Q1 LEVERAGE WITHOUT TAXES

AAA is an all-equity firm whose stock has a beta of 1.2 and an expected return of 12.5%. Suppose
it issues new risk-free debt with a 5% yield and repurchases 40% of its stock. Assume perfect
capital markets.
a. What is the beta of AAA stock after this transaction?
b. What is the expected return of AAA stock after this transaction?
c. Suppose that prior to this transaction, AAA expected earnings per share this coming year of
$1.50, with a forward P/E ratio (that is, the share price divided by the expected earnings for
the coming year) of 14. What is AAA’s expected earnings per share after this transaction?

SOLUTION

a. βe = βu (1 + d / e ) = 1.2 1 +  = 2
40
 60 

b. re ( )
=r f + b rm − r f ⇒ rm − r f =
12.5 − 5
1.2
=6.25 ⇒ re =5 + 2 ( 6.25) =17.5% from the CAPM,

40 (12.5 − 5)
or re =ru + d / e ( ru − rd ) =12.5 + =17.5
60
c. = =
p 14 (1.50) $21 . Borrow 40%(21) = 8.4, interest = 5%(8.4) = 0.42. Earnings = 1.50 – 0.42
1.08
=
= 1.08, per share = 1.80.
0.60

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Q2 LEVERAGE WITHOUT TAXES

ABC Inc has issued debt with a market value of $100.44 million and has outstanding 15.2 million
shares with a market price of $10 a share. It now announces that it intends to issue a further $58.56
million of debt and to use the proceeds to buy back common stock. Debtholders, seeing the extra
risk, mark the value of the existing debt down to $67 million. Assume perfect capital markets.
Calculate the new market price of the stock (i.e. price per share).

SOLUTION

Prior to announcement
D = 100.44
E = 15.2 ×10 = 152
D+E =
252.44

After announcement: D=67, E=252.44-67=185.44

After repurchase

D = 125.56
58.56
E = (15.2 − ) ×12.2 = 126.88
12.2
D+E =
252.44

Alternatively, consider this:

The market value of the firm’s equity increases by $33.44 million, the amount of the decrease in
the market value of the firm’s existing debt.
Therefore, the price of the stock increases to: ($152 million + $33.44 million)/15.2 million shares
= $12.2

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 Q3 CORPORATE TAXES AND TAX SHIELDS

AAA currently has $30 million in debt outstanding. In addition to 6.5% interest, it plans to repay
5% of the remaining balance each year. If AAA has a marginal corporate tax rate of 40%, and if
the interest tax shields have the same risk as the loan, what is the present value of the interest tax
shield from the debt?

SOLUTION

Interest tax shield in year 1 = $30 × 6.5% × 40% = $0.78 million.

As the outstanding balance declines, so will the interest tax shield. Therefore, we can value the
interest tax shield as a growing perpetuity with a growth rate of g = –5% and r = 6.5%:

$0.78
=PV = $6.78 million
6.5% + 5%

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Q4 CORPORATE TAXES AND TAX SHIELDS

Facebook, Inc. had no debt on its balance sheet in 2014, but paid $2 billion in taxes. Suppose
Facebook were to issue sufficient debt to reduce its taxes by $250 million per year permanently.
Assume Facebook’s marginal corporate tax rate is 35% and its borrowing cost is 5%.
If Facebook’s investors do not pay personal taxes (because they hold their Facebook stock in tax-
free retirement accounts), how much value would be created?

SOLUTION

$0.25 billion / 5% = $5 billion.

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 Q5 CORPORATE TAXES AND WACC

AAA Inc maintains a debt-equity ratio of 0.85, and has a cost of equity of 12%, and a cost of debt
of 7%. AAA’s corporate tax rate is 40%, and its market capitalization is $220 million.

a. If AAA’s free cash flow is expected to be $10 million in one year, what constant expected
future growth rate is consistent with the firm’s current market value, treating the firm as a
perpetuity?

b. What is the value of AAA’s interest tax shield?

SOLUTION

a. D / E =0.85 ⇔ D + E =1 + 0.85 =1.85

1 0.85
=
WACC 12% + 7% (1 − 0.40=
) 8.42%
1.85 1.85
FCF 10
V L = E + D = 220 × 1.85 = 407 = =
WACC − g 0.0842 − g
10
g= 0.0842 − = 5.96%
407

b. pretax WACC = 1 12% + 0.85 7% = 9.70%

1.85 1.85
FCF 10
=VU = = $267 million
pretax WACC − g 0.0970 − 0.0596
PV ( Interest Tax Shield ) = VL − VU = 407 − 267 = $140 million

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Q6 TRADE-OFF THEORY OF CAPITAL STRUCTURE

OC International is a shipping firm with a current share price of $5.50 and 10 million shares
outstanding. OC announces a plan to lower its corporate taxes by borrowing $20 million and
repurchasing shares. Suppose that OC pays a corporate tax rate of 30%, and that shareholders
expect the change in debt to be permanent.
a. If the only imperfection is corporate taxes, what will the share price be after this announcement?
b. Suppose the only imperfections are corporate taxes and financial distress costs. If the share price
rises to $5.75 after this announcement, what is the PV of financial distress costs Hawar will incur
as the result of this new debt?

SOLUTION
20
a. 0.3 × + 5.5 =
$6.10 / share
10
b. (6.1 – 5.75) × 10 = $3.5 million

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Q7 TRADE-OFF THEORY OF CAPITAL STRUCTURE

Real estate purchases are often financed with at least 80% debt. Most corporations, however, have
less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.

SOLUTION
According to tradeoff theory, a tax shield adds value while financial distress costs reduce a firm’s
value.
The financial distress costs for a real estate investment are likely to be low, because the property
can generally be easily resold for its full market value.
In contrast, corporations generally face much higher costs of financial distress. As a result,
corporations choose to have lower leverage.

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Q8 FINANCIAL DISTRESS AND RISK SHIFTING

The Bahia Corporation has fallen on hard times. It successfully issued 80 million Brazilian reals
of zero coupon bonds four years ago, but since then its business has gone from bad to worse. The
debt is due one year from now. Its only remaining asset is 20 million reals in cash. If Bahia’s
managers do nothing, the bondholders will receive all of this cash. Bahia can undertake the
following projects.
• Project X: Cost now is 20 million reals. Payoff is 160 million reals with probability 0.05
and zero reals with probability 0.95.
• Project Z: Cost now is 20 million reals. Payoff is 140 million reals with probability 0.05
and 50 million reals with probability 0.95.
Assume discount rates are all equal to 0.
a. What are the NPVs of projects X and Z?
b. What are today’s values of the debt and equity of Bahia if it rejects both projects X and Z and
leaves the 20 million reals? What if it accepts project X and rejects Z or accepts Z and rejects
X?
c. If the firm operates strictly in the interests of the shareholders, which strategy will it choose?
d. Could debtholders figure out a way to convince shareholders to choose Z?

SOLUTION
a. NPV of X = -12 million reals =-20+160*0.05=-12
NPV of Z =-20+140*0.05+50*0.95=34.5

b. Reject both X and Y:

V(Equity) = 0 million
V(Debt) = 20 million

Accept X:
V(debt) = 80*0.05=4 million
V(Equity)= (160-80)*0.05=4 million
Market value of the firm: 20-12=8

Accept Z:
V(Debt) =80*0.05+50*0.95=51.5 million
V(Equity)=60*0.05=3 million
Market value of the firm: 20+34.5=54.5

c. Shareholders will want to choose project X.

d. Debtholders could pay shareholders a bonus if and only if they choose Z, up to 51.5-4=47.5
million.