Introduction to Corporate Finance

13: Capital Structure

companies of this type is 12.5%, and the corporate tax rate is 40%. There are no taxes on

dividends or interest at the personal level. Slash and Burn calculates that there is a 10% chance

the company will fall into insolvency in any given year and that, if insolvency does occur, it will

impose direct and indirect costs totalling $12 million. If necessary, use the industry required

return for discounting insolvency costs.

a Compute the present value of insolvency costs for Slash and Burn.

b Compute the overall value of the company.

c Recalculate the value of the company, assuming that the company’s shareholders face a 25%

personal tax rate on equity income.

P13-15 Worldwide Contractors currently has no debt, and expects to earn $10 million in EBIT each year
for the foreseeable future. The required return on assets for contractors of this type is 12.5%,
and the corporate tax rate is 40%. There are no taxes on dividends or interest at the personal
level. Worldwide calculates that there is a 10% chance the company will become insolvent in any
given year and that, if insolvency does occur, it will impose direct and indirect costs totalling $12
million. If necessary, use the industry required return for discounting insolvency costs. Assume
that the managers of Worldwide are weighing two capital structure alteration proposals.
Proposal 1: Borrow $20 million at an interest rate of 6% and use the proceeds to repurchase
an equal amount of outstanding shares. With this level of debt, the likelihood
that Worldwide will become insolvent in any given year increases to 15%, and if
insolvency occurs then it will impose direct and indirect costs totalling $12 million.
Proposal 2: Borrow $30 million at an interest rate of 8% and use the proceeds to repurchase
an equal amount of outstanding shares. With this level of debt, the likelihood of
Worldwide becoming insolvent in any given year rises to 25%, and the associated
direct and indirect costs of insolvency, should it occur, increase to $20 million.
For each proposal, calculate both the present value of the interest tax shields and the overall
value of the company, assuming that there are no personal taxes on debt or equity income.

THE PECKING-ORDER THEORY

P13-16 Go to http://finance.yahoo.com and download recent balance sheets for Microsoft, BHP Billiton,
Archer Daniels Midland and Woolworths. Calculate several debt ratios for each company and
comment on the differences that you observe in the use of leverage. What factors do you think
account for these differences?

ADDING VALUE WITH CAPITAL STRUCTURE

Two firms, L and U, are the same in all respects except

capital structure. Firm L is levered and has a total market

value of $400 million (equity is $200 million and debt is

$200 million), and interest on its perpetual bonds is 3%.

Firm U is unlevered and has a total market value of $240

million. Its income before interest is $40 million, and the

corporate tax rate is 36%.

ASSIGNMENT

1 Can costless arbitrage profits be earned in this case?

2 What financial decisions would you take in order to

earn any costless arbitrage profits in this case? (Hint:

the value of the levered company is equal to the

unlevered value plus the value of the tax shield for

perpetual debt, calculated as the tax rate multiplied by

the amount of debt.)

mini case