DJ Jablonski

Individual Homework – Chapter 16

(Due Date: March 12, 2021)

Note: This is an individual assignment. While you can discuss questions with other students in
the class, you will have to finish all questions independently. You can type or handwrite your
answers. If you use Excel to work on questions, you will have to turn in your Excel files too.

All Work in Excel

1. Round Hammer is comparing two different capital structures: An all-equity plan (Plan I)
and a levered plan (Plan II). Under Plan I, the company would have 180,000 shares of
stock outstanding. Under Plan II, there would be 130,000 shares of stock outstanding and
$1.925 million in debt outstanding. The interest rate on the debt is 8%, and there are no
taxes.
a. If EBIT is $400,000, which plan will result in the higher EPS?

The EPS for plan 1 will be higher than plan 2 ($2.22 > $1.89).

b. If EBIT is $600,000, which plan will result in the higher EPS?

The EPS for plan 2 will be higher than plan 1 ($3.43 > $3.33).

c. What is the break-even EBIT?

Break Even EBIT = $554,400

2. In Problem 1, use M & M Proposition I to find the price per share of equity under each of
the two proposed plans. What is the value of the firm?

The price per share under M & M Proposition I = $38.50. At this price the value of the
firm would total $6,930,000.

3. Bellwood Corp. is comparing two different capital structures. Plan I would result in
12,700 shares of stock and $109,250 in debt. Plan II would result in 9,800 shares of stock
and $247,000 in debt. The interest rate on the debt is 10%.
a. Ignoring taxes, compare both of these plans to all all-equity plan assuming that EBIT
will be $79,000. The all-equity plan would result in 15,000 shares of stock
outstanding. Which of the tree plans has the highest EPS? The lowest?

Plan 2 would have the highest EPS, while All Equity would have the lowest EPS
($5.54 > $5.36 > $5.27).

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 b. In part (a), what are the break-even levels of EBIT for each plan as compared to that
for an all-equity plan? Is one higher than the other? Why?

The breakeven levels of EBIT for each plan are $71,250. They are both the same
breakeven level as we are comparing them to the same thing (all equity plan).

c. Ignoring taxes, when will EPS be identical for Plans I and II?

The EPS will be identical at the breakeven EBIT, so when EBIT is $71,250 the EPS
will be equal. (EPS would equal $4.75).

d. Repeating parts (a), (b), and (c) assuming that the corporate tax rate is 21%. Are the
break-even levels of EBIT different from above? Why or Why not?

Plan 2 would still have the highest EPS with taxes, while the all equity plan would
still have the lowest EPS with taxes. ($4.38 > $4.23 > $4.16).

The breakeven levels of EBIT for each plan are roughly $72,878. They are both the
same (within a dollar), as we are comparing them to the same thing (all equity plan).

The EPS will be identical at the breakeven EBIT, so when EBIT is $72,878 the EPS
will be equal. (EPS would equal $3.75).

4. Blitz Industries has a debt-equity ratio of 1.25. Its WACC is 8.3%, and its cost of debt is
5.1%. The corporate tax rate is 21%.
a. What is the company’s cost of equity capital?

Cost of Equity Capital = 13.73%

b. What is the company’s unlevered cost of equity capital?

Unlevered Cost of Equity Capital = 9.44%

c. What would be the cost of equity be if the debt-equity ratio were 2? What if it were
zero?

Cost of Equity if D/E was 2 = 16.30%

Cost of Equity if D/E was 0 = 9.44%

5. Meyer & Co. expects its EBIT to be $97,000 every year forever. The firm can borrow at
8%. The company currently has no debt, and its cost of equity is 13%. If the tax rate is
24%, what is the value of the firm? What will the value be if the company Borrows
$195,000 and uses the proceeds to repurchase shares?

Value of Firm Pre-Debt = $567,076.92

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 Value of the Firm After Debt = $613,876.92

6. In Problem 5, what is the cost of equity after recapitalization? What is the WACC? What
are the implications for the firm’s capital structure decision?

Cost of Equity after Recapitalization = 14.77%

WACC = 12.01%

The implications of this decision are that the weighted average cost of capital is lower
because the cost of debt is much lower than the cost of equity. However, this decision
also increases the cost of equity. Overall, the firm now needs a lower rate (WACC) to
consider if the firm should partake in an investment or not.