Business: Weighted Average Cost of Capital and Market Value Essay

Submitted By jennifer1992116
Words: 6072
Pages: 25
Open Document
CHAPTER 15
CAPITAL STRUCTURE
Basic Concepts

1. In a world with no taxes, distress costs, or transaction costs, the choice of debt or equity is irrelevant to the value of the firm. In this scenario, the firm is like a pizza. It doesn’t matter how you slice it, you still have a pizza – no more, no less.

2. Section 15.2 goes into this in detail. However, in a world with no taxes, transaction costs or distress costs, any change in capital structure that increases the value of the firm will have a direct impact on the shareholders. Similarly, when the value of the firm decreases, this will hurt both debt holders and shareholders. In a world with frictions (taxes, distress costs, transaction costs), this is not necessarily true.

3. False. A reduction in leverage will decrease both the risk of the equity and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the share price and the overall value of the firm unchanged.

4. False. Modigliani-Miller Proposition II (No Taxes) states that the required return on a firm’s equity is positively related to the firm’s debt-equity ratio [RS = R0 + (B/S)(R0 – RB)]. Therefore, any increase in the amount of debt in a firm’s capital structure will increase the required return on the firm’s equity.

5. Section 15.5 covers this in detail. The main impact is that taxes make debt valuable because of the tax shield that comes with debt. In addition, the risk of equity increases as debt increases in the capital structure. These are Propositions I and II of Modigliani & Miller’s theorem.

6. This is covered in Section 15.6. A firm is indifferent between equity and debt when:

7. The question requires the student to develop their own example. The relevant sections in the chapter that this question refers to are 15.3 and 15.4.

8. If the total asset value is £120,000 before the restructuring, the debt and equity values after the restructuring are £60,000 each. The debt to equity ratio is 1 and the debt to assets ratio is 0.5.

9. The table below outlines the income statement for the three states:

State
1
2
3
EBIT
£8,000
£10,000
£12,000
Interest
£6,000
£6,000
£6,000
NI
£2,000
£4,000
£6,000
ROE
3.33%
6.67%
10.00%

10. a. 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 1 billion 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
1.024
€ 2.56
€ 3.33
Interest
€ 0
€ 0
€ 0
Taxes
€ 0
€ 0
€ 0
NI
€ 1.024
€ 2.560
€ 3.328
EPS
€ 1.024
€ 2.560
€ 3.328
%EPS
-60.00%
–––
30.00%

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

Share price = Equity / Shares outstanding Share price = 12.68/1 Share price = €12.68

Shares repurchased = Debt issued / Share price Shares repurchased =€2 billion/€12.68 Shares repurchased = 157,728,707 The interest payment each year under all three scenarios will be:

Interest payment = €2 billion(.05) = €100 million

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
1.024
2.560
3.328
Interest
€ 0.1
€ 0.1
€ 0.1
Taxes
€ 0
€ 0
€ 0
NI
€ 0.924
€ 2.460
€ 3.228
EPS
€ 1.097
€ 2.921
€ 3.832
%EPS
-62.44%
–––
31.22%

11. a. A table outlining the income statement with taxes for the three possible states of the economy is shown below. The EPS is the net income divided by the 1 billion 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
1.024
2.560
3.328
Interest
Show More

Related Documents: Business: Weighted Average Cost of Capital and Market Value Essay

Encana Case Study

find the Weighted Average Cost of Capital for the energy firm EnCana. Finding the firms market value capital structure Value of debt: Short Term Debt: We assume that Encana’s short-term debt is NOT a part of its permanent capital structure because Encana’s business activities are project based (mining, oil and gas) and hence assumedly require different frequencies and magnitudes of short-term debt that vary with each project. Long-term Debt: We do not have the resources to calculate the market value…

Words 1002 - Pages 5

Nike Final Essay

Nike Inc. Cost of Capital Columbus: Team 3 Shaifali Singh Julien Steel Yash Desai Maria Diaz Shengyi Shen Dario Tabio Table of Contents:  Nike Background  Importance of Cost of Capital  WACC  Assumptions for Calculation of WACC Single cost or Multiple cost? Cost of Debt Cost of Equity WACC calculation methodology  Value of Nike Nike Inc. Background NorthPoint Large Cap Fund weighing whether to buy Nike’s stock. Nike has experienced sales growth declines in profits and…

