COMM30 - Alejandra Medina

1
Leered Inc. and Unleered Inc. are identical in eery respect except or capital
structure. Both companies expect to earn >150 million in perpetuity, and both distribute all o
their earnings as diidends. Leered`s perpetual debt has a market alue o >300 million and
the required return on its debt is . Leered`s stock sells or >100 per share, and there are 5
million shares outstanding. Unleered has 8 million shares outstanding worth >90 each.
Unleered has no debt. 1hese irms operate in the Modigliani-Miller world with no taxes. low
can you take adantage o this scenario

\e know that in the MM world with no taxes we should hae VL ~ VU . Does this hold

VU ~ >90 8 million ~ >20 million
VL ~ >300 million - >100 5 million ~ >800 million

No! VL VU . Since this iolates MM 1, we know that an arbitrage opportunity exists. 1o take
adantage o it, use the MM intuition as in class notes. lorm two portolios with the same
uture cash lows, one using Leered`s stock ,portolio L, and the other using Unleered`s
stock plus borrowing ,portolio U,. \ou already know that you will hae to buy the portolio
based on the underalued irm ,Unleered,, and ,short, sell the portolio based on the
oeralued irm ,Leered,. 1o do this, we can choose any - we like, say 10.

Buy 10 o the equity o Leered ,500,000 shares,.
Cash lows:
Initial cost: 500,000>100 ~ >50,000,000
luture cash lows: .1|>150,000,000 - 0.0>300,000,000| ~ >12,900,000

buy 10 o the equity o Unleered ,800,000 shares, and borrow 10 o
>300,000,000 at .

Cash lows:
Initial cost: 800,000>90 - 0.1>300,000,000 ~ >42,000,000
luture Cash lows: 0.1>150,000,000 - 0.10.0>300,000,000 ~ >12,900,000

luture cash lows are the same, but U costs less than L. Sell L and buy U!

1his is an arbitrage opportunity!!!

1oday you make a proit or sure o >50,000,000 - >42,000,000 ~ >8,000,000







COMM30 - Alejandra Medina
2
Consider the problem o estimating the cost o equity or Crab Inc., a non-listed
chain o restaurants specializing in crab meals. Crab has a debt-to-equity ratio o 2 and pays an
interest rate o 5 on its debt. Crab`s operations are highly similar to those o the publicly
traded Lobster Inc. and Shrimp Inc., which specialize in lobster meals and shrimp meals,
respectiely. Assume that none o these companies pays taxes. 1he risk ree rate is 2 and the
expected return on the market is 10. Lobster has a debt-to equity ratio o 1, an equity beta o
2, and a cost o debt o 3.6. Shrimp has a debt-to-equity ratio o 1.5, an equity beta o 3, and
a cost o debt o 4.4.

Are the debts o Crab, Lobster, and Shrimp risk ree \hat does this imply or their debt
betas

Lstimate Crab`s cost o equity. Be careul to do it using the inormation you hae
eiciently to aoid approximation errors.

Suppose now that Crab`s debt beta is .35, Lobster`s debt beta is .2 and Shrimp`s debt beta
is .3. Lstimate Crab`s cost o equity using the leering,de-leering ormulas or betas we
deried in class. \ou should get the same answer you obtained in b,.

: I gae you the cost o debt or each irm, the risk ree, and the expected return on the
market. Since the cost o debt must satisy the CAPM equation, you could hae inerred these
debt betas yoursel.

Suppose now that you only know the ollowing inormation. Crab has a debt-to-equity ratio
o 2. Crab`s operations are highly similar to those o the publicly traded Lobster Inc. and
Shrimp Inc., which specialize in lobster meals and shrimp meals, respectiely. None o these
companies pays taxes. 1he risk ree rate is 2 and the expected return on the market is 10.
Lobster has a debt-to equity ratio o 1 and an equity beta o 2. Shrimp has a debt-to-equity
ratio o 1.5 and an equity beta o 3. low would you estimate Crab`s cost o equity using this
inormation Careully explain how you approach and quality o estimates would dier rom
those you did in b, and c,.


