FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

Practice Problem Set #6

Capital Structure in Perfect Markets

– SOLUTION –

1. Financing choice in perfect markets

An entrepreneur wants to raise outside funding to finance an investment opportunity. The

firm currently has no assets. The investment opportunity requires an upfront investment of
$1,000 and is expected to generate total cash flow in one year’s time of either $1,000 or
$1,640, with equal probability. Given the riskiness of these cash flows, the unlevered cost of
capital (rU, or WACC) is estimated at 20%.

1) What is the NPV of the investment?

NPV = –1,000 + [(1/2)×1,000 + (1/2)×1,640] / (1+20%) = $100

2) What will be the value of the firm immediately after the capital is raised?
V = [(1/2)×1,000 + (1/2)×1,640] / (1+20%) = $1,100

3) Assume the entrepreneur raises the $1,000 with outside equity financing. How will the
cash flows next year be divided between the entrepreneur and the outside equity investor?
Low High
Total Cash Flow 1,000 1,640
Outside investor 909.1 1,490.9
Entrepreneur 90.9 149.1
Since the firm is worth $1,100 and the investor gave $1,000, she will demand
1,000/1,100 = 90.91% of the firm’s equity in exchange for the capital provided. This
determines the allocation of future cash flows (90.91% to the new investor, 9.09% to the
entrepreneur).

4) What is the entrepreneur’s expected cash flow next year?

Entrepreneur’s expected cash flow next year = (1/2)×90.9 + (1/2)×149.1 = $120

5) Assume instead the entrepreneur raises the $1,000 with debt financing. The bank charges
a 10% interest rate. What is the entrepreneur’s expected cash flow next year?
Low High
Total Cash Flow 1,000 1,640
Lender 1,000 1,100
Entrepreneur 0 540
Repayment promised to the bank next year = 1,000 × (1+10%) = $1,100
Entrepreneur’s expected cash flow next year = (1/2)×0 + (1/2)×540 = $270

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

6) Why is the entrepreneur not necessarily better off under the debt financing (relative to
equity financing)?
The entrepreneur earns a higher expected return under the debt financing alternative, but
her returns are also much riskier in this case. The higher expected return is just
compensation for bearing the extra risk.

7) What is the expected return on the debt? Why is this different from the interest rate?
The debt is risky in this example, since the lenders are owed 1,000 × (1+10%) = $1,100,
but the firm can only pay $1,000 in the low outcome. Therefore, the lender has to charge
a higher interest so that gains in the successful outcomes offset losses in the unsuccessful
outcomes. In this example, the lender earns 0% return in the low outcome and 10% in
the high outcome, so the expected return on the debt (rD) is 5%.

2. Market Values

Extron, Inc. has already made investments with a book value of $20 million. These
investments are expected to generate total cash flows (including any salvage) of $15 million
in each of the next 2 years. Beyond that, the firm has no further investment opportunities.
The appropriate discount rate, given the risk of its assets is 10%.

1) Suppose the firm has debt outstanding with a current market value of $10 million and 10
million equity shares. What do the book value and market value balance sheets look
like? (For debt, assume book value is a good approximation of market value.) What is
the current share price?
V = 15/(1+10%) + 15/(1+10%)2 = $26.03 million
E = V – D = 26.03 – 10 = $16.03 million
Book value balance sheet:
Assets: 20 Debt: 10
Equity: 10
Market value balance sheet:
Assets: 26.03 Debt: 10
Equity: 16.03
P = 16.03/10 = $1.60 per share

2) Now suppose Extron’s managers have identified a new investment opportunity. They
can invest $5 million today in the project, and expect it to generate total cash flow of $10
million in year 2. Assuming investors know about the new project, but they have not yet
raised the necessary capital, what does the market value balance sheet look like now?

