FNCE10002 Principles of Finance

Semester 2, 2024

Capital Structure and Payout Policy I

Tutorial Questions for Topic 9

Priority Questions:

B3, B4, B5

A. Short Answer Questions

Provide brief responses to the following question.

A1. For each statement indicate whether it is true or false and briefly explain why.

a) In a perfect capital market with no corporate taxes, as a firm takes on more and more debt
its weighted average cost of capital remains unchanged while its required return on equity
rises.

b) If a firm issues riskfree debt the risk of the firm’s equity will not change. So, riskfree debt
allows the firm to get the benefit of a low cost of debt without raising its cost of equity.

c) In the context of firms’ capital structure decisions, the theory predicts, when we’re
operating under the assumption of perfect capital markets, that the value of a firm’s
equity will rise in direct proportion to the level of debt in its capital structure.

B. Problems

B1. If a company’s debt-to-equity ratio is 40% calculate its debt-to-value and equity-to-value
ratios. What is the dollar value of debt and equity if the market value of the company’s assets
is $500 million? Show all calculations.

B2. If a company’s debt-to-value ratio is 40% calculate its debt-to-equity ratio. If the dollar value
of the company’s debt is $200 million calculate its market value of equity and its market
value of assets. Show all calculations.

B3. As CFO of the Magnificent Electronics Company (MEC), you are considering a
recapitalization plan that would convert MEC from its current all-equity capital structure to
one including substantial financial leverage. MEC now has 1,000,000 ordinary shares
outstanding, which are selling for $30 each, and you expect the company’s EBIT to be

Suggested Answers to Tutorial Questions for Topic 9 1

 $3,600,000 per year for the foreseeable future. The recapitalization proposal is to issue
$15,000,000 worth of long-term debt at an interest rate of 6.0% and use the proceeds to
repurchase 500,000 ordinary shares worth $15,000,000. Assuming there are no market
frictions such as corporate or personal income taxes, calculate the earnings per share and
expected return on equity for MEC shareholders under both the current all-equity capital
structure and under the recapitalization plan.

B4. Refer to question B3. The CFO is interested in examining how sensitive the EPS and ROE are
to variations in the EBIT based on the state of the economy. If there is normal growth, EBIT
will be $3,600,000; EBIT will be $1,200,000 if there is a recession and EBIT will be
$6,000,000 if there is an economic boom. She believes that each economic outcome is equally
likely. Assume there are no market frictions such as corporate or personal income taxes.

a) Calculate the expected earnings per share (EPS) and return on equity (ROE) for the
company’s shareholders under the three economic outcomes (recession, normal growth
and boom), for both the current all-equity capitalization and the proposed mixed
debt/equity capital structure.

b) Calculate the breakeven level of EBIT where earnings per share for the company’s
shareholders are the same under the current and proposed capital structures.

c) At what level of EBIT will the company’s shareholders earn zero EPS under the current
and the proposed capital structures?

B5. BBA Ltd has just issued $10 million in debt (at par or face value). The firm will pay interest-
only on this debt. BBA’s marginal tax rate is expected to be 30% for the foreseeable future.

a) Suppose BBA pays interest of 6% per year on its debt. What is its annual interest tax
shield?

b) What is the present value of the interest tax shield, assuming the tax shield’s risk is the
same as that of the loan?

c) Suppose instead that the interest rate on the debt is 5%. What is the present value of the
interest tax shield in this case?

Ten years have passed since BBA issued $10 million in perpetual interest-only debt with a
6% annual coupon. Tax rates have remained the same at 30% but interest rates have dropped
so BBA’s current cost of debt capital is 4%.

d) What is BBA’s annual interest tax shield now?

e) What is the present value of the interest tax shield now?

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C. Closing the loop with some selected finance research

Professor John Graham is the D. Richard Mead Professor of Finance at the Fuqua School of Business
at Duke University and as well as being one of the most accomplished researchers in corporate
finance over the last 20+ years, is also co-author of the prescribed text for this subject! In 2021 he
was President of the American Finance Association (which is widely considered the peak academic
body in finance) and as part of his duties he gave the Presidential Address in 2022 which was titled
“Presidential Address: Corporate Finance and Reality” where he reviews a substantial body of survey
literature that documents how finance practitioners make decisions in practice.

You can access the paper he presented here.

Section IV of the paper (from page 29) deals with empirical survey evidence of the capital structure
decisions made by corporations. In response to the question “Which of the following factors affect
how your firm chooses the appropriate amount of debt for your firm?” the paper reports the
percentage of respondent firms who answered either Important or Very Important. Figure 16 below
describes the survey results from Graham’s initial study (with Harvey) back in 2001 and compares
these with the results of a comparable 2022 study.

A key benefit of debt suggested by theory is the interest tax shield that debt provides. In the figure
above interest tax savings fell from being the second most important factor in 2001 to the 9 th most
important factor cited by firms in 2022. What factor(s) would help to explain this shift in ranking?

