FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

Practice Problem Set #7

Capital Structure with Taxes and Bankruptcy Costs

– SOLUTION –

1. Tax Shields

You have the following information for Mead Johnson Nutritionals (MJN):
• EBIT = $870 million (for simplicity, assume no depreciation, so EBITDA=EBIT)
• Unlevered cost of capital rU = 15%
• Corporate tax rate τc = 30%
1) What would be the total annual after-tax cash flow to all investors (debt and equity) if
MJN was an all-equity firm?
Total after-tax cash flow: EBIT × (1 – τc) = 870 × (1 – 30%) = $609 million

2) What would be the total annual after-tax cash flow to all investors (debt and equity) if
MJN has $1,500 million in debt at a 5% interest rate?
Cash flow to debt: Interest = D × rD = 1,500 × 5% = $75 million
Cash flow to equity: (EBIT – Interest) × (1 – τc) = (870–75) × (1–30%) = $556.5 million
Total after-tax cash flow: 75 + 556.5 = $631.5 million

3) What is the annual net tax benefit of the $1,500 in debt from part 2)?
Annual net tax benefit = 631.5 – 609 = $22.5 million
Or, annual net tax benefit = interest tax shield = 1,500 × 5% × 30% = $22.5 million

4) Estimate the present value of the tax shields associated with the $1,500 debt in part 2),
under each of the following assumptions:
a) There are no personal taxes, the debt will be kept outstanding at a fixed level
perpetually, and rD = 6%.
PVTS = τc × D = 30% × 1,500 = $450 million

b) There are no personal taxes, the debt will be kept perpetually to maintain a target D/V
ratio, and rD = 10%. MJN’s asset value is expected to grow at a 2% annual rate.
PVTS = τc × D × rD / (rU – g) = 30% × 1,500 × 10% / (15% - 2%) = $346.15 million

c) Debt will be kept outstanding at a fixed level perpetually, personal tax rate on interest
income τi = 35%, and personal tax rate on equity income (including dividends and
capital gains) τe =15%.
PVTS = D × τ* = D × [1 – (1 – τc)(1 – τe)/ (1 – τi)]
= 1,500 × [1 – (1 – 30%)(1 – 15%)/ (1 – 35%)] = $126.92 million

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

2. Recapitalization with Taxes

McDos Inc. is a leading supplier of operating systems. The company has 100 million shares
outstanding. The share price is currently $25. The debt structure is a reasonably complicated
set of lending agreements and bonds outstanding. Here is a summary:

Debt Terms Market Value ($ millions)

Bank Debt (Union Bank) Prime rate 455
Credit Facility (10 Banks) Libor rate 363
$100 million – 30 year debenture 9% coupon 123
$250 million – 15 year debenture 7% coupon 259
Total Market Value 1,200

The CFO of McDos, Mrs. Bit, has decided to review the capital structure of McDos. She
feels that the company should have a D/V ratio of 10%.
The company’s marginal tax rate is 35%, and you can ignore personal taxes.

1) What is the current D/V ratio?

E = $25 per share × 100 million shares = $2.5 billion
D = $1.2 billion
D/VL = 1.2 / (1.2 + 2.5) = 32.4%

2) How much debt should McDos retire?

VU = VL – D × τC = 3.7 – 1.2 × 35% = $3.28 billion
Under the proposed structure, D = 0.1×VL. Then,
VL = VU + D × τC = 3.28 + (0.1×VL) × 35% = 3.28 + 0.035 ×VL
⇒ VL = $3.40 billion
D = $0.34 billion
Amount of debt to retire = 1.2 – 0.34 = $0.86 billion

3) Suppose the firm decides to issue equity in order to retire this debt. Show the effect of
the recapitalization on the share price and the number of shares outstanding.
n × P = 0.86
E = VL – D = 3.4 – 0.34 = 3.06 = (0.1 + n) × P = 0.1P + 0.86
P = (3.06 – 0.86)/0.1 = $22 per share
n = $0.86 billion / $22 per share = 39 million shares
The recapitalization causes (i) the share price to fall by $3 due to the drop in the interest
tax shield value and (ii) the number of shares outstanding to increase by 39 million shares
(through equity issuance).

