Chapter 16: Capital Structure: Limits to the Use of Debt 16.1 a.

The value of a firms equity is the discou ted e!pected cash flo" to the firms stoc#holders. $f there is a boom% &ood Time "ill 'e erate cash flo" of ()*+ millio . Si ce &ood Time o"es its bo dholders (1*+ millio % the firms stoc#holders "ill receive (1++ millio ,- ()*+ millio . (1*+ millio / if there is a boom. $f there is a recessio % &ood Time "ill 'e erate a cash flo" of (1++ millio . Si ce the bo dholders have the ri'ht to the first (1*+ millio that the firm 'e erates% &ood Time stoc#holders "ill receive (+ if there is a recessio . The probability of a boom is 6+0. The probability of a recessio is 1+0. The appropriate discou t rate is 1)0. The value of &ood Times equity is: 2,+.6+/,(1++ millio / 3 ,+.1+/,(+/4 5 1.1) - $53.57 million The value of Good Times equity is $53.57 million. b. 6romised 7etur - ,8ace 9alue of Debt 5 :ar#et 9alue of Debt/ ; 1 Si ce the debt holders have bee promised (1*+ millio at the e d of the year% the face value of &ood Times debt is (1*+ millio . The mar#et value of &ood Times debt is (1+<.=> millio . The promised retur o &ood Times debt is: 6romised 7etur - ,8ace 9alue of ?o d 5 :ar#et 9alue of ?o d/ ; 1 - ,(1*+ millio 5 (1+<.=> millio / ; 1 - +.>@@+ The promised return on Good Times debt is 37.70%. c. The value of a firm is the sum of the mar#et value of the firms debt a d equity. The value of &ood Times debt is (1+<.=> millio . As sho" i part a% the value of &ood Times equity is (*>.*@ millio . The value of &ood Time is: 9L - ? 3 S - (1+<.=> millio 3 (*>.*@ millio - (16).* millio The value of Good Time Company is $ !".5 million. d. The mar#et value of a firms debt is the discou ted e!pected cash flo" to the firms debt holders. $f there is a boom% &ood Time "ill 'e erate cash flo" of ()*+ millio . Si ce &ood Time o"es its debt holders (1*+ millio % the firms bo dholders "ill receive (1*+ millio if there is a boom. Bhile the firms debt holders are o"ed (1*+ millio % &ood Time "ill o ly 'e erate (1++ millio of cash flo" if there is a recessio . The firms debt holders ca ot receive more tha the firm ca afford to pay them. Therefore% &ood Times debt holders "ill o ly receive (1++ millio if there is a recessio .

The probability of a boom is 6+0. The probability of a recessio is 1+0. The appropriate discou t rate is 1)0. $f o ba #ruptcy costs are priced i to the debt% the value of &ood Times debt is: 2,+.6+/,(1*+ millio / 3 ,+.1+/,(1++/4 5 1.1) -$ !.07 million !.07

Therefore# in a $orld $ith no ban%rupt&y &osts# Good Times debt $ould be $orth $ million. e.

The mar#et value of a firms debt is the discou ted e!pected cash flo" to the firms debt holders. Be # o" that the debt holders "ill receive (1*+ millio i a boom a d that the mar#et value of the debt is (1+<.=> millio . Let C be the amou t that bo dholders e!pect to receive i the eve t of a recessio : (1+<.=> millio - 2,+.6+/,(1*+ millio / 3 ,+.1+/,C/4 5 1.1) C - $'0 million Therefore# the mar%et value of Good Times debt indi&ates that the firms bondholders e(pe&t to re&eive $'0 million in the event of a re&ession.

f.

Si ce the firm "ill 'e erate (1++ millio of cash flo" i the eve t of a recessio but the firms bo dholders o ly e!pect to receive a payme t of (<+ millio % &ood Times cost of ba #ruptcy is e!pected to be ()+ millio ,- (1++ millio . (<+ millio /% should ba #ruptcy occur at the e d of the year. Good Time e(pe&ts ban%rupt&y &osts of $"0 million# should ban%rupt&y o&&ur at the end of the year.

16.)

a.

The total value of a firms equity is the discou ted e!pected cash flo" to the firms stoc#holders. $f the e!pa sio co ti ues% each firm "ill 'e erate ear i 's before i terest a d ta!es of () millio . $f there is a recessio each firm "ill 'e erate ear i 's before i terest a d ta!es of o ly (<++%+++. Si ce Stei ber' o"es its bo dholders (@*+%+++ at the e d of the year% its stoc#holders "ill receive (1.)* millio ,- () millio . (@*+%+++/ if the e!pa sio co ti ues. $f there is a recessio % its stoc#holders "ill o ly receive (*+%+++ ,- (<++%+++ . (@*+%+++/. The mar#et value of Stei ber's equity is: 2,+.<+/,(1%)*+%+++/ 3 ,+.)+/,(*+%+++/4 5 1.1* - $'7'#"! The value of )teinber*s equity is $'7'#"! . Stei ber's bo dholders "ill receive (@*+%+++ re'ardless of "hether there is a recessio or a co ti uatio of the e!pa sio . The mar#et value of Stei ber's debt is: 2,+.<+/,(@*+%+++/ 3 ,+.)+/,(@*+%+++/4 5 1.1* - $!5"# 7+ The value of )teinber*s debt is $!5"# 7+. Si ce Dietrich o"es its bo dholders (1 millio at the e d of the year% its stoc#holders "ill receive (1 millio ,- () millio . (1 millio / if the e!pa sio co ti ues. $f there is a recessio % its stoc#holders

