Debt Policy

Practice Questions- Financial Management

Question 1

Situation 1
Existing value of the firm $1000,000
Expected Earnings $125,000
Income Tax Rate 35%
Calculate value of the firm

Situation 2
Assume Debt of 50%
Interest Rate 10%
requity 12.5%
Calculate value of the firm, assuming income tax exists and validate the MM proposition.

Answer
Particular $ Zero Debt $500,000 of Debt
Expected operating income 125,000 125,000
Debt interest at 10% 50,000
Before-tax income 125,000 75,000
Tax at 35% 43,750 26,250
After-tax Income 81,250 48,750

Tax Shield = $50,000 * 35%= 17,500

We must assume that the $17,500 will be saved perpetually.

PV of after tax income = 81,250 / 0.125 = 650,000

PV of tax shield = 17,500 / 0.10 = $175,000
Value of the Levered Firm = 650,000 + 175,000 = 825,000

Question 2
The common stock and debt of Northern Sludge are valued at $70 million and $30 million
respectively. Investors currently require a 16% return on the common stock and 8% return on the
debt. If the firm issues an additional $10 million of common stock and uses this money to retire
debt, what happens to the expected return on the stock? Assume that the change in capital
structure does not affect the risk of the debt and that there are no taxes.

Answer
Expected return on assets is:
rassets = (0.08  30/100) + (0.16  70/100) = 0.136 = 13.6%
The new return on equity is:
requity = rassets + [D/E  (rassets – rdebt)]
= 0.136 + [20/80  (0.136 – 0.08)] = 0.15 = 15%
Question 3
Smoke and Mirrors currently has EBIT of $25,000 and is all-equity financed. EBIT is expected
to be permanent at this level. The firm pays income tax equal to 35%. The discount rate for the
firm’s project is 10%.
a. What is the market value of the firm?
b. Now assume the firm issues $50,000 of debt, paying interest of 6% per year, using the
proceeds to retire equity. The debt is expected to be permanent. What will happen to the
total value of the firm? (debt plus equity).
c. Recompute your answer to part b under the following assumptions. The debt issue raises
the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years.
If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is
10%. Should the firm issue debt?

Answer
EBIT ×(1−T c ) $ 25 , 000×(1−0. 35 )
V= = =$ 162 , 500
a. r 0 .10

b. The value of the firm increases by the present value of the interest tax shield:
0.35  $50,000 = $17,500
c. The expected cost of bankruptcy is: 0.30  $200,000 = $60,000

The present value of this cost is: $60,000/(1.10)3 = $45,079

Since this is greater than the present value of the potential tax shield, the firm should not issue
the debt.

Question 4
Alpha Firm and Beta Firm both produce medicines. Both firms’ assets and operations are
growing at the same rate and their annual capital expenditure are about the same. However,
Alpha is more efficient producer and is consistently more profitable. According to the Pecking
Order Theory, which firm should have the higher debt ratio? Explain.

Answer
Alpha Corp is more profitable and is therefore able to rely to a greater extent on internal finance
(retained earnings) as a source of capital. It will therefore have less dependence on debt, and the
lower debt ratio.
Question 5
The Rivoli Company has no debt outstanding, and its financial position is given by the following
data:
Assets (book _ market) $3,000,000
EBIT $500,000
Cost of equity, rs 10%
Stock price, P0 $15
Shares outstanding, numbers 200,000
Tax rate, T 40%

The firm is considering selling bonds and simultaneously repurchasing some of its stocks. If it
moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will
increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a
no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are 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?

Answer
A)
Original value of the firm (D = $0):
V=D+S
($15)(200,000) = $3,000,000

With financial leverage (wd=30%):

WACC = wd rd(1-T) + wers
= (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%.

