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1 d) If Dorval calls in the outstanding bonds, a bondholder who currently owns bonds with $100,000 of face value will have to sell them back to the firm at face value. The bonds would be more valuable than the face value since they pay a coupon rate above the current market rate. Bondholders are aware that their bonds can be called as this is one of the features of the issue; they insist on receiving a premium as compensation for this risk. In this case, it is not worthwhile for the firm to call in the outstanding bonds, so it will not happen. CHAPTER FOUR Qualitative Questions Question 1 The cost of debt at low levels of leverage is less than the cost of equity because debt is safer than equity. The cost of debt stays constant up to some safe debt/equity ratio. Financial leverage increases the risk of equity and shareholders will demand a higher rate of return. WACC drops with increasing leverage as high-cost equity is replaced with lower cost debt. There is an optimal capital structure where the WACC is at a minimum. Question 2 Leverage implies that a firm is required to make interest and principal payments, regardless of its cash flows. If such payments are not made on time and as specified by the debt contract, the lender may force the firm into liquidation. Financial leverage magnifies the effects on earnings per share of changes in sales levels. Financial risk is measured as the difference between the total risk to shareholders of the levered firm and the total risk to shareholders of the unlevered firm. Question 3 The firm s choice of financing sources should not affect the value of its assets. Investors can create their own leverage and they are not willing to pay for services that they can do themselves. The cost of equity capital increases as the degree of financial leverage increases. WACC is constant as the advantage of cheaper debt is offset by the higher cost of equity. Question 4 Interest on corporate debt is deductible from income before calculating tax. Interest payments on debt provide a tax shield. Firm value increases by the present value of the interest tax shields. The firm is evaluated as if it were financed with all equity and the present value of the interest tax shield is added. Question 5 Personal taxes favour capital gains and dividend income over interest income. Corporate taxes favour interest income over capital gains and dividend income. The tax shield provided by the corporate interest payments is partially cancelled by the higher personal tax rate on interest income. Solutions to Self-Test Questions 37

2 Question 6 Including debt in the capital structure increases the probability of bankruptcy. Direct and indirect costs are incurred when the firm is under threat of bankruptcy. Analyzing the impact of bankruptcy costs on the firm s capital structure decision requires estimating the expected value of these bankruptcy costs. The magnitude of the expected bankruptcy costs depends on the degree of financial leverage. Question 7 The value of the firm is reduced by the present value of potential bankruptcy costs. Estimating the optimal degree of financial leverage entails finding the optimal trade-off between the tax benefits and bankruptcy costs of debt. As financial leverage increases, the probability of bankruptcy increases and the present value of bankruptcy costs becomes significant. At some point short of 100% debt financing, the present value of the marginal bankruptcy costs exactly equals the marginal tax benefits of debt. Question 8 Firms with higher business risk should borrow less than firms with lower business risk. Firms with mainly tangible assets are likely to borrow more than firms with large intangible assets. Firms with mainly intangible assets are more likely to lose value when financial distress occurs. Firms in higher tax brackets can benefit most from tax shields and hence should borrow more than firms in lower tax brackets. Firms with relatively large investments in plant and equipment will have large capital cost allowances to claim and will have lower leverage ratios. Question 9 Business risk Agency costs Industry effects Signalling Managerial preference Question 10 Industry averages The opinions of rating and lending agencies Other factors that affect the firm s ability to service its debt obligations Qualitative Multiple Choice Questions Question 1 iv) Costs of management actions to ward off bankruptcy, including waste of management time Question 2 iii) When the left-hand side is less than the right-hand side, investors prefer dividends and capital gains, so firms should use all equity financing. 38 Solutions to Self-Test Questions