"ill receive othi ' si ce the firms bo dholders have a more se ior claim o all (<++%+++ of the firms ear i 's. The mar#et value of Dietrichs equity is: 2,+.<+/,(1%+++%+++/ 3 ,+.)+/,(+/4 5 1.1* - $!,5#!5" The value of -ietri&hs equity is $!,5#!5". Dietrichs bo dholders "ill receive (1 millio if the e!pa sio co ti ues a d (<++%+++ if there is a recessio . The mar#et value of Dietrichs debt is: 2,+.<+/,(1%+++%+++/ 3 ,+.)+/,(<++%+++/4 5 1.1* - $'3+#7'3 The value of -ietri&hs debt is $'3+#7'3. b. The value of Stei ber' is the sum of the value of the firms debt a d equity. The value of Stei ber' is: 9L - ? 3 S - (6*)%1@1 3 (<@<%)61 - $ #530#+35 The value of )teinber* is $ #530#+35. The value of Dietrich is the sum of the value of the firms debt a d equity. The value of Dietrich is: 9L - ? 3 S - (<>1%@<> 3 6=*%6*) - $ #530#+35 The value of -ietri&h is also $ #530#+35. c. Dou should disa'ree "ith the CEFs stateme t. The ris# of ba #ruptcy per se does ot affect a firms value. $t is the actual costs of ba #ruptcy that decrease the value of a firm. Gote that this problem assumes that there are o ba #ruptcy costs.

16.>

Direct Costs: Le'al a d admi istrative costs: Costs associated "ith the liti'atio arisi ' from a liquidatio or ba #ruptcy. These costs i clude la"yers fees% courtroom costs% a d e!pert "it ess fees. $ direct Costs: $mpaired ability to co duct busi ess: 8irms may suffer a loss of sales due to a decrease i co sumer co fide ce a d loss of reliable supplies due to a lac# of co fide ce by suppliers. $ ce tive to ta#e lar'e ris#s:

Bhe faced "ith proHects of differe t ris# levels% ma a'ers acti ' i the stoc#holders i terest have a i ce tive to u derta#e hi'h.ris# proHects. $ma'i e a firm "ith o ly o e proHect% "hich pays (1++ i a e!pa sio a d (6+ i a recessio . $f debt payme ts are (6+% the stoc#holders receive (1+ ,- (1++ . (6+/ i the e!pa sio but othi ' i the recessio . The bo dholders receive (6+ for certai . Go"% alter atively ima'i e that the proHect pays (11+ i a e!pa sio but (*+ i a recessio . Iere% the stoc#holders receive (*+ ,- (11+ . (6+/ i the e!pa sio but othi ' i the recessio . The bo dholders receive o ly (*+ i the recessio because there is o more mo ey i the firm. That is% the firm simply declares ba #ruptcy% leavi ' the bo dholders Jholdi ' the ba'.K Thus% a i crease i ris# ca be efit the stoc#holders. The #ey here is that the bo dholders are hurt by ris#% si ce the stoc#holders have limited liability. $f the firm declares ba #ruptcy% the stoc#holders are ot respo sible for the bo dholders shortfall. $ ce tive to u der.i vest: $f a compa y is ear ba #ruptcy% stoc#holders may "ell be hurt if they co tribute equity to a e" proHect% eve if the proHect has a positive G69. The reaso is that some ,or all/ of the cash flo"s "ill 'o to the bo dholders. Suppose a real estate developer o" s a buildi ' that is li#ely to 'o ba #rupt% "ith the bo dholders receivi ' the property a d the developer receivi ' othi '. Should the developer ta#e (1 millio out of his o" poc#et to add a e" "i ' to a buildi 'L 6erhaps ot% eve if the e" "i ' "ill 'e erate cash flo"s "ith a prese t value 'reater tha (1 millio . Si ce the bo dholders are li#ely to e d up "ith the property a y"ay% the developer "ill pay the additio al (1 millio a d li#ely e d up "ith othi ' to sho" for it. :il#i ' the property: $ the eve t of ba #ruptcy% bo dholders have the first claim to the assets of the firm. Bhe faced "ith a possible ba #ruptcy% the stoc#holders have stro ' i ce tives to vote for i creased divide ds or other distributio s. This "ill e sure them of 'etti ' some of the assets of the firm before the bo dholders ca lay claim to them. 16.1 Dou should disa'ree "ith the stateme t. $f a firm has debt% it might be adva ta'eous to stoc#holders for the firm to u derta#e ris#y proHects% eve those "ith e'ative et prese t values. This i ce tive results from the fact that most of the ris# of failure is bor e by bo dholders. Therefore% value is tra sferred from the bo dholders to the shareholders by u derta#i ' ris#y proHects% eve if the proHects have e'ative G69s. This i ce tive is eve stro 'er "he the probability a d costs of ba #ruptcy are hi'h. A umerical e!ample illustrati ' this co cept is i cluded i the solutio to questio 16.> u der the headi ' J$ ce tive to ta#e lar'e ris#sK. 16.* Dou should recomme d that the firm issue equity i order to fi a ce the proHect. The ta!.loss carry.for"ards ma#e the firms effective ta! rate Mero. Therefore% the compa y "ill ot be efit from the ta! shield that debt provides. :oreover% si ce the firm already has a moderate amou t of debt i its capital structure% additio al debt "ill li#ely i crease the probability that the firm "ill face fi a cial distress or ba #ruptcy. As lo ' as there are ba #ruptcy costs% the firm should issue equity i order to fi a ce the proHect. 16.6 a. $f the lo".ris# proHect is u derta#e % the firm "ill be "orth (*++ if the eco omy is bad a d (@++ if the eco omy is 'ood. Si ce each of these t"o sce arios is equally probable% the e!pected value of the firm is (6++ 2- ,+.*+/,(*++/ 3 ,+.*+/,(@++/4. $f the hi'h.ris# proHect is u derta#e % the firm "ill be "orth (1++ if the eco omy is bad a d (<++ if the eco omy is 'ood. Si ce each of these t"o sce arios is equally probable% the e!pected value of the firm is (1*+ 2- ,+.*+/,(1++/ 3 ,+.*+/,(<++/4. The lo$.ris% pro/e&t ma(imi0es the e(pe&ted value of the firm.

b.

