS be identical for Plans I and II? EBIT $ 36,000 1%

Explanation: a.

The income statement for each capitalization plan is: Allequity $ 90,000 $ 90,000 $ 90,000 8,000 14,400 0 I II $ 82,000 $ 36,000 $ 90,000 $ 5.86 $ 7.00 $ 5.00

EBIT Interest NI EPS

The Plan II has the highest EPS; All equity has the lowest EPS.
b.

The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is

calculated as: EPS = (EBIT RDD)/Shares outstanding This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest term is zero. To find the breakeven EBIT for two different capital structures, we simply set the equations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capital structure and Plan I is: EBIT/18,000 = [EBIT 0.08($100,000)]/14,000 EBIT = $36,000 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT/18,000 = [EBIT 0.08($180,000)]/10,800 EBIT = $36,000 The break-even levels of EBIT are the same because of M&M Proposition I.
c.

Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: [EBIT 0.08($100,000]/14,000 = [EBIT 0.08($180,000)]/10,800 EBIT = $36,000 This break-even level of EBIT is the same as in part b again because of M&M Proposition I.
d.

The income statement for each capitalization plan with corporate income taxes is: Allequity $ 90,000 $ 90,000 $ 90,000 8,000 14,400 0 32,800 30,240 45,360 I II $ 49,200 $ 45,360 $ 54,000 $ 3.51 $ 4.20 $ 3.00

EBIT Interest Taxes NI EPS

The Plan II still has the highest EPS; all-equity plan still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT RDD)(1 T)]/Shares outstanding This is similar to the equation we used before, except now we need to account for taxes. Again, the interest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all-equity plan and Plan I is: EBIT(1 0.40)/18,000 = [EBIT 0.08($100,000)](1 0.40)/14,000 EBIT = $36,000 The break-even EBIT between the all-equity plan and Plan II is:

EBIT(1 0.40)/18,000 = [EBIT 0.08($180,000)](1 0.40)/10,800 EBIT = $36,000 And the breakeven between Plan I and Plan II is: [EBIT 0.10($100,000)](1 0.40)/14,000 = [EBIT 0.08($180,000)](1 0.40)/10,800 EBIT = $36,000

7.

aw ard:

10 out of 10.00 points Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 25 percent debt. Currently, there are 12,000 shares outstanding, and the price per share is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9 percent, and there are no taxes. a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Round your answer to 2 decimal places. (e.g., 32.16)) Cash flow $ 300.00

b. What will Allisons cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cash flow $ 232.00

c. Assume that Allison unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Total Cash flow $ 300.00

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Mudpack, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is 25 percent debt. Currently, there are 12,000 shares outstanding, and the price per share is $56. EBIT is expected to remain at $36,000 per year forever. The interest rate on new debt is 9 percent, and there are no taxes. a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent? (Round your answer to 2 decimal places. (e.g., 32.16)) Cash flow $ 300.00 0.1%

b. What will Allisons cash flow be under the proposed capital structure of the firm? Assume she keeps all 100 of her shares. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Cash flow

232.00 0.1%

c. Assume that Allison unlevers her shares and re-creates the original capital structure. What is her cash flow now? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Total Cash flow $ 300.00 0.1%

Explanation: a.

The earnings per share are: EPS = $36,000/12,000 shares EPS = $3.00 So, the cash flow for the investor is: Cash flow = $3.00(100 shares) Cash flow = $300.00
b.

To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is: V = $56(12,000) V = $672,000 Under the proposed capital structure, the firm will raise new debt in the amount of: D = 0.25($672,000) D = $168,000 in debt. This means the number of shares repurchased will be: Shares repurchased = $168,000/$56 Shares repurchased = 3,000 Under the new capital structure, the company will have to make an interest payment on the new debt. The net income with the interest payment will be: NI = $36,000 0.090($168,000) NI = $20,880.00 This means the EPS under the new capital structure will be: EPS = $20,880.00/(12,000 3,000) shares EPS = $2.3200 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $2.3200(100 shares) Shareholder cash flow = $232.00
c.

To replicate the proposed capital structure, the shareholder should sell 25 percent of her shares, or 25

shares, and lend the proceeds at 9 percent. The shareholder will have an interest cash flow of: Interest cash flow = 25($56)(0.090) Interest cash flow = $126.00 The shareholder will receive dividend payments on the remaining 75 shares, so the dividends received will be: Dividends received = $2.3200(75 shares) Dividends received = $174.00 The total cash flow for the shareholder under these assumptions will be: Total cash flow = $126.00 + 174.00 Total cash flow = $300.00 This is the same cash flow we calculated in part a.

8.

aw ard:

10 out of 10.00 points ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes. a. Rico owns $39,000 worth of XYZs stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16)) Rate of return 15.35 %

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

Total cash flow Rate of return

$ 5,985 15.35

c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) ABC XYZ Cost of equity 10.92 % 15.35 %

d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) ABC XYZ WACC 10.92 10.92 % %

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes. a. Rico owns $39,000 worth of XYZs stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16)) Rate of return 15.35 1% %

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

Total cash flow Rate of return

5,985 0.1% 15.35 1% %

c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) Cost of equity 10.92 1% % 15.35 1% %

ABC XYZ

d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) WACC 10.92 1% % 10.92 1% %

ABC XYZ

Explanation: a.

