10. One side is that Continental was going to go bankrupt because its costs made it
uncompetitive. The bankruptcy filing enabled Continental to restructure and keep flying. The other side is that Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental simply abrogated them to the detriment of its employees. In this, and the last several questions, an important thing to keep in mind is that the bankruptcy code is a creation of law, not economics. A strong argument can always be made that making the best use of the bankruptcy code is no different from, for example, minimizing taxes by making best use of the tax code. Indeed, a strong case can be made that it is the financial manager’s duty to do so. As the case of Continental illustrates, the code can be changed if socially undesirable outcomes are a problem.
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic
1. a. Using M&M Proposition I with taxes, the value of a levered firm is: VL = [EBIT(1 – tC)/R0] + tCB VL = [$850,000(1 – .35)/.14] + .35($1,900,000) VL = $4,611,428.57 b. The CFO may be correct. The value calculated in part a does not include the costs
of any non-marketed claims, such as bankruptcy or agency costs.
2. a. Debt issue: The company needs a cash infusion of $1.2 million. If the company issues debt, the
annual interest payments will be:
Interest = $1,200,000(.08) = $96,000 The cash flow to the owner will be the EBIT minus the interest payments, or: 40 hour week cash flow = $400,000 – 96,000 = $304,000 50 hour week cash flow = $500,000 – 96,000 = $404,000 Equity issue:
If the company issues equity, the company value will increase by the amount of the issue. So, the current owner’s equity interest in the company will decrease to: Tom’s ownership percentage = $2,500,000 / ($2,500,000 + 1,200,000) = .68
b.
So, Tom’s cash flow under an equity issue will be 68 percent of EBIT, or: 40 hour week cash flow = .68($400,000) = $270,270 50 hour week cash flow = .68($500,000) = $337,838
Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more under this form of financing since the payments to bondholders are fixed. Under an equity issue, new investors share proportionally in his hard work, which will reduce his propensity for this additional work.
The direct cost of both issues is the payments made to new investors. The indirect costs to the debt issue include potential bankruptcy and financial distress costs. The indirect costs of an equity issue include shirking and perquisites. The interest payments each year will be: Interest payment = .08($70,000) = $5,600
This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario, the value of equity will be zero since shareholders will never receive a payment. Since the market value of the company’s debt is $70,000, and there is no probability of default, the total value of the company is the market value of debt. This implies the debt to value ratio is 1 (one).
At a 3 percent growth rate, the earnings next year will be: Earnings next year = $5,600(1.03) = $5,768 So, the cash available for shareholders is: Payment to shareholders = $5,768 – 5,600 = $168
Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt. The payments to stockholders will increase at the growth rate of three percent (a growing perpetuity), so the value of these payments today is:
Value of equity = $168 / (.08 – .03) = $3,360.00 And the debt to value ratio now is:
Debt/Value ratio = $70,000 / ($70,000 + 3,360) = 0.954
c.
3.
a.
b.
c.
At a 7 percent growth rate, the earnings next year will be: Earnings next year = $5,600(1.07) = $5,992.00 So, the cash available for shareholders is: Payment to shareholders = $5,992 – 5,600 = $392
Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt. The payments to stockholders will increase at the growth rate of seven percent (a growing perpetuity), so the value of these payments today is:
Value of equity = $392 / (.08 – .07) = $39,200 And the debt to value ratio now is: Debt/Value ratio = $70,000 / ($70,000 + 39,200) = 0.641
4. According to M&M Proposition I with taxes, the value of the levered firm is: VL = VU + tCB VL = $14,500,000 + .35($5,000,000) VL = $16,250,000 We can also calculate the market value of the firm by adding the market value of the
debt and equity. Using this procedure, the total market value of the firm is: V = B + S V = $5,000,000 + 300,000($35) V = $15,500,000 With no nonmarketed claims, such as bankruptcy costs, we would expect the two values
to be the same. The difference is the value of the nonmarketed claims, which are: VT = VM + VN $15,500,000 = $16,250,000 – VN VN = $750,000
5. The president may be correct, but he may also be incorrect. It is true the interest tax
shield is valuable, and adding debt can possibly increase the value of the company. However, if the company’s debt is increased beyond some level, the value of the interest tax shield becomes less than the additional costs from financial distress.