$f the lo".ris# proHect is u derta#e % the firms equity "ill be "orth (+ if the eco omy is bad a d ()++ if the eco omy is 'ood. Si ce each of these t"o sce arios is equally probable% the e!pected value of the firms equity is (1++ 2- ,+.*+/,(+/ 3 ,+.*+/,(1++/4. $f the hi'h.ris# proHect is u derta#e % the firms equity "ill be "orth (+ if the eco omy is bad a d (>++ if the eco omy is 'ood. Si ce each of these t"o sce arios is equally probable% the e!pected value of the firms equity is (1*+ 2- ,+.*+/,(+/ 3 ,+.*+/,(>++/4.

c. d.

7is#. eutral i vestors prefer the strate'y "ith the hi'hest e!pected value. 8ou tai s stoc#holders prefer the hi'h.ris# proHect si ce it ma!imiMes the e!pected value of the firms equity. $ order to ma#e stoc#holders i differe t bet"ee the lo".ris# proHect a d the hi'h.ris# proHect% the bo dholders "ill eed to raise their required debt payme t so that the e!pected value of equity if the hi'h.ris# proHect is u derta#e is equal to the e!pected value of equity if the lo" ris# proHect is u derta#e . As sho" i part a% the e!pected value of equity if the lo".ris# proHect is u derta#e is (1++. $f the hi'h.ris# proHect is u derta#e % the value of the firm "ill be (1++ if the eco omy is bad a d (<++ if the eco omy is 'ood. $f the eco omy is bad% the e tire (1++ "ill 'o to the firms bo dholders a d 8ou tai s stoc#holders "ill receive othi '. $f the eco omy is 'ood% 8ou tai s stoc#holders "ill receive the differe ce bet"ee (<++% the total value of the firm% a d the required debt payme t. Let C be the debt payme t that bo dholders "ill require if the hi'h.ris# proHect is u derta#e : E!pected 9alue of Equity - ,+.*+/,(+/ 3 ,+.*+/,(<++ ; C/ $ order for stoc#holders to be i differe t bet"ee the t"o proHects% the e!pected value of equity if the hi'h.ris# proHect is u derta#e must be equal to (1++. (1++ - ,+.*+/,(+/ 3 ,+.*+/,(<++.C/ C - (6++

Therefore# the bondholders should promise to raise the required debt payment by $ 00 12 $!00 . $5003 if the hi*h.ris% pro/e&t is underta%en in order to ma%e 4ountains sto&%holders indifferent bet$een the t$o pro/e&ts. 16.@ Stoc#holders ca u derta#e the follo"i ' measures i order to mi imiMe the costs of debt: 1. Use 6rotective Cove a ts: 8irms ca e ter i to a'reeme ts "ith the bo dholders that are desi' ed to decrease the cost of debt. There are t"o types of 6rotective Cove a ts: i. Ge'ative Cove a ts prohibit the compa y from ta#i ' actio s that "ould e!pose the bo dholders to pote tial losses. A e!ample "ould be prohibiti ' the payme t of divide ds i e!cess of ear i 's. ii. 6ositive Cove a ts specify a actio that the compa y a'rees to ta#e or a co ditio the compa y must abide by. A e!ample "ould be a'reei ' to mai tai its "or#i ' capital at a mi imum level. ). 7epurchase Debt: A firm ca elimi ate the costs of ba #ruptcy by elimi ati ' debt from its capital structure.

>.

Co solidate Debt: $f a firm decreases the umber of debt holders% it may be able to decrease the direct costs of ba #ruptcy should the firm become i solve t.

16.<

:odi'lia i a d :illers theory "ith corporate ta!es i dicates that% si ce there is a positive ta! adva ta'e of debt% the firm should ma!imiMe the amou t of debt i its capital structure. $ reality% ho"ever% o firm adopts a all.debt fi a ci ' strate'y. ::s theory i' ores both the fi a cial distress a d a'e cy costs of debt. The mar'i al costs of debt co ti ue to i crease "ith the amou t of debt i the firms capital structure so that% at some poi t% the mar'i al costs of additio al debt "ill out"ei'h its mar'i al ta! be efits. Therefore% there is a optimal level of debt for every firm at the poi t "here the mar'i al ta! be efits of the debt equal the mar'i al i crease i fi a cial distress a d a'e cy costs. There are t"o maHor sources of the a'e cy costs of equity: 1. Shir#i ' :a a'ers "ith small equity holdi 's have a te de cy to reduce their "or# effort% thereby hurti ' both the debt holders a d outside equity holders. :ore 6erquisites Si ce ma a'eme t receives all the be efits of i creased perquisites but o ly shoulder a fractio of the cost% ma a'ers have a i ce tive to overspe d o lu!ury items at the e!pe se of debt holders a d outside equity holders. i. $f 8ortu e remai s a all.equity firm% its value "ill equal 9U% the value of 8ortu e as a u levered firm. The 'e eral e!pressio for the value of a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? "here 9L 9U ? TC TS T? - the value of a levered firm - the value of a u levered firm - the mar#et value of the firms debt - the ta! rate o corporate i come - the perso al ta! rate o equity distributio s - the perso al ta! rate o i terest i come

16.=

).

