Solution

• a. A table outlining the income statement for the three possible states of the economy
is shown below. The EPS is the net income divided by the 7,400 shares outstanding.
The last row shows the percentage change in EPS the company will experience in a
recession or an expansion economy.
Recession Normal Expansion
EBIT $12,600 $18,000 $22,500
Interest 0 0 0
NI $12,600 $18,000 $22,500
EPS $1.70 $2.43 $3.04
%EPS –30 ––– +25
Solution
• The company’s share price is:
Share price = Equity/Shares outstanding
Share price = $222,000/7,400
Share price = $30
• If the company undergoes the proposed recapitalization, it will repurchase:
Shares repurchased = Debt issued/Share price
Shares repurchased = $60,000/$30
Shares repurchased = 2,000
Solution
• The interest payment each year under all three scenarios will be:
Interest payment = $60,000(.07)
Interest payment = $4,200
• The last row shows the percentage change in EPS the company will experience in a
recession or an expansion economy under the proposed recapitalization.
Recession Normal Expansion
EBIT $12,600 $18,000 $22,500
Interest 4,200 4,200 4,200
NI $ 8,400 $13,800 $18,300
EPS $1.56 $ 2.56 $3.39
%EPS –39.13 ––– +32.61
Solution
• a. With the information provided, we can use the equation for calculating WACC to find the
cost of equity. The equation for WACC is:
WACC = (E/V)RE + (D/V)RD(1 – TC)
• The company has a debt-equity ratio of 1.25, which implies the weight of debt is 1.25/2.25,
and the weight of equity is 1/2.25, so:
WACC = .078 = (1/2.25)RE + (1.25/2.25)(.047)(1 – .21)
RE = .1291, or 12.91%
• b. To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:
RE = RU + (RU – RD)(D/E)(1 – TC)
.1291 = RU + (RU – .047)(1.25)(1 – .21)
RU = .0883, or 8.83%
Solution
c. To find the cost of equity under different capital structures, we can again use M&M
Proposition II with taxes. With a debt-equity ratio of 2, the cost of equity is:
RE = RU + (RU – RD)(D/E)(1 – TC)
RE = .0883 + (.0883 – .047)(2)(1 – .21)
RE = .1536, or 15.36%
• With a debt-equity ratio of 1, the cost of equity is:
RE = .0883 + (.0883 – .047)(1)(1 – .21)
RE = .1209, or 12.09%
• And with a debt-equity ratio of 0, the cost of equity is:
RE = .0883 + (.0883 – .047)(0)(1 – .21)
RE = RU = .0883, or 8.83%
Solution
• Since Unlevered is an all-equity firm, its value is equal to the market value of its outstanding shares.
Unlevered has 3.4 million shares of common stock outstanding, worth $72 per share. Therefore, the
value of Unlevered:
VU = 3,400,000($72)
VU = $244,800,000
• Modigliani-Miller Proposition I states that, in the absence of taxes, the value of a levered firm
equals the value of an otherwise identical unlevered firm. Since Levered is identical to Unlevered in
every way except its capital structure and neither firm pays taxes, the value of the two firms should
be equal. Therefore, the market value of Levered, Inc., should also be $244.8 million. Since Levered
has 1.8 million outstanding shares, worth $101 per share, the market value of Levered’s equity is:
SL = 1,800,000($101)
SL = $181,800,000
Solution
• The market value of Levered’s debt is $60 million. The value of a levered firm equals
the market value of its debt plus the market value of its equity. Therefore, the current
market value of Levered is:
VL = B + S
VL = $60,000,000 + 181,800,000
VL = $241,800,000
• The market value of Levered’s equity needs to be $184.8 million, $3 million higher
than its current market value of $181.8 million, for MM Proposition I to hold. Since
Levered’s market value is less than Unlevered’s market value, Levered is relatively
underpriced and an investor should buy shares of the firm’s stock.
Solution
• a. Before the announcement of the stock repurchase plan, the market value of the
outstanding debt is $2,500,000. Using the debt-equity ratio, we can find that the value of the
outstanding equity must be:
Debt-equity ratio = B/S
.35 = $2,500,000/S
S = $7,142,857
• The value of a levered firm is equal to the sum of the market value of the firm’s debt and the
market value of the firm’s equity, so:
VL = B + S
VL = $2,500,000 + 7,142,857
VL = $9,642,857
• According to MM Proposition I without taxes, changes in a firm’s capital structure have no
effect on the overall value of the firm. Therefore, the value of the firm will not change after
the announcement of the stock repurchase plan.
Solution
• b. The expected return on a firm’s equity is the ratio of annual earnings to the market
value of the firm’s equity, or return on equity. Before the restructuring, the company
was expected to pay interest in the amount of:
Interest payment = .051($2,500,000)
Interest payment = $127,500
• The return on equity, which is equal to RS, will be:
ROE = RS = ($920,000 – 127,500)/$7,142,857
RS = .1110, or 11.10%
Solution
• c. According to Modigliani-Miller Proposition II with no taxes:
RS = R0 + (B/S)(R0 – RB)
.1110 = R0 + (.35)(R0 – .051)
R0 = .0954, or 9.54%
• This problem can also be solved in the following way:
R0 = Earnings before interest/VU
• According to Modigliani-Miller Proposition I, in a world with no taxes, the value of a
levered firm equals the value of an otherwise-identical unlevered firm. Since the value
of the company as a levered firm is $9,642,857 (= $2,500,000 + 7,142,857) and since
the firm pays no taxes, the value of the company as an unlevered firm is also
$9,642,857. So:
R0 = $920,000/$9,642,857
R0 = .0954, or 9.54%
Solution
• d.=In part c, we calculated the cost of an all-equity firm. We can use Modigliani-
Miller Proposition II with no taxes again to find the cost of equity for the firm with
the new leverage ratio. The cost of equity under the stock repurchase plan will be:
RS = R0 + (B/S)(R0 – RB)
RS = .0954 + (.50)(.0954 – .051)
RS = .1176, or 11.76%
Solution
• a. The expected return on a firm’s equity is the ratio of annual aftertax earnings to the
market value of the firm’s equity. The amount the firm must pay each year in taxes
will be:
Taxes = .21($1,320,000)
Taxes = $277,200
• So, the return on the unlevered equity will be:
R0 = ($1,320,000 – 277,200)/$6,700,000
R0 = .1556, or 15.56%
• Notice that perpetual aftertax annual earnings of $1,042,800, discounted at 15.56
percent, yields the market value of the firm’s equity.
Solution
• b. The company’s market value balance sheet before the announcement of the debt
issue is:
Debt 0
Assets $6,700,000 Equity $6,700,000
Total assets $6,700,000 Total D&E $6,700,000
• The price per share is the total market value of the stock divided by the shares
outstanding, or:

Price per share = $6,700,000/290,000

Price per share = $23.10
Solution
• c. Modigliani-Miller Proposition I states that in a world with corporate taxes:
VL = V U + TCB
• When the company announces the debt issue, the value of the firm will increase by the present
value of the tax shield on the debt. The present value of the tax shield is:
PV(Tax Shield) = TCB
PV(Tax Shield) = .21($1,900,000)
PV(Tax Shield) = $399,000
• Therefore, the value of the company will increase by $399,000 as a result of the debt issue. The
value after the repurchase announcement is:
VL = V U + TCB
VL = $6,700,000 + .21($1,900,000)
VL = $7,099,000
• Since the firm has not yet issued any debt, its equity is also worth $7,099,000.
• The company’s market value balance sheet after the announcement of the debt issue is:
Old assets $6,700,000 Debt 0
PV(tax shield) 399,000 Equity $7,099,000
Total assets $7,099,000 Total D&E $7,099,000
Solution
• d. The share price immediately after the announcement of the debt issue will be:
New share price = $7,099,000/290,000
New share price = $24.48
• e. The number of shares repurchased will be the amount of the debt issue divided by
the new share price, or:
Shares repurchased = $1,900,000/$24.48
Shares repurchased = 77,616.57
• The number of shares outstanding will be the current number of shares minus the
number of shares repurchased, or:
New shares outstanding = 290,000 – 77,616.57
New shares outstanding = 212,383.43
Solution
• f. The share price will remain the same after restructuring takes place. The total
market value of the outstanding equity in the company will be:
Market value of equity = $24.48(212,383.43)
Market value of equity = $5,199,000
• The market-value balance sheet after the restructuring is:
Old assets $6,700,000 Debt $1,900,000
PV(tax shield) 399,000 Equity 5,199,000
Total assets $7,099,000 Total D&E $7,099,000

• g. According to Modigliani-Miller Proposition II with corporate taxes:

RS = R0 + (B/S)(R0 – RB)(1 – TC)
RS = .1556 + ($1,900,000/$5,199,000)(.1556 – .05)(1 – .21)
RS = .1861, or 18.61%