Question:
1. Clusone Confectioneryis currently an all-equity firm with an expected return of 11%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. (Note, in carrying out this purely financial transaction, Clusone’s actual business activities would remain entirely unchanged). Clusone does not pay taxes.
- Suppose Clusone borrows to the point that its debt-equity ratio is 45. With this amount of debt, the debt cost of capital is 5%. What will the expected return of equity be after this transaction
- Suppose instead Clusone borrows to the point that its debt-equity ratio is 1.40. With this amount of debt, Clusone’s debt will be much riskier. As a result, the debt cost of capital will be 7%. What will the expected return of equity be in this case?
- A senior managerargues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stoc How would you respond to this argument?
2. Brescia Industries is an all-equity firm whose shares have an expected return of 11%. Brescia does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.50. Due to the increased risk, shareholders now expect a return of 14%. Assuming there are no taxes, what is the interest rate on the debt?
3. Camden Industrieshas just issued a perpetual bond with an annual coupon of 8% and nominal value equal to £15 million. The firm will pay interest only on this debt. Camden’s marginal tax rate is expected to be 30% for the foreseeable future.
- Ift he bond sells for an amount equal to the nominal value, what is the yield on Camden’s debt?
- What is the present value of the interest tax shield?
- Suppose instead thatthe annual coupon on the debt had been 7% but it had still sold at a price equal to the nominal value. What would the present value of the interest tax shield have been in this case?
Ten years have now passed since Camden issued £15 million in perpetual interest-only debt with an 8% annual coupon. Tax rates have remained the same at 30% but interest rates have dropped so that the yield on Camden’s bond is currently 4%.
- What is Camden’s annual interest tax shield now?
- What is the present value of the interest tax shield today?
4. Pineapple Manufacturing is currently an all-equity firm with 40 million shares outstanding and a stock price of €15 per share. Although investors currently expect Pineapple to remain an all-equity firm, Pineapple plans to announce that it will raise €200 million by issuing perpetual debt and use the funds to repurchase shares. Pineapple has no further plans to increase or decrease the amount of debt. Pineapple is subject to a 40% corporate tax rate.
- What is the market value of Pineapple’s existing assets before the announcement?
- What is the market value of Pineapple’s assets (including any tax shields) just after the announcement, but before the shares are repurchased?
- What is Pineapple’s share price just before the share repurchase? How many shares will Pineapple repurchase?
- What are Pineapple’s market value balance sheet and share price after the share repurchase?
Reference book is "Fundamentals of Corporate Finance" by Jonathan Berk, Peter Demarzo, and Jarrad Harford.
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