Worksheet #2

Capital Structure and Payout Policy

Please do not attempt this worksheet without first reading chapters 16 and 17 from RWJ. The worksheet
is designed to reinforce and supplement your learning on the aforementioned sections of the textbook.
Do your best in trying to complete this worksheet before the session but if you do not manage then do
not worry as I will provide a set of solutions to these questions at the end of the session. The worksheet is
really to keep you on your toes in learning the material and staying ahead of me!

1. What is meant by business risk and financial risk? If a firm has higher business risk than another
firm then does it also have a higher cost of equity? Explain. Business risk is the equity risk arising
from the nature of the firm’s operating activity, and is directly related to the systematic risk of
the firm’s assets. Financial risk is the equity risk that is due entirely to the firm’s chosen capital
structure. As financial leverage, or the use of debt financing, increases, so does financial risk
and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it
uses greater leverage.

2. Is there an identifiable debt-equity ratio that will maximize the value of a firm? Explain. Because
many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily
be identified or quantified, it’s practically impossible to determine the precise debt-equity ratio
that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes
much more expensive, it’s probably true that the firm is too highly leveraged.

3. What is meant by homemade leverage? Homemade leverage refers to the use of borrowing on
the personal level as opposed to the corporate level.

4. Firms often use the threat of a bankruptcy filing to force creditors to renegotiate terms. Is this
fair on creditors? Explain. One answer is that the right to file for bankruptcy is a valuable asset,
and the financial manager acts in shareholders’ best interest by managing this asset in ways that
maximize its value. To the extent that a bankruptcy filing prevents “a race to the courthouse
steps,” it would seem to be a reasonable use of the process. it could be argued that using
bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the
time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it.

5. Why is it that dividends are considered to be important, but at the same time dividend policy is
irrelevant? Dividend policy deals with the timing of dividend payments, not the amounts
ultimately paid. Dividend policy is irrelevant when the timing of dividend payments doesn’t
affect the present value of all future dividends.

6. What is the impact of a stock repurchase on a company’s debt ratio? Are stock repurchases
another way for the firm to use excess cash? Explain. A stock repurchase reduces equity while
 leaving debt unchanged. The debt ratio rises. A firm could, if desired, use excess cash to reduce
debt instead. This is a capital structure decision.

7. On Wednesday Jan 5, Rabiola Inc.’s board of directors declares a dividend of $0.75 per share
payable on Wednesday Feb 2, to shareholders of record as of Wednesday Jan 26. When is the
ex-dividend date? If shareholders buy stock before that date, who gets the dividends on those
shares, the buyer or the seller? Monday, January 24 is the ex-dividend day. The date is two
business days before the date of record. If you buy stock before January 24 then you are entitled
to the dividend. If you buy on January 24 or after, then the previous owner will get the dividend.
(Before the date the stock is cum-dividend and after it trades ex-dividend.)

8. If increases in dividends tend to be followed by (somewhat immediate) increases in share prices,

how can it be said that dividend policy is irrelevant? The change in price is due to the change in
dividends, not due to the change in dividend policy. Dividend policy can still be irrelevant
without a contradiction.

9. In the past, the U.S. tax code treated dividends payments to investors as ordinary income.
Hence, dividends were taxed at the investor’s marginal tax rate, which was as high has 38%. In
contrast, capital gains were taxed at the capital gains tax rate, which stood at 20% for almost all
investors. In 2002, the then President George W. Bush proposed a tax overhaul that called for a
15% tax rate on both dividends and capital gains for investors in high tax brackets, and a 5% rate
for investors in lower tax brackets. In 2003, the law became effective. Comment on how you
think the tax law change affects ex dividend stock prices. Do you think the relative attractiveness
of stock repurchase changes relative to dividend payments? Explain. The stock price drop on
the ex-dividend date should be lower. With taxes, stock prices should drop by the amount of the
dividend, less the taxes investors must pay on the dividends. A lower tax rate lowers the
investors’ tax liability. With a high tax on dividends and a low tax on capital gains, investors, in
general, will prefer capital gains. If the dividend tax rate declines, the attractiveness of dividends
increases.

10. Mourinho Motors has zero debt and a market value of $250,000. EBIT are projected to be
$28,000 if economic conditions are normal. If there is a strong expansion in the economy then
EBIT will be 30 higher, and if there is a recession then EBIT will be 50% lower. Mourinho is
considering a dent issue of $90,000 with a 7% interest rate. The proceeds of the debt will be
used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes
for this problem. (a) Compute EPS under each of the three economic scenarios before any debt
is issued and then compute the change in EPS when the economy expands or enters a recession;
(b) Repeat part (a) if the company goes through with their stock repurchase plan; (c) What
answers would you get to parts (a and b) above if Mourinho Motors had a 35% marginal tax
rate? (d) If the company has a market-to-book ratio of 1.0, compute ROE under each of the
three economic scenarios before any debt issued, then the percentage changes in ROE for
economic expansion and recession, assuming no taxes; (e) Repeat part (d) if the company goes
through with their stock repurchase plan; (f) Repeat parts (d and e) assuming the firm has a 35%
marginal tax rate.

