; l

(5)
(l'L')l rJ/\'Y\6):
J

ureW ';*n
,/ (r5-r) Air Tampa has just been incorporated, and its board of directors is currently grap-
Business andnnanciatr$ling with the question of optimal capital structurc. The company plar-rsto offer
Risk-MM Mo9l lornmute{ air servicesbetween Tampa and smaller surrounding cities. Jaxair has
'/
becn around for a few years, and it has about the same basic businessrisk as Air
Tagrpa would have. Jaxair's market-determined beta is 1.8, and it has a current
m"ri.,r rralue debt raiio (to:al@)tal assets)tT@and a federal_ql_y!,:-t-!ot"
taxrateof{Qpercent.AirTampa@11yprofi-la}IeaTT1?rtup,
, , ^ , r ' , , /r ( r ? h e n c e i r s r ? x i t E - w o - u l d o n l l b e 2 5 p c r c e n t . ' A i r T a m p a t s o w n e r s e x p e c t t h a t t l r e -
lu)'tv;'l'"u
Va ' \ c / r o t a lb o o k a n d u r a r k e t v a l u e - i * f - i E - J T i f r T s t o c k , i f i t u s c s z e r o d e - b t , w o u l d h e
$10 million. Air Tampa's CFO bclieves that the MM and Hamada foinirilai fbr:
,17 rfialalu.-e of a levered-firm and the levered firm's cost of capital should be used.
These are given in Equations 14-8, 15-1a, and 15-2a.
a. Estimate the beta of an unlevcred firm in the commuter airline businessbased irJ*
on Jaxair's market-deterrnined beta. (l{int: Jaxair's market-deterrnined beta is a
1everagedbeta.UseEquation14-Bandso1veforbu.)---*
b. Ndw-a-$Tme-thar rRF : 10o/oand ry : 75%. Find the required rate of return
,1 orr equity for an unlevered commuter airline. 4t>
rn
| 'r
c. Air Tampa is consideringthree capital structures:(1) $2 million debt, (2) $4 mil- l'tr" 4'
-[gYlo" debi, and (3) $6 million debt. Estimate Air Thmpa's r, for these debt leveis.
,i a. Calculate Air Tampa'{r,'pt $6 millit-rndebt assumingits fcdcral-plus-statetax
tt
*. is now 40 perientYompare this with yo,,,.n.r-.tponding uitt*.t to part ,
c. (I{int: Th-einclga;ein $e 3x 1at5causesVg to drop to $8 million.)
fu5-z)TCompanies U and l.-areidcnticaiin eve.yrerp.ii ""..pt that !J is unleveredylitel
rvrrvr tu*/ hu" $10 million oftdtrercent bonds outstanding. Assume (1) tlrat all of the "1y
wirhout ,,ii
^ ' ^ "rbti1zl
".. h a t there
tthat q r . no
t l r e r e arc n n c ncorporate . personal
^or t e w e q (3)
taxes, t h ; r t EBII
/ 1 . ) that
.// ^^^,,-.*+i^nc
"rffi,rro"r -.)r'l?\ nio.qte net"nnel F,BI'I

is $2 miliion, and (4) that the cost of equity to Company U is 1"0 percent.
'What
a. valuewould MM estimatefor eachfirm?
, b. What is r. for Firm U? For Firm L?
: VL : $20 million' I "
'"'I " c. Find S;, and thenshow that SL+ D
.,
f \

d. \fh,rt is the T(ACC for Firm U? For Firrn L? I ' l'

