GESTÃO FINANCEIRA II

PROBLEM SET 5: Solutions

Chapters 12, 14 and 15
Estimating the Cost of Capital
Capital Structure in a Perfect World
Debt and Corporate Taxes

(FROM BERK AND DEMARZO’S “CORPORATE FINANCE”)

LICENCIATURA – UNDERGRADUATE COURSE

2011-2012
Chapter 12
Estimating the Cost of Capital

12-1. Suppose Pepsico’s stock has a beta of 0.57. If the risk-free rate is 3% and
the expected return of the market portfolio is 8%, what is Pepsico’s equity
cost of capital?

3% + 0.57 (8%-3%) = 5.85%

12-14. In mid-2009, Ralston Purina had AA-rated, 6-year bonds outstanding with
a yield to maturity of 3.75%.
a. What is the highest expected return these bonds could have?
Risk-free => y = 3.75%
b. At the time, similar maturity Treasuries has a yield of 3%. Could these
bonds actually have an expected return equal to your answer in part
(a)?
No.
c. If you believe Ralston Purina’s bonds have 1% chance of default per
year, and that expected loss rate in the event of default is 40%, what is
your estimate of the expected return for these bonds?
y-d l= 3.75% – 1%(.40) = 3.35%

12-15. In mid-2009, Rite Aid had CCC-rated, 6-year bonds outstanding with a
yield to maturity of 17.3%. At the time, similar maturity Treasuries had a
yield of 3%. Suppose the market risk premium is 5% and you believe Rite
Aid’s bonds have a beta of 0.31. If the expected loss rate of these bonds in
the event of default is 60%, what annual probability of default would be
consistent with the yield to maturity of these bonds?

Rd = 3% + .31(5%) = 4.55%
= y – pL = 17.3% – p(.60)
p = (17.3% – 4.55%)/.60 = 21.25%
Chapter 14
Capital Structure in a Perfect Market

14-5. Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of
$5000 on which it pays interest of 10% each year. Both companies have
identical projects that generate free cash flows of $800 or $1000 each year.
After paying any interest on debt, both companies use all remaining free
cash flows to pay dividends each year.
a. Fill in the table below showing the payments debt and equity holders of
each firm will receive given each of the two possible levels of free cash
flows.
ABC XYZ
FCF Debt Payments Equity Dividends Debt Payments Equity Dividends
$800 0 800 500 300
$1,000 0 1000 500 500

b. Suppose you hold 10% of the equity of ABC. What is another portfolio
you could hold that would provide the same cash flows?
Unlevered Equity = Debt + Levered Equity. Buy 10% of XYZ debt and 10% of XYZ
Equity, get 50 + (30,50) = (80,100)
c. Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%,
what is an alternative strategy that would provide the same cash flows?
Levered Equity = Unlevered Equity + Borrowing. Borrow $500, buy 10% of ABC,
receive (80,100) – 50 = (30, 50)

14-6. Suppose Alpha Industries and Omega Technology have identical assets that
generate identical cash flows. Alpha Industries is an all-equity firm, with
10 million shares outstanding that trade for a price of $22 per share.
Omega Technology has 20 million shares outstanding as well as debt of $60
million.
a. According to MM Proposition I, what is the stock price for Omega
Technology?
V(alpha) = 10 22 = 220m = V(omega) = D + E E = 220 – 60 = 160m p = $8 per
share.
b. Suppose Omega Technology stock currently trades for $11 per share.
What arbitrage opportunity is available? What assumptions are
necessary to exploit this opportunity?
Omega is overpriced. Sell 20 Omega, buy 10 alpha, and borrow 60. Initial = 220 –
220 + 60 = 60. Assumes we can trade shares at current prices and that we can
borrow at the same terms as Omega (or own Omega debt and can sell at same
price).
14-8. Schwartz Industry is an industrial company with 100 million shares
outstanding and a market capitalization (equity value) of $4 billion. It has
$2 billion of debt outstanding. Management have decided to delever the
firm by issuing new equity to repay all outstanding debt.
a. How many new shares must the firm issue?
Share price = 4b/100m = $40, Issue 2b/40 = 50 million shares
b. Suppose you are a shareholder holding 100 shares, and you disagree
with this decision. Assuming a perfect capital market, describe what
you can do to undo the effect of this decision.
You can undo the effect of the decision by borrowing to buy additional shares, in the
same proportion as the firm’s actions, thus relevering your own portfolio. In this
case you should buy 50 new shares and borrow $2000.

14-12. Hardmon Enterprises is currently an all-equity firm with an expected

return of 12%. It is considering a leveraged recapitalization in which it
would borrow and repurchase existing shares.
a. Suppose Hardmon borrows to the point that its debt-equity ratio is
0.50. With this amount of debt, the debt cost of capital is 6%. What will
the expected return of equity be after this transaction?
re = ru + d/e(ru – rd) = 12% + 0.50(12% – 6%) = 15%
b. Suppose instead Hardmon borrows to the point that its debt-equity
ratio is 1.50. With this amount of debt, Hardmon’s debt will be much
riskier. As a result, the debt cost of capital will be 8%. What will the
expected return of equity be in this case?
re = 12% + 1.50(12% – 8%) = 18%
c. A senior manager argues that it is in the best interest of the
shareholders to choose the capital structure that leads to the highest
expected return for the stock. How would you respond to the argument?
Returns are higher because risk is higher—the return fairly compensates for the
risk. There is no free lunch.

