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FINM7402 Tutorial 4: Optimal Capital Structure II

· Questions from the Textbook: Chapter 16, Questions 16, 18, 26, 30, 31 and 33*

Text Book Questions

16-16. On May 14, 2008, General Motors (GM) paid a dividend of $0.25 per share. During the same quarter GM lost a staggering $15.5 billion or $27.33 per share. Seven months later the company asked for billions of dollars of government aid and ultimately declared bankruptcy just over a year later, on June 1, 2009. At that point a share of GM was worth only a little more than a dollar.

(a) If you ignore the possibility of a government bailout, the decision to pay a dividend given how close the company was to financial distress is an example of what kind of agency cost?

(b) What would your answer be if GM executives anticipated that there was a possibility of a government bailout should the firm be forced to declare bankruptcy?

16-18. Consider a firm whose only asset is a plot of vacant land, and whose only liability is debt of $15 million due in one year. If left vacant, the land will be worth $10.1 million in one year. Alternatively, the firm can develop the land at an upfront cost of $19.6 million. The developed land will be worth $34.3 million in one year. Suppose the risk-free interest rate is 9.9%, assume all cash flows are risk-free, and assume there are no taxes.

a. If the firm chooses not to develop the land, what is the value of the firm’s equity today? What is the value of the debt today?

b. What is the NPV of developing the land?

c. Suppose the firm raises $19.6 million from equity holders to develop the land. If the firm develops the land, what is the value of the firm’s equity today? What is the value of the firm’s debt today?

d. Given your answer to part (c), would equity holders be willing to provide the $19.6 million needed to develop the land?

16-26.

Ralston Enterprises has assets that will have a market value in one year as follows:

 

That is, there is a 3% chance the assets will be worth $65 million, a 7% chance the assets will be worth $75 million, and so on. Suppose the CEO is contemplating a decision that will benefit her personally but will reduce the value of the firm’s assets by $10 million. The CEO is likely to proceed with this decision unless it substantially increases the firm’s risk of bankruptcy.

a. If Ralston has debt due of $70 million in one year, the CEO’s decision will increase the probability of bankruptcy by what percentage?

b. What level of debt provides the CEO with the biggest incentive not to proceed with the decision?

16-30. According to the managerial entrenchment theory, managers choose capital structure so as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of default. On the other hand, if they do not take advantage of the tax shield provided by debt, they risk losing control through a hostile takeover.

Suppose a firm expects to generate free cash flows of $90 million per year, and the discount rate for these cash flows is 10%. The firm pays a tax rate of 40%. A raider is poised to take over the firm and finance it with $750 million in permanent debt. The raider will generate the same free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20% over the current value of the firm. What level of permanent debt will the firm choose, according to the managerial entrenchment hypothesis?

16-31. Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 50 million shares outstanding. The correct price for these shares is either $9 or $7 per share. Investors view both possibilities as equally likely, so the shares currently trade for $8.

IST must raise $450 million to build a new production facility. Because the firm would suffer a large loss of both customers and engineering talent in the event of financial distress, managers believe that if IST borrows the $450 million, the present value of financial distress costs will exceed any tax benefits by $30 million. At the same time, because investors believe that managers know the correct share price, IST faces a lemons problem if it attempts to raise the $450 million by issuing equity.

a. Suppose that if IST issues equity, the share price will remain $8. To maximize the long-term share price of the firm once its true value is known, would managers choose to issue equity or borrow the $450 million if

i. They know the correct value of the shares is $7?

ii. They know the correct value of the shares is $9?

b. Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price?

c. Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price in that case?

d. How would your answers change if there were no distress costs, but only tax benefits of leverage?

16-33. “We R Toys” (WRT) is considering expanding into new geographic markets. The expansion will have the same business risk as WRT’s existing assets. The expansion will require an initial investment of $45 million and is expected to generate perpetual EBIT of $15 million per year. After the initial investment, future capital expenditures are expected to equal depreciation, and no further additions to net working capital are anticipated.

WRT’s existing capital structure is composed of $600 million in equity and $250 million in debt (market values), with 10 million equity shares outstanding. The unlevered cost of capital is 10%, and WRT’s debt is risk free with an interest rate of 4%. The corporate tax rate is 40%, and there are no personal taxes.

a. WRT initially proposes to fund the expansion by issuing equity. If investors were not expecting this expansion, and if they share WRT’s view of the expansion’s profitability, what will the share price be once the firm announces the expansion plan?

b. Suppose investors think that the EBIT from WRT’s expansion will be only $4 million. What will the share price be in this case? How many shares will the firm need to issue?

c. Suppose WRT issues equity as in part (b). Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now? Why does it differ from that found in part (a)?

d. Suppose WRT instead finances the expansion with a $45 million issue of permanent risk-free debt. If WRT undertakes the expansion using debt, what is its new share price once the new information comes out? Comparing your answer with that in part (c), what are the two advantages of debt financing in this case?