Because growth is zero, the value of the company is:

Increasing the financial leverage by adding $900,000 of debt results in an increase in the firm’s
value from $3,000,000 to $3,348,214.286

B)
Using its target capital structure of 30% debt, the company must have debt of:
D = wd V = 0.30($3,348,214.286) = $1,004,464.286

Therefore, its debt value of equity is:

S = V – D = $2,343,750.
Stock Price= $2,343,750 / 200,000 = $11.718
Question 6
The Rogers Company is currently in this situation:
EBIT = $4.7 million Tax rate, T = 25%
Value of debt, D = $2 million rd = 10%
rs = 15% Shares of stock outstanding, n = 600,000
Stock price, P = $30.
The firm’s market is stable and it expects no growth, so all earnings are paid out as dividends.
The debt consists of perpetual bonds.

a. What is the total market value of the firm’s stock, S, and the firm’s total market value, V?
b. What is the firm’s weighted average cost of capital?

Answer
a. S = P(n) = $30(600,000) = $18,000,000
V = D + S = $2,000,000 + $18,000,000 = $20,000,000

b. wd = D/V = $2,000,000 / $20,000,000 = 0.10 or 10%

ws = S/V = $18,000,000 / $20,000,000 = 0.90 or 90%

WACC = wd rd(1 - T) + ws rs

= (0.10)(10%)(0.75) 1 (0.90)(15%) 5= 14.25%

Voi = 4700,000 / 0.1425 = 24,736,842

Question 7
Nichols Corporation’s value of operations is equal to $500 million after a recapitalization (the
firm had no debt before the recap). It raised $200 million in new debt and used this to buy back
stock. Nichols had no short-term investments before or after the recap. After the recap, wd =
40%. What is S (the value of equity after the recap)?

Answer
New Equity = $300 million

Question 8
Lee Manufacturing’s value of operations is equal to $900 million after a recapitalization. (The
firm had no debt before the recap.) Lee raised $300 million in new debt and used this to buy back
stock. Lee had no short-term investments before or after the recap. After the recap, wd = 1/3. The
firm had 30 million shares before the recap. What is P (the stock price after the recap)?

Answer
Question 9
The Rivoli Company has no debt outstanding, and its financial position is given in the
following data:
Expected EBIT $600,000
Growth rate in EBIT, gL 0%
Cost of equity, rs 10%
Shares outstanding, n0 200,000
Tax rate, T 25%

a. What is Rivoli’s intrinsic value of operations (i.e., its unlevered value)? What is its
intrinsic stock price? Its earnings per share?

Answer
a. Vop = $600,000 (1-0.25) / 0.10 = $4500,000

Ps = $4500,000 / 200,000 shares = $22.50

EPS = 600,000 (1-0.25) / 200,000 = $2.25

Question 10
Reliable Inc. currently is all-equity financed firm. It has 10000 shares of equity outstanding,
selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls
for a debt issue of $200,000 with the proceeds used to buy back stock. The high-debt plan would
exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays
no taxes.

a) What will be the debt-to-equity ratio after each restructuring?

b) If EBIT will be dither $90,000 or $130,000, what will be EPS for each financing mix for
both possible values of EBIT?

Answer
a) Market value of firm is: $100  10,000 = $1,000,000
With the low-debt plan, equity falls by $200,000, so:
D/E = $200,000/$800,000 = 0.25
8,000 shares remain outstanding.

With the high-debt plan, equity falls by $400,000, so:

D/E = $400,000/$600,000 = 0.67
6,000 shares remain outstanding.

b) Low-debt plan
EBIT $ 90,000 $130,000
Interest 20,000 20,000
Equity Earnings 70,000 110,000
 EPS [Earnings/8,000] $ 8.75 $ 13.75
Expected EPS = ($8.75 + $13.75)/2 = $11.25

High-debt plan
EBIT $ 90,000 $130,000
Interest 40,000 40,000
Equity Earnings 50,000 90,000
EPS [Earnings/6000] $ 8.33 $ 15.00
Expected EPS = ($8.33 + $15)/2 = $11.67

Although the high-debt plan results in higher expected EPS, it is not necessarily preferable
because it also entails greater risk. The higher risk shows up in the fact that EPS for the high-
debt plan is lower than EPS for the low-debt plan when EBIT is low, but EPS for the high-debt
plan is higher when EBIT is higher.