.,u
e. SupposeVu : $20 million and Vv- : $22 million. According to MM, do i
] C"
1-l

rri'i"* if not,
eouilibrium? lf
renresenran equilibrium?
u"iu", reprlsent explain the process
not. explain orocessby which equili
bv which equ rj""^l

rium would be restorid, Vr.,prvrrng t*;lri.rlo {f! "* 'tt" Jtt{ VUi
(rS-l) Refert,r Problem1.!-2.Assumethat all the factshold, exceptthat bodr fu.ms
MMwithcorporare
orate lJXt to a llu
lgct tO:1 40 percent
pefcent iederal-plus-state corporate r:lx
leGeral-PlU.ri-Sratc {-UfpOIaLc tax rate and that
faLs allu LIIaL lsu calcul
r"g LitrLur4l
raxesrrfrro6l"tn
15-2 is alsothe appropriaterequiredreturn for U when there are ti \\-r'
/ a. Whatvalue would MM now estimatefor eachfirm? (UsePropositionI. t' r '''
,/ --,-. n :-: -! f
'1,:.
/' b. What is r" for Firrn U? Firm L? I
"f
c. Find 51, and then show that 51 D : V; results in the sarnevalue
in p:rrt a. b
0 lr
\11'
/;l/- ,,',
d. lfhat is the VACC for Firm U? For Firm L?
\ r . ,
'l
aat l l f a c t sh o l c l ,c x c c p t t h a r b r l t h c o r -
.,i (rs-+)R ei e r r 6 p r e b i e r n sI - ! 2 a n d - 5 - - 1A. s s u r r r t ' r hboth firms nrust p:ry a l'ederal-plus
[ 4 i l l e r M o C e ! porate ancl pcrsouai taxes apply Assunlethat
srarccr:)f'porate tax rare o{ i,: that invest<lrsin botlr firrns f:rcc a tax
'I:,t- 19Y.",.1nd
r21teOf )B,t/o6r.iciebt incoirF-and'T,.= 2A']:/r, on avefagc,on stock inconre.
Assurnealsrrthat t[c r,1, calculated irl Pr-obiem 1'5-4 is thc appropriatc recluircd
pre-perso!al-tax rate for lJ.
-- Whn, is the vrrlue of the unlevered firtrr, Vr,;i (Note that Vg is tlow reduceclby
".
-
the per:solraitax on stock iircorne,hcnceV1. $tZ million as in Problem 15-3.)
b. Whirt is the valueof Vr-? i2 -Q :1p t"i
(lompare this with the gain
c. \fhat is the gain fr.ll le"eragein tl-rissituation? 'ir ' 'lV
frorrr leverag-c in Problern ]5-3. J < 4 -.( )
d.Set"['.:T"-:T6.-9.what'stlrer'a1rreoftlre.1evere{firnr?T1ren8.rin
'\+ J)-f t t-t
leverige? 2A ,Jc"'*"tt'zY
,': . N o w r u p p . r t . ' f . - ' l a - 0 , T . - 4 l l " l ' . w l r e t a r e t h e v a l u e o l t h r ' l c v t ' r e dh r t n
{1"1 /'46,a,*
andtheglln f.n,,tl."ltrg"i futtv .,}.":"-' +
-= 28"/", l'' 28o/o,anc{/T.: 40"/"' Norv what are the valuc of
[. Asstrrneihat Tu 'y* :
12-"ia-
the leveredfirrn artd the gain from leverage?

