Reference no: EM132623699

FINA2222 Corporate Financial Policy - The University of Western Australia

Case Study - Capital Recapitalization HD Inc.

Draft report - an analysis on capital structure and firm value

Capital structure in perfect markets vs. with taxes

In preparing the report, you decide to start from the scenario where the capital markets are perfect. Using Excel spreadsheets, you complete the following:

1. Compute the market debt to equity (D/E) ratio, the cost of equity (rE) and the weighted average cost of capital (WACC) for HD. It is assumed the cost of unlevered equity (rU) is 14.8%.

(Hint: the market value of debt is the sum of Long Term Debt and Short Term Debt/Current Portion of Long Term Debt subtracting Cash and Cash Equivalents from the balance sheet. Use market value of equity.)

2. Repeat the above assuming that market frictions exist, such as corporate tax.

3. Compare results in the above two questions, and use MM theory to explain the effect of capital structure on the equity cost of capital and WACC a) in perfect markets; and b) when corporate tax exists. (No calculation is needed.)

A Levered recapitalization

Next you show Benjamin the impact of the investment banker's share repurchase proposal: the company could raise $10 billion new debt at the current rate of 2.1% to repurchase its own shares.

4. Assuming the firm plans to keep this new debt outstanding forever, calculate the present value of the interest tax shield (ITS) of the new debt.

5. Compute the market value of the equity, the share price, and the number of shares outstanding, at the time of the announcement for the repurchase and after the repurchase is complete, respectively (assume no arbitraging).

6. Use the above analysis to explain whether this repurchase is a good deal. Discuss how this deal has affected the total value of the company.

Payout policy

7. Given that HD currently has an 80% dividend payout policy, you also show the interest income to lenders, and dividend income to shareholders, assuming both types of investors pay personal tax at 40% in each of the following tax environment: 1) the classic tax system; and 2) the imputation tax system. Explain which tax system is preferable theoretically.

The downside of leverage

8. Benjamin also requires you to include a discussion on the possible downside of this deal (leveraged recapitalization) that the executives of HD should be aware of.

Attachment:- Corporate Financial Policy.rar