16.1+

a.

$ this problem: ? TC TS T? - (1>%*++%+++ - +.1+ - +.>+ - +.>+

The value of 8ortu e as a levered firm is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - 9U 3 N 1 ; 21 ; +.1+/,1 ; +.>+/ 5 ,1 ; +.>+/4O P (1>%*++%+++ - 9U 3 ,+.1+/,(1>%*++%+++/ - 56 7 $5#+00#000 As "as stated i Chapter 1*% stoc#holders prefer a policy that ma!imiMes the value of the firm. 8quity holders $ill prefer 4ortune to be&ome a levered firm sin&e the debt $ill in&rease the firms value by $5.+ million.

ii. The $7S "ill prefer the pla that 'e erates the hi'hest amou t of ta! reve ue. The $7S ta!es corporate i come at 1+0% i terest i come at >+0% a d equity distributio s at >+0. U der the u levered pla : The $7S 'e erates (1%)++%+++ ,- +.1+ P (>%+++%+++/ of corporate ta! reve ue o the firms ear i 's a d (*1+%+++ ,- +.>+ P (1%<++%+++/ of perso al ta! reve ue o 8ortu es equity distributio s. Si ce the firm has o debt% o i terest payme ts are made% a d the $7S "ill ot 'e erate a y ta! reve ue o i terest. The 9:) *enerates $ #7+0#000 12 $ #"00#000 7 $5+0#0003 of ta( revenue under the unlevered plan. U der the levered pla : The $7S 'e erates (66+%+++ ,- +.1+ P (1%6*+%+++/ of corporate ta! reve ue o the firms ear i 's% ()=@%+++ ,- +.>+ P (==+%+++/ of perso al ta! reve ue o 8ortu es equity distributio s% a d (1+*%+++ ,- +.>+ P (1%>*+%+++/ of perso al ta! reve ue o the firms i terest payme ts. The 9:) *enerates $ #3!"#000 12 $!!0#000 7 $",7#000 7 $+05#0003 of ta( revenue under the levered plan. )in&e the all.equity plan *enerates hi*her ta( revenues# the 9:) $ill prefer an unlevered &apital stru&ture. iii. As a u levered firm% 8ortu e "ould 'e erate (1%<++%+++ of et i come every year i to perpetuity. Si ce the firm distributes all ear i 's to equity holders% this amou t "ill be ta!ed at a rate of >+0% providi ' a (1%)6+%+++ 2- (1%<++%+++ P ,1 ; +.>+/4 a ual after.ta! cash flo" to the firms equity holders. Si ce stoc#holders dema d a )+0 retur after ta!es% the value of 8ortu e if it "ere a u levered firm is equal to a perpetuity of (1%)6+%+++ per year% discou ted at )+0. 9U - (1%)6+%+++ 5 +.)+ - $!#300#000 The value of 4ortune as an unlevered firm is $!.3 million. The 'e eral e!pressio for the value of a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? "here 9L 9U ? TC TS T? - the value of a levered firm - the value of a u levered firm - the mar#et value of the firms debt - the ta! rate o corporate i come - the perso al ta! rate o equity distributio s - the perso al ta! rate o i terest i come

$ this problem: 9U ? TC TS T? - (6%>++%+++ - (1>%*++%+++ - +.1+ - +.>+ - +.>+

The value of 8ortu e as a levered firm is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - (6%>++%+++ 3 N 1 ; 21 ; +.1+/,1 ; +.>+/ 5 ,1 ; +.>+/4O P (1>%*++%+++ - (6%>++%+++ 3 ,+.1+/,(1>%*++%+++/ - $ #700#000 The value of 4ortune as a levered firm is $ b. i. .7 million.

U der the u levered pla % the firms ear i 's available to equity holders is (1%<++%+++. Si ce equity distributio s are ta!ed at a rate of )+0% the a ual after.ta! cash flo" to 8ortu es equity holders is (1%11+%+++ 2- (1%<++%+++ P ,1 ; +.)+/4. The annual after.ta( &ash flo$ to equity holders under the unlevered plan is $ #++0#000. U der the levered pla % the firms ear i 's available to equity holders is (==+%+++. Si ce equity distributio s are ta!ed at a rate of )+0% the a ual after.ta! cash flo" to 8ortu es equity holders is (@=)%+++ 2- (==+%+++ P ,1 ; +.)+/4. The annual after.ta( &ash flo$ to equity holders under the levered plan is $7,"#000.

ii. U der the u levered pla % 8ortu e "ill have o debt. The annual after.ta( &ash flo$ to debt holders under the unlevered plan is $0. U der the levered pla % the firm "ill ma#e a ual i terest payme ts of (1%>*+%+++ to debt holders. Si ce i terest i come is ta!ed at a rate of **0% the a ual after.ta! cash flo" to 8ortu es debt holders is (6+@%*++ 2- (1%>*+%+++ P ,1 ; +.**/4. The annual after.ta( &ash flo$ to debt holder under the levered plan is $!07#500 16.11 a. $ their o ta! model% :: assume that TC% T?% a d C,?/ are all Mero. U der these assumptio s% 9L 9U% si' ifyi ' that the capital structure of a firm has o effect o its value. There is o optimal debt. equity ratio. $ their model "ith corporate ta!es% :: assume that TC Q + a d both T? a d C,?/ are equal to Mero. U der these assumptio s% 9L - 9U 3 TC?% implyi ' that raisi ' the amou t of debt i a firms capital structure "ill i crease the overall value of the firm. This model implies that the debt.equity ratio of every firm should be i fi ite. $f TS - + a d the costs of fi a cial distress are Mero% the 'e eral e!pressio for the value of a levered firm equals: 9L - 9U 3 N 1 ; 2,1 ; TC/ 5 ,1 . T?/4O P ? ; C,?/ "here 9L 9U ? TC T? - the value of a levered firm - the value of a u levered firm - the mar#et value of a firms debt - the ta! rate o corporate i come - the perso al ta! rate o i terest i come

b.

c.