3 Question 3 iii) A high percentage of debt, but below 100% Question 4 i) Financial risk to the shareholders can be defined as total risk to the shareholders of the levered firm minus total risk of the unlevered firm. Question 5 iv) The weighted average cost of capital falls when debt financing is first added to the capital structure but then rises when financial risk becomes very high. Question 6 iv) DOL measures the sensitivity of a firm s earnings before interest and taxes (EBIT) to changes in sales. Question 7 iii) Indirect bankruptcy costs are incurred when a firm is under threat of bankruptcy, whereas direct bankruptcy costs are the result of actual bankruptcy. Question 8 iii) Firms with predominantly tangible assets Quantitative Multiple Choice Questions Question 1 iii) (100-30)(25,000) [(100-30)(25,000) - 333,000] = 1,750,000 1,417,000 = Question 2 iii) $27,692,308 Question 3 iv) $18.75 million E(EBIT) = 0.2(1.5) + 0.3(3.5) + 0.4(6.5) + 0.1(10.5) = $5 million $5,000,000(1-0.40) Firm value = = $18.75 million 0.16 Question 4 ii) $154 million EBIT(1-0.35) [EBIT(1-0.35) - 3,000,000] = 12,000,000 10,000, EBIT(0.65) = 12[EBIT(0.65) ,000] 6.5 EBIT = 7.8 EBIT - 36,000, EBIT = - 36,000,000 EBIT = $27,692,308 % change in EBIT DOL = % change in sales 1.67 * ( ) = % change in EBIT 220 Solutions to Self-Test Questions 39

4 Therefore, new EBIT level is $153,805,455 million. Question 5 iii) $432,000 Question 6 iii) 0.375% V U = change in EBIT = $145 million Change in EBIT = 8,805,4545 $120,000(1-40%) 18% V L = V U + T C D = $400, ($80,000) = $432,000 DOL = % EBIT % sales = $400,000 % sales = % EBIT DOL = 3% 8 = 0.375% Question 7 ii) $20.16 million Leverage indifference EBIT level EBIT * 7 million = EBIT* - $18 million (9%) $18 million 7 million - $32 EBIT * = $20.16 million Question 8 iv) 12.89% V L = V U + T C D = $22 million + 45%($8 million) = $25.6 million E = $25.6 million - $8 million = $17.6 million k E = 15% + (15% - 8%)a 8 b(1-45%) = 16.75% 17.6 WACC = 16.75%a b + 8% (1-45%)a b = 12.89% Question 9 ii) 6.60% EBIT EBIT $7.8 million - $6.8 million = = 14.71% $6.8 million sales Sales = EBIT EBIT DOL = 14.71% 2.23 = % 40 Solutions to Self-Test Questions

5 Quantitative Problems Problem 1 a) The degree of operating leverage (DOL) is the percentage change in earnings before interest expense and income taxes (EBIT), divided by the percentage change in sales. It measures the sensitivity of a firm s operating earnings to changes in sales volume. Specifically, DOL measures the percentage change in EBIT for a 1% change in sales. DOL is a function of the sales level at which it is measured. It is largest at the break-even point. At sales levels above the break-even point, DOL is positive, and at sales levels below the break-even point, DOL is negative, indicating that a firm s operating earnings do not even cover the fixed costs. b) For the Levis facility, break-even sales volume is: The current production level at 2,050,000 units is well above the break-even level. VC per unit = For the Fredericton facility, break-even sales volume is: The current production level at 60,000 units is well above the break-even level. VC per unit = c) DOL for the Levis facility: (S - VC) (S - VC - F) E (P - VC) = 5,800,000 = 966,667 units (10-4) Total VC Total quantity of units = $8,200,000 2,050,000 = $4 F (P - VC) = 3,550,000 = 42,178 units ( ) Total VC Total quantity of units = $950,000 60,000 = $ = (20,500,000-8,200,000) (20,500,000-8,200,000-5,800,000) = 12,300,000 6,500,000 = 1.89 For the Levis facility, at the sales level of 2,050,000 units, a 1% change in sales will result in a 1.89% change in EBIT. DOL for the Fredericton facility: (S - VC) (S - VC - F) = (6,000, ,000) (6,000, ,000-3,550,000) = 5,050,000 1,500,000 = For the Fredericton facility, at the sales level of 60,000 units, a 1% change in sales will result in a 3.37% change in EBIT. Hence, at expected production levels, the Fredericton facility has a higher degree of operating leverage than the Levis facility, resulting in a 94% A B higher EBIT for a 1% increase in sales. Problem 2 In this question, students must first consider whether the existence of taxes would provide a rationale for the use of debt financing by this highly conservative firm. Particular tax rates are Solutions to Self-Test Questions 41

