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FINM7402 Tutorial 3: Optimal Capital Structure

Questions from the Textbook:

Chapter 16, Questions 4*, 6, 9*, 10, 11, 13*, 14, 15, 16, 26*, 30, 31*, and 33*

Text Book Questions

16-4. Which type of firm is more likely to experience a loss of customers in the event of financial distress?

a. Campbell Soup Company or Intuit, Inc. (a maker of accounting software)?

b. Allstate Corporation (an insurance company) or Adidas AG (maker of athletic footwear, apparel, and sports equipment)?

16-6. Suppose Tefco Corp. has a value of $179 million if it continues to operate, but has outstanding debt of $181 million that is now due. If the firm declares bankruptcy, bankruptcy costs will equal $11 million, and the remaining $168 million will go to creditors. Instead of declaring bankruptcy, management proposes to exchange the firm’s debt for a fraction of its equity in a workout. What is the minimum fraction of the firm’s equity that management would need to offer to creditors for the workout to be successful?

16-9. Kohwe Corporation plans to issue equity to raise $40 million to finance a new investment. After making the investment, Kohwe expects to earn free cash flows of $9 million each year. Kohwe currently has five million shares outstanding and has no other assets or opportunities. Suppose the appropriate discount rate for Kohwe’s future free cash flows is 9%, and the only capital market imperfections are corporate taxes and financial distress costs.

a. What is the NPV of Kohwe’s investment?

b. Given these plans, what is Kohwe’s value per share today?

Suppose Kohwe borrows the $40 million instead. The firm will pay interest only on this loan each year, and it will maintain an outstanding balance of $40 million on the loan. Suppose that Kohwe’s corporate tax rate is 30%, and expected free cash flows are still $9 million each year.

c. What is Kohwe’s share price today if the investment is financed with debt?

Now suppose that with leverage, Kohwe’s expected free cash flows will decline to $8 million per year due to reduced sales and other financial distress costs. Assume that the appropriate discount rate for Kohwe’s future free cash flows is still 9%.

d. What is Kohwe’s share price today given the financial distress costs of leverage?

16-10. You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, “If we go bankrupt, we don’t have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right?

16-11. Facebook, Inc. has no debt. As Problem 21 in Chapter 15 makes clear, by issuing debt Facebook can generate a very large tax shield potentially worth nearly $2 billion. Given Facebook’s success, one would be hard pressed to argue that Facebook’s management are naïve and unaware of this huge potential to create value. A more likely explanation is that issuing debt would entail other costs. What might these costs be?

16-13. Your firm is considering issuing one-year debt, and has come up with the following estimates of the value of the interest tax shield and the probability of distress for different levels of debt:

 

Suppose the firm has a beta of zero, so that the appropriate discount rate for financial distress costs is the risk-free rate of 5%. Which level of debt above is optimal if, in the event of distress, the firm will have distress costs equal to

a. $1 million?

b. $5 million?

c. $27 million?

16-14. Marpor Industries has no debt and expects to generate free cash flows of $17 million each year. Marpor believes that if it permanently increases its level of debt to $45 million, the risk of financial distress may cause it to lose some customers and receive less favorable terms from its suppliers. As a result, Marpor’s expected free cash flows with debt will be only $16 million per year. Suppose Marpor’s tax rate is 40%, the risk-free rate is 3%, the expected return of the market is 13%, and the beta of Marpor’s free cash flows is 1.3 (with or without leverage).

a. Estimate Marpor’s value without leverage.

b. Estimate Marpor’s value with the new leverage.

16-15. Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.

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?

16-30. 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

16-4.

a. Intuit Inc.—its customers will care about their ability to receive upgrades to their software.

b. Allstate Corporation—its customers rely on the firm being able to pay future claims.

16-6.

Creditors receive 168 million in bankruptcy, so they need to receive at least this much. Therefore, Tefco could offer its creditors 93.9% of the firm in a workout.

16-9.

a. NPV = 9/0.09- 40 = $60 million

b. At the announcement of taking on the project,  the share value would increase because it is a positive NPV project.  For existing shareholders, the price appreciation would be NPV/no.of shares = 60/5 = $12.  Share price increase $12 at the announcement of taking on project.  The $40 million new capital will be raised at this new share price.    

c. The change in share price by using debt finance is: change in firm value/no. of share  = (NPV of the project + tax shield )/no. of shares = (60+0.3*40) /5 = 14.4.  Hence, using debt finance, there will be $14.4 appreciate in share price.  

d. The change in share price = (NPV of the project + tax shield )/no. of shares = (8/0.09 – 40 +0.3*40)/5 = $12.18. Hence, using debt finance with finance distress costs, there will be $12.18 appreciate in share price.  

16-10.

No, not necessarily. He has neglected the effect on customers. Customers will be less willing to buy the company’s cars because the warranty is not as solid as the company’s competitors. Since the warranty is presumably offered to entice customers to buy more cars, the overall effect could easily be to reduce value.

16-11.

Facebook has volatile cash flows and is a human-capital intensive firm. All of these things imply that Facebook has relatively high distress costs.

16-13.

a. 90

b. 60

c. 40

16-14.

a. r = 3% + 1.3 × (13% – 3%) = 16%

b. r = 3% + 1.3 × (13% – 3%) = 16%

16-15.

According to trade-off theory, tax shield adds value while financial distress costs reduce a firm’s value. The financial distress costs for a real estate investment are likely to be low, because the property can generally be easily resold for its full market value. In contrast, corporations generally face much higher costs of financial distress. As a result, corporations choose to have lower leverage.

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.

16-30.

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 = new equity value / new share outstanding

   = (old equity value + raised equity + NPV)/new no. of share outstanding

         = (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.