Therefore% the cha 'e i the value of a all.equity firm that issues debt a d uses the proceeds to repurchase equity is: Cha 'e i 9alue - N 1 ; 2,1 ; TC/ 5 ,1 . T?/4O P ?

$ this problem: TC T? ? C,?/ - +.>1 - +.)+ - (1%+++%+++ -+

The cha 'e i the value of the firm is: Cha 'e i 9alue - N 1 ; 2,1 ; +.>1/ 5 ,1 ; +.)+/4O P (1%+++%+++ - $ 75#000 The value of the firm $ill in&rease by $ 75#000 if it issues $ million of debt and uses the pro&eeds to repur&hase equity. d. $f TS - + a d the costs of fi a cial distress are Mero% the 'e eral e!pressio for the value of a levered firm equals: 9L - 9U 3 N 1 ; 2,1 ; TC/ 5 ,1 . T?/4O P ? "here 9L 9U ? TC T? - the value of a levered firm - the value of a u levered firm - the mar#et value of a firms debt - the ta! rate o corporate i come - the perso al ta! rate o i terest i come

Therefore% the cha 'e i the value of a all.equity firm that issues (1 of perpetual debt i stead of (1 of perpetual equity is: Cha 'e i 9alue - N1 ; 2,1 ; TC/ 5 ,1 . T?/4O P ,(1/ $f the firm is ot able to be efit from i terest deductio s% the firms ta!able i come "ill remai the same re'ardless of the amou t of debt i its capital structure% a d o ta! shield "ill be created by issui ' debt. Therefore% the firm "ill receive o ta! be efit as a result of issui ' debt i place of equity. $ other "ords% the effective corporate ta! rate "he co sideri ' the change i the value of the firm is Mero. Debt "ill have o effect o the value of the firm si ce i terest payme ts "ill ot be ta! deductible. $ this problem: TC T? -+ - +.)+

The cha 'e i the value of the firm is: Cha 'e i 9alue - N1 ; 2,1 ; TC/ 5 ,1 . T?/4O P ,(1/ - N1 ; 2,1 ; +/ 5 ,1 ; +.)+/4O P ,(1/ - .(+.)* The value of the firm $ill de&rease by $0."5 if it adds $ of perpetual debt rather than $ of equity. 16.1) a. $f F6C decides to retire all of its debt% it "ill become a u levered firm. The value of a all.equity firm is the prese t value of the firms after.ta! cash flo" to equity holders.

9U - 2,E?$T/,1 . TC/,1 ; TS/4 5 r+ "here 9U E?$T TC TS r+ - the value of a u levered firm - the firms a ual ear i 's before i terest a d ta!es - the ta! rate o corporate i come - the ta! rate o equity distributio s - the required rate of retur o the firms u levered equity

$ this problem: E?$T TC TS r+ - (1%1++%+++ - +.>* - +.1+ - +.)+

The value of F6C as a all.equity firm is: 9U - 2,E?$T/,1 . TC/,1 ; TS/4 5 r+ - 2,(1%1++%+++/,1 ; +.>*/,1 ; +.1+/4 5 +.)+ - $3#" 7#500 The value of ;<C $ill be $3#" 7#500 if it de&ides to retire its debt and be&ome an all.equity firm. b. The 'e eral e!pressio for the value of a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? "here 9L 9U ? TC TS T? - the value of a levered firm - the value of a u levered firm -the mar#et value of a firms debt - the ta! rate o corporate i come - the perso al ta! rate o equity distributio s - the perso al ta! rate o i terest i come

$ this problem: 9U ? TC TS T? - (>%)1@%*++ - ()%+++%+++ - +.>* - +.1+ - +.)*

The value of F6C as a levered firm is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - (>%)1@%*++ 3 N 1 ; 2,1 ; +.>*/,1 ; +.1+/ 5 ,1 ; +.)*/4O P ()%+++%+++ - $3#!57#500 The value of ;<C $ill be $3#!57#500 if it remains a levered firm. 16.1> a. The value of a all.equity firm is the prese t value of the firms e!pected cash flo"s to equity holders. 9U - E!pected ,Fperati ' $ come/ 5 r+ The estimates of 8rodos a ual operati ' i come a d their respective probabilities are listed belo": Fperati ' $ come (1%+++ ()%+++ (1%)++ 6robability +.1 +.1 +.*

