Corporate Finance
Solution for Assignment 3
Question 4
Clothex is an all-equity commercial firm with 80 million common shares outstanding and $960 million
stock market capitalization. Clothex plans an equity repurchase, financed with bond issuance, with a tar-
get of achieving a 25% debt-equity ratio. The firm plans to maintain this ratio indefinitely. Assume that
expected free cash flows are constant over time, there are no personal taxes, no bankruptcy costs, and that
the corporate tax rate is 20%. How many shares will they need to repurchase and at what price?
Answer:
The value of the firm after recapitalization is
VL = VU + τDL
where VU is the firm’s unlevered value, and equals the pre-announcement capitalization of the all-equity
firm, $960 million.
Given the firm’s target leverage ratio:
1
DL = .25EL ⇒ DL = VL
5
Therefore:
τ
VL = VU + VL ⇒ VL = 1000
5
and DL = 200.
The stock price before the transaction is announced is 960
80 = 12
1000−200
If n million shares are repurchased, the stock price after the transaction is completed is s = 80−n .
The share repurchase value equals debt issuance, i.e.s × n = 200 which implies
1000 − 200
× n = 200 ⇒ n = 16 million
80 − n
200
and s = 16 = 12.5.
No investor will sell his stock for less than the expected post recapitalization stock price.
Therefore the firm will repurchase 16 million shares at 12.5 per share.
Question 2
Assume a company with constant expected free cash flows to the firm, and constant linear tax rate on
corporate income. The firm can choose to finance with a fixed amount of common equity, perpetual debt
and preferred equity. If the unlevered cost of capital, the cost of debt, the cost of preferred equity and the
expected preferred dividends are all constant, derive the weighted average cost of capital for the firm as a
1
function of the cost of equity, cost of debt and cost of preferred equity.
Answer:
Notation:
Expected free Cash flows to the firm: C
Corporate tax rate: τ
Value of unlevered firm: VU
Value of levered firm: VL
expected preferred dividend: d P
MV of Debt: D, MV of common equity: E, MV of preferred equity: P
Cost of debt: r D , cost of equity r E , cost of preferred equity r P , unlevered cost of capital: r ∗ , WACC:b
r
Then:
C (1− τ )
VU = r∗ and VL = VU + τD.
C (1− τ )
By the definition of WACC: VL = r
b which implies
" #
C (1 − τ ) 1 (C − r D D )(1 − τ ) − d P dP E P D
r=
b = rE + r P + r D D (1 − τ ) = rE + rP + r D (1 − τ )
VL VL rE rP VL VL VL
Question 3
Propel Corporation plans to make a $50 million investment, initially funded completely with debt. The
free cash flows of the investment and Propel’s incremental debt from the project follow
Year 0 1 2 3
Free cash flows -50 40 20 25
Debt 50 30 15 0
Propel’s incremental debt for the project will be paid off according to the predetermined schedule shown.
Propel’s debt cost of capital is 8%, and its tax rate is 40%. Propel also estimates an unlevered cost of capital
for the project of 12%.
i. Use the APV method to determine the levered value of the project at each date and its initial NPV.
ii. Calculate the WACC for this project at each date. How does the WACC change over time? Why?
iii. Compute the project’s NPV using the WACC method.
Answer:
2
Year 0 1 2 3
VU 69.45 37.39 22.32
D 50 30 15 0
interest at 8% 4 2.4 1.2
i. tax shield at 40% 1.6 0.96 0.48
PV(tax shield) 2.69 1.3 0.44
VL 72.14 39.09 22.77
Initial Investment 50
NPV 22.14
ii. We will be using the formula WACC = rU − dτc (r D + ϕ(rU − r D )), where d = D/VL and ϕ =
T s /(τc D ) and T s =PV(Tax shields) since all tax shields are predetermined.
0 1 2 3
D 50 30 15 0
VL 72.14 39.09 22.77
d 69% 77% 66%
Ts 2.69 1.3 0.44
ϕ 13.40% 10.80% 7.40%
WACC 9.63% 9.41% 9.81%
The WACC fluctuates because the leverage ratio of the project changes over time (as does the persis-
tence of the debt)
FCF (t+1)+V (t+1)
L
iii. We will use the recursion VL (t) = 1+WACC (t)
.
Thus:
VL (2) = 25/1.0981 = 22.77
VL (1) = (20 + 22.77)/1.0941 = 39.09
VL (0) = (40 + 39.09)/1.0963 = 72.14
which coincides with the APV calculation.
