Corporate Finance: Capital Structure, WACC, NPV, Dividend and Homemade Leverage

This article discusses topics related to corporate finance such as capital structure, WACC, NPV, dividend, and homemade leverage. It includes explanations, formulas, and computations for each topic.

CORPORATE FINANCE
STUDENT ID:
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Question 2
(a) (i) Since the debt and equity of T. Holding are not traded, hence suitable comparison
ought to be drawn. Out of the two given choices in the form of Good Inc and Bad Inc, the
suitable choice seems to be Bad Inc considering the fact that it is a telecommunications
company unlike Good Inc which is a conglomerate with business interests across different
verticals (Damodaran, 2015).
The cost of equity can be computed using the CAPM approach.
Cost of equity (T Holdings) = Risk free rate + Beta * Market Risk Premium
Risk free rate = 5%, Market risk premium = 15% -5% = 10%, Beta = 1.2 (Bad Inc)
Hence, cost of equity (T Holdings) = 5 + 1.2 *10 = 17% p.a.
Taking the coupon rate of Bad Inc as the pre-tax cost of debt (i.e. 8%), the post-tax debt cost
= 8%(1-0.2) = 6.4% p.a.
Based on the given capital structure of T.Holdings, weight of debt = (3/9) =0.33
Weight of equity = (6/9) = 0.6667
Hence, WACC = 0.33*6.4 + 0.67*17 = 13.5% p.a.
(ii) It is known that the company (T. Holdings) in the near future would raise incremental
equity and would discharge all the outstanding debt, thereby ensuring that 100% equity
funding would be used. In the light of this, using WACC as the discount rate for the proposed
project would not be correct. Instead, the appropriate discount rate to be used must be 17%
which is the cost of equity since complete funding is expected to arise from equity only with
no contribution from debt (Parrino and Kidwell, 2014).
(b) (i) The operating cash flows for the first five years are highlighted below.

Relevant Explanations
1) Variable costs = 0.3* Revenues
2) Depreciation = Upfront investment/Useful life = $600 million/5 = $ 120 million
3) Depreciation is added back later since it is a non-cash charge and has been considered on
account of tax shield that it provides (Petty et. al., 2015).
(ii) The working capital changes during the first five years are indicated as shown below.
Explanation
1) Working capital required in year 1 = 10% of 800 = $ 80 million
2) Working capital required in year 2= 10% of 960 = $ 96 million
Incremental working capital required = 96-80 = $16 million
3) Working capital required in year 3 = 10% of 1152 = $ 115.2 million
Incremental working capital required = 115.2 – 80 -16 = $ 19.2 million
(iii) The NPV computation is indicated below.

Explanation:
After tax salvage value = 300*(1-0.2) = $ 240 million
(iv) The telecommunication project must be accepted since the project NPV has come out to
be positive. This implies that the given project would lead to enhancement of shareholders’
wealth by the same amount as the NPV (Brealey, Myers and Allen, 2014).
Question 3
(a) (i) Total dollar annual dividend Maureen receives based on current capital structure of
the firm
EBIT = EBT= $28,000 (No outstanding debt)
EAT = $28,000 (As no taxes)
It is given that all earning are distributed to the shareholders (5000 shares). Further, Maureen
possess 100 shares and hence, the amount of dividend = (28000/5000)*100 = $560
(ii) Number of shares which are purchased under the planned capital restructuring
Company has decided to issue 150 bonds for $1000 each and hence,

The total issue value of bonds = 150 *1000 = $150,000
One outstanding share value = $60
Company will repurchase = $150,000 /60 = 2500 shares
(iii) Total dollar annual dividend Maureen receives based on planned capital structure of the
firm
Company has equity of 2500 shares with a price of $60 each and debt of 1500 bonds for
$1000 each with an interest of 6%.
Shares (existing) = 5000
Repurchase = 2500
Current = 5000-2500 =2500
EBIT = $28000
Interest = 150,000 *6% =$9000
EBT = EBIT – interest = 28000-9000= $19,000
EAT = $19,000 (As no taxes)
 It is given that all earning are distributed to the shareholders (2500 shares). Further,
Maureen possess 100 shares and hence, the amount of dividend = (19000/2500)*100 =
$760
 If half of the shares are repurchased then Maureen would also hold 50 shares and hence,
the amount of dividend = (19000/2500)*50 = $380
(iv) Maureen’s cash flows from homemade leverage are for the three situations.
 Unlevered firm: Dividend for 100 shares = $560
 Levered firm: Dividend for 100 shares =$760 or $380
 Firm has decided to borrow money at the same rate and hence, the earned interest =
100*60*6% = $360

(v) Considering the fact that there is no tax, MM (Miller & Modigliani) proposition 1 states
that the capital structure would not matter. With regards to WACC, since there is no tax
shield available with issue of debt, hence the WACC would tend to be higher (Damodaran,
2015).
(b) Tax rate = 20%
(i) Total dollar annual dividend Maureen receives based on current capital structure of
the firm
EBIT = EBT= $28,000 (No outstanding debt)
Tax = 20% * 28000 = $56,000
EAT = 28000 – 56000 = $22,400
It is given that all earning are distributed to the shareholders (5000 shares). Further, Maureen
possess 100 shares and hence, the amount of dividend = (22400/5000)*100 = $448
(ii) Number of shares which are purchased under the planned capital restructuring
Company has decided to issue 150 bonds for $1000 each and hence,
The total issue value of bonds = 150 *1000 = $150,000
One outstanding share value = $60
Company will repurchase = $150,000 /60 = 2500 shares
(iii) Total dollar annual dividend Maureen receives based on planned capital structure of the
firm
Company has equity of 2500 shares with a price of $60 each and debt of 1500 bonds for
$1000 each with an interest of 6%.
Shares (existing) = 5000
Repurchase = 2500

Current = 5000-2500 =2500
EBIT = $28000
Interest = 150,000 *6% =$9000
EBT = EBIT – interest = 28000-9000= $19,000
Tax = $19000*20% =$3800
EAT = 19,000 -3800 = $15,200
 It is given that all earning are distributed to the shareholders (2500 shares). Further,
Maureen possess 100 shares and hence, the amount of dividend = (15200/2500)*100 =
$608
 If half of the shares are repurchased then Maureen would also hold 50 shares and hence,
the amount of dividend = (15200/2500)*50 = $304
(iv) Maureen’s cash flows from homemade leverage are for the three situations.
 Unlevered firm: Dividend for 100 shares = $448
 Levered firm: Dividend for 100 shares =$608 or $304
 Firm has decided to borrow money at the same rate and hence, the earned interest =
100*60*6% = $360
(v) As per MM (Miller & Modigliani) proposition with taxes, the capital structure would be
pivotal in this case owing to the interest shield that debt would offer. Further, WACC also in
this case would be lower as compared to no tax case as tax shield would lower the cost
associated with debt (Brealey, Myers and Allen, 2014).

References
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley,
John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley
Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education,
French Forest Australia