North Carolina State University Poole College of Management BUS 420 Financial Management of Corporations Capital Structure 1. The Vacation Day Lawn Chair Company (VDLC) is an unleveraged firm with 10m shares outstanding. VDLC is untaxed and faces no financial distress costs. VDLC's annual EBIT has been steady at $48m for many years and is expected to be so in the future. VDLCC pays out all its net income as dividends. VDLC's stock beta is 1.177. The risk-free rate and the market risk premium are 6% and 8.5% per year, respectively. Management is considering a capital restructuring by selling $150m of 6% annual coupon bonds and buying back $150m of shares. Answer the following questions and show your calculations. Potentially useful equations: (assuming EBIT is a level perpetuity) a. What is current cost of equity? V=EBIT/RWACC R WACC = [B/VIRB + [S/V] Rs Bs BA (V/S) BA[1 + (B/S)] Proposition I: V = _V Proposition II: Rs = Ro + (Ro - RB) (B/S) b. What is current weighted average cost of capital? c. What is the current market value of the firm? d. What is the current market value of equity? e. What is the current price of shares? f. What will be the post-restructuring value of the firm? g. What will be the post-restructuring value of equity? h. What will be the post-restructuring share price? i. What will be the post-restructuring cost of equity? Team # j. What will be the post-restructuring WACC? BUS 420- Capital Structure - page 3 2. World Outsourcing Corp. (WOC) is an unleveraged firm with 60m shares outstanding. WOC's marginal income tax rate is 40% per year; its financial distress costs are negligible. WOC has annual EBIT of $109.5m; this annual EBIT is expected into perpetuity. WOC's asset beta is 0.70; the risk-free return is 5% and the market risk premium is 8.5%. WOC's management is considering a capital restructuring in which it would sell $500m in 5% coupon bonds and use the proceeds to buy back shares. Answer the following questions and show your calculations. Potentially useful equations: (assuming EBIT is a level perpetuity) V= EBIT (1 - Tc) / RwAcc R WACC = [B/V] RB (1 - Tc) + [S/V] Rs Bs BA [1 + (B/S)(1-T)] Proposition I: VL = _Vy + TcB Proposition II: Rs = Ro + (Ro - RB) (B/S)(1 - Tc) a. What is unleveraged WOC's cost of equity and its weighted average cost of capital? b. Write down unleveraged WOC's market value balance sheet before announcing the restructuring. What is the price of WOC's shares? C. Team d. Write down WOC's market value balance sheet after the restructuring. Assuming the price of shares stays at the post-announcement level, how many shares are bought back and how many remain outstanding? e. What are WOC's post-restructuring cost of equity and weighted average cost of capital? | Write down WOC's market value balance sheet after it announces the restructuring but before it restructures. What is the price of shares? f. Draw and label Proposition I and Proposition II diagrams for this problem. Label the axes and points corresponding to WOC's pre-restructuring and post-restructuring positions.