EFFECTS OF FINANCIAL LEVERAGE ON FIRM VALUE

PROBLEM SET - SOLUTIONS

1. Which firm will have a higher asset beta: a firm that pays its sales force a fixed salary, or a firm
that pays its sales force a commission-based salary linked to sales? Justify (Assume that both
firms are in the same industry)
The firm which pays its sales force a fixed salary will have a higher proportion of fixed costs in its
cost structure, and therefore a higher degree of operating leverage. Therefore, it will have a higher
asset beta.

2. Which firm is likely to have a higher asset beta: a firm operating luxury resorts or a firm
manufacturing infant food? Justify.
The firm which manufactures infant foods is likely to be less cyclical than the firm which operates
luxury resorts. Therefore, it is likely to have a lower asset beta.

3. If a firm permanently borrows Rs. 50 crores at an interest rate of 10%, what is the present value of
the interest tax shield? Assume a 30% tax rate.
PV of tax shield with constant perpetual debt = tcD = 30% X Rs. 50 crores = Rs. 15 crores.

4. If a firm has a cost of debt of 10%, debt-equity ratio of 2:1, and expected return on its assets is
15%, what would the expected return on its equity be? Assume no taxes.
rE = rA + (rA – rD).(D/E) = 15% + (15% - 10%) x 2 = 25%

5. The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt-equity ratio is 0.5, what
is the equity beta? (Assume no taxes.)
D/E = 0.5 => D/V = 1/3 & E/V = 2/3. βA = βE.(E/V) + βD.(D/V).
So, 1.1 = βE * 2/3 + 0.3 * 1/3 => βE = 1.5
(Putting it differently, βE = βA + (βA – βD).(D/E))

6. An unlevered firm has a cost of equity of 10%. The firm is considering a new capital structure
with 50% debt. The interest rate on the debt would be 8%. Assuming there are no taxes, the firm’s
cost of equity with the new capital structure would be:
For the unlevered firm, rA = rE = 10%
After change in capital structure, D/E = 50%/(1 - 50%) = 1
Therefore, new cost of equity = rA + (rA- rD).D/E = 10% + (10% - 8%) x 1 = 12%.
7. Consider the following data for three firms.
Firm 1 Firm 2 Firm 3
Business Risk Similar Similar Similar
Growth Zero Zero Zero
Life Perpetual Perpetual Perpetual
Tax Nil Nil Nil
Current EBIT 20000 20000 40000
Interest 0 4000 4000
Equity Earnings/ PAT 20000 16000 36000
Expected return on equity
Expected return on debt 10% 10% 10%
Market value of equity 100000
Market value of debt 0
Market value of firm 100000

Assume that Firm 1 is correctly valued. Assume that the Miller-Modigliani propositions hold true.
Fill in the blanks in the table above.
Firm 1:
rE = PAT/ MVE = 20000/100000 = 20%. For an unlevered firm, rA = rE = 20%
Firm 2:
The firms have similar EBIT and similar business risk. Therefore, they should have the same firm
value. So, the firm should be valued at 100,000.
Value of the firm’s debt = Interest/ Expected return on debt = 4000/ 10% = 40000.
Therefore, market value of the firm’s equity = 100000 – 40000 = 60000
Therefore, expected return on equity = PAT/ MVE = 16000/60000 = 26.67%
Firm 3:
Firm 1 and Firm 3 have similar business risk. So, the expected return on assets should be the
same.
Therefore, rA = 20%
Therefore, market value of the firm = EBIT/ rA = 40000/20% = 200000
Value of the firm’s debt = Interest/ Expected return on debt = 4000/ 10% = 40000.
Therefore, market value of the firm’s equity = 200000 – 40000 = 160000
Therefore, expected return on equity = PAT/ MVE = 36000/160000 = 22.5%
8. Firm A is an unlevered firm with beta of 0.6. It initially has equity of 1000. Suppose the firm
takes leverage and its new capital structure comprises 40% debt. What will the firm’s βA, βE and
βD be after the change in capital structure. Assume that the debt is risk free. Disregard taxes.

βD = 0 since debt is risk free.

