Problem 16-9 Capital Structure Analysis Pettit Printing Company has a total mark
ID: 2780724 • Letter: P
Question
Problem 16-9 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 $12.54 million, and its tax rate is 35%, Pettit can change its capital structure either by 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 14% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 8% 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, rs is 149 . If t increases leverage, rs will be 16%. If it decreases leverage, rs 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. millionExplanation / Answer
1a) WACC=E/V×(Re)+D/V×(Rd)×(1-Tc)
Where, E= market value of equity= $ 50×1Mn shares outstanding= $ 50
D= Value of debt= $ 50 Mn
Re=Cost of equity=14%
Rd=Cost of debt=10%
Tc=Tax rate=35 %
V= Value of debt+ Value of equity= Value of debt (D) +Value of equity (E)= 50 +50=$ 100 Mn
Therefore, WACC=
(50/100)×(0.14)+50/100×(0.10)×(1-0.35)
=0.07+0.0325
=0.1025= 10.250 %
1b) The value of firm (V) can be found as:
V=FCFF/(WACC-g)
FCFF=Free Cash flow to the firm.
FCFF= EBIT (1- Tc)+Depreciation-Investments in Long term assets- Investments in working capital
=12.54(1-0.35)+0-0-0
= $ 8.151
(Note: Since no information is given we assumed Depreciation, Investments in Long term assets, and Investments in working capital to be 0).
WACC= 10.25 % from question 1a.
g= growth rate of FCFF or growth in stock. This is equal to 0 as stated in the question.
Therefore,
V=8.151/ (0.1025-0)
=$ 79.522 Mn
1c) Same formula as question 1a. The only thing that changes is that the out of $ 100 Mn debt share will increase from $ 50 Mn to $ 60 Mn, while equity share will fall from $ 50 Mn to $ 40 Mn. The cost of debt will increase from 10% to 14%, while the cost of equity will increase from 14% to 16%.
WACC=E/V×(Re)+D/V×(Rd)×(1-Tc)
=40/100 ×(0.16)+60/100×(0.14)×(1-0.35)
=0.064+0.0546
=0.1186= 11.86 %
1d) Same formula as 1b. The FCFF component stays same at $ 8.151, while WACC component changes from 10.25 % to 11.86%. g still stays at 0. Therefore, Value of the firm=
V=FCFF/ (WACC-g)
=8.151/(0.1186-0)
= $ 68.727 Mn