A table outlining the income statement for the three possible states of the economy is shown
below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows
the percentage change in EPS the company will experience in a recession or an expansion
economy.

Recession Normal Expansion

EBIT $14,000 $28,000 $36,400
Interest 0 0 0
NI $14,000 $28,000 $36,400
EPS $ 2.80 $ 5.60 $ 7.28
% EPS –50 ––– +30

If the company undergoes the proposed recapitalization, it will repurchase:

Share price = Equity / Shares outstanding

Share price = $250,000/5,000
Share price = $50

Shares repurchased = Debt issued / Share price

Shares repurchased =$90,000/$50
Shares repurchased = 1,800

The interest payment each year under all three scenarios will be:
Interest payment = $90,000(.07) = $6,300

The last row shows the percentage change in EPS the company will experience in a recession
or an expansion economy under the proposed recapitalization.

Recession Normal Expansion

EBIT $14,000 $28,000 $36,400
Interest 6,300 6,300 6,300
NI $7,700 $21,700 $30,100
EPS $2.41 $ 6.78 $9.41
% EPS –64.52 ––– +38.71

A table outlining the income statement with taxes for the three possible states of the
economy is shown below. The share price is still $50, and there are still 5,000 shares
outstanding. The last row shows the percentage change in EPS the company will experience in
a recession or an expansion economy.

Recession Normal Expansion

EBIT $14,000 $28,000 $36,400
Interest 0 0 0
Taxes 4,900 9,850 12,740
NI $9,100 $18,200 $23,600
EPS $1.82 $3.64 $4.73
% EPS –50 ––– +30

A table outlining the income statement with taxes for the three possible states of the
economy and assuming the company undertakes the proposed capitalization is shown below.
The interest payment and shares repurchased are the same as in part b of Problem 1.

Recession Normal Expansion

EBIT $14,000 $28,000 $36,400
Interest 6,300 6,300 6,300
Taxes 2,695 7,595 10,535
NI $5,005 $14,105 $19,565
EPS $1.56 $4.41 $6.11
% EPS –64.52 ––– +38.71

Notice that the percentage change in EPS is the same both with and without taxes.

Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to
the market value of equity. Using the equation for ROE:

ROE = NI/$250,000

The ROE for each state of the economy under the current capital structure and no taxes is:

Recession Normal Expansion

ROE .0560 .1120 .1456
% ROE –50 ––– +30

The second row shows the percentage change in ROE from the normal economy.

If the company undertakes the proposed recapitalization, the new equity value will be:

Equity = $250,000 – 90,000

Equity = $160,000

So, the ROE for each state of the economy is:

ROE = NI/$160,000

Recession Normal Expansion

ROE .0481 .1356 .1881
% ROE –64.52 ––– +38.71

If there are corporate taxes and the company maintains its current capital structure, the ROE
is:

ROE .0364 .0728 .0946

% ROE –50 ––– +30
 If the company undertakes the proposed recapitalization, and there are corporate taxes, the
ROE for each state of the economy is:

ROE .0313 .0882 .1223

% ROE –64.52 ––– +38.71

Notice that the percentage change in ROE is the same as the percentage change in EPS. The
percentage change in ROE is also the same with or without taxes.

11. Farias Corp. is comparing two different capital structures. Plan A would result in 7,000 shares of
stock and $160,000 in debt. Plan B would result in 5,000 shares of stock and $240,000 in debt.
The interest rate on the debt is 10%. (a) Ignoring taxes, compare these two plans to an all-equity
plan assuming that EBIT will be $39,000. The all-equity plan will result in 11,000 shares of stock.
Which if the three plans has the highest and lowest EPS? (b) In part (a), what are the breakeven
levels of EBIT for each plan as compared to that for an all-equity plan? Is one higher than the
other? (c) Ignoring taxes, when will EPS be identical for Plan A and B? (d) Repeat (a, b and c)
assuming that the marginal tax rate is 40%. Are the breakeven EBIT levels different from before?
Explain.

The income statement for each capitalization plan is:

I II All-equity
EBIT $39,000 $39,000 $39,000
Interest 16,000 24,000 0
NI $23,000 $15,000 $39,000
EPS $ 3.29 $ 3.00 $ 3.55

The all-equity plan; Plan II has the lowest EPS.

