Question

1. Piedmont Printing Company has a total market value of $120 million, consisting of 1 million shares selling for $60 per share and $60 million of 9% perpetual bonds now selling at par. The company’s EBIT is $15.888 million, and its tax rate is 25%. Piedmont can change its capital structure by either increasing its debt to 65% or decreasing it to 35%. If it decides to increase its use of leverage, it must call its old bonds and replace them with new ones with a 11% coupon. If it decides to decrease its leverage, it will call its old bonds and replace them with new 7% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. The firm pays out all earnings in dividends; hence, its stock is a zero-growth stock. Its current cost of equity is 13%. If it increases leverage, the cost of equity will be 15%. If it decreases leverage, the cost of equity will be 11%. What is the total corporate value if Piedmont increases its leverage?

Answer 1

Currently debt to equity ratio is 1:1 i.e. equity and debt are in same proportion of total market value.

Now if debt increased to 65% than equity will be 35%.

First we calculate cash flow in normal 50% 50% term.

EBIT -.09*60=10.488 million

With 25% tax rate total profit will be

0.75*10.488=7.866 million

Now first we calculate WACC when leverage is increased by below

= 0.35*15 + 0.65*.75*.11

=10.6125%

This will help us calculate firm value by below formula:

Market value= operating cash flow / WACC

Note- As we are using WACC in denominator we shall use cash flow to the firm i.e. we shall not subtract interest income to debt holders.

So here if we consider market value to X than we shall have

X=(EBIT-.25*EBT)/.106125

Here EBIT is 15.888 million and EBT is 15.888-.11*.65*X

So

.106125x = 15.888-.25*15.888+.25*.11*.65*x

.106125x -.017875x = .75*15.888

.08825x=.75*15.888

X=.75*15.888/.08825

X=135 million

This is our corporate value after leverage increase.

Thank You!!