{.)(;t*\

VL , Vutt 1t"^
€14-r++" 4
-i9
6 .u't T=rc..-re F
a-
r {2.pY
 ().tt i
- Vr^ t,
l:/
.tI I
, , t 7 l : ' t L t r l t ; . 1 ' t'
i
{:. , ,r.V,
\
' '/ (IA) aboutto cornmence operadonfes an interna-
lsdt"ternational Associates is iust havebookassets
'-^'i^^ol Ascnciereq ll
/
""J;;;i;t."ln-"to t'# il;ill of-$L0 million' andit '
M'.w}ftand However'because
beforeldFs'
withodt expectsto earn a tO p.r.erri t.i"." on theseassets
Taxes
ffi tootgttgovernffi€;G;Il-wil1. not pay any tax€s;
o f certain rax arra ngem.n** h-.rlt raisethe
trying to decide
,rr", ir, ir, tl, ,rr" sirr be zero.Managementis
for an 3!l1q91, i6jm
,.q"iiij bro million, rt ir f.r"*"-rnrr"rft..tpitali'zatlonrate at_11:ne
i. thisbusiness_is ti p.r..ni;-th"t 1u,1u.=1i,96*-Further,IA bo-rro1rcan
rfl5;".;;;tm. th"i theMM assumptions "pflv'.. tt tl,i?,
,.; . D E;-Aiog to MM, what will be the value of IA if it usesno debt?If it uses '') 1'd"'l
n L - Lt b.t- ".
96 million of 6 Percentdebt? of D : $0' D ; $6gril--
b. Vhat are the valuesof'ti."WeCC a1{ ru"atdebt levels
firm value?Phy?
.: , LtlL'[- tP'af iion, ".,d D : $10 *illioii'u;,it"r "ri*iio"s l"u.r"g.-have,on
the problem\ra-:-6"/1'EBIT: $1'6 million'-r'u.l=
r, "c. i;i;;h. iniiiuif;d;f
federal-plus-state corporate tax r4te
!.q /rirlllrrow assumethat a 40 p".c.ttt
rr"lu"i fo, n *itrr r-.io d"bt a'd with $6 millidn of
e*iselFind the new -;;il;; '
debt, usingthe MM formulas' 2i "o
-:'$0'
of tn. WaCC and r" at debt leveis of D D : $5 mil-
; d. What are the values
tax rate?Plot the
il;;;Jil': sio *1ri"", ".;;"-1".*a4b percentcorporare
berween;il;I"-;at-f;. fit-'"ttd the debtratio' andbetween
relationships
capital costs and the debt ratio' What
thatcanbeused?
J"ri"t-"t ounto{ debtfinancing
6;ffioh:iir"li. -""t-"ti cost of ,ht:
A r/
-\ \.w..
y is the vatueof tf,. frrrn ,i ii.tir debtlevel?What is the *!d.. _r^+G^,
u^\
.,.{\', ? in your graph?
as the debt ratioTri-ses'---."
(lf The interestrate on debt inereases
l"',^. L:^t^-- lo.,ol" of
nf !9bt, nrobabilitv of finlncia
the pro!a!1litv3{
.lphr the hnanctalidrstress ttses'
i'i ilht;h;-levels

.l

t i . . b "t ii n - :s ; !()
\
ii 'l
ii\ i' t-'1",
9! .t:,.

.,
'\. "i
?c.,ta

\s
-x
\.
{-,
t i r ' l
V: i"'":]"* 4t
'rn ,*"n' 11. . r-rs'
J 1

j \ t ,
i I r I l - r
' - i -
;'t$ Jli P1* '\L')' l/
,"r1 i
f
,4 rJl
i r'*-#* ;.f,g-,$vrrr.* il {; b r+1
!

r_t
'ifn 'irt'
Jv.t

1t. J
'i-il'..,.--.,,1 i l
fr Li yc,l ii* ..lu rr+ ,
,"t $ , -i,
r . ' ,
,{.r;tl ..6H1
,[,]:t^tVl
''l't i:
"- r' rt' i i '^!
I w. '
t r i 14 '.U , a.,
l-, ^,)'v'' A -.rJ /
',{*,:1
t*r' ,i;*'tt
 '
' ( ' i ' ; " " " 1 i ' ' l "'
t ,t)*'
.I.r';,,|i', , I't,,','i' l,:,n't 1
1r.n{ ; 7,'4i {' \','',,',,. t , , '
, /

I i i - ] 'i , i . . ) . ' n { , ' \ ' . :} :- rJ

,. e4-4)Pertit Printing Company has a total market valuq of $100 rnillion, consistingof .
CapitalStructure
Analysis 1 million sharesselling for $50 pcr shirc and $50 milfiijn of 1f percent perpetual'
bonds now selling at par. The company's EBIT is $11*2_+million,-and its iax-rate is
JJ percent. Pettit-can change its capital structure by eifher incrcasing its debt to'';;i
70 percent (basedo. market valuei) or decreasingit to 30 percent.lf it decides.l,;

