TEMA 1

1. The Rivoli Company has no debt outstanding, and it financial position is given by
the following data:

Asstes (book=market) $3,000,000
EBIT $500,000
Cost of equity 10%
Stock price $15
Shares outstanding 200,000
Tax rate 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 Rivolis stock?
c. What happens to the firms earnings per share after the recapitalization?
d. The $500,000 EBIT given previously is actually the expected value from
the following probability distribution:

Probability EBIT
10% -$100,000
20% 200,000
40% 500,000
20% 800,000
10% 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 companys 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 firms 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 companys EBIT was $500,000 last
year, and since the universitys 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 firms investment banker the following estimated costs of
debt and equity for the firm at different debt levels (in thousands of dollars):

Amount borrowed kd ks
$ 0 - 15%
250 10% 15.5%
500 11% 16.5%
750 13% 18.0%
1,000 16% 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 PizzaPlaces
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 firms business risk?
(2) What is operating leverage, and how does it affect a firms 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 Probability EBIT
Bad 25% $2,000
Average 50% 3,000
Good 25% 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 PizzaPlaces
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 firms 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?