AF4320: Corporate Finance

Lecture 6-1: Capital Structure (Part 1)

Group Exercise 1 – EBIT and leverage

Money Inc. has no debt outstanding and a total market value of $250,000. Earnings before interest
and taxes (EBIT) are projected to be $21,000 if economic conditions are normal. If there is a strong
expansion in the economy, then EBIT will be 25% higher. If there is a recession, then EBIT will be 40%
lower. Money is considering a $100,000 debit issue with an interest rate of 8%. The proceeds will be
used to repurchase shares of stocks. There are currently 5,000 shares outstanding. Ignore taxes for
this problem.

a. Calculate earnings per share (EPS) under each of the three economic scenarios before any
debt is issued. Also, calculate the percentage changes in EPS when the economy expands or
enters a recession.

b. Repeat part (a) assuming Money goes through with share repurchase.

c. What do you observe?

Thinking process

a. Calculate the earnings per share using the above information before the share repurchase as
follows:

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest 0 0 0
Net income $12,600 $21,000 $26,250
No. of shares 5,000 5,000 5,000
Earnings per share $2.52 $4.20 $5.25
(EPS)

% Change in EPS -40 % - +25 %

b. With the share repurchase, first determine how many shares can be repurchased with
$100,000 of debt proceeds.

Debt proceeds
Shares to be repurchased =
Price per share

$ 100,000
=
$ 250,000 /5000

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$ 100,000
=
$ 50

= 2,000 shares

Issuing $100,000 of debt will result in an incremental interest expense at 8% p.a. This
reduces the net income, which shall be shared by a lower number of shareholders (5,000
shares – 2,000 shares = 3,000 shares) as follows:

Recession Normal Expansion

EBIT $12,600 $21,000 $26,250
Interest - 8,000 -8,000 -8,000
Net income $4,600 $13,000 $18,250
No. of shares 3,000 3,000 3,000
Earnings per share $1.53 $4.33 $6.08
(EPS)

% Change in EPS -65 % - +40 %

c. It can be observed that:

 In the normal situation, taking on debt and reducing the equity will result in higher
earnings per share. Although the net earnings are reduced by the interest rate, the
earnings are shared by a lower number of shareholders, with a net positive impact
of EPS increasing from $4.20 to $4.33
 When there is a recession and the earnings are reduced, the interest rate burden
reduces the EPS from $2.52 to $1.53, leading to a negative impact on the EPS of the
company.
 In a period where earnings expanded, replacing equity with debt gives more profits
to the shareholders as the interest rate payments are fixed and any excess income is
enjoyed by the shareholders.
 It can also be noted that with more debt, the impact of any change in earnings
(whether positive or negative) is magnified.

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Class Exercise 2 – MM proposition I (No taxes)

Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate
debt. As a result, the firm's debt–equity ratio is expected to rise from 35 percent to 50 percent. The
firm currently has $3.5 million worth of debt outstanding. Locomotive pays no taxes.

a. What is the market value of Locomotive Corporation before the repurchase announcement?
b. What is the market value of Locomotive Corporation after the repurchase announcement?

Thinking process

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 AF4320: Corporate Finance

a. Value of the firm before restructuring.

Calculate the market values of equity using the debt-equity ratio.

Debt
Debt-equity ratio =
Equity

$ 3.5 M
0.35 =
Equity

$ 3.5 M
Equity =
0.35

Equity = $10M

Calculate the value of the firm as follows. In the absence of further information, the market
value of the debt is assumed to be the book value.

V =B+S
= $3.5M + $10M
= $13.5M

b. According to MM Proposition I without taxes, changes in a firm’s capital structure have no

effect on the overall value of the firm.

Value of the firm after restructuring = $13.5M

Proof as follows:

X represents the amount of debt to be issued to purchase stocks.

To achieve a debt-to-equity ratio of 0.5, the equation looks like this:

B $ 3.5 M + x
= = 0.5
S $ 10 M −x

$3.5M + x = ($10M – x)*0.5

X = $1M

B = $3.5M + $1M = $4.5M

S = $10M – $1M = $9.0M

V =B+S
= $4.5M + $9M
= $13.5M

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Class Exercise 3 – MM proposition I (with taxes)

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Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use
the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6
percent. Green is currently an all-equity firm worth $6.3 million with 400,000 shares of common
stock outstanding. After the sale of the bonds, Green will maintain the new capital structure
indefinitely. Green is subject to a corporate tax rate of 40 percent.

a. What is the market value of the company before the repurchase announcement?

b. What is the market value of the company after the repurchase announcement?

Thinking process

a. Value of the firm before restructuring.

V =B+S
= 0 + $6.3M
= $6.3M

b. Value of the firm after restructuring.

