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Assignment 3

This document discusses concepts related to capital structure and leverage. It covers three main topics: [1] how leverage affects earnings per share under different economic conditions, [2] how shareholders can homemade leverage to achieve desired cash flows regardless of a firm's capital structure, and [3] how corporate tax shields and leverage interact to determine a firm's value. Specifically, it shows how debt can increase earnings per share but also increases risk, and how shareholders have flexibility to control their payouts through own financial decisions. It also demonstrates mathematically how debt affects the valuation of a firm when corporate taxes are considered.

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Thu Yến
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18 views

Assignment 3

This document discusses concepts related to capital structure and leverage. It covers three main topics: [1] how leverage affects earnings per share under different economic conditions, [2] how shareholders can homemade leverage to achieve desired cash flows regardless of a firm's capital structure, and [3] how corporate tax shields and leverage interact to determine a firm's value. Specifically, it shows how debt can increase earnings per share but also increases risk, and how shareholders have flexibility to control their payouts through own financial decisions. It also demonstrates mathematically how debt affects the valuation of a firm when corporate taxes are considered.

Uploaded by

Thu Yến
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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PRACTICE 3: CAPITAL STRUCTURE - BASIC CONCEPT

1. EBIT and Leverage


a.
Recession Normal Expansion
EBIT $12,600 $21,000 $26,250
Interest  0 0 0
NI  $12,600 $21,000 $26,250
EPS  $2.52 $4.2 $5.25
%∆EPS -40 - +25

b. Interest payment = $99,000 x 8% = $7,920


Share price = Equity / Shares outstanding = 275,000 / 5,000 = $55/share
Share purchased = Debt issued / Share price = 99,000 / 45 = 1,800
Remained share = 5,000 – 1,800 = 3,200 shares
Recession Normal Expansion
EBIT $12,600 $21,000 $26,250
Interest  7,920 7,920 7,920
NI  $4,680 $13,080 $18,330
EPS  $1.46 $4.09 $5.73
%∆EPS -64 - +40

2. Homemade Leverage
a. EPS = EBIT / Shares outstanding = $33,000 / 6000 shares = $5.50
Cash flow = $5.50 x 100 shares = $550
b.
V = shares outstanding x price per share = 6,000 x $58 = $348,000
B = Proportion of Debt x Market Value of the Firm = 35% x $348,000 = $121,800
Shares repurchased = Debt issued / Share price = $121,800 / $58 = 2,100
Remained share = 6,000 – 2,100 = 3,900 shares
NI = EBIT – Interest = $33,000 – (8% x $121,800) = $23,256
EPS = EBIT / Shares outstanding = $23,256 / 3,900 = $5.963
Shareholder cash flow = $5.96 x 100 shares = $596.3
c.
The shareholder should sell 35 percent of their shares, and lend the proceeds at 8
percent:
Interest cash flow = 35 shares x $58 x 8% = $162.4
Dividends received = $5.963 x 65 shares = $387.6
Total cash flow = $162.4 + $387.6 = $550
d.
The capital structure is irrelevant because shareholders can create their own
leverage or unleverthe stock to create the payoff they desire, regardless of the
capital structure the firm actually chooses
3. Firm Value
a. V U = EBIT (1 - T C) / R0 = $19,750 (1 – 0) / 15% = $131,666

b. V U = EBIT (1 - T C) / R0 = $19,750 (1 – 35%) / 15% = $85,583.33


If debt is 50 percent of V U => B = 50% x V U = 42,791
V L= V U +T c B
= 85,583.33 + 35% x 42,791
= $100,560.42

If debt is 100 percent of V U => B = 100% x V U = 85,583.33


V L= V U +T c B
= 85,583.33 + 35% x 85,583.33
= $115,537.50

c.
If debt is 50 percent of V L => B = 50% x V L
V L= V U +T c B
V L= 85,583.33 + 35% x 50% x V L
V L= $103,737.37

If debt is 100 percent of V L => B = 100% x V L


V L= V U +T c B
V L= 85,583.33 + 35% x 100% x V L
V L= $131,666.66

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