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Question 2 ending

0
0.850
5.20%
18.69
%
13.49
%
16.67
%
643,77
3
643,77
3
1.000
16.67
%
0
0.000
6.16%
32.50
%
67.50
%
0.000
%
16.67
%

Levered Beta
Risk free Rate Rf
Return of market Rm
Market risk premium (RmRf)
Cost of equity Re
Market Value of Equity
Market Value of Capital
Equity to Capital Ratio
We*Re
Market Value of Debt
Debt to capital Ratio
Cost of Debt
Tax rate
Tax Shield (1-T)
Rd(1-Tc)*(D/V)
WACC

Debt/Total capital
Actual
10%
20%
643,77 651,10 658,43
3
5
7

Capital (Market Value)


Added Value

Debt/Capital Ratio
10%
20%
30%
0.871
0.892
0.915
5.20% 5.20% 5.20%
18.69
18.69
18.69
%
%
%
13.49
13.49
13.49
%
%
%
16.94
17.24
17.54
%
%
%
628,51 613,25 598,00
6
9
2
651,10 658,43 665,76
5
7
9
0.965
0.931
0.898
16.36
16.05
15.76
%
%
%
22,589 45,178 67,766
0.035
0.069
0.102
6.16% 6.16% 6.16%
32.50
32.50
32.50
%
%
%
67.50
67.50
67.50
%
%
%
0.144
0.285
0.423
%
%
%
16.50
16.34
16.18
%
%
%

7,332

14,664

30%
665,76
9
21,996

As we notice from the above graph, each time we added 10% debt, the market
value increased by 7332 thousand and created new value for the company. Thus,
we can conclude that adding more debt adds value, and this value is the
compensation for the increase in risk the company is bearing. So, we can say that
the increase here is the present value of the tax benefit of the debt added.

Question 3.
A company always seeks a way to try to find its optimal debt structure. Even though
this is not easy and there is always a tradeoff between debt and equity, one might
explore different structure debt scenarios to make up his mind of which one is the
best. In CPK, we have 3 different debt structures 10, 20 and 30%. We have explored
at the end of our last question the importance and value that debt creates and we
need to explore further more debts implications. To start with, even though debt
gives value through a benefit of tax shield it also gives rise to distress costs.
The levered value of a firm under the trade off theory is:
VL= Vu + PV(interest tax shield) PV(Financial Distress Costs).
As stated before we have the present value of interest tax shield calculated we just
need to calculate the present value of financial distress costs and make our
conclusion.
Distress costs can vary between direct and indirect costs. Bankruptcy direct costs
can vary between 3-6% and indirect costs which are much more and cant be
calculated are estimated to up to 30%.

A Market-Based Study of the Cost of


Default
We are going to assume that CPK which has never been rated nor had any debt is
somehow safe even though its share price declined 10% but it maintains a high
growth rate. So we are going to assume 28% of bankruptcy (3% direct and 25%
indirect).

0
Debt
Interest Rate
Interest
Net Income Before Interest/Tax(EBIT)
Interest Coverage Ratio
Debt Rating
Default Rate
Bankruptcy Cost
Vu (Market Value Unlevered)
PV(Financial Distress Cost)

0
6.16%
0.00
30504
28%
643773
-

Debt/Capital Ratio
10%
20%
30%
22589
45178
67766
6.16%
6.16%
6.16%
2782.9
1391.48
4174.39
6
30504
30504
30504
21.92
10.96
7.31
AAA
AA
A
0.01%
0.28%
0.53%
28%
28%
28%
643773 643773 643773
18.03 504.72 955.36

So to calculate the present value of financial distress cost we have first to calculate
the interest coverage ratio by each scenario so we get the Debt
Rating(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/syntra
ting.htm ).Then refer to this debt rating to calculate the percentage of default cost.(
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/apv.htm)
We notice that the present value of financial distress costs increased significantly
from 18.03 thousand to 955.36 thousand between the 10% to 30% rate. So, the
increase is not proportional rather we can see an increase of more than 50 times in
costs, because of the shift and the change in rating as interest coverage ratio
decrease.
After calculating the present value of financial distress costs, we can finally
calculate the value of the leverage firm using all of its components.

Vu (Market Value Unlevered)


Tax Rate
Debt
PV Tax shield Benefit
PV(Financial Distress Cost)
VL
Delta VL

Actual
643773
32.5%

Debt/Total capital
10%
20%
643773
643773
32.5%

22589
0.0

7341.4

32.5%

30%
643773
32.5%

45178

67766

14682.9

22024.0

0.00

18.03

504.72

955.36

643773.00

651132.45

658960.57

666752.31

7359.45

7828.12

7791.74

From the above table, we can clearly see that each debt scenario adds a significant
value to the company, where its value reaches 651132.45 for the 10% scenario to
666752.31 thousand for the 30% scenario.
10% scenario Debt:
This is the safest debt structure. With only 10% debt, the company can enjoy
7341.4 of tax shield benefit and a very low distress cost of 18.03 thousand and
interest of 1391.48 thousand. In addition, the company can still be safe because its
only issuing 22589 thousand and its open line of credit is up to 75 million. In
addition the total added value from no debt structure to 10% debt structure is
7359.45 thousand.
20% Scenario Debt:

This is second safest scenario. With only 20% debt, the company can enjoy 14682.9
thousand of tax shield benefit and a distress costs which jumped to 504.72
thousand and interest of 2782.96 thousand. In addition, the company is somehow
safe because its only issuing 45178 thousand of debt which leave it with 30 million
for the open line of credit. In addition the total added value from 10% debt structure
to 20% debt structure are 7828.12 thousand which is more than double the 10%
addition.
30% scenario debt:
The 30% scenario debt is a little risky. With interest of 4174.39 thousand and 67766
thousand of outstanding debt, the company is left with a little of the open line credit
which makes it risky and needy if anything wrong happens. Even though the
company will benefit from a tax shield benefit of 22024 thousand, the company is
getting less added value from the 20% structure. Delta added value (30%20%)<Delta added value (20%-10%). The company gets a lot of benefits from this
debt scenario but in our opinion it is too risky.
CPK has always been conservative since it went public maintaining no debt, so we
suggest that the 20% debt structure is the best scenario, because it gives us more
benefits of the 10% scenario and less risk than the 30% debt scenario. Thus, it
combines the benefits of both making the companys value increase and maintain
an acceptable level of risk.
To explore more one can also assume different scenarios for EBIT and there effects
on the debt rating and the bankruptcy costs. But, from the given data here it is
sufficient to explore the given scenarios.