Chapter 17
Capital Structure
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remain unlevered forever. If OPC does not retire the debt, the company will use the
$2.5 million in cash to buy back some of its stock on the open market. Repurchasing
stock also has no transaction costs. The company will generate $1,300,000 of annual
earnings before interest and taxes in perpetuity regardless of its capital structure.
The firm immediately pays out all earnings as dividends at the end of each year.
OPC is subject to a corporate tax rate of 35 percent, and the required rate of return
on the firm’s unlevered equity is 20 percent. The personal tax rate on interest income
is 25 percent, and there are no taxes on equity distribution. Assume there are no
bankruptcy costs.
a.
What is the value of OPC if it chooses to retire all of its debt and become an
unlevered firm?
b.
What is the value of OPC if is decides to repurchase stock instead of retiring its
debt?
(
Hint:
Use the equation for the value of a levered firm with personal tax on inter-
est income from the previous problem.)
c.
Assume that expected bankruptcy costs have a present value of $400,000. How
does this influence OPC’s decision?
McKENZIE CORPORATION’S CAPITAL BUDGETING
Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional com-
pany. Sam is considering opening several new restaurants. Sally Thornton, the company’s
CFO, has been put in charge of the capital budgeting analysis. She has examined the
potential for the company’s expansion and determined that the success of the new restau-
rants will depend critically on the state of the economy over the next few years.
McKenzie currently has a bond issue outstanding with a face value of $29 million that
is due in one year. Covenants associated with this bond issue prohibit the issuance of any
additional debt. This restriction means that the expansion will be entirely financed with
equity at a cost of $5.7 million. Sally has summarized her analysis in the following table,
which shows the value of the company in each state of the economy next year, both with
and without expansion:
Economic
Growth Probability
Without
Expansion With Expansion
Low .30 $25,000,000 $27,000,000
Normal .50 30,000,000 37,000,000
High .20 48,000,000 57,000,000
1.
What is the expected value of the company in one year, with and without expansion?
Would the company’s stockholders be better off with or without expansion? Why?
2.
What is the expected value of the company’s debt in one year, with and without the
expansion?
3.
One year from now, how much value creation is expected from the expansion? How
much value is expected for stockholders? Bondholders?
4. If the company announces that it is not expanding, what do you think will happen to
the price of its bonds? What will happen to the price of the bonds if the company does
expand?
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Capital Structure and Dividend Policy
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5.
If the company opts not to expand, what are the implications for the company’s future
borrowing needs? What are the implications if the company does expand?
6. Because of the bond covenant, the expansion would have to be financed with equity.
How would it affect your answer if the expansion were financed with cash on hand
instead of new equity?
Some Useful Formulas of Financial Structure
The Miller Model and the Graduated
Income Tax
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