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

3. Tax Shield & Equity/Debt Financing

FarmPharm is a veterinary biotech startup whose only asset is a patent to a new drug. The
company has 10 million shares outstanding, and it wishes to raise $130 million in order to
conduct clinical trials, produce, and sell the drug. Once the investment is made, the expected
after-tax cash flows will depend on the success of the clinical trials and are estimated as
follows:
Success Level
Failure Success
Probability 10% 90%
EBIT 0 285.7
Taxes 0 85.7
Net Income ($ millions) 0 200.0
Assume these are one-time cash flows that will occur in exactly one year.
An analysis of comparable firms indicates that if the project is all-equity financed, the
company will have an estimated cost of equity of 25%.
FarmPharm’s marginal tax rate is 30%.

1) Assume that the market knows about the patent and believes the management’s expected
cash flow forecasts. What is the price per share before any financing is raised?
There are no assets in place other than the patent, so the market value of the firm before
the financing is raised is just the NPV of the growth opportunity that results from owning
the patent:
NPV = (10%×0 + 90%×200)/(1 + 25%) – 130 = $14 million
P = $14 million / 10 million shares = $1.40 per share

2) Assume the project will be financed with equity and there are no transaction costs. After
the financing is raised, what will be the value of the firm? What will be the new share
price? How many shares will they have to issue?
n × P = 130
Firm Value = V = 14 + 130 = $144 million
V = (10 + n) × P = 10P + 130
⇒ P = (144 – 130)/10 = $1.40 per share
n = 130/1.40 = 92.86 million shares

3) Suppose instead the firm decides to fund the project partially using a $50 million debt
issue. The debt will have the following features:
- One-year bond with a stated interest rate of 20%.
- Privately placed with no direct issuance costs.
- Ignore financial distress costs (i.e., we allow for default, but there is no additional
deadweight value loss in the event of bankruptcy).

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

i. Complete the table below for the projected cash flows from the investment next year
to investors under this debt financing scenario:
Success Level
Failure Success
Probability 10% 90%
EBIT 0 285.7
Interest 0 10
Taxes 0 82.7
Net Income ($ millions) 0 193

Total Cash Flows to

Investors:
Debt 0 60
Equity 0 143

ii. What is the cost of debt (i.e., expected yield)?

Expected cash flow to debtholders = 90% × 60 = $54 million
D = 50 = 54/(1 + rD) ⇒ rD = 54/50 – 1 = 8%

iii. What is the expected interest tax shield from debt financing next year?
In case of success, they pay 50×20% = $10 million in interest, which reduces taxes
paid by 10×τc. In case of failure, they pay no interest or taxes, so there is no tax
shield. Therefore, the expected interest tax shield is 90%×10×30% = $2.7 million.

iv. Calculate the present value of the expected interest tax shield.
PV(E[tax shield]) = 2.7/(1+8%) = $2.5 million

v. Assuming the firm issues equity to fund the remaining $80 million required for the
investment, at what price will the new equity be issued?
VL = VU + PV(E[tax shield]) = 144 + 2.5 = $146.5 million
n × P = 80
E = VL – D = 146.5 – 50 = 96.5 = (10 + n) × P = 10P + 80
P = (96.5 – 80)/10 = $1.65 per share
n = 80/1.65 = 48.48 million new shares

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

4. Bankruptcy Costs

Company X has the following capital structure:

Equity 100 million shares outstanding
Debt Two zero-coupon bonds maturing in one year with the following face values
• Senior: $500 million
• Subordinated: $300 million
The company operates for one year. The cash flows of firm X at the end of the year are:
• $900 million in state BEST
• $500 million in state OK
• $100 million in state BAD
All outcomes are equally likely. There is no additional asset liquidation value at the end of
the year.
The cash flows at the end of the year are distributed among X’s claimants. However, if there
are not enough cash flows to meet the debt obligations at the end of the year, the firm will go
bankrupt and 20% of its cash flows will go to lawyers, i.e., only 80% of the cash flows will
be left to distribute among its claimants. Ignore taxes.

