Capital Structure & Financial Planning 2015-2016

Tutorial II
[Capital Structure, BDH 14-16]
Problem 1
Miller Industries is an all-equity firm with 20 million shares outstanding and a stock price of
9 per share. Miller has been an all-equity firm for many years and investors expect that it
will remain unlevered in the future. Suddenly Miller announces that the old CFO will be
replaced. After the announcement investors expect that a new CFO will quickly issue 80
million of debt and use the proceeds to repurchase shares. They expect that the 80 million of
debt will not change in the future. Miller Industries faces a corporate tax rate of 25%, apart
from which there are no further imperfections.
a) What is the market value of Millers assets just before the announcement that the old
CFO will be replaced?
b) What is the market value of Millers equity just after the announcement that the old CFO
will be replaced?
c) As expected, the new CFO announces that she will immediately issue 80 million debt to
repurchase shares and that she has no plans for future changes of this level of debt. How
many shares will Miller repurchase?
d) Present Millers market value balance sheet.
- Just before the announcement that the old CFO will be replaced
- Just after the announcement that the old CFO will be replaced
- Just after the debt issue but before the share repurchase
- Just after the share repurchase.
e) What are the effects of the relevering of Miller Industries on a shareholder holding a portfolio with 1,000 shares of Miller Industries if the shareholder does not offer his/her shares
in the repurchase?
f) Now suppose that future debt will grow forever at 2%. How would you calculate the
value of the tax shields? What additional information do you need to perform this
calculation?
Problem 2
The CFO of a biotechnology firm must choose one of two strategies. The payoffs and their
likelihood of the two strategies are shown below. The risk of each strategy is fully
diversifiable.
Strategy
A

a)

Probability
50%
50%

Payoffs
( millions)
120
80

25%
75%

200
40

Calculate the expected payoff of both strategies. Which strategy has the highest expected
payoff?
Suppose that the firm has debt of 80 million due at the time of the payoffs of the strategies.
b) Calculate the payoff to equity holders in each state for each strategy, and calculate the
expected payoff to equity holders of both strategies. Which strategy has the highest
expected payoff?
c) If the CFO chooses the strategy that maximizes the expected payoff to equity holders,
what is the expected agency cost to the firm from having 80 million in debt due?

Problem 1
a) Since Miller is expected to remain unlevered, the market value of Millers (operating)
assets equals the market value of its equity, that is 180 (=20x9) million.
b) The market value of Millers equity is equal to the sum of the market value of the
unlevered firm and the value of the expected interest tax shields. Since expected future
debt levels are 80 million, the value of the future interest tax shields equal 20
(=TxD=0.25x80) million. Hence, the market value of Millers equity is 200 (=180+20)
million.
c) After the announcement that the old CFO will be replaced the Price of Millers stock is
10 (=200/20) per share. Hence Miller will repurchase 8 (=80/10) million shares.
d) Millers market value balance sheet in millions
Before
After
After debt
After share
Item
announcement announcement
issue
repurchase
Operating assets
180
180
180
180
Tax shields
0
20
20
20
Cash
0
0
80
0
Equity
180
200
200
120
Debt
0
0
80
80
e)

f)

The value of the investors portfolio increases from 9,000 (=1,000x9) to 10,000
(=1,000x10), the risk and hence the expected return of the portfolio increases since the
(unchanged) risk of Millers assets has to be shouldered by less equity. [If 40% of his/her
shares are repurchased, the investor holds 6,000 (=600x10) in shares and 4,000
(400x10 in cash). Although the equity part is now more risky than before the repurchase,
the shareholders total portfolio (both shares and cash) is less risky because the tax shield
is less risky than the firms operating assets].
When debt is growing forever at a constant rate forever, the annual tax savings are a
growing perpetuity of cash flows, and can be valued accordingly. The interest on the debt
is needed to calculate the annual tax savings. The cost of debt is needed as discount rate
to calculate the present value of future tax savings. Example: with a cost of debt equal to
the interest on debt of 4.5%, the value of the tax shields is 36 (=0.045x0.25x80/(0.0450.02) million.

Problem 2
a) Expected payoff strategy A: 100 (=0.5x120+0.5x80) million, expected payoff strategy
B: 80 (=0.25x200+0.75x40) million. Strategy A has the highest expected payoff.
b) Expected payoff strategy A: 20 (=0.5x(120-80)+0.5x(80-80)) million, expected payoff
strategy B: 30 (=0.25x(200-80)+0.75xmax{40-80,0}) million. Strategy B has the highest
expected payoff for equity holders.
c) The CFO will choose strategy B. The expected agency cost to the firm is 20 (=100-80)
million.