National Tsing Hua University

Corporate Finance
Instructor: Tak-Yuen Wong
Problem Set 2 -Solution

D D/E
Problem 1. (a) Debt-equity ratio = 25% implies leverage ratio l = D+E = D/E+1 = 0.25
1.25
=
0.20. As the firm value is $3.5 million, the initial amount of debt is 3.5 × 0.20 = $0.7 million.
(b) In the good year, the firm value is $5 million, which is a 5−3.5 3.5
= 42.86% increase.
Before debt adjusts, the amount of debt remains at $0.7 million, and thus, equity value
must be 5 − 0.7 = $4.3 million. In the bad year, the firm value is $2.5 million, which is
a 2.5−3.5
3.5
= −28.57% decrease. Before debt adjusts, the amount of debt reamains at $0.7
million, and thus, equity value must be 2.5 − 0.7 = $1.8 million.
(c) To keep debt-equity ratio constant, the debt must be adjusted to 5 × 0.20 = $1 million.
In the good year, this is an increase from the initial debt $0.7 million by 1−0.7
0.7
= 42.86%. In
the bad year, the debt must be reduced to 2.5 × 0.20 = $0.5 million. The percentage change
is 0.5−0.7
0.7
= −28.57%.
(d) Since the percentage change in the debt value full match the percentage change in the
firm value in all situations, the tax shield shares the same risk as the firm’s asset.

Problem 2. (a) First, debt value is 13 − 9.49 = $3.51 billion. So, the leverage ratio is
l = 3.51
13
= 0.27. WACC is rwacc = (1 − 0.27) × 9.4% + 0.27 × 7.1% × (1 − 0.35) = 8.1%.
(b) Simply apply the WACC method for discounting FCFs. The project NPV is
52 100 65
−100 + + 2
+ =$85.11 million.
1.081 (1.081) (1.081)3

D/E
Problem 3. (a) Given the debt-equity ratio of 0.7, the leverage ratio is l = D/E+1 = 0.7
1.7
=
0.4118. The WACC is rwacc = (1 − 0.4118) × 11.3% + 0.4118 × 6.28% × (1 − 0.32) = 8.41%.
With these information, we can apply the WACC method for project valuation. The project
NPV is
0.7
−6 + =$23.1 million.
0.0841 − 0.06
(b) After the investmentm, the upfront cost $6 million becomes sunk, and only the present
value of future FCFs, 23.1 + 6 = $29.1 million, will be added to the firm value. With a
leverage ratio of 41.18%, the firm should add 29.1 × 0.4118 = $11.98 million of debt to keep
the debt-equity ratio constant.
(c) First, we can use the pretax WACC to get the unlevered firm value: rwacc pre−tax
= (1 −
0.4118) × 11.3% + 0.4118 × 6.28% = 9.23%. The project NPV without the tax shield is
0.7
−6 + =$15.65 million.
0.0923 − 0.06
Therefore, the value attributable to the tax shield is 23.1 − 15.65 = $7.45 million.
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Problem 4. (a) First, we need to get information about the cost of capital. Using the
CAPM, the equity cost of capital is rE = 4.5 + 0.4 × (10.2 − 4.5) = 6.78%. With a 16%
D/E
debt-equity ratio, the leverage ratio is 1+D/E = 0.16
1.16
= 13.79%. The market capitalization
is 2.6 × 48 = $124.8 billion, which also implies the debt value is 0.16 × 124.8 = $19.968
billion and the firm value is 19.968 + 124.8 = $144.768 billion. The WACC is then rwacc =
(1 − 0.1379) × 6.78% + 0.1379 × 4.7% × (1 − 0.32) = 6.29%. The expected growth rate of
FCFs g must satisfy
5.8
=144.768 ⇒ g = 2.28%.
0.0629 − g
(b) Using the information in (a), we can compute the project cost of capital (pretax wacc):
pre−tax
rA = rwacc = (1−0.1379)×6.78%+0.1379×4.7% = 6.49%. Note that upon annoucement,
the market expects capital structure to change and the financial risk embedded in the equity
return will change as well. Applying MM proposition 2, we can assess the equtiy return
under the new capital structure
rE = 0.0649 + 0.4 × (0.0649 − 0.05) =7.09%.
Note that the asset return remains at 6.49% because it is the real side but the financial
side change: both debt-equity ratio (D/E=6.49%) and debt cost of capital (rD = 5%) have
increased with the annoucement. With the new equity return, we can recompute the after-tax
wacc as rwacc = (1 − 0.2857) × 7.09% + 0.2857 × 5% × (1 − 0.32) = 6.04%, where 0.2857 = 1.4 0.4

is the new leverage ratio. Observe that the after-tax WACC is lower than that in (a) depsite
the increase in equity risk and financial leverage due to the presence of interest tax shield.
The firm value is then
5.8
=$154.42 billion.
0.0604 − 0.0228
The debt amount must be 154.42 × 0.2857 = $44.12 billion and equity value is 154.42 × (1 −
0.2857) = $110.3 billion. Lastly, we determine the change in stock price. The problem is that
both the stock price and the shares outstanding after recapitalization are unknowns. Let p
be the stock price and n be the number of shares repurchased. We need two equations to pin
down p and n together. First, note that the firm will be borrowing 44.12 − 19.97 = $24.15
billion. Thus, the expenditure on buyback equals the new borrowing
p × n =24.15.
Second, after repurcahse, the equity value is by definition,
p × (2.6 − n) =110.3,
where 2.6 − n is the shares outstanding after repurchasing n shares. By substitution,
24.15
× (2.6 − n) =110.3 ⇒ 24.15 × 2.6 = 110.3n + 24.15n ⇒ n = 0.467.
n
Thus after recapitalization, shares outstanding are 2.6 − 0.467 = 2.133 billion shares and the
110.3
new stock price p must be p = 2.133 = $51.77 per share. The increase from $48 the initial
price is due to the increase in tax shield.
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Problem 5. (a) Before repurchase, the price per share is 1,000

20
= $50.
100
(b) With $100 million, the company can repurchase 50 = 2 million shares. That is, 10% of
its shares.
(c) After the repurcahse, shares outstanding becomes 20 − 2 = 18 million. As $100 million
of cash, which belongs to shareholders before the repurchase, is spent on the open market
operation, the equity value after repurchase goes down to 1, 000 − 100 = $900 million. The
price per share becomes 900
18
= $50. The price before and after repurchase is the same, so
that the open market operation can be conducted at $50.

Problem 6. (a) The market capitalization is 500 × 15 = $7, 500 million. Given the capital
structure, the enterprise value is 7, 500 − 250 = $7, 250. This implies that after the dividend
is paid, the share price (ex-dividend price) becomes 7,250
500
= $14.5 per share.
(b) With perfect capital market, the price does not change with share repurchase as in
problem 5.
(c) The value of a share to the shareholder with repurcahse is $15. With dividend issuance,
shareholders receive 250
500
= $0.5 per share. In total, the value of a share is 0.5 + 14.5 = $15
per share. Therefore, the investors are indifferent between the two policies.

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