The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The
EPS is calculated as:

EPS = (EBIT – RDD)/Shares outstanding

This equation calculates the interest payment (RDD) and subtracts it from the EBIT, which
results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-
equity capital structure, the interest term is zero. To find the breakeven EBIT for two different
capital structures, we simply set the equations equal to each other and solve for EBIT. The
breakeven EBIT between the all-equity capital structure and Plan I is:

EBIT/11,000 = [EBIT – .10($160,000)]/7,000

EBIT = $44,000

And the breakeven EBIT between the all-equity capital structure and Plan II is:
EBIT/11,000 = [EBIT – .10($240,000)]/5,000
EBIT = $44,000

The break-even levels of EBIT are the same because of M&M Proposition I.

Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT,
we get:
[EBIT – .10($160,000)]/7,000 = [EBIT – .10($240,000)]/5,000
EBIT = $44,000
This break-even level of EBIT is the same as in part b again because of M&M Proposition I.

The income statement for each capitalization plan with corporate income taxes is:

I II All-equity
EBIT $39,000 $39,000 $39,000
Interest 16,000 24,000 0
Taxes 9,200 6,000 15,600
NI $ 13,800 $ 9,000 $ 23,400
EPS $ 1.97 $ 1.80 $ 2.13

The all-equity plan still has the highest EPS; Plan II still has the lowest EPS.
We can calculate the EPS as:

EPS = [(EBIT – RDD)(1 – tC)]/Shares outstanding

This is similar to the equation we used before, except now we need to account for taxes.
Again, the interest expense term is zero in the all-equity capital structure. So, the breakeven
EBIT between the all-equity plan and Plan I is:

EBIT(1 – .40)/11,000 = [EBIT – .10($160,000)](1 – .40)/7,000

EBIT = $44,000

The breakeven EBIT between the all-equity plan and Plan II is:

EBIT(1 – .40)/11,000 = [EBIT – .10($240,000)](1 – .40)/5,000

EBIT = $44,000

And the breakeven between Plan I and Plan II is:

[EBIT – .10($160,000)](1 – .40)/7,000 = [EBIT – .10($240,000)](1 – .40)/5,000

EBIT = $44,000

The break-even levels of EBIT do not change because the addition of taxes reduces the income
of all three plans by the same percentage; therefore, they do not change relative to one
another.
12. Benitez Industries has a debt-equity ratio of 1.50. Its WACC is 10%, and its cost of debt is 7%.
The corporate tax rate is 35%. (a) What is the company’s cost of equity capital? (b) What is the
company’s unlevered cost of equity capital? (c) What is the cost of equity if the debt-equity ratio
was 2.0? What if it were 1.0? What if it were zero?

With the information provided, we can use the equation for calculating WACC to find the cost of
equity. The equation for WACC is:

WACC = (E/V)RE + (D/V)RD(1 – tC)

The company has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and the
weight of equity is 1/2.5, so

WACC = .10 = (1/2.5)RE + (1.5/2.5)(.07)(1 – .35)

RE = .1818 or 18.18%

To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:

RE = RU + (RU – RD)(D/E)(1 – tC)

.1818 = RU + (RU – .07)(1.5)(1 – .35)
RU = .1266 or 12.66%

To find the cost of equity under different capital structures, we can again use M&M Proposition
II with taxes. With a debt-equity ratio of 2, the cost of equity is:

RE = RU + (RU – RD)(D/E)(1 – tC)

RE = .1266 + (.1266 – .07)(2)(1 – .35)
RE = .2001 or 20.01%

With a debt-equity ratio of 1.0, the cost of equity is:

RE = .1266 + (.1266 – .07)(1)(1 – .35)

RE = .1634 or 16.34%

And with a debt-equity ratio of 0, the cost of equity is:

RE = .1266 + (.1266 – .07)(0)(1 – .35)

RE = RU = .1266 or 12.66%

13. Rabiola Restaurants expects EBIT of $14,000 for every year forever. Currently, the company has
no debt, and its cost of equity is 16%. The firm can borrow at 9%. If the corporate tax rate is
35%, what is the value of the firm? What will happen to the value of the firm if the company
switches to 50% debt?
 With no debt, we are finding the value of an unlevered firm, so:

VU = EBIT(1 – tC)/RU
VU = $14,000(1 – .35)/.16
VU = $56,875

With debt, we simply need to use the equation for the value of a levered firm. With 50 percent
debt, one-half of the firm value is debt, so the value of the levered firm is:

VL = VU + tC(D/V)VU
VL = $56,875 + .35(.50)($56,875)
VL = $66,828.13

And with 100 percent debt, the value of the firm is:

VL = VU + tC(D/V)VU
VL = $56,875 + .35(1.0)($56,875)
VL = $76,781.25

14. Fernando Fabrics currently has 350,000 shares outstanding that sell for $90 per share. Assuming
that no market imperfections or taxes exist, what will the price per share be after each of the
following: (a) Fernando has a 5-for3 stock split; (b) Fernando has a 15% stock dividend; (c)
Fernando has a 42.5% stock dividend; (d) Fernando has a 4-for-7 reverse stock split. Then
compute the new number of shares outstanding for parts (a) through (d).

