Exercise Set 2

1. a) False. Just because the risk of financial distress stays the same doesn’t necessarily have
to mean that the expected costs should stay unchanged. When the appetite for
debt/equity ratio of a company grows larger the level of direct costs in case of a
bankruptcy increases, thus, leaving the stockholders with a smaller (if any) residual cash
flow, which should result in an increase in the expected rate of return demanded by
stockholders.

b) False. The company cannot always provide positive NPV investments, thus there are
times when the stockholders are worse off when contributing capital to their firm.

2. Operating income: 0,6M, market value of assets (all equity financed) V=5M

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 0,6𝑀

a) Return on assets: 𝑅𝑂𝐴 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠
= 5𝑀
= 0,12 = 12%
b) Debt: 1M
Equity: 4M
Beta of the firm, 𝛽𝑖 = 1,2
Beta of the company debt, 𝛽𝐷 = 0,3
Return on debt, 𝑟𝐷 = 0,08

With the information given we can calculate the new return on equity:

𝐷
𝑟𝐸 = 𝑟𝐴 + ∗ (𝑟𝐴 − 𝑟𝐷 )
𝐸
1
𝑟𝐸 = 0,12 + ∗ (0,12 − 0,08)
4
𝑟𝐸 = 0,13

c) 𝛽𝑖 = 1,2

d)
𝐷
𝛽𝐸 = 𝛽𝑖 + ∗ (𝛽𝑖 − 𝛽𝐷 )
𝐸
1
𝛽𝐸 = 1,2 + ∗ (1,2 − 0,3)
4
𝛽𝐸 = 1,425

3. N=0,5M, P=40, EBIT=2M, 𝑟𝐷 =0,07, V=0,5M*40=20M

a) Under the current (all equity) capital structure my cash flow will be:

1000
𝐶𝐹 = 2𝑀 ∗ = 4000 (€)
500 000

b) 𝐷 = 0,4 ∗ 𝑉 = 0,4 ∗ 20𝑀 = 8𝑀

 𝐸 = 0,6 ∗ 𝑉 = 0,6 ∗ 20𝑀 = 12𝑀

12𝑀
Now there are only = 0,3𝑀 shares left
40

Cash flow to bondholders:

𝐶𝐹𝐷 = 𝐷 ∗ 𝑟𝐷 = 8𝑀 ∗ 0,07 = 0,56𝑀

Cash flow to stockholders:

𝐶𝐹𝐸 = 𝐸𝐵𝐼𝑇 − 𝐶𝐹𝐷 = 2𝑀 − 0,56𝑀 = 1,44𝑀

My cash flow will be:

1000
𝐶𝐹 = ∗ 1,44𝑀 = 4 800 (€)
300 000

c) I could mimick the original capital structure by having an ownership of

𝑥 ∗ 1,44𝑀 = 4000
𝑥 ≈ 0,278% of the shares

In the new capital structure this would leave me with

0,00278 ∗ 300 000 ≈ 833 shares

So, I would need to sell 1000 − 833 = 167 shares.

d) It is irrelevant for the firm to do a capital restructuring which the stockholder could do
on his own.

4. a) 𝑉𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 10𝑀

𝑇𝐶 = 20%

𝑃𝑉(𝑏𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦 𝑐𝑜𝑠𝑡𝑠)
= 0,3 ∗ 10𝑀 = 3𝑀
𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑏𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦

𝑉𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 𝑉𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 + 𝑃𝑉(𝑑𝑒𝑏𝑡 𝑠ℎ𝑖𝑒𝑙𝑑𝑠) − 𝑃𝑉(𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑑𝑖𝑠𝑡𝑟𝑒𝑠𝑠)

𝑃𝑉(𝑑𝑒𝑏𝑡 𝑠ℎ𝑖𝑒𝑙𝑑𝑠) = 𝐷 ∗ 𝑟𝐷
 When bankruptcy costs are excluded the value of the firm for its respective debt-to-assets
ratio is:

Present value
Value of the firm (bankruptcy
Debt/Assets of debt shields,
costs excluded), M
M
0,0 0 10
0,1 0,2 10,2
0,2 0,4 10,4
0,3 0,6 10,6
0,4 0,8 10,8
0,5 1 11
0,6 1,2 11,2
0,7 1,4 11,4
0,8 1,6 11,6

b) When bankruptcy costs are incuded we can subtract the present value of bankruptcy
costs from the respective company value (before bankruptcy costs) for different debt-
to-assets scenarios to obtain the value of the firm (after bankruptcy costs):

Probability Value of the firm Value of the firm

Present value of
Debt/Assets of (bankruptcy costs (bankruptcy costs
bankruptcy costs, M
bankruptcy excluded), M included), M
0,0 0% 10 0 10
0,1 2% 10,2 0,06 10,14
0,2 8% 10,4 0,24 10,16
0,3 12 % 10,6 0,36 10,24
0,4 20 % 10,8 0,6 10,2
0,5 30 % 11 0,9 10,1
0,6 40 % 11,2 1,2 10
0,7 60 % 11,4 1,8 9,6
0,8 80 % 11,6 2,4 9,2
 c)

Firm value with different levels of debt:

12
11.5
11
10.5
Value, M

10
9.5
9
8.5
8
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
Debt(Assets

Bankruptcy costs excluded Bankruptcy costs included

When bankruptcy costs are excluded, the firm holds 80% debt of its assets to obtain
the optimal capital structure. In this way the present value of the debt shields is
maximized and in the absence of costs of financial distress the high amount of debt
doesn’t harm the firm’s overall valuation.