MM Proposition I states that in a world with corporate taxes:

𝑉𝐿 = 𝑉𝑈 + 𝑇𝑐𝐵
= $6.3M + $2M * 40%
= $6.3M + $0.8M
= $7.1M

Sanity check: The value of the levered firm, VL should be higher than the unlevered firm, VU
because of the tax benefit of Debt.
Yes, VL is $7.1M while VU is $6.3M

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Class Exercise 4 – MM proposition II (No taxes)

Locomotive Corporation is planning to repurchase part of its common stock by issuing corporate
debt. As a result, the firm's debt–equity ratio is expected to rise from 35 percent to 50 percent. The
firm currently has $3.5 million worth of debt outstanding. The cost of this debt is 8 percent per year.
Locomotive expects to have an EBIT of $1.35 million per year in perpetuity. Locomotive pays no
taxes.

b. What is the expected return on the firm's equity before the announcement of the stock
repurchase plan?
c. What is the expected return on the equity of an otherwise identical all-equity firm?
d. What is the expected return on the firm's equity after the announcement of the stock
repurchase plan?

Thinking process

b. The expected return on a firm’s equity is the ratio of annual earnings to the market
value of the firm’s equity, or return on equity. Before the restructuring, the company’s
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 AF4320: Corporate Finance

EBIT would need to be reduced by interest for $3.5M debt at 8%. No taxes are
payable. Equity was calculated in Class Exercise 2 as $10M.

Net income
ROE or RS =
Equity

$ 1.35 M −$ 3.5 M (8 %)
=
$ 10 M

$ 1.07 M
=
$ 10 M

= 0.107 or 10.7%

Sanity check: The cost of equity should be higher than the cost of debt because equity
holders assume higher risks.
Yes, Cost of equity, RS is 10.7% while cost of debt is 8%

c. According to Modigliani-Miller Proposition II with no taxes, the cost of equity of a

levered firm is equal to the cost of capital of an unlevered firm plus a premium that is
proportional to the market value debt-equity ratio. We can use the cost of equity of a
levered firm above, RE to derive the cost of equity of an all equity firm (i.e. unlevered
firm, RU).

B
R S = R0 + (R0 - RB¿)
S

10.7% = R0 + 35 % (R0 – 8%)

10.7% = R0 + 0.35 R0 – 0.028

0.107+0.028 = 1.35RU

R0 = 0.1 or 10%

Sanity check: The cost of equity for levered firm, RS should be higher than the cost of equity
of unlevered firm, R0 because leverage brings more risks of financial distress
and investors attach a premium for debt leverage.
Yes, Cost of equity for levered firm, RS is 10.7% while cost of equity for
unlevered firm, R0 is 8.18%

d. In part c, we calculated the cost of an all-equity firm. We can use Modigliani-Miller

Proposition II with no taxes again to find the cost of equity for the firm with the new
leverage ratio. The cost of equity under the stock repurchase plan will be:

B
RS = R0 + (R0 - RB¿
S
= 0.1 + 0.5 (0.1 – 0.08)
= 0.1 +0.01
= 0.11 or 11%

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 AF4320: Corporate Finance

Sanity check: The cost of equity, RS for firms with higher leverage would be higher than that
of lower leverage because of the increased risk when debt to equity ratio
increases.
Yes, Cost of equity for the 50% levered firm, RS is higher at 11% while cost of
equity for the 35% levered firm, RS is 10.7%.

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Class Exercise 5 – MM proposition II (with taxes)

Green Manufacturing, Inc., plans to announce that it will issue $2 million of perpetual debt and use
the proceeds to repurchase common stock. The bonds will sell at par with a coupon rate of 6
percent. Green is currently an all-equity firm worth $6.3 million with 400,000 shares of common
stock outstanding. After the sale of the bonds, Green will maintain the new capital structure
indefinitely. Green currently generates annual pretax earnings of $1.5 million. This level of earnings
is expected to remain constant in perpetuity. Green is subject to a corporate tax rate of 40 percent.

a. What is the expected return on Green's equity before the announcement of the debt issue?
b. What is Green's stock price per share immediately after the repurchase announcement?
c. How many shares will Green repurchase as a result of the debt issue?
d. How many shares of common stock will remain after the repurchase?
e. What is the required return on Green's equity after the restructuring?

Thinking process

a. Expected return of equity before restructuring is the ratio of annual earnings to the
market value of the firm’s equity, or return on equity. Before the restructuring, the
company’s Earnings before tax would need to be reduced by the tax amount at 40%.
As this is an all-equity firm, the return on equity is that of an unlevered firm, RU.

