Question

Capital Structure Analysis

Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $11.60 million, and its tax rate is 20%. Pettit can change its capital structure by either increasing its debt to 60% (based on market values) or decreasing it to 40%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 11% coupon. If it decides to decrease its leverage, it will call its old bonds and replace them with new 9% 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 as dividends; hence, its stock is a zero growth stock. Its current cost of equity, r_s, is 14%. If it increases leverage, r_s will be 16%. If it decreases leverage, r_s will be 13%.

Present situation (50% debt):
What is the firm's WACC? Round your answer to three decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million

60% debt:
What is the firm's WACC? Round your answer to two decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million

40% debt:
What is the firm's WACC? Round your answer to two decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million

Answer 1

1.

a). kD = Coupon Rate = 10% (As the bond is selling at par)

kE = rS = 14%

kE = 50/100 = 0.5

kD = 50/100 = 0.5

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.5 x 10% x (1 - 0.20)] + [0.5 x 14%] = 4% + 7% = 11%

b). Net Income = [EBIT - Interest] x (1 - t)

= [$11.60 - ($50 x 0.10)] x (1 - 0.20) = $6.60 x 0.8 = $5.28 million

V = Net Income / wacc = $5.28 / 0.11 = $48 million

2.

a). kD = Coupon Rate = 11% (As the bond is selling at par)

kE = rS = 16%

kE = 1 - 0.6 = 0.4

kD = 0.6

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.6 x 12% x (1 - 0.20)] + [0.4 x 16%] = 5.76% + 6.4% = 12.16%

b). Net Income = [EBIT - Interest] x (1 - t)

= [$11.60 - ($50 x 0.11)] x (1 - 0.20) = $6.1 x 0.8 = $4.88 million

V = Net Income / wacc = $4.88 / 0.1216 = $40.13 million

3.

a). kD = Coupon Rate = 9% (As the bond is selling at par)

kE = rS = 13%

kE = 1 - 0.4 = 0.6

kD = 0.4

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.4 x 9% x (1 - 0.20)] + [0.6 x 13%] = 2.88% + 7.8% = 10.68%

b). Net Income = [EBIT - Interest] x (1 - t)

= [$11.60 - ($50 x 0.09)] x (1 - 0.20) = $7.1 x 0.8 = $5.68 million

V = Net Income / wacc = $5.68 / 0.1038 = $53.18 million