For simplicity, you can assume that discount rates are zero, i.e., rD = 0 and rE=0.

1) What is the value of company X (debt + equity)?

Since the discount rate is zero, the value of the company equals its expected future cash
flows net of bankruptcy costs:
(1/3)×(900) + (1/3)×(500×80%)+(1/3)×(100×80%) = $460 million

2) What is the expected cost of bankruptcy?

The expected cost of bankruptcy is:
(1/3)×(0) + (1/3)×(500×20%)+(1/3)×(100×20%) = $40 million

3) What are the cash flows in each state of the economy next year for each class of investor
(senior bondholders, subordinated bondholders, and equityholders)? Assume priority
rules are strictly adhered to in case of bankruptcy.
Best OK Bad
Total cash flow 900 500 100
Bankruptcy costs 0 100 20
Available for investors 900 400 80

Senior debt 500 400 80

Subordinated debt 300 0 0
Equity 100 0 0

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

4) What is the current market value of each bond and the price per share of the equity?
Again, since rD = 0 and rE=0, market value equals expected cash flows next year:
Senior debt = (1/3)×(500) + (1/3)×(400)+(1/3)×(80) = $326.67 million
Subordinated debt = (1/3)×(300) + (1/3)×(0)+(1/3)×(0) = $100 million
Equity = (1/3)×(100) + (1/3)×(0)+(1/3)×(0) = $33.33 million
With 100 million shares outstanding, the share price is 33.33 / 100 = $0.33 per share.

5) What are the promised yields (YTM based on current market prices) on the two bonds?
Promised yield = (Promised payment / market value) – 1
Senior debt promised yield = 500 / 326.67 – 1 = 53.1%
Subordinated debt promised yield = 300 / 100 – 1 = 200%

5. Optimal Debt Level with Taxes and Bankruptcy Costs

Nadir, Inc., an unlevered firm with a high level of taxable income. Nadir’s tax rate is 40%
(ignore personal taxes) and the market value of its equity is $12 million.
Management is considering the use of debt. The risk-free rate is estimated at 5%. The
proceeds of the debt issue would be used to pay a one-time special dividend and the debt
would be kept at a constant level for the foreseeable future. The firm’s analysts have
estimated that if the firm was to default and enter bankruptcy, it would incur distress costs of
$8 million, and that the probability of default will increase with leverage according to the
following schedule:

Annual Default
Value of Debt Probability
$2.5 million 0%
$5.0 million 0.5%
$8.0 million 1%
$9.0 million 2%
$10.0 million 4%

1) What is the optimal level of debt?

We know that VL = VU + PV(E[tax shield]) – PV(E[bankruptcy cost]). Thus, we want to
find the level of debt that maximizes PV(E[tax shield]) – PV(E[bankruptcy cost]).
With a fixed level of debt and ignoring personal taxes, we estimate PV(E[bankruptcy
cost]) = D × τC.
𝑝𝑝∗𝑐𝑐 𝑝𝑝∗8
Given that realized distress costs = $8 million, PV(E[bankruptcy cost]) = 𝑝𝑝+𝑟𝑟 = 𝑝𝑝+5%.
𝑓𝑓

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FIN 448, Sections 1 & 2, Spring 2019 Advanced Financial Management

The following table shows the net gain of leverage for the various proposed debt levels:
Value Probability PV(tax PV(bankruptcy Gain to
of Debt of Default shield) cost) Leverage
$2.5 million 0% 1 0 1
$5.0 million 0.50% 2 0.73 1.27
$8.0 million 1% 3.2 1.33 1.87
$9.0 million 2% 3.6 2.29 1.31
$10.0 million 4% 4 3.56 0.44
The optimal level of debt is therefore $8 million.

2) What will be the value of the firm at this optimal capital structure?
The value of the firm with $8 million of debt is:
VL = VU + PV(E[tax shield]) – PV(E[bankruptcy cost])
= 12 + 3.2 – 1.33 = $13.87 million