'bonds and replace them with nerv 8 percenr coupon l'ronds.'l

he bornpany will
s e l l or
sell o r repurchase
r e p u r c h a s estock
s t o c k at
a t the
t h e new
n e w equilibrium
e q u i l i b r i u m price
o r i c . . to c ormplete,
t o complete_tbe
m n l e r etllfq
l r e ^caprtal
c n n i t a li:
structure change.
The firm pays out all earningsas dividendsl hence,irs stock is a zero growth
-t4
stock. Its current cost of cquity, r., is pcrcent. If it increasesleveragefr* :, !-' f'' c {
16 percent.If it decreases leverage,r,wiil be 13 percent.'Whar is thehrm'sW
and total corporare value under each capital structure? i'
r 'i
(14-5' Beckman
BeckmanEngineering
Ensi and
nd Associates (BEA) is considering a change in itS c
its ca
OptimaiCapitalStructure structure. BEA currently has $20 million iq debt garrxi,g€:a rareof 8 ger"egi
with Hamada
its pr-i-e
stock !s $!0 pir. shlrt with 2 mittionshais 6utit""ai"g. BEAisidj
growth firm and paysout all of its earningsas dividends.EBIT'i"s$1a.933
and BEA facesa 40 percentfederal-plus-siate ta* rate. The ma.rketris!
is 4 perc-ent,
and thc risk free rate is 5 petcent.BEA is conside.rine
i
debt levelto a capitalstrucrurcwith 40 percenrdebq basedon m-ar
repurchasing shares wirh the e*tta tnonej' that it borrows. BEll will hz

tlrc olri dcbt irt order to issuener.l,debt, and the rate on the nerv del-rt
will be 9 pera-^,
e l r r r [. J l : , l\ r i r sr b c r r o f 1 . 0 . t.2.ty..
,1.?1t
a . \ \ ' l r , r ri s B F . A ' st r r r l c v e r e b
d b r a ?u s e r n a r l i c rT . , r l r rDc / s r v h e n u n l e v c r i n g .. ; . 1 r , '
b. wirar a.c llF.{s neiv beia a'd cost of cq(iit1 if ir has 40 perct,nt
debt?
c. \\il1;1 I .rlc lJ.[-.r|s \Y{cc a,lrdr.rnl vnluc t-,frhc {inn with 40 percent debt?
' (r+-d)Llliort.\rhlcr;.,l, tryi,lgt'i1.,'.J"t.r-i,-,c
itsoptirnal.^,k"f'r,?,i.;.,i.$thi"r*
WACC a n d O p t i m a l consiststlfonly clebt and contrrt()ne.quity.The fi.ur does not crrrr.entlyuse preferrecl
C a p i t aSl t r u c t u f e
stock ir.rits capital stluct_ure,and rt does nor plan to do so i" ttt" lri".". To
estinratc
how lxuch its debt wouid cost ar differ,-,r-rt debt levels,ttr.."*p,"ry's treasury staff
has consulted with investmenr bankers and, on the basis "i iii ir.-.iir.urriorri
iru,
createdthe following table:

Market Markei Market

Debt-to-Vai.ue Equityto-Value Debt-to-Equity Before-Tax
Ratio(ur,1) Ratio(w") Ratio(D/S)' BondRating Costof Debt(ra)
0.0 1.0 0.00 A 7.0%
0"2 0.8 a.25 BBB 8.0 , l , t t . j

0.4 0.6 0.67 BB 10.0 ^ t . f ' - )

