Question

QUESTION 66

The following information applies to the next 10 problems.

The Wallace Corporation is a zero growth firm with an expected EBIT of $800,000 on a permanent basis, and corporate tax rate of 40 percent. Wallace uses no debt, and the cost of equity to an unlevered firm in the same risk class is 12.0 percent. The firm has 100,000 shares outstanding.

What is the value of the firm?

		$2,500,000
		$2,800,000
		$3,800,00
		$4,000,000
		$4,400,000

1 points   

QUESTION 67

What is the EPS (earnings per share) of the firm?

		$4.0
		$4.2
		$4.4
		$4.6
		$4.8

1 points   

QUESTION 68

What is the price per share of the firm's stock?

		$34
		$36
		$38
		$40
		$44

1 points   

QUESTION 69

The following information applies to the next 7 problems.

Now, the Wallace Corporation decides to change its capital structure by borrowing $1.5 million at 8% interest on a permanent basis, and repurchasing some of its stocks. We still assume the same information from above. The Wallace Corporation is a zero growth firm with an expected EBIT of $800,000 on a permanent basis, and corporate tax rate of 40 percent. When Wallace used no debt, and the cost of equity to an unlevered firm in the same risk class is 12.0 percent. The firm had 100,000 shares outstanding before the repurchase.

What is the value of the firm with $1.5 million debt, according to MM with corporate taxes?

		$3,600,000
		$3,800,000
		$4,350,00
		$4,600,000
		$5,250,000

1 points   

QUESTION 70

What is the value of equity?

		$2,700,000
		$3,100,000
		$3,350,000
		$3,450,000
		$3,750,000

1 points   

QUESTION 71

What is the firm's cost of equity when the firm uses $1,500,000 debt?

		12.5%
		13.16%
		13.54%
		14.25%
		15.16%

1 points   

QUESTION 72

What is the stock price of the firm at which shares are repurchased?

		$38
		$40.33
		$43
		$44
		$46

1 points   

QUESTION 73

What is the number of shares the firm repurchases with $1,500,000?

		32,609
		34,091
		34,884
		37,190
		39,474

1 points   

QUESTION 74

What is the EPS (earnings per share) of the firm, when the firm uses $1,500,000 debt?

		$5.35
		$5.53
		$5.77
		$6.05
		$6.42

1 points   

QUESTION 75

What is the firm's value when both corporate and personal taxes are considered. Assume that the personal tax rates of Wallace's investors are 30 percent on debt (interest) income and 20 percent (on average) on income from stocks.

		$4,00,000
		$4,211,333
		$4,314,286
		$4,471,429
		$4,600,000

Answer 1

Question 66

Value of Firm = EBIT* (1-Tax rate)/ Cost of Equity

Given:

EBIT = $ 800,000

Tax rate = 40%

Cost of Equity

Therefore, Value of firm = $ 800,000* (1-40%) / 12%

=> $ 480,000 / 12%

ANSWER : VALUE OF FIRM=> $ 4,000,000

Q 67

EPS of firm = (EBIT - Interest * (1-Tax Rate)) / No. of Shares Outstanding

Given:

EBIT = $ 800,000

Tax rate = 40%

No. of Shares outstanding = 100,000

EPS = ($ 800,000 -0- (1-40%)) / 100,000

=> EPS = ($ 800,000* 0.60) / 100,000

=> 480,000/100,000

Answer EPS of firm = 4.8

Q 68

Price per share of firm's stock = Value of Firm / No. of Shares Outstanding

Note : In question 66, we have computed the value of the firm as $ 4,000,000

No. of Shares outstanding = 100,000

Answer: The Price per share of the firm = $4,000,000 / 100,000 = $ 40

Q 69

The MM theorem states that the market value of a firm is computed using its earnings power and the risk of its underlying assets, and is independent of the manner in which it finances its investments and distributes its dividends.

In other words, the capital structure does not influence the valudation of a firm, and leveraging does not increase the market value of the firm. Debt and Equity shareholders have the same priority.

MM Proposition 1	V l = VU + rc* B
=>	V l = (EBIT* (1-rc))/R0 + rc B
Given:
	EBIT	8,00,000
	rc = Tax rate	40%
	R0 = Cost of Equity	12%
	B = Total Debt	15,00,000
=>	800000*(1-.4) / .12 + 1500000*.4
=>	480,000/.12 + 600,000
=>	40,00,000+600,000 (Value of leverage or tax shield)
Answer	The Value of the firm with corporate taxes = $ 46,00,000

Q 70

Value of firm with $ 1.5 Million Debt = $ 46,00,000 (See Question 69)

Less : Value of Debt issued = $ 15,00,000 (given)

Answer : Cost of Equity = $ 31,00,000

Q 71

Cost of Equity (when firm uses $ 1.5 Million of Debt)

	r s = r0 + B/S* (1-Tax)* (r0-rB)
r s	Cost of Equity	To ascertain
r 0	Cost of Equity to unlevered firm	12%
rB	Cost of debt/ borrowing	8%
B	Borrowing/Debt	15,00,000
B-S	Total firm value (refer Q 69)less Debt	46,00,000
Tax	Tax rate (given as)	40%
=>	12% + 1500000/3100000*(1-.4)*(12%-8%)
=>	12%+ 0.48*.6*4%
=>	12%+(0.11613*100)
=>	12% + 1.1613%
Answer	Cost of Equity = 13.1613 or 13.16%

Q 72

Value of firm after repurchase or recapitalization = Value of firm (refer question 69) / No. of shares outstanding

=> $46,00,000 / 100,000

Answer = $ 46

Q 73

No. of shares that the firm repurchases with $ 15,00,000 = $ 15,00,000/ 46 (refer question 72) = 32,609

Q 74

No. of shares outstanding after repurchase = 100,000 - 32,609 shares (see Q 73) = 67,391 shares

The EPS calculation will take 67,391 shares outstanding in to consideration

EPS = (Earnings (1- Tax) - Interest Payments* (1-Tax)) / Shares outstanding after re-purchase

=> EPS = (8,00,000 *(1-40%) - 15,00,000*8%*(1-40%)) / 67,391

=> EPS = (480,000 - 1,20,000*60%) / 67,391

=> EPS = (480,000 - 72,000) /67,391

=> EPS = $408,000 / 67,391 shares

Answer : EPS = $ 6.0542208 or $ 6.05

Cross- check

We can now cross-check/ verify the Stock price of the firm using the formula EPS ( Q 74) / Cost of Equity (Q 71)

=> $6.0542208/ ($13.161/100)

=> $ 6.0542208 / $.13161

=> 46.001222 0r $ 46 ( This is the value of firm after re-purchase or recapitalization) - Refer Question 72

Q 75

Personal tax on income from Equity = 20%

Cost of Equity

Therefore, Value of firm = $ 800,000* (1-40%) / 12%*(1+20%)

=> $ 480,000 / 14.4

ANSWER : VALUE OF FIRM=> $ 33,33,333 - A

Personal tax on interest on debt = 30%

Interest rate = 8%

Interest Income + personal tax = 10.4%

Value of firm when both corporate and personal taxes are factored in : $ 33,33,333 + $ 878,000 = $ 42,11,333