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

NPV of the new project = –5 + 10/(1+10%)2 = 3.26

V = Assets in place + NPV(Growth opportunity) = 26.03 + 3.26 = 29.30
Market value balance sheet:
Assets: 29.30 Debt: 10
Equity: 19.30

3) Now suppose the firm raises the $5 million through a new equity issue. What does the
market value balance sheet look like after the financing?
Assets in place increased by $5 million, so V = 29.30 + 5 = 34.30
Market value balance sheet:
Assets: 34.30 Debt: 10
Equity: 24.30

3. True/False

Explain whether you agree or disagree with the following statement and WHY:
"In perfect financial markets with no taxation, pure capital structure changes have no effect on
the expected return and risk of the equity of the company."
False. As debt level increases, so does the risk to the equityholders, because they now have a
lower stake but still bear all the risk of the corporation. The debtholders do not participate in
the risk. The expected return to the equityholders increases to compensate for the risk. The
value to the equityholders, however, does not change following pure capital structure
changes in perfect market.

4. M&M

ABC is a small company whose only asset is a project idea (i.e., they do not yet have the
cash to make this investment) which requires an investment of $1.5 million and will generate
risky cash flows next year. ABC will cease to exist after the cash flows are realized and
distributed to investors.
The total cash flow from the project (including any salvage or terminal value) will depend on
the state of the economy next year, as follows:
• If the economy is going to be BAD, then the cash flow is going to be $4.4 million.
• If the economy is going to be OK, then the cash flow is going to be $4.8 million.
• If the economy is going to be GOOD, then the cash flow is going to be $5.2 million.

All states of the economy are equally likely. For these types of risky investments, the market
requires 20% return.

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

The firm has no debt, and there are currently 500,000 shares outstanding.
Assume perfect markets (i.e., there are no taxes or transaction costs, no asymmetric
information or incentive problems).

1) What is the current value of a share of ABC’s equity (before any capital is raised)?
[Hint: Recall firm value consists of assets in place plus the NPV of future growth
opportunities.]
We know that the market value of the firm consists of both the value of assets in place
plus the NPV of growth opportunities. In this case, there are no assets in place.
The PV of the project’s expected cash flows is:
[(1/3)×4.4 + (1/3)×4.8 + (1/3)×5.2] / (1+20%) = $4.0 million.
Therefore, the NPV of the project = PV – Investment = 4.0 – 1.5 = $2.5 million.
Thus, V = 0 + 2.5 = $2.5 million.
In other words, if we had the capital inside the firm, the firm’s market value would be
$4.0 million. Since the capital is not yet there, we have 4 – 1.5 = $2.5 million.
Since there is no debt, V = E = 2.5 million. So, the price per share = $2.5 million / 0.5
million shares = $5 per share.

2) Suppose ABC wants to raise new equity to fund the project.

i. How many shares should ABC issue? At what price?
Since we are in perfect markets, the financing transaction has no value implications
(we’re just exchanging $1.5 million in cash for shares worth $1.5 million), so the
share price should stay the same. At $5 per share, we need to issue 1.5/5 = 0.3
million (or 300,000) additional shares. We now bring in $1.5 million in new capital
into the firm, which is invested in assets in place. So the value of the firm is now 2.5
+ 1.5 = $4.0 million (i.e., the full PV of the future expected cash flow). There is still
no debt, so the equity is worth $4.0 million, but now there are more shares
outstanding.
The “long” way to calculate the new share price (which will be useful in imperfect
markets) is as follows. Let n be the number of new shares issued and P be the issue
price per share. Since the firm has to raise $1.5 million to undertake the project, n×P
= 1.5. We also have (0.5 + n) × P = 4, which is equivalent to 0.5P + nP = 0.5P + 1.5
= 4. Solving the equation, we get P = (4 – 1.5)/0.5 = $5 per share, and n = 1.5/5 = 0.3
million shares.

ii. When the firm is liquidated next year, what will be the cash flows per share in each
possible state of the economy?
Since there are now 0.8 million shares outstanding (= 0.5 + 0.3) and no debt, the cash
flows per share are as follows:

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

Bad OK Good
Total CF ($millions) 4.4 4.8 5.2
CF/share 5.5 6.0 6.5

iii. For a new equityholder (who bought a share at the price you calculated in part 2i),
calculate the actual realized percentage return on investment in each of the three
possible states of the economy next year. Calculate the mean and standard deviation
of the investment return.
Since the new investor paid $5 per share, her percentage return in each state is as
follows:
Bad OK Good
Total CF ($millions) 4.4 4.8 5.2
CF/share 5.5 6.0 6.5
% Return 10% 20% 30%

Mean 20%
Standard Deviation 8.2%

3) Suppose instead that ABC is going to finance the project by raising $0.5 million in equity
and $1.0 million in debt. Banks are willing to lend the $1.0 million at a rate of 10%.
i. How many shares should ABC issue? At what price?
Again, there are no value effects of a financing transaction in perfect markets, so the
share price stays at $5 and now we need to issue $500,000/5 = 100,000 shares. In this
case, firm value is still the same (PV = $4 million), but there is debt worth $1 million.
Since V = D + E, the market value of the equity is E = V – D = 4 – 1 = $3 million.
The “long” way of calculating the new share price is as follows. Now we only have
to raise $0.5 million in equity, so we have n×P = 0.5. Also, we have (0.5 + n) × P =
3, which is equivalent to 0.5P + nP = 0.5P + 0.5 = 3. Solving the equation, we get P
= (3 – 0.5)/0.5 = $5 per share, and n = 0.5/5 = 0.1 million shares. Thus, ABC needs
to issue 100,000 shares at $5 per share.

ii. When the firm is liquidated next year, what will be the cash flows to equityholders
per share in each possible state of the economy?
There are now 0.6 million shares outstanding (= 0.5 + 0.1), but the equityholders need
to pay the lender 1 × (1+10%) = $1.1 million before they get their cash flow:
Bad OK Good
Total CF ($millions) 4.4 4.8 5.2
Debt 1.1 1.1 1.1
Equity 3.3 3.7 4.1
Equity / share 5.5 6.17 6.83

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

iii. For a new equityholder (who bought a share at the price you calculated in part 3i),
calculate the actual realized percentage return on investment in each of the three
possible states of the economy next year. Calculate the mean and standard deviation
of the investment return.
Bad OK Good
Total CF ($millions) 4.4 4.8 5.2
Debt 1.1 1.1 1.1
Equity 3.3 3.7 4.1
Equity / share 5.5 6.17 6.83
% Return 10% 23.3% 36.7%

Mean 23.3%
Standard Deviation 10.9%

iv. Verify that you get the same expected return to the equityholders using the formula
we derived in class for rE [rE = rA + (D/E)×(rA-rD)].
rE = rA + (D/E)×(rA – rD) = 20% + (1.0/3.0)×(20% – 10%) = 23.3%

4) Which type of financing provides a higher expected return to the shareholders? Does this
mean the shareholders are better off? Explain.
The equityholders have a higher expected return in the debt financing case, but this does
not mean they are better off. The equity is riskier (note the higher standard deviation of
returns), so they are just receiving fair compensation for the risk they are bearing.

5. M&M with Default

ABC is a small company whose only asset is a project idea (i.e., they do not yet have the
cash to make this investment) which requires an investment of $1.5 million and will generate
risky cash flows next year. ABC will cease to exist after the cash flows are realized and
distributed to investors.

The cash flow from the project will depend on the state of the economy next year, as follows:

If the economy is going to be BAD, then the cash flow is going to be $1.3 million.
If the economy is going to be OK, then the cash flow is going to be $2.3 million.
If the economy is going to be GOOD, then the cash flow is going to be $3.3 million.

All states of the economy are equally likely. For these types of risky investments the market
requires 15% return.