However, when bankruptcy costs are included, the optimal capital structure for the
firm is to hold debt level at 30% of its assets’ value. With any higher debt levels the
firm’s value will decrease as a result of higher bankruptcy costs.

5. EBIT=20M 𝑟𝐴 = 𝑟𝐸 = 0,08 𝑟𝐷 = 𝑟𝑓 = 0,02 𝑟𝑚 = 0,06 𝑇𝑐 = 0,2

a) Value of Taranga:

(1 − 𝑇𝑐 ) ∗ 𝐸𝐵𝐼𝑇 0,8 ∗ 20𝑀

𝑉= = = 200𝑀
𝑟𝐴 0,08

b)
𝑟𝐴 = 𝑟𝑓 + 𝛽𝐴 (𝑟𝑚 − 𝑟𝑓 )

𝑟𝐴 − 𝑟𝑓 0,08 − 0,02
𝛽𝐴 = 𝛽𝐸 = = = 1,5
𝑟𝑚 − 𝑟𝑓 0,06 − 0,02

40 160
c) 𝐷 = (200) ∗ 𝑉 = 0,2𝑉 𝐸 = (200) ∗ 𝑉 = 0,8𝑉
 (i) New rate of return for equity:

𝐷
𝑟𝐸 = 𝑟𝐴 + ∗ (𝑟𝐴 − 𝑟𝐷 )
𝐸

0,2𝑉
𝑟𝐸 = 0,08 + ∗ (0,08 − 0,02) = 0,095
0,8𝑉

New cost of capital for Taronga:

𝑟𝑖 = 0,2 ∗ 0,02 ∗ (1 − 0,2) + 0,8 ∗ 0,095 = 0,0792

New value for Taranga:

(1 − 𝑇𝑐 ) ∗ 𝐸𝐵𝐼𝑇 0,8 ∗ 20𝑀

𝑉= = ≈ 202,02𝑀
𝑟𝑖 0,0792

Change in share price:

202,02𝑀
− 1 = 0,0101 = 1,01%
200𝑀

(ii)
New value of Taronga:

𝑉𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 𝑉𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 + 𝑃𝑉(𝑑𝑒𝑏𝑡 𝑠ℎ𝑖𝑒𝑙𝑑𝑠)

𝑉𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 200𝑀 + 40𝑀 ∗ 0,02
𝑉𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 200,8𝑀

Change in share price:

200,8𝑀
− 1 = 0,004 = 0,4%
200𝑀

d) New after-tax WACC equals to 7,92 % as calculated in part (c).

 6. What we know:
market
premium 0,06
market return 0,097
debt return 0,0725
risk free return 0,037
Tax rate 0,4
D/V 0,18
E/V 0,82

Book values in total and market values for equity, debt and in total for Micron Technology,
SunDisk and STEC:

Book value Market value D E

Micron
Technology 5602,00 10684,57 2759,51 7925,06
SunDisk, Inc. 4157,13 10110,46 975,15 9135,31
STEC, Inc. 275,41 699,17 0 699,17

We can calculate the levered beta for assets by using the formula:

𝐸 𝐷
𝛽𝐿 = ∗ 𝛽𝐸 + ∗ 𝛽𝐷 ∗ (1 − 𝑇𝑐 )
𝑉 𝑉

We can further unlever the asset betas by the formula:

𝛽𝑈 = 𝛽𝐸

where 𝛽𝐸 is the beta for equity for a levered firm.

We can also work out the equity returns with the formula:

𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 ∗ 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

Implementing these formulas, we can calculate the levered and unlevered betas for equity
and assets and equity returns for each company:

Beta for equity Beta for assets Equity return

Beta for debt Levered Unlevered Levered Unlevered Levered
Micron
Technology 0,3 1,25 0,97 0,97 1,25 0,11
SunDisk, Inc. 0,3 1,36 1,25 1,25 1,36 0,12
STEC, Inc. 0,6 1,00 1,00 1,00 1,00 0,10
Beta (unlevered) for assets of Flash Memory is:

1,25 + 1,36 + 1
𝛽𝐴 = ≈ 1, 2033
3

This is also the beta (levered) for Flash Memory’s equity.

The opportunity cost for equity of Flash Memory:

𝑟𝐸 = 𝑟𝑓 + 𝛽𝐸 ∗ 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑟𝐸 = 0,037 + 1,2033 ∗ 0,06
𝑟𝐸 ≈ 0,1092

By calculating the WACC for Flash Memory, we get:

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝐸 ∗ + 𝑟𝐷 ∗ ∗ (1 − 𝑇𝑐 )
𝑉 𝑉

𝑊𝐴𝐶𝐶 = 0,1092 ∗ 0,82 + 0,0725 ∗ 0,18 ∗ (1 − 0,4)

𝑊𝐴𝐶𝐶 ≈ 9,74%