To find the new stock price, we multiply the current stock price by the ratio of old shares to new
shares, so:
a. $90(3/5) = $54.00
b. $90(1/1.15) = $78.26
c. $90(1/1.425) = $63.16
d. $90(7/4) = $157.50

To find the new shares outstanding, we multiply the current shares outstanding times the ratio
of new shares to old shares, so:
a: 350,000(5/3) = 583,333
b: 350,000(1.15) = 402,500
c: 350,000(1.425) = 498,750
d: 350,000(4/7) = 200,000

15. Marvel Inc. has 8,000 shares outstanding. The market value of equity for the company is
$308,500. The firm has $38,500 in cash and a market value of fixed assets is $270,000. The firm
currently has no debt. The company has declared a dividend of $1.30 per share. The stock goes
ex-dividend tomorrow. Ignoring any tax effects, what is the stock selling for today? What will it
sell for tomorrow? What will the balance sheet for the firm look like after the dividends are
paid?
 The stock price is the total market value of equity divided by the shares outstanding, so:
P0 = $308,500 equity/8,000 shares = $38.56 per share
Ignoring tax effects, the stock price will drop by the amount of the dividend, so:
PX = $38.56 – 1.30 = $37.26
The total dividends paid will be:
$1.30 per share(8,000 shares) = $10,400
The equity and cash accounts will both decline by $10,400.

16. Now suppose that Marvel Inc. has announced that it is going to repurchase $10,400 worth of
stock. What effect will this transaction have on the equity value of the firm? How many shares
will be outstanding? What will the price per share be after the repurchase? Ignoring tax effects,
show how the stock repurchase is essentially the same as the cash dividend.

Repurchasing the shares will reduce cash and shareholders’ equity by $10,400. The shares
repurchased will be the total purchase amount divided by the stock price, so:
Shares bought = $10,400/$38.56 = 269.69
And the new shares outstanding will be:
New shares outstanding = 8,000 – 269.69 = 7,730.31
After repurchase, the new stock price is:
Share price = ($308,500 – 10,400)/7,730.31 shares = $38.56
The repurchase is effectively the same as the cash dividend because you either hold a share
worth $38.56, or a share worth $37.26 and $1.30 in cash. Therefore, you participate in the
repurchase according to the dividend payout percentage; you are unaffected.

17. You own 1,000 shares in UPBS Corp. You will receive a $2.30 per share dividend in one year. In
two years, UPBS will pay a liquidating dividend of $53 per share. The required return on UPBS
stock is 15%. What is the current share price of your stock ignoring taxes? If you would rather
have equal dividends in each of the next two years, show how you can accomplish this by
creating homemade dividends. (Dividends will be in the form of an annuity.)

The price of the stock today is the PV of the dividends, so:

P0 = $2.30/1.15 + $53/1.152 = $42.08
To find the equal two year dividends with the same present value as the price of the stock, we
set up the following equation and solve for the dividend (Note: The dividend is a two year
annuity, so we could solve with the annuity factor as well):
$42.08 = D/1.15 + D/1.152
D = $25.88
We now know the cash flow per share we want each of the next two years. We can find the
price of stock in one year, which will be:
P1 = $53/1.15 = $46.09
Since you own 1,000 shares, in one year you want:
Cash flow in Year one = 1,000($25.88) = $25,881.40
But you’ll only get:
Dividends received in one year = 1,000($2.30) = $2,300
Thus, in one year you will need to sell additional shares in order to increase your cash flow. The
number of shares to sell in year one is:
Shares to sell at time one = ($25,881.40 – 2,300)/$46.09 = 511.67 shares
 At Year 2, you cash flow will be the dividend payment times the number of shares you still own,
so the Year 2 cash flow is:
Year 2 cash flow = $53(1,000 – 511.67) = $25,881.40

18. Salazar Industries and Hugo Chemicals are two firms with the same business risk but different
dividend policies. Salazar pays no dividends, but Hugo has an expected dividend yield of 5%.
Suppose that the capital gains tax rate is zero, whereas the income tax rate is 35%. Salazar has
an expected earnings growth rate of 15% annually, and its stock price is expected to grow at this
same rate. If the aftertax expected returns on the stock are equal (because they are in the same
risk class), what is the pretax required return on Hugo’s stock?

Assuming no capital gains tax, the aftertax return for the Gordon Company is the capital gains
growth rate, plus the dividend yield times one minus the tax rate. Using the constant growth
dividend model, we get:
Aftertax return = g + D(1 – t) = .15
Solving for g, we get:
0.15 = g + .05(1 – .35)
g = .1175
The equivalent pretax return for Gordon Company, which pays no dividend, is:
Pretax return = g + D = .1175 + .05 = .1675 or 16.75%