Question 2) Hello Ltd is currently an all equity firm with an expected return of 12%. It is considering borrowing money to buy back some of its existing shares, thus, increasing its leverage. Required : a) Suppose Hello Ltd borrows to the point that its debt-equity ratio is 0.50. With this amount of debt, the debt cost of capital is 6%. What will be the expected return of equity be after the transaction? b) Suppose Hello Ltd borrows to the point that debt-equity ratio is 1.50. At this point debt will be much riskier, therefore the cost of debt will be 8%. What is the expected return of equity in this scenario? c) A senior Manager argues that it ios in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument? Question 3 Armstrong Ltd has $10 million in permanent debt outstanding. The firm will pay interest only on debt. The company's marginal tax is at 35% for the foreseeable future. Required: a) Suppose Armstrong pays interest of 6% per year on its debt, what is the annual interest tax shield? b) What is the present value of the interest tax shield, assuming its risk is the same as the loan? c) Suppose instead that the interest rate on the debt is 15%. What is the present value of the interest tax shield fro this case? Question 4 Summit Builders has a market debt-equity ratio of 0.65 and a corporate tax is 40%, and pays 7% interest on its debt. By what amount does the interest tax shield from its debt will lower Summit's WACC? argument?

Answer 2

a) The expected return of equity after the transaction = 15%

b) The expected return of equity in when debt equity is 1.5 = 18%

c) The argument of management that it is in better interest of shareholders may not be true because adding more debt would keep weighted average cost of capital as same and at the same time with Increase in debt there would be Increase in risk to the firm.

Answer 3

a) The annual interest tax shield = $0.21 Million

b) The present value of the interest tax shield = $3.5 Million

c) The present value of the interest tax shield is interest rate is 15% = $3.5 Million

Answer 4

The amount of the interest tax shield from its debt that will lower Summit's WACC = 1.10%

Due to interest tax shield the WACC would reduce by 1.10% as the interest expenses are tax deductible but at the same time it would increase risk to the firm as debts are considered to be risky source of capital.

Step-by-step explanation

Answer 2

a) Cost of Levered Equity = Cost of Unlevered Equity + (Cost of Unlevered Equity - Cost of Debt) * Debt/Equity

Cost of Levered Equity = 12 % + (12% - 6%) * 0.5

Cost of Levered Equity = 15%

So, the expected return of equity after the transaction = 15%

b) Cost of Levered Equity = Cost of Unlevered Equity + (Cost of Unlevered Equity - Cost of Debt) * Debt/Equity

Cost of Levered Equity = 12 % + (12% - 8%) * 1.5

Cost of Levered Equity = 18%

So, the expected return of equity in this scenario = 18%

c) Weighted Average cost of capital(WACC) = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt

WACC when debt Equity is 0 = 100% * 12% + 0*0 = 12%

WACC when debt Equity is 0.5 = 1/(1+0.5) * 15% + 0.5/(1+0.50)*6% = 12%

WACC when debt Equity is 1.5 = 1/(1+1.5) * 18% + 1.5/(1+1.50)*8% = 12%

So the argument of management that it is in better interest of shareholders may not be true because adding more debt would keep weighted average cost of capital as same and at the same time with increase in debt the risk to the firm rises.

Answer 3

a) The annual interest tax shield = Debt * Interest rate * Tax rate

The annual interest tax shield = 10 * 6% * 35% = $0.21 Million

b) The present value of the interest tax shield = Debt * Tax rate

the present value of the interest tax shield = 10 * 35% = $3.5 Million

c) The present value of the interest tax shield in case interest rate is 15%

The present value of the interest tax shield = Debt * Tax rate

The present value of the interest tax shield = 10 * 35% = $3.5 Million

Answer 4

The amount of the interest tax shield from its debt that will lower Summit's WACC = Weight of debt * Tax rate * Interest rate

The amount of the interest tax shield from its debt that will lower Summit's WACC = 0.65/(1+0.65) * 40% * 7%

The amount of the interest tax shield from its debt that will lower Summit's WACC = 1.10%

So, due to interest tax shield the WACC would reduce by 1.10% as the interest expenses are tax deductible but at the same time it would increase risk to the firm as debts are considered to be risky source of capital.