6 provided. Then students must consider whether the existence of bankruptcy costs would favour the adoption of debt financing. With the tax rates given, there is no benefit to changing the capital structure to include debt, since the following condition is satisfied: (1 - Tax rate on interest income) = (1 - Corporate tax rate) (1 - Tax rate on income from shares) (1-0.44) = (1-0.4)( ) = 0.56 The effective tax rates are the same, regardless of how the firm distributes earnings to security holders. The existence of bankruptcy costs would argue against the use of debt, since the use of debt increases the chance that such costs will be incurred, and there are no offsetting benefits in this scenario. Problem 3 Date: December 31, 20X1 To: Sasha Khan Kerri Song From: U.N. Owen, Finance Student Re: Financing Alternatives Many businesses start small with personal savings as the main source of financing. As business expands and financing need increases, owners should explore other financing alternatives. One possibility is to issue new common shares. There are advantages and disadvantages of issuing new common shares. Advantages: Equity is a permanent source of capital, which reduces the risk to the issuer. Common-share financing improves the firm s debt-to-equity ratio. Disadvantages: Issuing new common shares dilutes the control of current shareholders. Cost of equity may be higher than debt, as new shareholders expect a higher return on their investment. Another possibility is to introduce debt into the capital structure. The advantage of debt is that the firm may save some income taxes because the interest expense is tax deductible and using debt is using financial leverage. The disadvantage is that using debt introduces financial risk into the firm because there are required periodic cash payments (interest and principal). The effective annual interest rate for each loan proposal can be calculated as: Bank West: Bank Central: a % 363 b = 7.787% P % % Q - 1 = 8.00% 42 Solutions to Self-Test Questions

7 Bank East: ± % % = 7.814% Island Bank: 7% 1-7% - 5% = % You should choose Bank West, since the effective annual interest rate on that loan is the lowest, at 7.787%. Cases Case 1: ReginON Corporation (ROC) In this question, a firm alters its capital structure to match the industry norm. Students must take into account the impact of the debt tax shield on firm value when assessing how much debt to retire and must consider how equity value will be affected. a) Total-debt-to-value ratio for ROC at the current time: Total debt Total value = (1,500, ,750,000) (1,500, ,750, ,750,000) = 6,250,000 = or 52.1% 12,000,000 b) To reduce the total-debt-to-value ratio to the industry norm of 45%, ROC would have to issue shares and use the proceeds to pay down some of its debt. With less debt, there will be less debt tax shields and this will reduce market value somewhat. New firm value = current market value of firm - (tax rate debt reduction) = 12,000,000 - (0.40 change in debt) New amount of debt = current debt - change in debt = 6,250,000 - change in debt New debt New value = 45% (6,250,000 - change in debt) (12,000, * change in debt) = ,250,000 - change in debt = 0.45(12,000, * change in debt) 6,250,000 - change in debt = 5,400, change in debt 850,000 = 0.82 change in debt change in debt = 850, = 1,036,585 New debt level = 6,250,000-1,036,585 = 5,213,415 New firm value = 12,000, (1,036,585) = 11,585,366 Solutions to Self-Test Questions 43

8 New debt-to-value ratio = 5,213,415 11,585,366 = 45% The firm must pay down $1,036,585 of debt in order to achieve the desired 45% debtto-value ratio. c) Market value of outstanding equity after altering the capital structure: Value of equity = new firm value - value of debt = 11,585,366-5,213,415 = 6,371,951 Although the total value of equity has increased, the per share value will be lower. Equity was issued to raise the funds (resulting in a higher number of shares outstanding) to retire the debt, and less debt results in lower tax shields so value is lost. Case 2: HamilOak Corporation (HOC) Report on Recapitalization Opportunity The following tables show the calculations of HOC s EPS and return on investment as a function of the firm s EBIT, both without debt and with debt. 1) Before recapitalization: No debt and 2 million shares outstanding 2) After recapitalization: Borrow $100 million at 9% and use the cash to repurchase 2 million shares at $50 per share Economic Conditions Recession Normal Expansion EBIT $ 10 million $ 30 million $ 40 million Less: Interest expense EBT 10 million 30 million 40 million Less: Tax (35%) 3.5 million 10.5 million 14 million Net income $ 6.5 million $ 19.5 million $ 26 million Number of shares 4 million 4 million 4 million EPS $ $ $ 6.50 Share price $ 50 $ 50 $ 50 ROI 3.25% 9.75% 13% Economic Conditions Recession Normal Expansion EBIT $10.0 million $30.0 million $40.0 million Less: Interest expense 9.0 million 9.0 million 9.0 million EBT 1.0 million 21.0 million 31.0 million Less: Tax (35%) 0.35 million 7.35 million million Net income $0.65 million $13.65 million $20.15 million Continued > 44 Solutions to Self-Test Questions

