M&M and Taxes $\color{#c34632}\text{[Lo2]}$ In previous Problem, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm's capital structure decision?

Calculating WACC $\color{#c34632}\text{[Lo1]}$ Citee Corp. has no debt but can borrow at $6.1$ percent. The firm's WACC is currently $9.4$ percent, and the tax rate is $21$ percent.
a. What is the company's cost of equity?
b. If the firm converts to $25$ percent debt, what will its cost of equity be?
c. If the firm converts to $50$ percent debt, what will its cost of equity be?
d. What is the company's WACC in part (b)? In part (c)?

Homemade Leverage $\color{#c34632}\text{[Lo1]}$ FCOJ, Inc., a prominent consumer products firm, is debating whether to convert its all-equity capital structure to one that is $30$ percent debt. Currently, there are $5,800$ shares outstanding, and the price per share is $\$ 57$. EBIT is expected to remain at $\$ 32,000$ per year forever. The interest rate on new debt is $8$ percent, and there are no taxes.

a. Allison, a shareholder of the firm, owns $100$ shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of $100$ percent?
b. What will Allison's cash flow be under the proposed capital structure of the firm? Assume she keeps all $100$ of her shares.
c. Suppose the company does convert, but Allison prefers the current all-equity capital structure. Show how she could unlever her shares of stock to re-create the original capital structure.
d. Using your answer to part (c), explain why the company's choice of capital structure is irrelevant.

Calculating WACC $\color{#c34632}\text{[Lo1]}$ Blitz Industries has a debt-equity ratio of $1.25$. Its WACC is $8.3$ percent, and its cost of debt is $5.1$ percent. The corporate tax rate is $21$ percent.

a. What is the company's cost of equity capital?
b. What is the company's unlevered cost of equity capital?
c. What would the cost of equity be if the debt-equity ratio were $2$ ? What if it were $1$ ? What if it were zero?

Ghost, Inc., has no debt outstanding and a total market value of $\$ 185,000$. Earnings before interest and taxes, EBIT, are projected to be $\$ 29,000$ if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be $30$ percent higher. If there is a recession, then EBIT will be $40$ percent lower. The company is considering a $\$ 65,000$ debt issue with an interest rate of $7$ percent. The proceeds will be used to repurchase shares of stock. There are currently $7,400$ 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 the company goes through with recapitalization. What do you observe?

M&M $\color{#c34632}\text{[Lo2]}$ Tool Manufacturing has an expected EBIT of $\$ 51,000$ in perpetuity and a tax rate of $21$ percent. The firm has $\$ 126,000$ in outstanding debt at an interest rate of $5.35$ percent, and its unlevered cost of capital is $9.6$ percent. What is the value of the firm according to M&M Proposition I with taxes? Should the company change its debt-equity ratio if the goal is to maximize the value of the firm? Explain.

Jet Corporation expects an EBIT of $23,500 every year forever. The company currently has no debt, and its cost of equity is 15%.

a. What is the current value of the company? b. Assume the company can borrow at 10%. If the corporate tax rate is 35%, what will the value of the firm be if the company takes on debt equal to 50% of its unlevered value? What if it takes on debt equal to 100% of its unlevered value? c. What will the value of the firm be if the company takes on debt equal to 50% of its levered value? What if the company takes on debt equal to 100% of its levered value?

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $780,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth$390,000 and the interest rate on its debt is 8%. Both firms expect EBIT to be $87,000. Ignore taxes.

a. Rico owns$48,750 worth of XYZ’s stock. What rate of return is he expecting?
b. Illustrate how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.
c. What is the cost of equity for ABC? What is it for XYZ?
d. What is the WACC for ABC? For XYZ? What principle have you illustrated?

Homemade Leverage and WACC $\color{#c34632}\text{[Lo1]}$ ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. $\mathrm{ABC}$ is all-equity financed with $\$ 720,000$ in stock. XYZ uses both stock and perpetual debt; its stock is worth $\$ 360,000$ and the interest rate on its debt is $7$ percent. Both firms expect EBIT to be $\$ 73,000$. Ignore taxes.

a. Rico owns $\$ 43,500$ worth of XYZ's stock. What rate of return is he expecting?
b. Show how Rico could generate exactly the same cash flows and rate of return by investing in $\mathrm{ABC}$ and using homemade leverage.
c. What is the cost of equity for $\mathrm{ABC}$ ? What is it for $\mathrm{XYZ}$ ?
d. What is the WACC for $\mathrm{ABC}$ ? For $\mathrm{XYZ}$ ? What principle have you illustrated?

Meyer & Co. predicts its EBIT to be $83,000 every year forever. The firm can borrow at 8%. The company currently has no debt, and its cost of equity is 13%. If the tax rate is 35%, what is the value of the firm? What will the value be if the company borrows$125,000 and uses the proceeds to repurchase shares?

Firm Value $\color{#c34632}\text{[Lo2]}$ Change Corporation expects an EBIT of $\$ 31,200$ every year forever. The company currently has no debt, and its cost of equity is $11$ percent.
a. What is the current value of the company?
b. Suppose the company can borrow at $6$ percent. If the corporate tax rate is $22$ percent, what will the value of the firm be if the company takes on debt equal to $50$ percent of its unlevered value? What if it takes on debt equal to $100$ percent of its unlevered value?
c. What will the value of the firm be if the company takes on debt equal to $50$ percent of its levered value? What if the company takes on debt equal to $100$ percent of its levered value?

In early $2015$, Abercrombie & Fitch (ANF) had a book equity of $\$ 1390$ million, a price per share of $\$ 25.52$, and $69.35$ million shares outstanding. At the same time, The Gap (GPS) had a book equity of $\$ 2983$ million, a share price of $\$ 41.19$, and $421$ million shares outstanding.

a. What is the market-to-book ratio of each of these clothing retailers?

b. What conclusions can you draw by comparing the two ratios?

a. Return on assets, or ROA, can be expressed as the product of two ratios. Which two?\

b. Return on equity, or ROE, can be expressed as the product of three ratios. Which three?

Homemade Leverage $\color{#c34632}\text{[Lo1]}$ The Day Company and the Knight Company are identical in every respect except that Day is not levered. Financial information for the two firms appears in the following table. All earnings streams are perpetuities, and neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.

a. An investor who can borrow at $6$ percent per year wishes to purchase $5$ percent of Knight's equity. Can he increase his dollar return by purchasing $5$ percent of Day's equity if he borrows so that the initial net costs of the strategies are the same?
b. Given the two investment strategies in (a), which will investors choose? When will this process cease?