Suggested Answers to Tutorial Questions for Topic 9 3

 study

FNCE10002 Principles of Finance

Semester 2, 2024

Capital Structure and Payout Policy I

Suggested Answers to Tutorial Questions for Topic 9

A. Short Answer Questions

A1. a) True. As a firm’s debt-to-equity ratio rises the expected rate of return on its equity rises as
equity becomes riskier. According to the CAPM, shareholders will require to be
compensated for this increased (systematic) risk, resulting in a higher required return on
equity.

b) False. According to our analysis, any use of leverage will raise the required return on
equity as equity becomes riskier.

c) False. The theoretical analysis concludes that the level of debt does not influence the
market value of the firm. As the level of debt rises the market value of equity falls
because the debt raised is being used to buy back the firm’s shares.

B. Problems

B1. A D/E ratio of 0.40 implies that D = 0.40(E).

Substituting the above expression in the debt-to-value ratio, we get:

D/(D + E) = 0.40(E)/[0.40(E) + E] = 0.40(E)/1.40(E).

D/(D + E) = 0.40/1.40 = 0.286 or 28.6%.

E/(D + E) = 1 – 0.286 = 0.714 or 71.4%.

If the market value of the firm’s assets is $500 million:

Market value of debt, D = 0.286 × 500 = $143 million.

Market value of equity, E = 0.714 × 500 = $357 million.

B2. A D/(D + E) ratio = 0.40 implies:

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 D = 0.40(D + E)

D = 0.40D + 0.40E

So, D(1 – 0.40) = 0.40E

That is, the D/E ratio = 0.40/(1 – 0.40) = 0.667 or 66.7%

Alternatively, D/E ratio = [D/(D + E)]/[E/(D + E)]

So, D/E ratio = 0.40/(1 – 0.40) = 0.667 or 66.7%

If the market value of debt, D = 200 million, we have:

Market value of equity, E = 200/0.667 = $300 million

Market value of assets = D + E = 200 + 300 = $500 million

B3. The total market value of the firm with no debt is: 1000000 × 30.00 = $30,000,000.

After the recapitalization:

The market value of the firm’s debt is: $15,000,000.

The market value of equity is: 500000 × 30.00 = $15,000,000.

The analysis for the recapitalization plan is as follows.

Current Structure Proposed Structure

(All Equity Financing) (50% Debt/50% Equity)
EBIT $3,600,000 $3,600,000
Interest on debt (6.0%) $0 $900,000
Net income $3,600,000 $2,700,000
Shares outstanding 1,000,000 500,000
Earnings per share $3.60 $5.40
Return on equity
(P0 = $30.00/share) 12.0% 18.0%

No debt: EPS = 3600000/1000000 = $3.60.

With debt: EPS = 2700000/500000 = $5.40.

No debt: ROE = Net Income/Equity value = 3600000/30000000 = 12.0%.

With debt: ROE = Net Income/Equity value = 2700000/15000000 = 18.0%.

Alternatively:

No debt: ROE = EPS/Price today = 3.60/30.00 = 12.0%.

With debt: ROE = EPS/Price today = 5.40/30.00 = 18.0%.

B4. a) The analysis for the three states of the economy with no debt is as follows.

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 EBIT $1,200,000 $3,600,000 $6,000,000
Interest (6%) $0 $0 $0
Net income $1,200,000 $3,600,000 $6,000,000
Total shares 1,000,000 1,000,000 1,000,000
EPS $1.20 $3.60 $6.00
ROE 4.0% 12.0% 20.0%

The analysis for the three states of the economy with debt is as follows.

EBIT $1,200,000 $3,600,000 $6,000,000

Interest (6%) $900,000 $900,000 $900,000
Net income $300,000 $2,700,000 $5,100,000
Total shares 500,000 500,000 500,000
EPS $0.60 $5.40 $10.20
ROE 2.0% 18.0% 34.0%

b) The breakeven EBIT (EBIT*) where the earnings per share are the same under the two
capital structures can be calculated as follows:

No debt: EPS = (EBIT* – 0)/1000000 = (EBIT* – 900000)/500000 = EPS (with debt)

Solving this gives us: EBIT* = $1,800,000.

c) In the no debt case, a zero EBIT is where the earnings per share is also zero. In the debt
case, an EBIT equal to the interest on debt will result in a zero earnings per share.

B5. a) Interest tax shield = 10.0 × 0.06 × 0.30 = $0.18 million.

b)

c) Interest tax shield = 10.0 × 0.05 × 0.30 = $0.15 million.

As expected, the present value of the tax shield remains the same as this is perpetual debt.

d) Interest tax shield = 10.0 × 0.06 × 0.30 = $0.18 million.

e)

The tax shield remains the same, but its present value has changed (it is higher) because
the discount rate has changed as the cost of debt is now lower.

Suggested Answers to Tutorial Questions for Topic 9 6