9 Number of shares 2 million 2 million 2 million EPS $0.325 $6.825 $ Share price $50 $50 $50 ROI 0.65% 13.65% 20.15% Analysis of Risk Associated with Recapitalization The leverage-indifference EBIT level: Expected EBIT = (0.3)($10 million) + (0.4)($30 million) + (0.3)($40 million) = $27 million As the expected EBIT exceeds the leverage indifference EBIT level, we tend to favour the recapitalization plan. Under the current capital structure: Expected EPS = (0.3) ($1.625) + (0.4) ($4.875) + (0.3) ($6.50) = $ per share Standard deviation of EPS: 0.3( ) ( ) ( ) 2 = 2.16 Under the proposed capital structure: Expected EPS = (0.3)($0.325) + (0.4)($6.825) + (0.3)($10.08) = $ per share Standard deviation of EPS: Summary EBIT million = EBIT - 9 million 2 million EBIT = 2(EBIT) - 9 million EBIT = $9 million s = = or 1.93 CV = = ( ) ( ) ( ) 2 = s = = CV = = 0.66 The analysis shows that a substitution of debt for equity will increase EPS and ROI in the normal and expansion scenarios, but will decrease EPS and ROI in the recession scenario. These results, however, are insufficient to make a recommendation on whether the firm should recapitalize because they do not show the impact of the recapitalization on the market value of HOC and its share price; they will be affected somewhat upon the accounting conventions that are used to calculate EBIT; and they do not account for the financial distress costs that debt financing generates. Solutions to Self-Test Questions 45

10 Case 3: Edmontuk Inc. (EI) a) In a no-tax M&M perfect world, after raising the fund by issuing common shares, The current common equity is $8,571,429 - $5,000,000 = $3,571,429 If $5 million is to be raised by issuing debt, E = V U = EBIT k U = $1,200,000 14% = $8,571,429 5 k E = 14% + (14% - 9%)a b = 21% EBIT - interest $1,200,000 - $5 million (9%) = = $ million k E 21% V L = E + D = $5 million + $ million = $ million WACC = 9%a b + 21%a b = 14% The fundamental determinant is EBIT, that is, a firm s investment decision. b) In an M&M world with corporate tax: i) V U = EBIT(1 - T C) $1,200,000(1-40%) = = $ million k U 14% ii) V L = V U + T C D = $ million + 40% ($5 million) = $ million E = V L - D = $ million - $5 million = $ million 5 million k E = 14% + (14% - 9%)(1-40%)a million b = 21% 5 million million WACC = 9%(1-40%)a b + 21%a million million b = 10.08% iii) V L = V U + T C D = $ million + 40%($6 million) E = = $ million million - 6 million = million 6 million k E = 14% + (14% - 9%)(1-40%)a million b = 26% 6 million million WACC = 9%(1-40%)a b + 26%a million million b = 9.61% c) In a no-tax M&M perfect world, a firm s capital structure decision is irrelevant. Regardless of how much debt a firm uses, the firm s value remains unchanged. Only a firm s investment decision can change a firm s value. With corporate tax, a firm can use debt to increase its own value. The more debt, the higher a firm s total value, the lower its cost of capital (WACC). But debt financing increases a firm s cost of equity and reduces its equity value. This is financial risk. Other factors a firm needs to consider are personal taxes, bankruptcy costs, business risk, and agency costs. 46 Solutions to Self-Test Questions

If you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60

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