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CHAPTER 17
Capital Structure Decisions:
Extensions
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Proposition I:
VL = VU.
Proposition II:
rsL = rsU + (rsU - rd)(D/S).
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EBIT $500,000
VU = = = $3,571,429.
rsU 0.14
VL = VU = $3,571,429.
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VL = D + S = $3,571,429
$3,571,429 = $1,000,000 + S
S = $2,571,429.
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3. Find rsL.
(
$1,000,000
= 14.0% + (14.0% - 8.0%) $2,571,429 )
= 14.0% + 2.33% = 16.33%.
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+($3,571,429)(16.33%)
$2,571,429
VU =
EBIT(1 - T) =
$500,000(0.6) = $2,142,857.
rsU 0.14
VL = D + S = $2,542,857
$2,542,857 = $1,000,000 + S
S = $1,542,857.
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3. Find rsL.
(
$1,000,000
= 14.0% + (14.0% - 8.0%)(0.6) $1,542,857 )
= 14.0% + 2.33% = 16.33%.
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1 Debt
0 0.5 1.0 1.5 2.0 2.5 (Millions of $)
[
VL = VU + 1 - (1 - Td)]
(1 - Tc)(1 - Ts)
D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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[ ]
VL = VU + 1 - (1 - 0.40)(1 - 0.12) D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
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Levered beta
EBIT = $500,000
T = 40%
rU = 14% = rTS
rd = 8%
Required reinvestment in net
operating assets = 10% of EBIT =
$50,000.
Debt = $1,000,000
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Calculating VU
NOPAT = EBIT(1-T)
= $500,000 (.60) = $300,000
Investment in net op. assets
= EBIT (0.10) = $50,000
FCF = NOPAT Inv. in net op. assets
= $300,000 - $50,000
= $250,000 (this is expected FCF
next year)
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VTS = rdTD/(rsU g)
= 0.08(0.40)$1,000,000/(0.14-0.07)
= $457,143
VL = VU + VTS
= $3,571,429 + $457,143
= $4,028,571
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40.00%
35.00%
30.00%
Cost of Capital
MM rsL
25.00%
MM WACC
20.00%
Extension rsL
15.00%
10.00% Extension WACC
5.00%
0.00%
0% 20% 40% 60% 80% 100%
D/V
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Equity as an option
Equity as an option
V = P[N(d1)] - Xe -r t[N(d2)].
RF
d2 = d1 - t.
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Black-Scholes Solution
V = $4[N(d1)] - $2e-(0.06)(1.0)[N(d2)].
ln($4/$2) + [(0.06 + 0.36/2)](1.0)
d1(0.60)(1.0)
=
= 1.5552.
d2 = d1 - (0.60)(1.0) = d1 - 0.60
= 1.5552 - 0.6000 = 0.9552.
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V = $4(0.9401) - $2e-0.06(0.8303)
= $3.7604 - $2(0.9418)(0.8303)
= $2.196 Million = Value of Equity
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Value of Debt
Managerial Incentives
Managerial Incentives
3.00
2.50
Value (millions)
2.00
Equity
1.50
Debt
1.00
0.50
0.00
0.00 0.20 0.40 0.60 0.80 1.00
Volatility (sigma)
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