Net income
ROE or R0 =
Equity

$ 1.5 M −$ 1.5 M (40 %)

=
$ 6.3 M

$ 0.9 M
=
$ 6.3 M

= 0.1429 or 14.29%

Sanity check: The cost of equity should be higher than the cost of debt because equity
holders assume higher risks.
Yes, Cost of equity, R0 is 14.29% while cost of debt is 8%

b. Using the market value calculated in Exercise 3 above, the share price immediately after
the announcement of the debt issue will be:

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Market value
New share price =
Number of share

$ 7.1 M
=
400,000

= $17.75

c. The number of shares repurchased will be the amount of the debt issue divided by the new
share price, or:

Shares to be repurchased = $2,000,000 / $17.75

= 112,676.06 shares

d. The number of shares outstanding will be the current number of shares minus the
number of shares repurchased, or:

New shares outstanding = 400,000 – 112,676.06

= 287,323.94 shares

e. The required return on Green's equity after the restructuring would increase because of the
leverage. Calculate the return for a levered firm using the MM proposition II with corporate
taxes as follows:

B
R S = R0 + (R0 - RB¿(1 - Tc
S

$2 M
= 14.29% + (14.29% - 6%) (1 – 40%)
$ 17.75∗287,323.94

$2 M
= 0.1429 + (0.04974)
$ 5.1 M

= .1624 or 16.24%

Sanity check: The cost of equity, Rs for firms with leverage would be higher than that of no
leverage because of the increased risk when debt is taken.
Yes, Cost of equity for the levered firm, Rs is higher at 16.24% while cost of
equity for the unlevered firm, R0 is 14.29%.

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 AF4320: Corporate Finance

Multiple Choice
Question Answer
1. A firm’s ________ is referred to as its capital structure.
a. mix of current and fixed assets
b. amount of capital invested in the firm
c. typical amount of dividends it pays d
d. mix of debt and equity used to finance its assets
e. amount of cash versus receivables

2. A general rule for managers to follow is to set the firm’s capital

structure such that the firm’s:
a. size is maximized.
b. value is maximized. b
c. bondholders are secured.
d. suppliers of raw materials are satisfied.
e. dividend payout is maximized.

3. The unlevered cost of capital equals:

a. the cost of capital for a firm with no equity in its capital
structure.
b. the cost of capital for a firm with no debt in its capital structure. b
c. the interest tax shield times pretax net income.
d. the cost of preferred stock for an all-equity firm.
e. the profit margin for a firm with some debt in its capital
structure.

4. MM Proposition I without taxes proposes that:

a. the value of an unlevered firm exceeds that of a levered firm.
b. there is one ideal capital structure for each firm.
c
c. leverage does not affect the value of the firm.
d. shareholder wealth is directly affected by the capital structure
selected.
e. the value of a levered firm exceeds that of an unlevered firm.

5. Nvidea’s has debt with a book value of $263,000 and a market value of
$285,000. The firm’s equity has a book value of $612,000 and a market
value of $418,000. The tax rate is 15 percent and the cost of capital is a
11.4 percent. What is the market value of this firm based on MM V ≡ $285,000 +
Proposition I without taxes? 418,000
a. $703,000 V ≡ $703,000
b. $897,000
c. $875,000
d. $819,770
e. $837,150

6. A firm should always select the capital structure that:

a. produces the highest cost of capital.
b. maximizes the value of the firm. b
c. minimizes taxes.
d. maximizes current dividends.

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 AF4320: Corporate Finance

e. has no debt.

7. According to ________ the value of the levered firm equals the value of
the unlevered firm.
a. MM Proposition I with no tax
b. MM Proposition II with no tax a
c. MM Proposition I with tax
d. MM Proposition II with tax
e. both MM Proposition I with tax and MM Proposition I without
tax

8. A levered firm is a company that has:

a. accounts payable as its only liability.
b. some debt in its capital structure.
b
c. an all-equity capital structure.
d. a tax loss carry forward.
e. taxable income.

9. MM Proposition I with taxes:

a. explains how a firm’s WACC increases with the use of financial
leverage.
b. reveals that the tax shield on debt causes an increase in the value
of a firm. b
c. supports the argument that business risk is determined by the
capital structure employed by a firm.
d. supports the argument that the cost of equity decreases as the
debt-equity ratio increases.
e. reaches the final conclusion that the capital structure decision is
irrelevant to the value of a firm.

10. A firm has a cost of debt of 6.7 percent and a cost of equity of 12.3
percent. The debt–equity ratio is .81. There are no taxes. What is the
firm's weighted average cost of capital? d
a. 7.76%
WACC
b. 8.81% = .123(1/1.81)
c. 9.04% + .067(.81/1.81)
d. 9.79% = .0979, or
e. 11.24% 9.79%

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