Session 10: Leverage and Payout Policy I
Read: Chapter 15: Debt and Taxes
Chapter 18: Capital Budgeting and Valuation with Leverage (18.1-18.3)
1. Gestion Bernaise has 10 million shares outstanding, now trading £70 per share.
The firm has estimated the expected rate of return to shareholders at about 15
percent. It has also issued £200 million long-term bonds at an interest rate of 8
percent. It pays tax at a marginal rate of 35.4 percent.
a. What is the company’s after-tax WACC?
b. How much higher would WACC be if the company used no debt at all? (For
this problem you can assume that the firm’s overall beta is not affected by its
capital structure or by interest tax shields).
2. Suppose that Pfizer moves to a 40 percent book debt ratio by issuing debt and
using the proceeds to repurchase shares. Consider only corporate taxes.
Reconstruct its book and market balance sheets to reflect the new capital
structure. How much additional value is added if the assumptions in the table are
correct?
3. Acort Industries has 10 million shares outstanding and a current share price of
$40 per share. It also has long-term debt outstanding. This debt is risk free, is
four years away from maturity, has annual coupons with a coupon rate of 10%
and a $100 million face value. The first of the remaining coupon payments will be
due in exactly one year. The riskless interest rates for all maturities are constant
at 6%. Acort has EBIT of $106 million, which is expected to remain constant each
year. New capital expenditures are expected to equal depreciation and equal $13
million per year, while no changes to net working capital are expected in the
future. The corporate tax rate is 40%, and Acort is expected to keep its debt-
equity ratio constant in the future (by either issuing additional new debt or buying
back some debt as time goes on).
a. Based on this information, estimate Acort’s WACC.
b. What is Acort’s equity cost of capital?
4. You are a consultant who was hired to evaluate a new product line for Markum
Enterprises. The upfront investment required to launch the product line is $10
million. The product will generate free cash flow of $750,000 the first year, and
this free cash flow is expected to grow at a rate of 4% per year. Markum has an
equity cost of capital of 11.3%, a debt cost of capital of 5%, and a tax rate of
35%. Markum maintains a debt-equity ratio of 0.40.
a. What is the NPV of the new product line (including any tax shields from
leverage)?
b. How much debt will Markum initially take on as a result of launching this
product line?
c. How much of the product line’s value is attributed to the present value of
interest tax shields?
Book Values
Net Working Cap
ital
$10,752
$8,144
Long
-
term debt
21,460
Other long
-
term liabilities
Long
-
term assets
86,900
68,048
Equity
Total assets
97,652
97,652
Total value
Market Values
Net Working Capital
$10,752
$8,144
Long
-
term debt
PV interest tax shield
2,850
21,460
O
ther long
-
term liabilities
Long
-
term assets
283,373
267,371
Equity
Total assets
296,975
296,975
Total value
