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    This document provides solutions to capital structure and leverage assignment problems. Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value. Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable. Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.

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    This document provides solutions to capital structure and leverage assignment problems. Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value. Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable. Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.

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    47 views3 pages

    FM II Assignment 17 Solution 19

    Uploaded by

    Raazia
    This document provides solutions to capital structure and leverage assignment problems. Problem 1 calculates WACC at different debt levels, finding the unlevered beta and then recalculating WACC after a recapitalization. The new WACC is lower, so the firm should proceed with recapitalization to increase firm value. Problem 2 evaluates EPS with and without a new investment that uses either more debt or equity financing. EPS is higher if leverage is used due to tax benefits, so debt financing is preferable. Problem 2 also calculates the unlevered beta from the levered beta using the Hamada equation.

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    of 3

    Lahore School of Economics

    Financial Management II
    Capital Structure and Leverage – 3
    Assignment 17 Solution
    Problems for Assignment
    Q1) a. WACC = wdrd(1 – T) + wcrs
    = (0.2)(8%)(1 – 0.4) + (0.8)(12.5%)
    = 10.96%.

    b. The firm's current levered beta at 20% debt can be found using the CAPM formula.
    rs = rRF + (rM – rRF)b
    12.5% = 5% + (6%)b
    b = 1.25.

    c. Using Hamada equation’s:


    bL = bU[1 + (1 – T)(D/E)]
    1.25 = bU[1 + (1 – 0.4)(0.2/0.8)]
    1.25 = bU(1.15)
    bU = 1.086957.

    d. bL,40% = bU[1 + (1 – T)(D/E)]


    bL,40%= 1.086957 [1 + (1 – 0.4)(0.4/0.6)]
    bL,40% = 1.086957(1.4)
    bL,40% = 1.521739.

    The firm's cost of equity is derived using the CAPM equation.


    rs = rRF + (rM – rRF)b
    rs = 5% + (6%)1.521739
    rs = 14.13%.

    e. The relevant before-tax cost of debt is now 9.5% and the cost of equity is 14.13%.
    WACC = wdrd(1 – T) + wcrs
    = (0.4)(9.5%)(1 – 0.4) + (0.6)(14.13%)
    = 10.76%.

    f. The firm should be advised to proceed with the recapitalization as it causes the WACC to decrease
    from 10.96% to 10.76%. As a result, the recapitalization would lead to an increase in firm value.

    Q2) Without new investment:


    Sales $12,960,000
    VC 10,200,000
    FC 1,560,000
    EBIT $ 1,200,000
    Interest 384,000*
    EBT $ 816,000
    Tax (40%) 326,400
    Net income $ 489,600

    *Interest = 0.08($4,800,000) = $384,000.

    EPSOld = $489,600/240,000 = $2.04.


    With new investment:
    Debt Stock
    Sales $12,960,000 $12,960,000
    VC (0.8)($10,200,000) 8,160,000 8,160,000
    FC 1,800,000 1,800,000
    EBIT $ 3,000,000 $ 3,000,000
    Interest 1,104,000** 384,000
    EBT $ 1,896,000 $ 2,616,000
    Tax (40%) 758,400 1,046,400
    Net income $ 1,137,600 $ 1,569,600

    **Interest = 0.08($4,800,000) + 0.10($7,200,000) = $1,104,000.

    EPSD = $1,137,600/240,000 = $4.74.

    EPSS = $1,569,600/480,000 = $3.27.

    EPS should improve, but expected EPS is significantly higher if financial leverage is used.

    Examples
    Q1) a) Market value of equity = Market price of share x Number of shares outstanding
    = $2 x 190,000
    = $380,000
    Debt = $95,000
    Total Assets = 95,000 + 380,000 = $475,000

     wd = 95000/475000 = 0.2 ws = 380000/475000 = 0.8

    rs = Rrf + RPM*b
    = 5% + 6%*1.2
    = 12.2%

    WACC = wdrd(1 – T) + wsrs


    = (0.2)(8.5%)(1 – 0.4) + (0.8)(12.2%)
    = 10.78%.

    b) WACC will change after recapitalization due to change in weights as well as cost of capital.

    Increase in debt = $95,000


    New debt level = 95000 + 95000 = $190,000

    Decrease in equity = $95,000


    New equity level = 380,000 – 95000 = $285,000

    Number of shares repurchased = Decrease in equity/Price of share = 95000/2 = 47,500


    New number of shares outstanding = 190,000 – 47,500 = 142,500

    New wd = 190000/475000 = 0.4 new ws = 285000/475000 = 0.6

    New rd = 10%
    To calculate new rs, the new levered beta is needed.
    To calculate the new levered beta, the unlevered beta has to be calculated first at existing D/E using Hamada’s
    equation.

    bL = bU[1 + (1 – T)(D/E)]
    1.2 = bU[1 + (1 – 0.4)(95000/380000)]
    1.2 = bU(1.15)
    bU = 1.04347.

    The new levered beta now is:


    bL = bU[1 + (1 – T)(D/E)]
    bL = 1.04347 [1 + (1 – 0.4)(190000/285000)]
    bL = 1.46086.

    The firm's cost of equity is derived using the CAPM equation.


    rs = rRF + (rM – rRF)b
    rs = 5% + (6%)1.46086
    rs = 13.765%.

    WACC = wdrd(1 – T) + wsrs


    = (0.4)(10%)(1 – 0.4) + (0.6)(13.765%)
    = 10.659%.

    c) The market price of the share will also change after recapitalization.
    As growth rate is 0%, EPS = D1

    EPS = (EBIT – rd*Debt level)(1 – T)


    Number of shares
    = (89000 – 0.1*190000)(1 – 0.4)
    142,500
    = $0.2947 per share

    Therefore, D1 = EPS = $0.2947


    P0 = D1/rs = 0.2947/.13765 = $2.14

    Q2) From the Hamada equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU as bU = b/[1 + (1 – T)(D/E)].

    bU = 1.2/[1 + (1 – 0.4)($2,000,000/$8,000,000)]
    bU = 1.2/[1 + 0.15]
    bU = 1.0435.

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