The e!pected value of 8rodos operati ' i come is the probability."ei'hted avera'e of its ear i 's estimates: E!pected 9alue - ,(1%+++/,+.1+/ 3 ,()%+++/,+.1+/ 3 ,(1%)++/,+.*+/ - $3#000 4rodos e(pe&ted operatin* in&ome every year is $3#000. Si ce 8rodos e!pected operati ' i come "ill remai u cha 'ed i to perpetuity a d the required retur o the firms u levered equity is )+0% the value of 8rodo i a "orld "ithout ta!es is: 9U - E!pected ,Fperati ' $ come/ 5 r+ - (>%+++ 5 + .)+ - $ 5#000 The value of 4rodo in a $orld $ithout ta(es is $ 5#000. b. i. :odi'lia i.:iller 6ropositio $ states that i a "orld "ithout corporate ta!es: 9L - 9U "here 9L - the value of a levered firm 9U - the value of a u levered firm

Cha 'es i capital structure have o effect o the value of a firm i a "orld "ithout ta!es. Therefore% if 8rodo issues (@%*++ of 1+0 debt a d uses the proceeds to repurchase equity% the value of the firm "ill remai at (1*%+++ i a "orld "ithout ta!es. 9n a $orld $ithout ta(es# the value of 4rodo $ill remain at $ 5#000. ii. The value of a levered firm equals the mar#et value of its debt plus the mar#et value of its equity. 9L - ? 3 S The total value of 8rodo ,9L/ is (1*%+++% a d the mar#et value of the firms debt ,?/ is (@%*++. Therefore% the value of 8rodos equity is: S - 9L ; ? - (1*%+++ . (@%*++ - $7#500 The mar%et value of 4rodos equity equals $7#500 in a $orld $ithout ta(es. iii. Accordi ' to :odi'lia i.:iller 6ropositio $$ ,Go Ta!es/: rS - r+ 3 ,?5S/,r+ ; r?/ "here r+ - the required rate of retur o the equity of a u levered firm rS - the required rate of retur o the equity of a levered firm r? - the cost of debt

$ this problem: r+ - +.)+ r? - +.1+

? - (@%*++ S - (@%*++ The required rate of retur o 8rodos levered equity is: rS - r+ 3 ,?5S/,r+ ; r?/ - +.)+ 3 ,(@%*++ 5 (@%*++/,+.)+ ; +.1+/ - +.)+ 3 ,1/,+.)+.+.1+/ - 0.30 The required rate of return on 4rodos levered equity is 30%. iv. $ the abse ce of ta!es% a firms "ei'hted avera'e cost of capital ,r"acc/ equals: r"acc "here - 2? 5 ,?3S/4 r? 3 2S 5 ,?3S/4rS ? - the mar#et value of the firms debt S - the mar#et value of the firms equity r? - the cost of debt rS - the required retur o a firms equity.

$ this problem: ? - (@%*++ S - (@%*++ r? - +.1+ rS - +.>+ 8rodos "ei'hted avera'e cost of capital is: r"acc 2? 5 ,?3S/4 r? 3 2S 5 ,?3S/4rS 2(@%*++ 5 ,(@%*++ 3 (@%*++/4,+.1+/ 3 2(@%*++ 5 ,(@%*++ 3 (@%*++/4,+.>+/ ,15)/,+.1+/ 3 ,15)/,+.>+/ 0."0

4rodos $ei*hted avera*e &ost of &apital is "0%. c. i. Ta!es "ill decrease the value of the firm because the 'over me t becomes a claima t o the firms assets. 7ecall that the siMe of the pie does ot cha 'e% but o" less is available for the firms stoc#holders a d bo dholders.

ii. :odi'lia i.:iller 6ropositio $ states that i a "orld "ith corporate ta!es: 9L - 9U 3 TC? "here 9L 9U TC ? - the value of a levered firm - the value of a u levered firm - the corporate ta! rate - the value of debt i a firms capital structure

The value of a all.equity firm is the prese t value of the firms after.ta! cash flo" to equity holders. 9U - E!pected ,Fperati ' $ come/P,1 ; TC/ 5 r+ - 2(>%+++P,1 . .1+/4 5 + .)+ - (=%+++ Thus: 9U - (=%+++ TC - +.1+

- (@%*++

The value of 8rodo i a "orld "ith corporate ta!es is: 9L - 9U 3 TC? - (=%+++ 3 ,+.1+/,(@%*++/ - $ "#000 The value of 4rodo is $ "#000 if &orporate in&ome is ta(ed at a rate of +0%. d. The 'e eral e!pressio for the value of a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? Bhere 9L 9U ? TC TS T? - the value of a levered firm - the value of a u levered firm - the mar#et value of a firms debt - the ta! rate o corporate i come - the perso al ta! rate o equity distributio s - the perso al ta! rate o i terest i come

The value of a all.equity firm ,9U/ is the prese t value of the firms e!pected after.ta! cash flo"s to equity holders. 9U - 2E!pected ,Fperati ' $ come/P,1 . TC/,1 ; TS/4 5 r+ "here 9U TC TS r+ - the value of a u levered firm - the ta! rate o corporate i come - the ta! rate o equity distributio s - the required rate of retur o the firms u levered equity

$ this problem: E,F$/ TC TS r+ - (>%+++ - +.1+ - +.1* - +.)+

The value of 8rodo as a all.equity firm i a "orld "ith both corporate a d perso al ta!es is: 9U - 2E!pected ,Fperati ' $ come/P,1 . TC/,1 ; TS/4 5 r+ - 2,(>%+++/,1 ; +.1+/,1 ; +.1*/4 5 +.)+ - (@%6*+ Thus: 9U ? TC TS T? - (@%6*+ - (@%*++ - +.1+ - +.1* - +.>*

The value of 8rodo as a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - (@%6*+ 3 N 1 ; 2,1 ; +.1+/,1 ; +.1*/ 5 ,1 ; +.>*/4OP(@%*++ - $,#"!5

The value of 4rodo as a levered firm is $,#"!5 in a $orld $ith both &orporate and personal ta(es. 16.11 a. The preside t is i correct "he he claims that commo stoc# is the cheapest form of fi a ci '. Bhile =.*0 is the lo"est pre.ta! rate that :ueller ca obtai % the lo"est after.ta! rate that the firm ca obtai is 11.+*0 N- ,1 ; +.>*/,+.1@/O o the pollutio .co trol bo ds. :r. Da iels is also i correct. $f there are perso al ta!es% the i crease i the value of the firm is ot simply TC?R rather% the i crease i firm value "ould be N1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ?. :s. Ie derso is also i correct. Co sider the follo"i ' e!pressio for the i crease i firm value due to debt: 9 - N1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ?

