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Solution - Capital Structure - PDF Solution - Capital Structure PDF

This document contains 5 questions regarding capital structure and weighted average cost of capital (WACC). [1] For Question 1, the company raises debt and its WACC increases from 25% to 23.58%. [2] Question 2 calculates a company's levered value and WACC if it takes on 20% debt. [3] Question 3 examines the effects of a share buyback on firm value and WACC. [4] Question 4 calculates unlevered value, WACC, and net income for an all-equity vs levered firm. [5] Question 5 analyzes reducing debt from 40% to 30% and calculates the new firm value and WACC.

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200 views

Solution - Capital Structure - PDF Solution - Capital Structure PDF

This document contains 5 questions regarding capital structure and weighted average cost of capital (WACC). [1] For Question 1, the company raises debt and its WACC increases from 25% to 23.58%. [2] Question 2 calculates a company's levered value and WACC if it takes on 20% debt. [3] Question 3 examines the effects of a share buyback on firm value and WACC. [4] Question 4 calculates unlevered value, WACC, and net income for an all-equity vs levered firm. [5] Question 5 analyzes reducing debt from 40% to 30% and calculates the new firm value and WACC.

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Zahid
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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Solution - Capital Structure.pdf

Financial Management (Monash University)

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Self-Assessment Questions: Capital Structure

Question 1
KTC Ltd is currently an all equity company and has an unlevered value of $100million. The
firm’s current cost of capital is 25%. Due to insufficient internal funding for KTC’s
upcoming projects the firm’s financial manager has decided to raise external funds of
$20million through debt borrowings at 10% interest rate. Its corporate tax rate is 30%.
Assume that the firm operates under the perfect capital market with corporate taxes as
argued by Modigliani and Miller. Determine KTC’s weighted average cost of capital if the
firm proceeds with raising external funds.

Question 2
S&G Inc. is considering converting its all-equity capital structure to one that is of 20% debt.
Currently, there are 20,000 shares outstanding and the price per share is $13.95.Earnings
before interest and taxes (EBIT) are expected to remain at $120,200 per year forever. The
cost of debt is 8%, and the tax rate is 35%.If the firm converts its all-equity capital
structure to 20% debt, what is the levered firm value and WACC of S&G?

Question 3
Smartech Company is a levered firm with a current total value of $500 million comprising
of $400 million equity and the remaining from debt capital. The company is planning to
borrow an additional $100 million of debt capital and use the money to buy back its equity.
The current cost of equity of Smartech before the share buyback is 11% and their pre-tax
cost of debt is 7%. The corporate tax rate is 30%. Calculate the weighted average cost of
capital of the firm after the share buyback.

Question 4
Comfort Textiles is currently a levered firm with $300,000 debt and firm value of
$1,000,000. The firm incurs pre-tax cost of debt of 7% and pays tax rate of 30%. If the firm
were all-equity financed, the firm’s shareholders would require a rate of return of 12%.
Assume that the Comfort Textiles maintains perpetual EBIT, calculate the firm’s
(a) Unlevered firm value.
(b) Current WACC.
(c) Net income.

Question 5
Kiki is a levered firm that is made up of 40% debt and 60% equity financing. The firm’s
current market value is $50million; cost of equity is 15% while cost of debt before tax is
8%. Kiki is considering reducing debt borrowing to 30% debt and 70% equity. Tax rate is
30%. Calculate Kiki’s firm value and WACC if the firm reduces debt financing and increases
equity financing.

Answers:
1. VL= $106million; kL = 27.44%; WACC = 23.58%
2. VL= $300,000;kL = 31.25%; WACC = 26.04%
3. VU= $470m; VL= $530m; kU = 10.4%; kL = 11.84%; WACC = 9.22%
4. (a) VL= $910,000; (b) kL = 13.5%; WACC = 10.92%; (c) NI = $94,500
5. VL= $48,351,648.35; kU = 12.77%; kL = 14.2%; WACC = 11.62%;

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Question 1
VL = VU + tD
= $100million + (0.30 x $20million)
= $106million

VL = D + E
$106,000,000 = $20,000,000+ E
E = $86,000,000

D
k L = k U + (k U - k D )(1 - t )
E
$20,000,000
k L = 25% + (25% - 10%)(1 - 0.3) = 27.44%
$86,000,000

$86,000,000 $20,000,000
WACC = (27.44%) + (10%)(1 - 0.3) = 23.58%
$106,000,000 $106,000,000

Question 2
VU = $13.95 x 20,000 shares
= $279,000

VL = VU + TD
VL = $279,000 + 0.35(0.2 x VL)
VL = $300,000

EBIT(1 - T)
VU 
kU
$279,000 = $120,200 (1-0.35)/kU
kU =28%

Cost of equity and WACC are the same for an unlevered firm.

D
k L = k U + (k U - k D )(1 - T)
E
20
k L = 28% + (28% - 8%)(1 - 0.35)
80
= 31.25%

WACC = 0.8(31.25%) + 0.2(8%) (1-0.35)


= 26.04%

Question 3
Before buyback:
VL = VU + TD
$500m = VU + 0.3($100m)
VU = $470m

After buyback:

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VL = $370m + 0.3($200m)
= $530m

Before buyback:
D
k L = k U + (k U - k D )(1 - T )
E
$100m
11% = k U + (k - 7%)(1 - 0.3)
$400m U
k U = 10.40%

After buyback:
$200m
k L = 10.4% + (10.4% - 7%)(1 - 0.3)
$330m
= 11.84%

WACC = ($330/$530)(11.84%) + ($200m/$530m)(7%)(1-0.3)


= 9.22%

Question 4
(a) VU = $1,000,000 - (0.30 x $300,000)
= $910,000

D
(b) k L = k U + (k U - k D )(1 - t )
E
$300,000
k L = 12% + (12% - 7%)(1 - 0.3) = 13.5%
$7,000,000

$700,000 $300,000
WACC L = (13.5%)+ (7%)(1 - 0.3) = 10.92%
$1,000,000 $1,000,000

EBIT(1 - T)
VU 
(c) kU

$910,000 = EBIT(1-0.3)/0.12
EBIT = $156,000

Net Income = EBIT – Interest – Tax Payment


= ($156,000 - $21,000) (1-0.3)
= $94,500

Question 5

VU = $50m - (0.30 x $20m)


= $44m

VL = VU + TD
VL = $44m + 0.3(0.3 x VL)
VL = $48,351,648.35

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D
k L = k U + (k U - k D )(1 - T)
E
0.4
15% = k U + (k - 8%)(1 - 0.3)
0.6 U
k U = 12.77%

0.3
k L = 12.77% + (12.77% - 8%)(1 - 0.3)
0.7
= 14.20%

WACC = 0.7(14.2%) + 0.3(8%) (1-0.3)


= 11.62%

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