Words 1618 - Pages 7

Essay on Long-Term Financial Decisions

THIS PART 11 12 13 The Cost of Capital Leverage and Capital Structure Dividend Policy INTEGRATIVE CASE 4 O’GRADY APPAREL COMPANY CHAPTER 11 The Cost of Capital INSTRUCTOR’S RESOURCES Overview This chapter introduces the student to an important financial concept, the cost of capital. The mechanics of computing the sources of capital-debt, preferred stock, common stock, and retained earnings are reviewed. The relationship between the cost of capital and both the firm's financing…

Words 4674 - Pages 19

Nova Chemical Essay

alternatives in annual financing to handle the sharp increases in needed capital spending. One alternative includes the sale of Nova’s Industrial Products Division which…

Words 1090 - Pages 5

Essay on Marriott Case

Hansen Abdullah Al-Gwaiz, Yun Yan, Chuanjie Lan, Minyuan Ma，and Avinav Sharma 09/09/2013 Assessment of Marriott’s Growth Strategy and Cost of Capital In this memorandum we will first discuss the four strategies that Marriott has outlined to achieve its new goal of higher growth. Second, we evaluate the WACC approach that the Company uses to estimate its cost of capital, delineate how to apply the WACC method, and discuss its merits. The Company has outlined four strategies in order to achieve its…

Words 1039 - Pages 5

Essay on Corp Fin Pres

completely. Investors seem to be concerned with both market risk and other risk factors. Therefore, the it may not produce a correct estimate of ri. ri = rRF + βi (rM – rRF) + ??? 2 Fama-French 3 factor model The required return is based on 3 factors.  In addition to the market factor, there are also a size factor and book-tomarket factor. Rt  R f , t   *( Rm , t  R f ,t )  s * SMBt  h * HMLt   t  3 The Cost of Capital    WACC Component costs Adjusting for risk 4 As a financial manager…

Words 1500 - Pages 6

Case Analysis Essay

Corporation: The Cost of Capital (Abridged) Problem Marriott Corporation must determine the appropriate annual hurdle rates at each of the firm’s three divisions in order to accurately value and determine whether they should partake in an investment project. Options  Maintain the current capital structure  Change their current capital structure by implementing target debt and equity ratios Recommendation Marriott should apply the target capital structure in order to minimize costs and maximize…

Words 1727 - Pages 7

Essay about American Home Products Case

Introduction 3 Background 3 Culture of the Business 3 Stages of Development 3 Core problem 4 analysis and options 4 Risk analysis 5 First: The Business Risk 5 Second: The Financial Risk 6 Other kinds of risk: 7 Financial Analysis 7 The WAAC 7 Ratio Analysis 11 Recommendations: 12 References: 12 Introduction Background In 1981, AHP had reached sales of more than $4 billion by producing 1,500 marketed brands in 4 different kind of business; prescription drugs, packaged drugs, food…

Words 2301 - Pages 10

Capital Structure Analysis - Walmart Essay

Every business decision is associated in one way or another with the financial condition of the organization. The results of a working capital analysis will assist in the determination of organization¡¦s ability to remain in a particular line of business. The primary focus of Team C¡¦s analysis of Wal-Mart, Inc is its current and future financial condition. The most imperative areas that are found in the Capital Structure Analysis Report fall into the following categories: Working Capital Management…

Words 4067 - Pages 17

Case Studies in Finance: Estimating the Cost of Capital Essay

ESTIMATING THE COST OF CAPITAL QUESTION 1: a)b)c) The Capital Assets Price Model (CAPM) is used to describe the relationship between risk and expected return and is often used to estimate a cost of equity (Investopedia, 2009). The cost of equity(COE) of the discount rate is: R = Rf + β*(E - Rf) (1) Rf = Risk free rate of return, usually U.S. treasury bonds β = Beta for a company E = Expected return of the market (commercial airlines market)…

Words 2000 - Pages 8