What does capital structure theory attempt to do

Fall.2016

1. ABC Corp.’s projected capital budget is $2,000,000, its target capital structure is 60% debt & 40% equity and its forecast net income is $600,000. If the company follows a residual dividend policy, what is the amount of total dividends in dollars and percentage, will it pay

out?

2. Collins Company projects the following data for the coming year. If the firm follows the

residual dividend policy AND maintains its current target capital structure, what will its

payout ratio be?

EBIT $2,000,000 Capital Budget $850,000 Interest rate 10% %Debt/%Equity 40%/60%

Debt outstanding $5,000,000 Taxes 40%

3. What is considered the primary factor that determines a firm’s dividend policy?

MINI CASE Chapter 15 Capital Structure Decisions 1. Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant

chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your 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 from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

% Financed With Debt rd 0% --- 20 8.0% 30 8.5 40 10.0 50 12.0 If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent. a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value. Answer: The basic definitions are: (1) V = (2) FCF = (3) WACC = (4) rs And rd are: (5) ws and wd are percentages of the firm that are:

Vop = ∑ FCFt

(1 + WACC)t

∞

t=1

The impact of capital structure on value depends upon: b. (1) What is business risk? What factors influence a firm's business risk? Answer:

b. (2) What is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10. Answer: c. Now, to develop an example which can be presented to PizzaPalace’s 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 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000. 1. Construct partial income statements, which start with EBIT, for the two firms. Answer: Here are the fully completed statements: Firm U Firm L Assets $ $ Equity $ $ EBIT $ $ INT (12% ___ _____ EBT $ $ Taxes (40%)___ ____ NI $_____ $_____ c. 2. Now calculate ROE for both firms. Answer: Firm U Firm L BEP % % ROI % % ROE % % TIE c. 3. What does this example illustrate about the impact of financial leverage on ROE? Answer: Conclusions from the analysis:





o ROIU = %.

o ROIL = %.

 Firm L has:

o ROEU = %.

o ROEL = %.

Therefore, the use of financial leverage has:

 At the expected level of EBIT, ROEL & ROEU relative to one another are:

 The use of debt will ___________ ROE only if ROA __________ the after-tax cost of debt. Here ROA = unleveraged ROE = 9.0% _____ rd(1 - t) = ___%(0.6) = ____%, so the use of debt _______ ROE.

2.  Finally, note that the TIE ratio is:

d. Explain the difference between financial risk and business risk. Answer: e. What happens to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return? Answer:

Firm U Firm L EBIT $ $ Interest $_____ $_____ EBT $ $ Taxes $_____ $_____

NI $_____ $_____

ROIC % % ROE % %

f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models. Answer: MM theory begins with the assumption of:

MM theory later includes: Miller later included: MM theory ignores: MM assumed that investors and managers have: . The pecking order theory states that Firms: . One agency problem is that managers can: A second agency problem is the potential for: Firms with many investment opportunities should maintain: The market timing theory states that managers try to

g. What does the empirical evidence say about capital structure theory? What are the implications for managers? Answer: h. With the above points in mind, now consider the optimal capital structure for PizzaPalace. h. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Answer: MM theory implies: that beta: h. (2) Now calculate the corporate value. Answer:

i. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting the value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace’s optimal capital structure? Answer: First, find the dollar value of debt. The optimal capital structure is for wd = %. This gives the highest corporate value, the lowest WACC, and the highest stock price per share. But notice that wd = 40% is very similar to the optimal solution; in other words, the optimal range is pretty flat