$f the corporate bo ds are issued: TC TS T? ? 9 - +.>* -+ - +.1* - (1++ millio

- N1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - N1 ; 2,1 ; +.>*/,1 ; +/ 5 ,1 ; +.1*/4O P (1++ millio - ()>.*> millio

$f the corporate bo ds are issued% the value of the firm "ill i crease by ()>.*> millio . $f the pollutio .co trol bo ds are issued: TC TS T? ? 9 - +.>* -+ -+ - (1++ millio

- N1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? - N1 ; 2,1 ; +.>*/,1 ; +/ 5 ,1 ; +/4O P (1++ millio - (>* millio

$f the pollutio .co trol bo ds are issued% the value of the firm "ill i crease by (>* millio . Therefore% :s. Ie derso s claim that the debt choice does ot matter is also i correct. b. :ueller should ot be i differe t about "hich fi a ci ' pla it chooses. $ssui ' equity adds o value to the firm% a d the t"o debt alter atives add differe t amou ts to the value of the firm. 7a #i ' the alter atives: Type of 8i a ci ' 1. 6ollutio Co trol ?o ds ). Corporate ?o ds >. Commo Stoc# 9alue Added (>* millio ()>.*> millio (+

Gote that this a alysis o ly implies that debt adds value relative to equity. The absolute value of this firm is li#ely to fall "ith a y of the three fi a ci ' choices si ce pollutio .co trol equipme t represe ts a cash outflo". 16.1* a. The 'e eral e!pressio for the value of a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? ; C,?/ "here 9L 9U ? TC T? C,?/ - the value of a levered firm - the value of a u levered firm - the mar#et value of the firms debt - the ta! rate o corporate i come - the perso al ta! rate o i terest i come - the prese t value of the costs of fi a cial distress a d a'e cy costs

The value of a all.equity firm ,9U/ is the prese t value of the firms after.ta! cash flo"s to equity holders. 9U - 2,E?$T/,1 . TC/,1 ; TS/4 5 r+ "here 9U E?$T TC TS r+ - the value of a u levered firm - the firms ear i 's before i terest a d ta!es - the ta! rate o corporate i come - the ta! rate o equity distributio s - the required rate of retur o the firms u levered equity

$ this problem: E?$T TC TS r+ - (<++%+++ - +.>* -+ - +.1+

The value of Bei ber' as a all.equity firm i a "orld "ith both corporate a d perso al ta!es is: 9U - 2,E?$T/,1 . TC/,1 ; TS/4 5 r+ - 2,(<++%+++/,1 ; +.>*/,1 ; +/4 5 +.1+ - (*%)++%+++ Thus: 9U ? TC TS T? C,?/ - (*%)++%+++ - (1%)++%+++ - +.>* -+ - +.1* - (6+%+++ ,- +.+* P (1%)++%+++/

The value of Bei ber' as a levered firm i a "orld "ith both corporate a d perso al ta!es is: 9L - 9U 3 N 1 ; 2,1 ; TC/,1 ; TS/ 5 ,1 . T?/4O P ? ; C,?/ - (*%)++%+++ 3 N 1 ; 2,1 ; +.>*/,1 ; +/ 5 ,1 ; +.1*/4OP(1%)++%+++ . (6+%+++ - $5#+""#353 The value of =einber* as a levered firm is $5#+""#353 in a $orld $ith both &orporate and personal ta(es.

b.

Si ce the value of Bei ber' is (*%)++%+++ as a u levered firm a d (*%1))%>*> as a levered firm% the added value of i cludi ' debt i the firms capital structure is ()))%>*> ,- (*%1))%>*> . (*%)++%+++/. The added value of the firms debt is $"""#353.

16.16

a.

Si ce GETC is a all.equity firm% its cost of capital is equal to the required retur o its equity. Use the Capital Asset 6rici ' :odel ,CA6:/ to determi e the required retur o GETCs u levered equity. Accordi ' to CA6:: "here rS rf E,rm/ S rS - rf 3 S2E,rm/ ; rf4

- the required retur o a firms equity - the e!pected retur o a ris#.free asset - the e!pected rate of retur o the mar#et portfolio - the beta of a firms equity

The beta of a firms equity is equal to: S - Cov,!% m/ 5 )m "here Cov,!% m/ - the covaria ce bet"ee the retur o the firms commo stoc# a d the retur o the mar#et portfolio )m - the varia ce of retur s o the mar#et portfolio

$ this problem: Cov,!% m/ - +.+1< )m - +.+1 The beta of GETCs equity is: S - Cov,!% m/ 5 )m - +.+1< 5 +.+1 - 1.) Thus: rf - +.1+ E,rm/ - +.)+ S - 1.)

The required retur o GETCs capital is: rS - rf 3 S2E,rm/ ; rf4 - +.1+ 3 1.),+.)+ ; +.1+/ - 0.""