COMM30 - Alejandra Medina
3

All companies hae costs o debt that exceed the risk ree rate, so it must be the case that
their debt is risky. Recall that debt betas are zero i debt is risk ree. But since the debt o all
irms is risky, what we know that that both irms will hae positie debt betas.

Since we know that debt is risky or all irms, we should try to aoid making the assumption
that debt is risk ree. 1here are a ew ways to do this.

lirst way:

Recall that MM2: or


\e know Crab`s D,L and rD, so i we can estimate its rU we can get its rL through MM2.

Use CAPM to get Lobster`s rL ~ 2 - 2x,10 - 2, ~ 18
Use MM2 to get Lobster`s rU ~ .5x3.6 - .5x18 ~ 10.8

Use CAPM to get Shrimp`s rL ~ 2 - 3 x,10 - 2, ~ 26
Use MM2 to get Shrimp`s rU ~ .4x26 - .6x4.4 ~ 13.04

Lstimate Crab`s unleered cost o capital as the aerage o the numbers or Lobster and
Shrimp:

Crab`s rU ~ ,10.8 - 13.04, , 2 ~ 11.92

Get Crab`s leered cost o equity using MM2:

Crab`s rL ~ 11.92 - 2x,11.92 - 5, ~ 25.6


Recall that

I you hae an estimate o Crab`s leered equity beta, you can plug it into CAPM to get its cost
o equity. So let`s estimate Crab`s leered equity beta.

Lobster`s unleered beta is U ~ .5 x 2 - .5 x .2 ~ 1.1
Shrimp`s unleered beta is U ~ .4 x 3 - .6 x .3 ~ 1.38

Lstimate Crab`s unleered beta as U ~ ,1.1 - 1.38, , 2 ~ 1.24

Lstimate Crab`s leered beta as L ~ 1.24 - ,1.24 - .35,x2 ~ 2.9

Get Crab`s cost o equity using CAPM ~ 2 - 2.9x,10 - 2, ~ 25.6

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COMM30 - Alejandra Medina

4
1he key here is that we don`t know anything about the risk o debt: we don`t hae each
irm`s cost o debt so we cannot get a eel or how risky it is nor we can estimate debt betas
using CAPM. But it is important or us to know i it is sae to assume that all irms can borrow
at the risk ree rate or equialently that all debt betas are zero. I we know debt is not too risky,
then assuming it is risk ree will gie an approximate but close answer. 1his is what we will do,
but we know our ignorance orces us to make an assumption. \e know we will get an
approximate but not ully accurate answer. But in practice you would try to estimate irm`s cost
o debt or debt betas in some way and then do what we did in b, and c,.

lirst way: assume rD ~ rl

Recall that MM2: or


\e know Crab`s D,L and we assume rD ~ 2, so i we can estimate its rU we can get its rL
through MM2.

Use CAPM to get Lobster`s rL ~ 2 - 2x,10 - 2, ~ 18
Use MM2 to get Lobster`s rU ~ .5x2 - .5x18 ~ 10.0

Use CAPM to get Shrimp`s rL ~ 2 - 3 x,10 - 2, ~ 26
Use MM2 to get Shrimp`s rU ~ .4x26 - .6x2 ~ 11.6

Lstimate Crab`s unleered cost o capital as the aerage o the numbers or Lobster and
Shrimp:

Crab`s rU ~ ,10 - 11.6, , 2 ~ 10.8

Get Crab`s leered cost o equity using MM2:

Crab`s rL ~ 10.8 - 2x,10.8 - 2, ~ 28.4

Second way: assume D ~ 0




I you hae an estimate o Crab`s leered equity beta, you can plug it into CAPM to get its cost
o equity. So let`s estimate Crab`s leered equity beta.