The firm has no debt and there are currently 100,000 shares outstanding.

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

Assume perfect markets (i.e., there are no taxes or transaction costs, no asymmetric
information or moral hazard problems).

Suppose that ABC is going to finance the project only with debt. For this type of financing
the bank requires a coupon rate of 15%.

1) What is the share price after the announcement of the debt financing?
The PV of the project’s expected cash flows is:
[(1/3)×1.3 + (1/3)×2.3 + (1/3)×3.3] / (1+15%) = $2 million.
The firm now consists of $1.5 million investment and $0.5 million NPV. The market
value of the equity is now E = V – D = 2 – 1.5 = $0.5 million. Since there are 0.1 million
shares outstanding (with no additional shares issued), the price per share is $0.5 million /
0.1 million shares = $5 per share.

2) What is the debt to value ratio after the financing?

From part 1), we know D = 1.5 and V = 2, so the debt to value ratio is 1.5/2 = 0.75.

3) What are the realizations of the project cash flows next year to the equityholders and to
the debtholders in each state of the economy in this case? [Hint: Note that when the
economy is BAD, the firm cannot repay all the debt.]
State Bad Ok Good
Cash Flow 1.3 2.3 3.3
Debt 1.3 1.5×(1+0.15)=1.725 1.5×(1+0.15)=1.725
Equity 0 2.3 – 1.725 = 0.575 3.3 – 1.725 = 1.575

4) Calculate the actual realized percentage return on investment for the debtholders in each
of the three possible states of the economy next year.
State Bad Ok Good
Debt (1.3–1.5)/1.5=–13.33% (1.725–1.5)/1.5=15% (1.725–1.5)/1.5=15%

5) What is the expected return on debt? Explain why the expected return on the debt differs
from the required coupon rate.
Expected return to debtholders: (1/3)×(–13.33%) + (1/3)×15% + (1/3)×15% = 5.56%
The expected return on the debt is lower than the promised return (15%) because the
debtholders do not expect to get the 15% in the bad states (i.e., when the firm defaults).

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

6. WACC / M&M

Tiger Corp. currently has a debt-to-value ratio (D/V) of 0.35. Their cost of debt (rD) is 8%
and the company’s equity beta is 1.5. The risk-free rate is 5%, and the expected market risk
premium (rM – rf) is 10%. The current market value of the firm (i.e., debt plus equity) is
$100 million, and there are 1 million shares outstanding. Assume all debt is perpetual.
Ignore taxes and all other market frictions.

1) What is the weighted average cost of capital for Tiger Corp.?

rE = rf + β(rM – rf) = 5% + 1.5 × 10% = 20%
WACC = (D/V)rD + (E/V)rE = 0.35 × 8% + (1 – 0.35) × 20% = 15.8%

The CEO suggests that the company needs to increase their debt-to-value ratio to 45% by
issuing bonds and repurchasing shares. As a result of this restructuring, the cost of debt will
rise to 10%.

2) How much additional debt does Tiger need to issue?

Desired D/V = 0.45 = D/100 ⇒ D = 100 × 0.45 = $45 million
Current D/V = 0.35 = D/100 ⇒ D = 100 × 0.35 = $35 million
Need to issue 45 – 35 = $10 million in debt

3) At what price will the shares be repurchased? How many shares will be repurchased?
Since we are ignoring taxes and other market frictions, the financing transaction will have
no impact on firm value and the shares will be repurchased at their current price. The
firm is currently valued at $100 million and is 65% equity, so E = $65 million. With 1
million shares outstanding, the current price per share is $65.
Since they issued $10 million in debt, they will repurchase $10 million / $65 per share =
153,846 shares.

4) What will the company’s WACC be after the restructuring?

We know that in perfect markets financing does not affect the value or risk of the assets,
so the WACC is the same as before, 15.8%.

5) What is the new cost of equity capital?

