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Changes in Capital Structure

Look again at our calculation of Big Oil`s WACC. Suppose Big Oil is excused from paying taxes. How would its WACC change? Now suppose Big Oil makes a large stock issue and uses the proceeds to pay off all its debt. How would the cost of equity change?

20. Changes in Capital Structure. Refer again to problem 19. Suppose Big Oil starts from the financing mix in Table 4.13, and then borrows an additional $200 million from the bank. It then pays out a special $200 million dividend, leaving its assets and operations unchanged. What happens to Big Oil`s WACC, still assuming it pays no taxes? What happens to the cost of equity?

21. WACC and Taxes. БІАААмThe after-tax cost of debt is lower when the firm`s tax rate is higher; therefore, the WACC falls when the tax rate rises. Thus, with a lower discount rate, the firm must be worth more if its tax rate is higher.БІАААн Explain why this argument is wrong.

22. Cost of Capital. An analyst at Dawn Chemical notes that its cost of debt is far below that of equity. He concludes that it is important for the firm to maintain the ability to increase its borrowing because if it cannot borrow, it will be forced to use more expensive equity to finance some projects. This might lead it to reject some projects that would have seemed attractive if evaluated at the lower cost of debt. Comment on this reasoning.

2 Burg`s 6 million shares are now worth only 6 million АГАз $4 = $24 million. The debt is selling for 80 percent of book, or $20 million. The market value balance sheet is:

3 Compare the two income statements, one for Criss-cross Industries and the other for a firm with identical EBIT but no debt in its capital structure. (All figures in millions.) Notice that Criss-cross pays $.7 million less in taxes than its debt-free counterpart. Accordingly,the total income available to debt plus equity holders is $.7 million higher. 4 For Hot Rocks,

5 WACC measures the expected rate of return demanded by debt and equity investors in the firm (plus a tax adjustment capturing the tax- deductibility of interest payments). Thus the calculation must be based on what investors are actually paying for the firm`s debt and equity securities. In other words, it must be based on market values. 6 From the CAPM:

7 Jo Ann`s boss is wrong. The ability to borrow at 8 percent does not mean that the cost of capital is 8 percent. This analysis ignores the side effects of the borrowing, for example, that at the higher indebtedness of the firm the equity will be riskier, and therefore the equity holders will demand a higher rate of return on their investment.

Bernice Mountaindog was glad to be back at Sea Shore Salt. Employees were treated well. When she had asked a year ago for a leave of absence to complete her degree in finance, top management promptly agreed. When she returned with an honors degree, she was promoted from administrative assistant (she had been secretary to Joe-Bob Brinepool, the president) to treasury analyst.

Bernice thought the company`s prospects were good. Sure, table salt was a mature business, but Sea Shore Salt had grown steadily at the expense of its less well-known competitors. The company`s brand name was an important advantage, despite the difficulty most customers had in pronouncing it rapidly. Bernice started work on January 2, 2000. The first two weeks went smoothly. Then Mr. Brinepool`s cost of capital memo assigned her to explain Sea Shore Salt`s weighted-average cost of capital to other managers. The memo came as a surprise to Bernice, so she stayed late to prepare for the questions that would surely come the next day.

Bernice first examined Sea Shore Salt`s most recent balance sheet, summarized in Table 4.14. Then she jotted down the following additional points:

The company`s bank charged interest at current market rates, and the long-term debt had just been issued. Book and market values could not differ by much.

But the preferred stock had been issued 35 years ago, when interest rates were much lower. The preferred stock was now trading for only $70 per share.

The common stock traded for $40 per share. Next year`s earnings per share would be about $4.00 and dividends per share probably $2.00. Sea Shore Salt had traditionally paid out 50 percent of earnings as dividends and plowed back the rest.

Earnings and dividends had grown steadily at 6 to 7 percent per year, in line with the company`s sustainable growth rate:

Sustainable = return АГАз plowback growth rate on equity ratio = 4.00/30 АГАз .5 = .067, or 6.7%

Sea Shore Salt`s beta had averaged about .5, which made sense, Bernice thought, for a stable, steady-growth business. She made a quick cost of equity calculation using the capital asset pricing model (CAPM). With current interest rates of about 7 percent, and a market risk premium of 8 percent,

CAPM cost of equity = rE = rf + АГАІ(rm rf) = 7% + .5(8%) = 11%

This cost of equity was significantly less than the 16 percent decreed in Mr. Brinepool`s memo. Bernice scanned her notes apprehensively. What if Mr. Brinepool`s cost of equity was wrong?

Was there some other way to estimate the cost of equity as a check on the CAPM calculation? Could there be other errors in his calculations?

Bernice resolved to complete her analysis that night. If necessary, she would try to speak with Mr. Brinepool when he arrived at his office the next morning. Her job was not just finding the right number. She also had to figure out how to explain it all to Mr. Brinepool.