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MFE 6200 Capital Structure Assignment Help

1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with \$800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth \$400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be \$95,000 and all income will be distributed as dividends. Ignore taxes.

a. Richard owns \$30,000 worth of XYZ stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.

c. Now assume ABC and XYZ each pay a 20% marginal corporate tax, but Richard pays no taxes. Repeat a) and b). Is the outcome different than in a) and b)? Explain. Which firm would Richard prefer to invest in? Why?

d. Now assume ABC and XYZ each pay a 20% marginal corporate tax, and Richard pays a 15% tax on dividends. Repeat a) and b). Is the outcome different than in a), b), and c)? Explain. Which firm would Richard prefer to invest in? Why?

2. Shadow Corp. has no debt but can borrow at 7%. The firm’s WACC is currently 11%, and the tax rate is 35%.

a. What is Shadow’s cost of equity?

b. If the firm converts to a 25% debt-to-equity ratio, what will its cost of equity be?

c. What is Shadow’s WACC after it converts to the 25% debt-to-equity ratio? d. Assume that converting to the 25% debt-to-equity ratio does not significantly increase Shadow Corp.’s probability of bankruptcy. Should Shadow Corp. convert to the new capital structure? Explain

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Solution 1:

Given is the following information:

EBIT of both the firms is \$95,000.

ABC is equity financed with \$800,000 in stock.

XYZ is equity-debt financed.

Stock is \$400,000

Interest rate on debt is 10%.

a) The rate of return earned will be the dividend yield.

Calculation of net income for XYZ:

And the Richard owns \$30,000 shares and the dividend received will be the 55,000*(30,000/400000) i.e. \$4,125.

Rate of return that shareholder expects = 4125/ 30000 = 13.75%

b) To generate exactly the same cash flows in the other company, the shareholder needs to match the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net \$30,000. The shareholder should then borrow \$30,000. This will create an interest cash flow of:

Interest cash flow = (\$3000).

The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive dividends in proportion to the percentage of the company's share they own. The total dividends received by the shareholder will be:

= 7,125

Thus the total cash flow = 7,125-3000

= 4,125

Now, the shareholder return = 4,125/30,000 = 13.75%

a)  Calculation of net income for both the companies:

Repeat part (a) and (b)

In this case the dividend apportioned for the shareholder = 44,000*(30,000/400000) = \$3,300

Rate of return = 3300/30,000 = 11%

To generate exactly the same cash flows in the other company, the shareholder needs to match the capital structure of ABC. The

shareholder should sell all shares in XYZ. This will net \$30,000. The shareholder should then borrow \$30,000. This will create an interest

cash flow of:

Interest cash flow = (\$3000).

The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive dividends in

proportion to the percentage of the company's share they own. The total dividends received by the shareholder will be:

Dividend received = 76,000 * (60,000/800,000)

= 5,700

Thus the total cash flow = 5,700-3000

= 2,700

Now, the shareholder return = 2700/30,000 = 9%

Yes, the outcomes are different as calculated above because in this situation the net income attributable to the shareholder is less as compared in part (a) and (b). Since the net income is less as calculated in part (a) and (b) then the rate of return will also fluctuate. The shareholder is not able to generate similar rate of return through homemade leverage due to the effect of the corporate taxation. The shareholder should invest in the XYZ Company as it is a leveraged company and the shareholder will earn better return in this company and this is less risky as compared to the equity financed company.

Solution 2:

Given is the following information:

WACC is 11%

Tax rate 35%

a) Calculation of cost of equity:

Since it is all equity financed company and in such company the wighted average cost of capital is equal to the cost of equity.

Cost of equity = WACC = 11%

b) To find the cost of equity for the company with leverage, we need to use M&M Proposition II with taxes, so:

RE= Ro+ (Ro–RD)(D/E)(1 –t)

RE= .11 + (.11 –.07)(.25/.75)(1 –.35)

RE= .1187, or 11.87% .

c) Calculation of WACC:

WACC= (E/V) Re + (D/V) Ro(1-t)

=.11(.75) + (.25).11(.65)

=0.0825 + 0.017875

= 0.1004 or 10.04%

d) It is assumed that converting to the 25% debt equity ratio does not significantly increase the probability of the bankruptcy of the company. It is evident that the cost of capital has decreased in case of the 25% debt equity ratio as compared to the cost of capital of the equity financed company. Since it lowers the cost of raising the finance the company should convert to the new capital structure considering all the other financial factors.

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