0.6 0.4 i.50 c 1,2.0 t
0.11 0.7 ! ' ' t
4.00 D 15.0

!.lliott irsesthe CAPM to estirnate iis cost 'f common equir1,,r.. rhe company
rhat rhelislqfrec rate_,k5 percenr,thc market iirk'pr.n.,iu,n is 6'peicent.
:r'rl-:,.t
rr: rrx ratc,js40_qdrcent.Elliort estinratesthat if ir had no detrt,its ''unlevered',
lnd
bcta, b1,,*.o..ld be l.TBased on this information, what is thefirms optimal
capi-
tal sti'rrcrrirc, arrd what would thc weighredr,,.r"g,. cost of ."p;t^i be ar'the op,ini.t
c a p i t a ls t r u c r u r e ?
 ,J-"aq Jr-,*.A-/_-
1111:L-,'u:',I i ,,' ir "; ," i.,,' ,1.,.i- 1 '
I ilr;- . ) n,d- ,.' ;i", il,.t ,' 1,,
i - 1t, :.1-

(s-6)A stock is trading at $80 per share. The stock is eipecii.d to h,rve a year-end divi- 1zp, 1 + 4
ConstantGrowthRate,g dend of $4 per share (D, : 4), ivhich is expected to grow at some constant rare g to
throughout time. The stock's required rate of return is 14 percent. If you are ar1
analyst who believesin efficient markets, what would be your forecast of g? q/.
l,
$-t) You are considering an investnrent in the common stock of Keiller Corp. The stock
,
ConstantGrowth is expected to pay a diviclend of $2 a share ar rhe end of the ycar (D1 : $2.00). l
VaLuation I
Thc stock hrs a beta equal to 0.9. The risk-frce rate is 5.6 pcr<:ent,and thc merl<et i\
\,!'
risk premium is 6 percent.Thc srock'sdividend is expectedto grow ar somc cen- 11"! L t17-
, \\ stant rate g. The stock currently sells for: $25 a shf,frffisslffi@Tfiemarket is in i
equilibrium,u'hat doesthe market believewill be the stocl<price at the end qf I
3 years?(Thatis, what ispj?)
, e, flzt/ P3 , *#B<l
(5-') Assumethat the averagefirrn in your cornpan '/ilqprry i, .*p3.*i io ,.o* ", " 2a.37
supernormal Growthconstant ratc of 6 percent and irs
s t o c k V a l u a t i o n a b o u t a s r i s k y a s t L c " u . r a g . f i r m dividcnd
yicld is 7 percent. )bur
iffiiutifsucce5s?ullycom-
company is
t
to( 't+y's
pleted some R&D work that le;:dsyou to cxpect that its earningsand dividcnds
u,ill grow at a rate of 50 percent [Dr : IJ0(1 + g) : Ds( 1.50)] this year ancl25
percent the following yeaL after which growth shorild match the 6 percent indus-
try averagerate. The last clividend paid (D6) \,{as$t }7hat is the value per share

constant
;j.il:#:,;::il ;.i,;;.,,;;,i"ffi^il;.:-Jr?-?;;;;,,s,ock,ha,
.. .. g',ot Growth paid a dividend of $2 yesierda.rlycru expec tlr* Jirria"rrJ
stock Valuation ;gr;;;-;;;h, ,ut" or
5 pet.-..rtper year ro.'trr" """f 3 ycars,ir.a, iiyo,. uuy the stoc:k,you
plan to 6old
i i i l i l { ! ( r "'a'
itfot3yearsandthent.t,tr.._, 'a g'
, ol? tJre
'$r:-" } ^D" . Vt ?z
Find the.expccted dividendfor each "'^' 3'q'.Tb"ii'"
ncxt yeirs; rhat is, calculateD1, 7t
fr-;nr-"
Jr. ?,,":g,o::N;;;,h;;;;: i,5j ;".\;'V'"' 2 ,1 L a ? . y z
b. Giver
dt,td:,jlT#;:f,!?!i'::.$:;.,H1?i::j"i1ffi;",,,3*J3X1**'j
dividendsffeam;that is, calcuraie.theJV"f Dr, Dzr andb3,
""a iri"" Jrr* ther.
PVs. .5.71 *- b,Zq I :' r .'
c' l'ou exp^ecthe price
9f rhi gtcp\ t )';rJ from now to be $34.73;rhar is, you
expectP3 to equal $34.73. Discountedat a 1.2p.r."tri r*t.,-*h;t
presenr value of this expectedfuture stock price?f" ir tlt.
otlrr, _oia., ."i.irirt" ,n.
PV of $34.73. -: ,,. i i
d. If you plan to buy rhc srock,hord ir 3 years, and
rvhatis the nrostyou shouldpay for {o1
' - therr":^"'
seilit '"-
f'r $34.73,
Xi "
it? ,,i , i":"
e' UseEquation5-2 to calculati die prcsent,r,alue of this stock.Assumethat g :
5%",and it is constanf. , ;-i
f' Is the vaiue of this stock depen.lentt pc-inhorv long you plan
to hold it? In
;'ir:;{TililrIn:l:r/l?tll:lf
:'s,H::i.yf
Li*nT,";iv*?*ir'i"r'"' ' - : - ' : - r - - - . ^ . ' ! ' .j i ' i
- -

