CAPITAL STRUCTURE

Problem 1.

Söderköping Steel AB has 125 million shares, trading at SEK 8/share, no debt and a cost
of equity of 9%. You believe that if the company is able to borrow SEK 400 million and
buy back shares, the cost of capital will drop to 8%. If there is no growth in the savings
(from a lower cost of capital) and the shares are bought back at SEK 10/share, estimate
the value per share for the remaining shares after the buyback.

Problem 2.

Fjärilshusets Design AB is an all-equity funded firm with 150 million shares trading at 10
SEK/share, with a cost of equity (and capital) of 12%. The firm is considering borrowing 1
SEK billion and using the entire proceeds to buy back shares, an action that it believes
will lower its cost of capital to 10%. Assuming that the firm is right in its belief and that it
is a mature firm with no growth expected in the future, estimate the price at which
shares were bought back, if the price per share for the remaining shares after the
buyback is 12.50 SEK/share.

Problem 3.

You have been asked to estimate the beta for Vitale Enterprises, a company that
produces and sells cosmetics in the United States. The firm is publicly traded and has
100 million shares outstanding, trading at $ 10 a share; the firm also has $ 500 million in
debt outstanding (in market value terms). The regression beta for the firm has a very
large standard error but the average regression beta for publicly traded cosmetics
companies in the United States is 1.20; the average market debt to equity ratio for these
companies is 80%. The tax rate for all firms in the US is 40%, the treasury bond rate is
4.2% and the risk premium for mature equity markets is 4%.

A. Make your best estimate of the cost of equity for Vitale Enterprises.
B. Vitale is planning on buying a clothing company. It is estimated that the
acquisition will cost $ 1 billion and that half of the funds for acquisition will come from a
new debt issue. The average unlevered beta for clothing companies is 1.25 and you can
continue to use a 40% tax rate. Estimate the new cost of equity for Vitale.

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Problem 4.

The German firm Hamburg Stahl- und Platten AG, a publicly traded firm, has 80 million
shares trading at Euro 10 a share and Euro 200 million in debt (market value and book
value). The firm currently has a beta of 1.20 and a pre-tax cost of debt of 5%. The
riskfree rate is 4% and the market risk premium is 4.5%. The marginal tax rate is 40%.

A. Estimate the current cost of capital for the firm.

B. The firm has announced that it will be borrowing Euro 200 million and buying
back shares. The rating for the firm will drop to BBB, causing the pre-tax cost of
debt to rise to 6%. Estimate the new cost of capital for the firm.
C. Now assume that investors are rational and that the firm is growing 4% a year in
perpetuity. How many shares can Hamburg Stahl- und Platten AG expect to buy
back with Euro 200 million?

Problem 5.

Byarum Hud AB is a cosmetics firm that is examining its financing policy for possible
changes. The firm has 10-year bonds outstanding with a face value of SEK 30 million and
interest expenses of SEK 1.5 million a year; the firm has operating lease commitments of
SEK 5 million a year for the next 5 years. The firm is rated BB and the default spread for
BB rated bonds is 4%. There are 2 million shares trading at SEK 10 a share and the
current levered beta for the firm is 2.80 (this was computed with the operating leases
treated as part of the debt of the firm). The risk free rate is 5% and the market risk
premium is 4%.

The corporate tax rate for the firm is 28%.

A. Estimate the market value of outstanding debt (including operating leases) at the
firm today.
B. Estimate the current cost of capital for the firm.
C. The firm believes it can lower its cost of capital to 8.25% if it moves to its optimal
debt to capital ratio of 50%. If it is correct in this belief, estimate the pretax cost of debt
for the firm at its optimal debt ratio.

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Problem 6.