The rate of return earned will be the dividend yield. The company has debt, so it must make an interest payment. The net income for the company is: NI = $71,000 0.065($325,000) NI = $49,875 The investor will receive dividends in proportion to the percentage of the companys shares they own. The total dividends received by the shareholder will be: Dividends received = $49,875($39,000/$325,000) Dividends received = $5,985 So the return the shareholder expects is: R = $5,985/$39,000 R = 0.1535, or 15.35%
b.

To generate exactly the same cash flows in the other company, the shareholder needs to match the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net $39,000. The shareholder should then borrow $39,000. This will create an interest cash flow of: Interest cash flow = 0.065($39,000)

Interest cash flow = $2,535 The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive dividends in proportion to the percentage of the companys shares they own. The total dividends received by the shareholder will be: Dividends received = $71,000[($39,000 + 39,000)/$650,000] Dividends received = $8,520 The total cash flow for the shareholder will be: Total cash flow = $8,520 2,535 Total cash flow = $5,985 The shareholder's return in this case will be: R = $5,985/$39,000 R = 0.1535, or 15.35%
c.

ABC is an all equity company, so: RE= RA = $71,000/$650,000 RE= 0.1092, or 10.92% To find the cost of equity for XYZ we need to use M&M Proposition II, so: RE = RA + (RA RD)(D/E)(1 T) RE = 0.1092 + (0.1092 0.065)(1)(1) RE = 0.1535, or 15.35%
d.

To find the WACC for each company we need to use the WACC equation: WACC = (E/V)RE + (D/V)RD(1 T) So, for ABC, the WACC is: WACC = (1)(0.1092) + (0)(0.065) WACC = 0.1092, or 10.92% And for XYZ, the WACC is: WACC = (1/2)(0.1535) + (1/2)(0.065) WACC = 0.1092, or 10.92% When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital structure; this is M&M Proposition II without taxes.

9.

aw ard:

10 out of 10.00 points STP Corp. uses no debt. The weighted average cost of capital is 7.6 percent. The current market value of the equity is $14 million and the corporate tax rate is 35 percent. What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Round your answer to 2 decimal places. (e.g., 32.16)) EBIT $ 1,636,923.08

Worksheet

Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.

STP Corp. uses no debt. The weighted average cost of capital is 7.6 percent. The current market value of the equity is $14 million and the corporate tax rate is 35 percent. What is the EBIT? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Round your answer to 2 decimal places. (e.g., 32.16)) EBIT $ 1,636,923.08 0.01%

Explanation:

If there are corporate taxes, the value of an unlevered firm is: VU = EBIT(1 T)/RU Using this relationship, we can find EBIT as: $14,000,000 = EBIT(1 0.35)/0.076 EBIT = $1,636,923.08

10.

aw ard:

10 out of 10.00 points Skillet Industries has a debtequity ratio of 1.5. Its WACC is 9.2 percent, and its cost of debt is 6.0 percent. The corporate tax rate is 35 percent. a. What is the companys cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity capital 17.15 %

b. What is the companys unlevered cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16)) Unlevered cost of equity capital 11.65 %

c-1 What would the cost of equity be if the debtequity ratio were 2? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity

18.99

c-2 What would the cost of equity be if the debtequity ratio were 1.0? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity 15.32 %

c-3 What would the cost of equity be if the debtequity ratio were zero? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity 11.65 %

Worksheet

Learning Objective: 16-01 The effect of financial leverage.

Skillet Industries has a debtequity ratio of 1.5. Its WACC is 9.2 percent, and its cost of debt is 6.0 percent. The corporate tax rate is 35 percent. a. What is the companys cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity capital 17.15 1% %

b. What is the companys unlevered cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16)) Unlevered cost of equity capital 11.65 1% %

c-1 What would the cost of equity be if the debtequity ratio were 2? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity 18.98 1% %

c-2 What would the cost of equity be if the debtequity ratio were 1.0? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity 15.32 1% %

c-3 What would the cost of equity be if the debtequity ratio were zero? (Round your answer to 2 decimal places. (e.g., 32.16)) Cost of equity 11.65 1% %

Explanation: a.

With the information provided, we can use the equation for calculating WACC to find the cost of equity. The equation for WACC is: WACC = (E/V)RE + (D/V)RD(1 T) The company has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and the weight of

equity is 1/2.5, so WACC = 0.092 = (1/2.5)RE + (1.5/2.5)(0.060)(1 0.35) RE = 0.17150, or 17.15%

b.

To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so: RE = RU + (RU RD)(D/E)(1 T) 0.17150 = RU + (RU 0.060)(1.5)(1 0.35) RU = 0.1165, or 11.65%
c.

To find the cost of equity under different capital structures, we can again use M&M Proposition II with taxes. With a debt-equity ratio of 2, the cost of equity is: RE = RU + (RU RD)(D/E)(1 T) RE = 0.1165 + (0.1165 0.060)(2)(1 0.35) RE = 0.1898, or 18.98% With a debt-equity ratio of 1.0, the cost of equity is: RE = 0.1165 + (0.1165 0.060)(1)(1 0.35) RE = 0.1532, or 15.32% And with a debt-equity ratio of 0, the cost of equity is: RE = 0.1165 + (0.1165 0.060)(0)(1 0.35) RE = RU = 0.1165, or 11.65%