>8TCs overall &ost of &apital is ""%. b. GETC should purchase the machi e "ith the hi'her et prese t value ,G69/. 7emember that the firm "ill eed a machi e for the e!t four years. Si ce the eco omic life of the Ieavy.Duty :odel is four years% the firm "ill o ly eed to purchase the machi e o ce. G69IEA9D DUTD - .6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/

The Ieavy.Duty :odel "ill 'e erate (61+ of cost savi 's every year for four years. This is equivale t to the firm 'e erati ' (61+ of additio al ear i 's each year for four years. ?ecause these ear i 's are subHect to a corporate i come ta! of >10% the a ual after.ta! cash flo" created by the firms additio al savi 's is (1)).1+ 2- (61+,1 ; +.>1/. Si ce the required retur o GETCs equity is ))0% the firms after.ta! a ual cost savi 's ca be valued as a a uity "ith four a ual payme ts of (1)).1+% discou ted at ))0. 69,A ual Cost Savi 's/ - (1)).1+A1+.)) - (1%+*>.>1 GETC uses strai'ht.li e depreciatio . Si ce the eco omic life of the Ieavy.Duty :odel is four years% GETC "ill reco' iMe a a ual depreciatio e!pe se of ()*+ ,- (1%+++ 5 1 years/. The a ual ta! shield provided by this added e!pe se is (<* ,- ()*+P+.>1/. The depreciatio ta! shield is valued as a four.year a uity "ith a ual payme ts of (<*% discou ted at ))0. 69,Depreciatio Ta! Shield/ - (<*A1+.)) - ()11.=6 The G69 of the Ieavy.Duty :odel is: G69IEA9D DUTD - .6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/ - .(1%+++ 3 (1%+*>.>1 3 ()11.=6 - ()6*.)@ The ><5 of the ?eavy.-uty @odel is $"!5."7. Si ce the eco omic life of the Li'ht.Bei'ht :odel is o ly ) years% the firm "ill eed to buy o e machi e o" a d o e i t"o years. The cash flo"s associated "ith the seco d purchase must be discou ted by t"o years. G69L$&IT BE$&IT - .6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/ 3 2,. 6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/4 5 ,1.))/ )

The Li'ht.Bei'ht :odel "ill 'e erate a ual cost savi 's of (616 for t"o years. This is equivale t to the firm 'e erati ' (616 of additio al ear i 's each year for t"o years. Si ce these ear i 's are subHect to a corporate i come ta! of >10% the a ual after.ta! cash flo" created by the firms additio al savi 's is (1+6.*6 2- (616,1 ; +.>1/. Si ce the required retur o GETCs equity is ))0% the firms after.ta! a ual cost savi 's ca be valued as a t"o.year a uity "ith a ual payme ts of (1+6.*6% discou ted at ))0. 69,A ual Cost Savi 's/ - (1+6.*6A)+.)) - (6+6.1+ GETC uses strai'ht.li e depreciatio . Si ce the eco omic life of the Li'ht.Bei'ht :odel is t"o years% GETC "ill reco' iMe a a ual depreciatio e!pe se of ()*+ ,- (*++ 5 ) years/. The a ual ta! shield provided by this added e!pe se is (<* ,- ()*+P+.>1/. This depreciatio ta! shield is valued as a t"o.year a uity "ith a ual payme ts of (<*% discou ted at ))0. 69,Depreciatio Ta! Shield/ - (<*A)+.)) - (1)6.@< The G69 of the Li'ht.Bei'ht :odel is: G69L$&IT BE$&IT - .6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/ 3 2,. 6rice 3 69,A ual Cost Savi 's/ 3 69,Depreciatio Ta! Shield/4 5 ,1.))/ )

- .(*++ 3 (6+6.1+ 3 (1)6.@< 3 2,.(*++ 3 (6+6.1+ 3 (1)6.@</4 5 ,1.))/) - $3',.'+ The ><5 of the Ai*ht.=ei*ht @odel is $3',.'+. )in&e its ><5 is hi*her# >8TC should pur&hase the Ai*ht.=ei*ht @odel. c. i. :odi'lia i.:iller 6ropositio $ states that i a "orld "ith corporate ta!es: 9L - 9U 3 TC? "here 9L 9U TC ? - the value of a levered firm - the value of a u levered firm - the corporate ta! rate - the value of debt i a firms capital structure

$ this problem: 9U - (1+ millio ? - () millio TC - +.>1 The e" value of GETC "ill be: 9L - 9U 3 TC? - (1+%+++%+++ 3 ,+.>1/,()%+++%+++/ - $ 0#!'0#000 The value of the >8TC $ill be $ 0#!'0#000 if the C4;s plan adopted. ii. The value of a levered firm is the sum of the mar#et value of the firms debt a d the mar#et value of the firms equity. 9L - ? 3 S $ this problem: 9L - (1+%6<+%+++ ? - ()%+++%+++ Therefore% the value of GETCs levered equity must be: S - 9L ; ? - (1+%6<+%+++ . ()%+++%+++ - $'#!'0#000

The value of >8TCs levered equity is $'#!'0#000. d. Si ce the value of GETC as a levered firm is (1+%6<+%+++ a d costs of fi a cial distress are )0 of this value% the GETCs costs of fi a cial distress total ()1>%6++ ,- +.+) P (1+%6<+%+++/. This reduces the firms value to (1+%166%1++. Si ce this amou t is 'reater tha (1+ millio % the value of GETC as a u levered firm% addi ' debt to the firms capital structure i creases the firms value. GETC should ot remai a u levered firm.