Lobster`s unleered beta is U ~ .5 x 2 ~ 1.0
Shrimp`s unleered beta is U ~ .4 x 3 ~ 1.2

Lstimate Crab`s unleeed beta as U ~ ,1.0 - 1.2, , 2 ~ 1.1

Lstimat Crab`s leered beta as L ~ 1.1 x ,1-2, ~ 3.3

Get Crab`s cost o equity using CAPM ~ 2 - 3.3x,10 - 2, ~ 28.4
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COMM30 - Alejandra Medina
5

Seashell has 100 million shares worth >12 per share and no debt. Its cost o
capital is 10. It has a perpetual ,beore tax, random Cl with mean >200 million and it pays
taxes at a 40 tax rate. Seashell plans a leeraged recapitalization, in which it will issue >600
million in perpetual debt at an interest rate o 5 per year and use the proceeds to repurchase
shares. 1he irm operates in the Modigliani-Miller world with taxes.

\hat are Seashell`s irm alue, cost o equity, and \ACC beore the recapitalization

\hat are Seashell`s irm alue, equity alue, debt alue, cost o equity, and \ACC ater the
recapitalization Compare you results to those in a, and interpret the dierences.

\hat happens with Seashell`s equity alues and share price at the time o the announcement
but beore the recapitalization is executed

low many shares can Seashell repurchase and how many shares outstanding are let ater
the transaction Check that shareholders would be indierent between selling their shares in
the recapitalization and keeping them.


Beore the recap:

VU ~ 100M>12 ~ >1200M ,~>200M,1-.4, , .1,

rL ~ ru ~ r\ACC ~ 10

Ater the recap, and recalling that MM1 should hold:

VL ~ >1200M - .4>600M ~ >1440M ,by MM 1,

D ~ >600M

VL ~ >1440M ~ >600M - LL , and thus LL ~ >840M ,VL ~ D - LL,

rL soles: >840M ~ |>200M - .05>600M|,1-.4, , rL , this gies rL ~ 12.14

or use MM 2: rL ~ 10 - ,600,840,,10 - 5,,1-.4, ~ 12.14


r\ACC ~ ,600,1440,5,1-.4, - ,840,1440,12.14 ~ 8.33

So, eerything holds up as it should in the MM world. Ater the recap, irm alue goes up by
the present alue o the interest tax shields ,MM 1,, the cost o equity goes up ,MM 2,, and
\ACC decreases.

At the time o the announcement shareholders and inestors hear the news and think: \ill
the recap change the alue o my shares \ell, we are in the MM world with taxes, so capital
COMM30 - Alejandra Medina
6
structure matters, that is, irm alue will go up as a result o the recap because we will gain the
alue o the interest tax shields.

At the announcement, the alue o equity goes up to >1440M. Since there are 100M shares, the
share price at the announcement is >1440M , 100M ~ 14.4. \hy Shareholders will capture
the ull beneit o the interest tax shields and would not be willing to sell their shares at any
lower price.

1o see this, suppose the irm was able to repurchase shares at the pre-announcement price o
>12 per share. 1hen, it will buy back >600M,>12 ~ 50M shares and thus the remaining shares
would be 100M - 50M ~ 50M. Since the alue o equity ater the recap is >840M, the share
price ater the recap would be >840M,50M ~ >16.8. A shareholder who sold his shares in the
recap at >12 would be a ool, since had he not sold the shares they would be worth >16.8 ater
the recap. Put dierently, a shareholder who did not sell his shares would earn a capital gain o
>16.8 - >12 ~ >4.8 per share. 1his cannot be! Nobody would want to sell shares at this lower
price. 1he irm must buy the shares at a price such that those shareholders who sell and those
who don`t receie the same alues.

So Seashell raises >600M in debt and can buy back shares at >14.4 a share, so it will buy
back >600M,>14.4 ~ 41,666,666 shares. So ater the transaction there will be 100,000,000 -
41,666,666 ~ 58,333,334 shares let, each worth >14.4, and thus the alue o equity will be
>14.458,333,334 ~ >840M ,consistent with our calculations in b,.

Note that i you sell your shares beore the recap you get a proit o >14.4->12 ~ >2.4, but you
would get the same i you did not because >14.4 is the price that preails ater the recap. Note
also that irm alue goes up by the alue o the tax shields which are equal to .4 x >600M ~
>240M. I you diide by the number o shares beore the recap 100M you get >2.4. 1his is by
how much share prices go up.