14-13. Suppose Microsoft has no debt and an equity cost of capital of 9.2%. The
average debt-to-value ratio for the software industry is 13%. What would
its cost of equity be if it took on the average amount of debt for its industry
at a cost of debt of 6%?
At a cost of debt of 6%:
D
rE rU (rU rD )
E
0.13
rE 0.092 (0.092 0.06)
0.87
0.0968
9.68%.
14-17. Mercer Corp. has 10 million shares outstanding and $100 million worth of
debt outstanding. Its current share price is $75. Mercer’s equity cost of
capital is 8.5%. Mercer has just announced that it will issue $350 million
worth of debt. It will use the proceeds from this debt to pay off its existing
debt, and use the remaining $250 million to pay an immediate dividend.
Assume perfect capital markets.
a. Estimate Mercer’s share price just after the recapitalization is
announced, but before the transaction occurs.
MM => no change, $75
b. Estimate Mercer’s share price at the conclusion of the transaction.
(Hint: use the market value balance sheet.)
Initial enterprise value = 75 10 + 100 = 850 million
New debt = 350 million
E = 850 – 350 = 500
Share price = 500/10 = $50
c. Suppose Mercer’s existing debt was risk-free with a 4.25% expected
return, and its new debt is risky with a 5% expected return. Estimate
Mercer’s equity cost of capital after the transaction.
Ru = (750/850) 8.5% + (100/850) 4.25% = 8%
Re = 8% + 350/500(8% – 5%) = 10.1%
14-18. In June 2009, Apple Computer had no debt, total equity capitalization of
$128 billion, and a (equity) beta of 1.7 (as reported on Google Finance).
Included in Apple’s assets was $25 billion in cash and risk-free securities.
Assume that the risk-free rate of interest is 5% and the market risk
premium is 4%.
a. What is Apple’s enterprise value? 128-25=103 million
b. What is the beta of Apple’s business assets?
E
Because the debt is risk free, U E
E D
128
(1.7)
103
2.11

c. What is Apple’s WACC? rWACC rf E[ RMkt ] rf 5 2.11 4 13.4%

rE rf E[ RMkt ] rf 5 1.7 4 11.8%

Alternatively: E

E D $128 $25
rwacc rE rD (11.8%) (5%) 13.4%
E D E D $103 $103
Chapter 15
Debt and Corporate Taxes

$8.30
15-5. Your firm currently has $100 million in debt outstanding with a 10%
interest rate. The terms of the loan require the firm to repay $25 million of
the balance each year. Suppose that the marginal corporate tax rate is
40%, and that the interest tax shields have the same risk as the loan. What
is the present value of the interest tax shields from this debt?

15-10. Rogot Instruments makes fine Violins and Cellos. It has $1 million in debt
outstanding, equity valued at $2 million, and pays corporate income tax at
rate 35%. Its cost of equity is 12% and its cost of debt is 7%.
a. What is Rogot’s pretax WACC?
E D 2 1
rwacc rE rD (1 c ) 12 7 10.33%
E D E D 3 3

b. What is Rogot’s (effective after-tax) WACC?

E D 2 1
rwacc rE rD (1 c ) 12 7(.65) 9.52%
E D E D 3 3

15-16. Milton Industries expects free cash flow of $5 million each year. Milton’s
corporate tax rate is 35%, and its unlevered cost of capital is 15%. The
firm also has outstanding debt of $19.05 million, and it expects to
maintain this level of debt permanently.
a. What is the value of Milton Industries without leverage?
5
VU $33.33 million
0.15

b. What is the value of Milton Industries with leverage?

VL VU C D 33.33 0.35 19.05 $40 million
15-18. Kurz Manufacturing is currently an all-equity firm with 20 million shares
outstanding and a stock price of $7.50 per share. Although investors
currently expect Kurz to remain an all-equity firm, Kurz plans to announce
that it will borrow $50 million and use the funds to repurchase shares.
Kurz will pay interest only on this debt, and it has no further plans to
increase or decrease the amount of debt. Kurz is subject to a 40%
corporate tax rate.
a. What is the market value of Kurz’s existing assets before the
announcement?
Assets = Equity = $7.50 × 20 = $150 million
b. What is the market value of Kurz’s assets (including any tax shields)
just after the debt is issued, but before the shares are repurchased?
Assets = 150 (existing) + 50 (cash) + 40% × 50 (tax shield) = $220 million
c. What is Kurz’s share price just before the share repurchase? How many
shares will Kurz repurchase?
$170 million
E = Assets – Debt = 220 – 50 = $170 million. Share price $8.50 .
20
50
Kurz will repurchase 5.882 million shares.
8.50

d. What are Kurz’s market value balance sheet and share price after the
share repurchase?
Assets = 150 (existing) + 40% 50 (tax shield) = $170 million
Debt = $50 million
E = A – D = 170 – 50 = $120 million
$120
Share price $8.50 / share .
20 5.882