Build A Model : Capital Structure And Real Options
Build a Model
| Solution | ||||||||
| Chapter: | 15 | |||||||
| Problem: | 13 | |||||||
| Reacher Technology has consulted with investment bankers and determined the interest rate it would pay for different capital structures, as shown below. Data for the risk-free rate, the market risk premium, an estimate of Reacher’s unlevered beta, and the tax rate are also shown below. Based on this information, what is the firm’s optimal capital structure and what is the weighted average cost of capital at the optimal structure? | ||||||||
| Percent Financed with Debt (wd) | Before-tax Cost Debt (rd) | Input Data | ||||||
| Risk-free rate | 4.5% | |||||||
| Market risk premium | 5.5% | |||||||
| Unlevered beta | 0.8 | |||||||
| 0% | 6.0% | Tax rate | 40.0% | |||||
| 10% | 6.1% | |||||||
| 20% | 7.0% | |||||||
| 30% | 8.0% | |||||||
| 40% | 10.0% | |||||||
| 50% | 12.5% | |||||||
| 60% | 15.5% | |||||||
| 70% | 18.0% | |||||||
| Fill in formulas in the yellow cells to find the optimum capital structure. | ||||||||
| Debt/Value | Equity/Value | Debt/Equity | A-T Cost of | Levered | Cost of | |||
| Ratio (wd) | Ratio (ws) | Ratio (wd/ws) | Debt (rd) | Beta | Equity | WACC | ||
| 0% | ||||||||
DII Labs: After tax cost of debt. | 10% | |||||||
| 20% | ||||||||
| 30% | ||||||||
| 40% | ||||||||
| 50% | ||||||||
| 60% | ||||||||
| 70% | ||||||||
| WACC at optimum debt ratio = | ||||||||
| Optimum debt ratio = | ||||||||
| Reacher Technology’s EBIT was $40 million last year and is not expected to grow (g=0) and pays out 100% of earnings as dividends annually. The firm is currently financed with all equity and it has 10 million shares outstanding and is considering recaptizing its equity with debt where new debt would be issued and proceeds used to buyback stock. Show the firm’s market value of operations, MV of debt, MV of equity, shares outstanding, and stock price for each level of debt the firm is considering. | ||||||||
| EBIT= | $ 40.00 | FCF= | ||||||
| Debt/Value | WACC | MV | MV of Debt | MV of Equity | #Shares | Stock | ||
| Price | ||||||||
| 0% | 10 | |||||||
| 10% | ||||||||
| 20% | ||||||||
| 30% | ||||||||
| 40% | ||||||||
| 50% | ||||||||
| 60% | ||||||||
| 70% | ||||||||
| Complete Reacher’s income statement for each debt level. Show net income, dividends per share, ROE, and re-estimate stock price using the constant growth formula: | ||||||||
| Income | ||||||||
| Statement | 0% | 10% | 20% | 30% | 40% | 50% | 60% | 70% |
| EBIT | ||||||||
| INT | ||||||||
| EBT | ||||||||
| -TAX | ||||||||
| NI | ||||||||
| DPS | ||||||||
| ROE | ||||||||
| P0 | ||||||||
&P of &N
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