Using the M&M II formula:
rE = rA + (D/E)×(rA – rD) = 15.8% + (0.45/0.55)×(15.8% – 10%) = 20.55%

6) Are equityholders better off after this financing transaction? Why or why not?
No – their expected return has increased, but this is merely compensation for the greater
risk they bear with higher leverage.

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

7. Equity and Debt Financing in Perfect Markets

Acort Industries owns assets that have an 80% probability of having a market value of $50
million in one year. There is a 20% chance the assets will be worth only $20 million. The
current risk-free rate is 5%, and Acort’s assets have a cost of capital of 10%. Acort operates
in a perfect markets setting.

1) If Acort is unlevered, what is the current market value of its equity?

V = E = [80%×50 + 20%×20] / (1+10%) = $40 million

2) Suppose instead that Acort has some debt outstanding – a zero coupon bond with a face
value of $20 million due in one year.
i. What is the value of Acort’s equity in this case?
D = 20 / (1+5%) = $19.05 million
E = V – D = 40 – 19.05 = $20.95 million

ii. What is the cost of debt (rD)? How do you know?

The assets will be worth $20 million in the worst case scenario, which is enough to
pay off the debt. Therefore, the debt is risk-free, and the cost of debt should be the
risk-free rate (5%).

iii. What is the current market value of the debt?

D = 20 / (1+5%) = $19.05 million

iv. What is the expected return on Acort’s equity with and without the leverage?
rE without leverage = rA = rU = 10%
rE with leverage = rA + (D/E)×(rA – rD) = 10% + (19.05/20.95)×(10% – 5%) = 14.55%

3) What is the lowest possible realized return (in percentage terms) of Acort’s equity with
and without leverage?
Without leverage, the equity is currently worth $40 million and could be worth as little as
$20 million next year. This is a return of –50%.
With leverage, the equity is currently worth $21 million, but could be worth 0 next year.
This would be a return of –100%. We see here the effect of leverage in magnifying the
risk to equityholders, even though the risk of the firm’s assets has not changed.

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FIN 448, Sections 2 & 3, Fall 2020 Advanced Financial Management

8. Equity issuance and EPS

Yerba Industries is an all-equity firm whose stock has a beta of 1.2 and an expected return of
10%. There are currently 1 million shares outstanding and the firm expects to generate
perpetual free cash flow of $5 million.
The firm now decides to issue $10 million in new equity and plans to invest the proceeds in a
risk-free project earning $0.5 million per year. The risk-free rate is 5%.
Assume perfect capital markets.

1) Calculate Yerba’s stock price per share both before and after the new issuance.
Before the new issuance:
V = E = 5 / 10% = $50 million
Share price = $50 million / 1 million shares = $50 per share
After the new issuance:
n × P = 10
(1 + n) × P = 50 + 10 = 60
P + nP = P + 10 = 60
P = $50 per share
n = 10 / P = 10 / 50 = 0.2 million shares

2) Calculate Yerba’s EPS both before and after the new issuance.
Before the new issuance:
Earnings = $5 million
EPS = $5 million / 1 million shares = $5 per share
After the new issuance:
Earnings = 5 +0.5 = $5.5 million
EPS = $5.5 million / (1 + 0.2) million shares = $4.58 per share

3) How can you reconcile your answers to parts 1) and 2)? Why does EPS dilution not lead
to a lower stock price?
The stock price did not change because with a financing transaction, we are simply
exchanging new shares for their equivalent value in cash. The higher total firm value
offsets the greater number of shares across which that value is spread.
To understand why EPS declines while the stock price stays the same, note that the risk
of the firm has declined. The firm is now a portfolio of a safe asset and a risky asset, so
its weighted average cost of capital is now: (50/60)*10% + (10/60)*5% = 9.17%
Lower risk implies a lower expected return, which is reflected in the lower EPS. Since
the cash flows are perpetuities, we can calculate the new share price as EPS/rE = 4.58 /
.092 = $50.

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