Sandhult Pharmaceuticals AB has 100 million shares trading at SEK 10.40 a share, no
debt outstanding or cash holdings and reported after-tax operating income of SEK 180
million in the most recent financial year. The market is pricing the company as a stable
growth firm, with an expected growth rate of 4% and a cost of capital of 10%. (The risk
free rate is 5% and the market risk premium is 4%; the tax rate is 28%)

A. Assuming that the market is pricing the company correctly, what return on
capital is it assuming in perpetuity?
B. You have been hired as a turn-around CEO of Sandhult Pharmaceuticals. You
believe that you can increase the debt to capital ratio to 20% (with an after-tax
cost of debt of 4%). Estimate the cost of capital after the increased debt.
C. You also believe that you can double the return on capital on both existing and
new investments for the firm while maintaining your existing reinvestment rate
for the next 3 years. After year 3, you will maintain the higher return on capital
but your growth rate will drop back to 4%. Estimate the new firm value with the
changes in your debt ratio and return on capital.

Problem 7.

Arvidsvik Cream AB is a cosmetics firm that has seen its stock price fall and its earnings
decline in the last year. You have been hired as the new CEO of the company, and a
careful analysis of Arvidsvik’s current financials reveals the following:

- The firm currently has after-tax operating earnings of SEK 300 million on revenues of
SEK 10 billion and a capital turnover ratio (sales/book value of capital) of 2.5.

- The firm is expected to reinvest 60% of its after-tax operating income.

- The firm is all-equity financed and has a cost of capital of 10%.

A. Estimate the value of the firm, assuming existing policies continue forever.
(Returns on capital and reinvestment rates remain constant forever as well.)
B. Assume that you can increase operating margins from 3 to 5% without affecting
the capital turnover ratio, that you can lower the reinvestment rate to 40%, and
that the cost of capital will become 9%, if you shift to your optimal debt ratio.
How much would your firm value increase if you were able to make these
changes.

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Problem 8.

Carlstens Metallica AB was a firm with 100 million shares trading at SEK 18/share, debt
outstanding of SEK 600 million and a cost of capital of 10%, prior to a recapitalization. It
has just borrowed SEK 920 million and completed a buyback of 40 million shares at SEK
23/share. If the remaining shares trade at SEK 28 after the buyback, estimate the cost of
capital after the buyback. (You can assume that the company is in stable growth,
growing 2% a year in perpetuity)

Problem 9.

Hellström E Street AB is a publicly traded company that is considering a restructuring

plan. The company currently has 200 million shares trading at SEK 12/share and total
debt outstanding of SEK 600 million. The firm currently has a (levered) beta of 1.20, the
risk free rate is 2%, the equity risk premium is 6% and the marginal tax rate is 40%.

A. The firm is planning to double its SEK debt and use the proceeds from the new
debt to pay dividends & buy back stock. If it’s bond rating will drop to BBB with a
default spread of 2.5% over the risk free rate, estimate the cost of capital after
the recapitalization.
B. You estimate that if the firm doubles its debt, its value as a business will increase
by 2%. Estimate the pre-tax cost of debt that currently faces (before
recapitalization), if the firm is mature with no growth expected in perpetuity.
Estimate that the value of the firm increases by 60.
C. Now assume that the firm plans to use half of the proceeds (new debt) to buy
back stock at SEK 12.50/share and the other half to pay a special dividend to the
remaining shareholders. Estimate the value per share of the remaining shares
after the recapitalization.

Problem 10.

You are given the assignment of evaluating the financial options Everöd Motor AB. The
company that have service stations all over the south of Sweden. The company
currently has 150 million shares, trading at SEK 10 a share, and SEK 500 million in debt
(book and market). The firm currently has a beta (levered) of 1.20 and a pre-tax cost of
debt of 6%; the marginal tax rate is 40%; the risk free rate is 4% and the equity risk
premium is 5%. The firm is considering borrowing SEK 500 million and buying back
stock; it believes that doing so will lower its cost of capital to 8%. (You can assume no
growth in the savings in perpetuity)

A. Assuming that the firm can buy back stock at SEK 10.25/share, estimate the
increase in value per share for the remaining shares.
B. Now assume that you do not know what the price per share will be on the stock
buyback. How much would the price per share on the buyback have to be for the
value per share on the remaining shares to remain unchanged at SEK 10/share?