1. The Norad Inc. currently has debt with market value of $1,000,000 which is the same as its book value. The debt is a perpetual debt with a coupon rate of 6 percent. Company's earnings before interest and taxes (EBIT) are $560,000, and it is a zero-growth company. Norad'scurrent cost of equity is 10% percent, and its tax rate is 40 percent. The firm has 60,000 shares of common stock outstanding selling at a price per share of $50.
a) What is Norad' current total market value and weighted average cost of capital?
b) Noradis considering restructure its capital structure to 40 percent debt and 60 percent equity, based on market values. Norad is planning to use the new funds to replace the old debt and the rest to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 8 percent, while the required rate of return on equity would increase to 12 percent. If this plan were carried out, what would be Norad's new WACC and total value?
c) Now assume that Norad is considering changing from its original capital structureto a new capital structure with 45 percent debt and 55 percent equity. If it makes this change, its resulting market value would be $4,800,000. What would be its new stock price per share?
d) Now assume thatNorad is considering changing from its original capital structure to a new capital structure that results in a stock price of $60 per share. The resulting capital structure would have a $2,400,000 total market value of equity and $2,200,000 market value of debt. How many shares would Norad repurchase in the recapitalization?
2. FaceIt Company has an EBIT of $1,000,000, a growth rate of 8%, and its tax rate is 40%. To support its growth, FaceIt must reinvest 30% of its EBIT in net operating assets. FaceIt has $500,000 in 6% debt outstanding. Similar company with no debt has a cost of equity of 10%.
a. Assuming that MM extension with growth is correct, what are: the value of FaceIt's tax shield; itsunlevered value; and itsvalue of equity?
b. How does MM with taxes differ from trade-off theory of capital structure? Provide the appropriate graphs.
3. Manchuri Inc. expects EBIT of $4,000,000 for the current year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 16 percent, and the company pays a 10 percent rate on its $10,000,000 of long-term debt. One million shares of common stock are outstanding. The company is considering tofinance a project costing $2,000,000, and it will fund this project in accordance with its target capital structure.
a) If the firm follows a residual distribution policy (with all distributions in the form of dividends) and has no other projects, what is its expected dividend payout ratio and the dividend paid out per share?
b) Compare and contrast tax-preference, bird-in-hand, and clientele effect theories of dividend policy.