Corporate Finance
Questions
1. Protos, Inc., has no debt outstanding and a total market value of $300,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 50 percent lower. Money is considering a $100,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.
a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also calculate the
percentage changes in EPS when the economy expands or enters a recession.
b) Repeat part (a) assuming that Protos goes through with recapitalization. What do you observe?
2. Repeat parts (a) and (b) in Problem 1 assuming Protos has a tax rate of 25 percent.
3.- The company with the common equity accounts shown here has declared a stock dividend of 15 percent when the market value of its stock is $45 per share. What effects on the equity accounts will the distribution of the stock dividend have?
4.- Sangria Corporation has a target capital structure of 65 percent common stock and 35 percent debt. Its cost of equity is 16 percent, and the cost of debt is 6 percent. The relevant tax rate is 25 percent. What is Sangria's WACC?
5.- Given the following information for Telefonica Co., find the WACC.
Assume the company's tax rate is 15 percent.
Debt: 5,000 bonds outstanding, 5 percent coupon, $1,000 par value, 10 years to maturity, selling for 105 percent of par; the bonds make semiannual payments.
Common stock:
185,000 shares outstanding, selling for $60 per share; the beta is 1.20.
Market: 8 percent market risk premium and 4 percent risk-free rate.
Sample Solution
. Earnings per Share (EPS) and Recapitalization:
a) Before Recapitalization:
- Normal Economy: EPS = $25,000 / 5,000 shares = $5/share
- Expansion: EBIT = $25,000 * (1 + 25%) = $31,250; EPS = $31,250 / 5,000 shares = $6.25/share; Change = 25% increase
Full Answer Section
- Recession: EBIT = $25,000 * (1 - 50%) = $12,500; EPS = $12,500 / 5,000 shares = $2.50/share; Change = 50% decrease
b) After Recapitalization:
- Proceeds from debt issuance: $100,000
- Shares repurchased: $100,000 / $5/share (initial EPS) = 20,000 shares
- New shares outstanding: 5,000 shares - 20,000 shares = 3,000 shares
- EPS recalculated:
- Normal Economy: $25,000 / 3,000 shares = $8.33/share; Increase = 66.6%
- Expansion: $31,250 / 3,000 shares = $10.42/share; Increase = 108.4%
- Recession: $12,500 / 3,000 shares = $4.17/share; Increase = 66.8%
Observation: Recapitalization leads to significantly higher EPS in all scenarios due to share buyback, amplifying the impact of economic changes.
2. EPS with Taxes (25% Tax Rate):
a) Before Recapitalization:
-
Taxable income: Adjust EBIT for taxes (EBIT * (1 - Tax Rate))
- Normal Economy: $25,000 * (1 - 0.25) = $18,750
- Expansion: $31,250 * (1 - 0.25) = $23,437.50
- Recession: $12,500 * (1 - 0.25) = $9,375
-
Net income: Subtract taxes from taxable income
- Normal Economy: $18,750 - $4,687.50 (taxes) = $14,062.50
- Expansion: $23,437.50 - $5,859.38 (taxes) = $17,578.12
- Recession: $9,375 - $2,343.75 (taxes) = $7,031.25
-
EPS recalculated: Divide net income by outstanding shares
- Normal Economy: $14,062.50 / 5,000 shares = $2.81/share
- Expansion: $17,578.12 / 5,000 shares = $3.52/share; Increase = 25%
- Recession: $7,031.25 / 5,000 shares = $1.41/share; Decrease = 50%
b) After Recapitalization: Similar calculations with adjusted outstanding shares (3,000).
3. Stock Dividend Effect on Equity Accounts:
- Total dividend declared: 15% * $45/share * 5,000 shares = $33,750
- Decrease in retained earnings: $33,750
- Increase in common stock: Number of shares issued = Dividend / Market value per share = $33,750 / $45 = 750 shares
- No change in total equity: Decrease in retained earnings balanced by increase in common stock.
4. Sangria Corporation's WACC:
- Weight of equity: 65%
- Weight of debt: 35%
- Cost of equity: 16%
- After-tax cost of debt: 6% * (1 - 0.25) = 4.5%