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Individual Assignment

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1. Recapitalization in Perfect Markets

For this problem, ignore taxes, bankruptcy costs and any other market frictions.

Olin Mfg. has assets that will produce total cash flow in one year (and none thereafter) of either $200 million or $260 million, depending on the state of the economy.  Suppose that these outcomes are equally likely.  The firm is currently all-equity financed.  Under their current all-equity financial structure, the expected return on their equity (r_E) is 15%.

Olin is considering changing capital structures by borrowing $50 million and using the proceeds to repurchase equity.  At this level of debt, the interest rate on the debt will be 6%.

After this change in capital structure:

1. What will be the market value of the equity?

• What will be the expected return to equityholders (r_E)?

• What will be the weighted average cost of capital?

Suppose that Olin subsequently decides to increase the debt issuance to $75 mm, still using all the proceeds to repurchase shares.

• As a result of this higher debt level, we expect the weighted average cost of capital to be (circle one):

1. Lower than in part 3)
2. Same as in part 3)
3. Higher than in part 3)

• As a result of this higher debt level, we anticipate the expected return to equityholders (r_E) will be (circle one):

1. Lower than in part 2)
2. Same as in part 2)
3. Higher than in part 2)

• As a result of this higher debt level, we expect the Price/Earnings ratio to be (circle one):

1. Lower than with $50 million in debt
   1. Same as with $50 million in debt
   1. Higher than with $50 million in debt

• Recapitalization with Taxes

Reconsider Olin Mfg. from Problem 1.  Again,

• Assets will produce total cash flow in one year (and none thereafter) of either $200 million or $260 million, depending on the state of the economy.  Suppose that these outcomes are equally likely.
• Currently the firm is all-equity financed with r_E = 15%.  There are currently 10 million shares outstanding.
• The firm is considering changing capital structures by borrowing $50 million and using the proceeds to repurchase equity.  At this level of debt, the interest rate on the debt will be 6%.

Suppose Olin faces a corporate tax rate of 35%.  Ignore personal taxes and assume that Olin plans to keep their debt fixed at the new dollar level perpetually.

1. At what price do you anticipate Olin will repurchase the shares?

• How many shares will they repurchase?

• Tax Shields

You have the following information for Mead Johnson Nutritionals (MJN):

• EBIT = $870 million (for simplicity, assume no depreciation, so EBITDA=EBIT)
• Unlevered cost of capital r_U = 15%
• Corporate tax rate t_c = 30%

1. What would be the total annual after-tax cash flow to all investors (debt and equity) if MJN was an all-equity firm?

• What would be the total annual after-tax cash flow to all investors (debt and equity) if MJN has $1,500 million in debt at a 5% interest rate?

• What is the annual net tax benefit of the $1,500 in debt from part 2)?

• Estimate the present value of the tax shields associated with the $1,500 debt in part 2), under each of the following assumptions:
• There are no personal taxes, the debt will be kept outstanding at a fixed level perpetually, and r_D = 6%.
• There are no personal taxes, the debt will be kept perpetually to maintain a target D/V ratio, and r_D = 10%.  MJN’s asset value is expected to grow at a 2% annual rate.
• Debt will be kept outstanding at a fixed level perpetually, personal tax rate on interest income t_i = 35%, and personal tax rate on equity income (including dividends and capital gains) t_e =15%.

• Debt Capacity for Disney

The following information is for Disney since 2007 (in $million):

Assume corporate tax rate t_c = 35% and ignore personal taxes for this question.

1. From a cash flow perspective, can Disney afford to increase their debt by $10 billion (to a total of $25.1 billion)?  Assume management wants to:

• Allow for EBITDA to fall to the level of 2009 (the most recent recessions).
• Maintain capital expenditures at their average level over the past 3 years.
• Use the proceeds of the new debt issue to repurchase equity shares.

Use the following information on average D/EBITDA and yields by credit rating to figure out the new credit rating and interest rate.  Project the D/EBITDA ratio based on 2014 EBITDA, not the worst-case scenarios (i.e., the 2009 EBITDA).  As the computed D/EBITDA ratio is not going to exactly equal the average D/EBITDA by credit rating, use the credit rating whose ratio is the closest.

• Assuming Disney completed the $10 billion debt issue and share buyback described in part 1), would they still be able to afford to pay dividends at the current level of dividends per share?  The share price at the end of 2014 was $89.03.

[Hint:  You need to first calculate how many shares they will repurchase.  Refer to page 25 of lecture notes for Case #1 on the Swedish Match case.]

• Tax-Bankruptcy Tradeoff for AVX Corporation

AVX Corp. (NYSE: AVX), a leading manufacturer and supplier of electronic components, currently has no debt outstanding and a market value of $2.27 billion.  They are considering changing their capital structure to take advantage of the interest tax shield.  However, the management is concerned about financial distress costs, so they want to evaluate the tax-bankruptcy tradeoff.  AVX’s EBITDA over the last 12 months is $200 million.  You also have the following information on average default rates, average financial ratios, and interest rates by credit rating.  Assume a risk-free rate of 2%.

1. Use the information above to determine how much debt AVX should issue if they want to achieve a credit rating of “A.”  Assume any cash raised by issuing debt will be paid out to equityholders, so that the debt issuance does not affect operating cash flows.

• If AVX targets an “A” credit rating, what is the NET value impact from leverage?  Write down any formulas you use.  Use the following assumptions:

• Debt will be kept at a fixed level and rolled over perpetually.
• AVX will be able to fully utilize interest tax shields each year.
• Corporate tax rate t_c = 35%.
• Personal tax rate on interest income t_i = 35%, and personal tax rate on equity income (including dividends and capital gains) t_e =15%.
• If the firm defaults, they will incur financial distress costs of approximately 15% of firm value (use the current unlevered market value).

• Is AVX better off as an “A” firm or as an unlevered firm?

• Is AVX better off as an “A” firm or a “BBB” firm?

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