Determine whether shareholders are better off or worse off with more leverage.
Using the results of problem 2, we calculated the total value per share when firm borrows money to repurchase shares.
From the calculation below, we can see that total market value of equity declined from 10,000 to 6,700, while total value per share rose from $10 to $11.70. Therefore, as the firm borrows and repurchases shares, the total value of equity declined, but the price per share rose.
Assume that all the new debt is used to repurchase shares. Share price = (Total market value of equity + Cash paid out)/
Number of original shares
Based on this assumption change, we will go through all the calculations one more time and estimate the impact of this change across the board.
The table ...view middle of the document...
This calculation is done in the table 5.2. The leveraged beta is utilized to estimate the true weighted average cost of capital (WACC) for various capital structures.
Table 5.2 estimated the cost of equity, leveraged beta, weighted average cost of capital, free cash flow and the value of the assets for various capital structures.
Table 5.2 – Value of Assets for various Capital Structures
Table 5.3 – Value of Levered firm for various Capital Structures
Table 5.3 presents the value of levered firm, which is equal to value of equity (of the value of levered firm’s stocks) plus the value of the firm’s debt for various capital structures.
In the table 5.5 we estimate the value of each share for the levered firm based on the total value of the levered firm and the number of shares outstanding various capital structures.
Table 5.4 – Stock Value of Levered Firm
Table 5.5 summarized all the key figures estimated in the tables above. This table repeats the result of the estimations above and reports the value of operations, value of debt, value of equity, stock price, the number of outstanding shares, net income and earnings per share for different capital structures.
Table 5.5 – Return of a Levered Firm in Various Capital Structures
Notice that price per share and earnings per share are maximized under the same capital structure that minimized the WACC and maximized the value of the firm.
We summarized the results graphically in figure 5.6. Notice that the cost of equity and the cost of debt both increase as debt increases. The WACC initially falls, but the rapidly increasing cost of equity and debt cause WACC to increase when debt financing goes above 50%. The minimum WACC and maximum firm value occur at the same capital structure, which is 50% debt financing. This is the optimal capital structure for this firm.