STUs
Disco Factory Inc. is financed solely by equity and it is considering issuing
debt and using the proceeds to repurchase some of the outstanding shares at the
current market price of $30. There are currently 200,000 shares outstanding.
EBIT is expected to remain at $1.5 million, with all earnings paid out as
dividends. The firm can issue debt at a rate of 8%, and the firm’s tax rate is
40%. Three alternative amounts of debt are being considered:
|
Amount of debt
|
0
|
$1,000,000
|
$2,000,000
|
|
Required return on equity
|
15%
|
15.50%
|
16%
|
Assume
that all stock repurchases will be made at $30 per share. (15 marks)
a.
Using the M&M Proposition I with taxes, calculate the value of the firm at
each debt level.b. What is the optimum amount of debt?
c. Show that, at the optimum capital structure, the firm also minimizes the WACC.
d. Show that, at the optimum capital structure, the firm also maximizes the price of the outstanding shares.
SOLUTION
PREVIEW
a. Using the M&M Proposition
I with taxes, calculate the value of the firm at each debt level.
a. Case 1: All equity
VU = EBIT(1 – T)/ R E
U
= $1,500,000(1 – 0.40)/(0.15) =
$6,000,000
Case 2: Debt =
$1,000,000
VL = VU + TD =
$6,000,000 + (0.40)($1,000,000) = $6,400,000