(5-16) Investors require a 15 per:centrate of return on Levine Companry'sstock (r, :

constdntcrowth I5%).
stockvaluiltion 'What
a. will be Levine's stock valrre if the previous dividend was Dq : $2 and if
investors expect dividends to grow at a constant cornpound annual rate of
(1) *5 pcrcent, (2) 0 percent, (31 -5percent,and (4) 10 percent?
44 oe b ,,/
i'.if.t
n,u:r**
f""l1?, ii,rr
,.^,* !'?i
^"'jL^?,Trr,
;?J",,t,,"*"#';iLu5u",'*
^;#;xp ,,,,
!_"1'_'.L",'
:'.:n.Iif. g_*q, i'..t t9=4g11;1 i i
s ;;;ff ;l''J ected
X'"i:$""" itf
grorvthrate (l ) 1.5pgrcenr#?t lfuc-rcenE
is -E-<t" trresercas;onabre
-$-rp resurts? q
Explain.
Explain. #':;:;'
c. Is it reasonable to expect
q-r,,,rvnri"ucrio t5 / .;- ;, d.dr;2- 4
*)".7)'2 :"'5
tliat a c'nstant growth stock would have g > r*? No
(16-7) tire Welch Cornpany is consiclcringtluee independer-rt projects,each of which
Residual
Dividendrequires a $5 rnillion investrnent.Thc estirnatell inrernil rare o{ returilTRRRlirli
Policv'""' ' ' projecrs iilrc presented
.,x, ofTapfitl for tl.rese . L(r',";w
below: -td :
{- DFF,v"t 5 ^."ilrJ-' '..
6efY'c? H (high
risl<): = 20% O.a
cost.fcepiral t6Y";tRIl /t,
e r.E o.lu ?|il,*,
FaTlU t FY-i*,iu1*".aiu*'rirt1, a"r,"r*pu", :1,2"/";IRR=10% lO't -'f---
J^O^"' l)rojectL (low risl); cosr of capital: 8"/o;fRR : 9% J .O5 r'
, 0 v,,\tz
"ff that.thcproiecrs'cost-of capitalvarics,becauscrhep.rojccrs haveclifferent y
,':: rotf Not: 4
z lo f ? ^- t levelsof risk. The company'soptimal capital
'Welch structure"alls for 50 percentdebt ' z-8t75
)^ L " 1.t-hnd 50-pcrce,,t.orr,..'o-,,cq,tiry. expectsto hcvc ,r"t irr.o-e ii Si,z-szlbo.
rit / t - ? - z9i5 - If Welch basesits dividendi on the residualmodel,wlrat will its payout iatio-be?* iG-lg
- Ks
0",^J*re ,, t;15;}t;. tir'tr,s,Arrir.,r];,"' ,",,?*!*fc,nr,*?,ri
e;