Solutions to Text Book Questions

16-16.

a. Agency problem—cashing out

b. By paying a dividend, executives increased the probability of bankruptcy and therefore the probability of receiving government funds. Since these government funds are funds that investors would not otherwise be entitled to, the payment of a dividend could actually raise firm value in this case.

16-18

a. The Balance sheet of the company in one year is:

Assets: Vacant land	10.1	Liabilities: Debt	10.1
		Equity:	0

The company’s debt is $15 million which is higher than the total assets, so the debtholders can only claim the total assets of the company, and because equity holders are residual claimants of the company, the equity is zero:

equity = 0

The present value of debt is:

debt =  = $9.19 million

b. If the company choose to develop the land then the incremental cash flows associated with the project are:

Year 0      Year 1

-19.6m 34.3 – 10.1 = 24.2 m

So the NPV of development is:

NPV = – 19.6 = $2.42 million

c. The Balance sheet of the company in one year is:

Assets: Developed land	34.3	Liabilities: Debt	15
		Equity:	19.3

The total asset is $34.3 million, and debt is 15 million. Since equity holders are residual claimants, the equity is:

 asset -debt = 34.3 – 15 = $19.3

Hence, the present value of equity and debt is:

 

debt =  = $13.65 million

d. Although the development’s NPV for the firm is positive and can create value for debt holders, Equity holders will not be willing to accept the deal, because for them it is a negative NPV investment for equity holders (17.56 – 19.6 < 0). This example shows underinvestment problem can happen as an agency problem between equity holders and shareholders.

16-26.

a. Without personal spending, there is a 3% chance of bankruptcy.

With $10 million personal spending, there is a 10% chance—so the probability of bankruptcy increased by 7%.

b. Debt between $85 and $95 million will provide the CEO with the biggest incentive not to proceed with personal spending, because by doing so the chance of bankruptcy would increase by 28%.

16-30.

Unlevered Value.

Levered Value with Raider = 900 + 40%(750) = $1.2 billion

To prevent successful raid, current management must have a levered value of at least

Thus, the minimum tax shield is $1 billion – 900 million = $100 million, which requires  million in debt.

16-31.

a. i. Borrowing has a net cost of $30 million,

Selling  million shares at a premium of $1 per share has a benefit of $56.25 million, Therefore, issue equity.

ii. Borrowing has a net cost of $30 million.

Selling  million shares at a discount of $1 per share has a cost $56.25 million, Therefore, issue debt.

b. If IST issues equity, investors would conclude IST is overpriced, and the share price would decline to $7.

c. If IST issues debt, investors would conclude IST is undervalued, and the share price would rise.

The new share price is  (450-30)/50 = $8.4

d. If there are no costs from issuing debt, then equity is only issued if it is over-priced. But knowing this, investors would only buy equity at the lowest possible value for the firm. Because there would be no benefit to issuing equity, all firms would issue debt.

16-33.

a. Project has the same business risk as WRT’s existing asset,  so the expansion risk should be R_u= 0.1

After-tax NPV of expansion =EBIT*(1-t)/project required rate of return – initial cost=15*(1-0.4)/0.1 – 45= 45 million

Equity value =600+45 = 645m,  and share price:  645/10 = $64.5 per share

b. NPV of expansion  million. Share price

New shares issued = 45/57.9 = 0.7772 million shares

c. Share price =(600+45+45)/10.7772 = $64.02 per share

Note: the numerator is the pre-issue value + amount raised in the SEO.

The share price is now lower than the answer from part (a), because in part (a), share price is fairly valued, while here shares issued in part (b) are undervalued. New shareholders’ gain of (64.02 – 57.9) ´ 0.777 = $4.8 million = old shareholders’ loss of (64.5 – 64.02) × 10 = 4.8 m.

d. Tax shield = 40% × (45) = $18 million

Share price =(600+npv+tax shield)/10 = (600+45+18)/10 = 66.3 per share.

Gain of $2.28 per share compared to case (c). $0.48 = avoid issuing undervalued equity, and $1.80 from interest tax shield.