Tema 1 MFI - MRFI 2013-2014

TEMA 1

1. The Rivoli Company has no debt outstanding, and it financial position is given by the following data: Asstes (book=market) EBIT Cost of equity Stock price Shares outstanding Tax rate

$3,000,000 $500,000 10% $15 200,000 40%

The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it uses $900,000 of debt, its cost of equity will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, before tax, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are expectationally constant over time. a. What effect would this use of leverage have on the value of the firm? b. What would be the price of Rivoli’s stock? c. What happens to the firm’s earnings per share after the recapitalization? d. The $500,000 EBIT given previously is actually the expected value from the following probability distribution: Probability 10% 20% 40% 20% 10%

EBIT -$100,000 200,000 500,000 800,000 1,100,000

What is the probability distribution of EPS with zero debt and with $900,000 of debt? Which EPS distribution is riskier? 2. Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company’s EBIT is $13.24 million and its tax rate is 15%. Pettit can change its capital structure by either increasing its debt to $70 million or decreasing it to $30 million. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its leverage, it will call in its bonds and replace them with new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. If it increases leverage, cost of equity will be 16%. If it decreases leverage, cost of equity will be 13%. a. What is the firm’s cost of equity at present? b. Should the firm change its capital structure?

c. Suppose the tax rate is changed to 34%. This would lower after-tax income and also cause a decline in the price of the stock and the total value of the equity, other things held constant. Calculate the new stock price (at $50 million of debt). d. Continue the scenario of Part c, but now re-examine the question of the optimal amount of debt. Does the tax rate change affect your decision about the optimal use of the financial leverage? 3. Assume you have just been hired as business manager for PizzaPlace, a pizza restaurant located adjacent to campus. The company’s EBIT was $500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPlace plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the-counter market. The firm is currently financed with all equity; it has 100,000 shares outstanding; and the current price $20 per share. When you took your MBA corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained form the firm’s investment banker the following estimated costs of debt and equity for the firm at different debt levels (in thousands of dollars): Amount borrowed $ 0 250 500 750 1,000

kd 10% 11% 13% 16%

ks 15% 15.5% 16.5% 18.0% 20.0%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPlace is in the 40% corporate tax bracket. a. Now, to develop an example that can be presented to PizzaPlace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. (1) Construct partial income statements, which start with EBIT, for the two firms. (2) Now calculate return on equity (ROE) for the two firms. (3) What does this example illustrate about the impact of financial leverage on ROE? b. (1) What is business risk? What factors influence a firm’s business risk? (2) What is operating leverage, and how does it affect a firm’s business risk? c. (1) What is meant by financial leverage and financial risk? (2) How does financial risk differ form business risk? d. Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution:

Economic state Bad Average Good

Probability 25% 50% 25%

EBIT $2,000 3,000 4,000

Redo the Part a) of the analysis for Firms U and L, but add basic earning power (BEP), return on investment (ROI) defined as (Net Income + Interest)/(Debt + Equity), and times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the economy, and then calculate the expected values. Finally, calculate the standard deviation and coefficient of variation of ROE. What does this example illustrate about the impact of debt financing on risk and return? e. How are financial and business risk measured in a stand-alone risk framework? f. What does capital structure theory attempt to do? What lessons can be leaned from capital structure theory? g. With the above points in mind, now consider the optimal capital structure for PizzaPlace. (1) What valuation equations can you use in the analysis? (2) Could either the MM or the Miller capital structure theories be applied directly in this analysis based, and if you presented an analysis based on these theories, how do you think the owners would respond? h. (1) Describe briefly, without using numbers, the sequence of events that would take place if PizzaPlace does recapitalize. (2) What would be the new stock price if PizzaPlace recapitalized and used these amounts of debt: $250,000; $500,000; $750,000. (3) How many shares would remain outstanding after recapitalization under each debt scenario? (4) Considering only the levels of debt discussed, what is PizzaPlace’s optimal capital structure? i. It is also useful to determine the effect of any proposed recapitalization on EPS. Calculate EPS at debt levels of $0, $250,000, $500,000, $750,000 assuming that the firm begins with zero debt and recapitalizes to each level of debt in a single step. Is EPS maximized at the same level that maximizes stock price? j. Calculate the firm’s WACC at each level of debt. What is the relationship between the WACC and the stock price? k. Suppose that you discovered the PizzaPlace had more business risk than you originally estimated. Describe how this would affect the analysis. What if the firm has less business risk than originally estimated?