For the unlevered firm, βA = βE = 0.6

βA remains the same after the change in capital structure since the risk of the business does not
change.
After change in capital structure, by MM Proposition II,
βE = βA + (βA – βD).D/E = 0.6 + (0.6 – 0).40%/60% = 1.0

9. The market value of the debt of Firm C is Rs. 200 crore while the market value of its equity is Rs.
250 crores. Its shares are listed and have a beta of 1.2. The beta of the firm’s debt may be
considered to be zero.
Long term government securities are currently trading with a yield-to-maturity of 8%. The market
risk premium is 7%.
The firm plans to raise fresh equity of Rs. 50 crores and use the same to repay an equivalent
amount of its debt.
Estimate the weighted average cost of capital and cost of equity of the firm before and after
the proposed change in capital structure is implemented.
Assume that the beta of the firm’s debt continues to be zero after the change in capital structure.
Assume continuous rebalancing of the capital structure. Assume there are no taxes.
Before change in capital structure,
rE = rF + βE.MRP = 8% + 1.2 x 7% = 16.4%

WACC (without taxes) = rE.E/V + rD.D/V = 16.4% x 250/(250+200) + 8% x 200/(250+200) =

12.67%
(rD = 8% since the firm’s debt is risk-free)

Without taxes, rA = WACC = rD.D/V + rE.E/V

After change in capital structure,

Since rA wouldn’t change with capital structure, in the absence of taxes, WACC would also not
change.
Therefore, WACC after the change in capital structure would also be 12.67%.
By MM Proposition II,
New rE = rA + (rA – rD).D/E =12.67% + (12.67% - 8%) x 150/300 = 15.0%
10. Two firms U and L, are exactly identical in all respects except for their capital structure. While
firm U is all equity financed, Firm L is financed by a mix of debt and equity.
Starting today, the two firms have a life of one year only. The payoff expected from the
operations of each of the firms at the end of one year is Rs. 2000 in case the economy is in a good
state and Rs. 1500 in case the economy is in a bad state.
The current market value of firm L’s equity is Rs. 700 and that of its debt is also Rs. 500. The
current market value of firm U’s equity is Rs. 1000. Firm L’s debt bears an interest rate of 10%
p.a. and is repayable one year from today at which time the amount payable is Rs. 550.
A strategy to benefit from the arbitrage opportunity this situation offers is described below but
with some blanks. Fill in the blanks.
Today

Shortsell stock of Firm L for Rs. 700

Borrow Rs. 300 at an interest rate of 10% p.a.

Buy stock of Firm U for Rs. 1000

After 1 year

Sell stock of Firm U

If the economy is in a good state:

You get Rs. 2000 by selling the stock of Firm U

It costs you Rs. 1450 to return the stock you borrowed

It costs you Rs. 330 to repay the loan you took

So, you have a net surplus of Rs. 220

If the economy is in a bad state:

You get Rs. 1500 by selling the stock of Firm U

It costs you Rs. 950 to return the stock you borrowed

It costs you Rs. 330 to repay the loan you took

So, you have a net surplus of Rs. 220

11. The market value of the debt of Company ABC is Rs. 100 crore while the market value of its
equity is Rs. 200 crores. Its shares are listed and have a beta of 0.9. ABC’s debt may be
considered risk-free and the beta of its debt may be considered to be zero.
Government securities are currently trading with a yield-to-maturity of 8%. The expected return
on the market portfolio is 18%. Taxes may be disregarded.
Estimate the weighted average cost of capital of ABC. What would ABC’s cost of capital be if the
company was unlevered.
Make and justify assumptions if you find any necessary.
When ABC is levered,
D = Rs. 100 crores; E = Rs. 200 crores; So, D/V = 1/3 and E/V = 2/3.
βE = 0.9; βD = 0; rD = 8% (since ABC’s debt can be considered risk-free and G-Secs are trading
with a YTM of 8%); t = 0% (since taxes may be disregarded)
rf = 8%; rm = 18%; (rm – rf) = 10%
rE = rf + βE.(rm – rf) = 8% + 0.9 * 10% = 17%
WACC = rE.E/V + rD.(1 - t).D/V = 17% * 2/3 + 8% * 1 * 1/3 = 14%
Since there are no taxes, WACC = rA. Based on MM Proposition I, rA remains the same
irrespective of capital structure. So, is ABC were unlevered, its cost of capital would remain the
same i.e. 14%.
(This can be arrived at in other ways as well, for instance:
Unlevering the β, βA = βE.E/V + βD.D/V = 0.9 * 2/3 = 0.6
If ABC is unlevered,
WACC of an unlevered firm = expected return on assets
= rA = rf + βE.(rm – rf) = 8% + 0.6 * 10% = 14%.)