Question 1 (Q1) The basic theory of capital structure

In perfect capital markets, what is the relationship between capital structure and cost of capital

(WACC)? Use the famous Miller-Modigliani proposition I and II, and WWJ as an example to

explain this thoroughly.

Tips:

1. Complete the table in Excel spreadsheet Q1 Perfect Mkt.

2. Draw a chart using debt level (D) against rE and WACC to support the discussion of MM

proposition I and II. (Paste the chart in appendix.)

3. Show your calculations for each variable in row (6) to (15) using debt = $3 billion.

FINA2222 2022 Sem 2 Joey Yang 4

Question 2 (Q2) Impact of leverage on valuation and share price

To test the valuation effect of leverage, you assume that WWJ could borrow a maximum of $3

billion at a pre-tax cost of debt based on the firms AAA credit rating, and that the aggregate

amount of debt will remain constant in perpetuity. Also, you assume that the proceeds of the

loan would be used to repurchase shares or be paid as a special dividend to shareholders.

What is the amount of tax benefit, i.e., the present value of interest tax shields? How does

WWJs value and price per share change in the four-stage process, namely pre-recapitalization

(or initial), at the announcement of debt, when debt is issued, and after the fund is spent on (1)

repurchasing shares, or (2) paying a lumpsum of special dividend?

Tips:

1. Complete tables a and b under Q2 in Excel spreadsheet Q2 Valuation & Q3 WACC.

2. Show workings.

This imput table supports the analysis of the case on WWJ company: Capital Structure, Valuation, and Cost of Capital All values are in milions except for share price and percentages All values are in millions except for share price and percentages a. Interest tax shieid New debt (in million $ s) PV(Int Tax Shiolds) in million \$s b. Effect of additional debt on the value of WWJ and price per share Consolidated Balance Sheet 11.S. Traseuru vinld raspus This imput table supports the analysis of the case on WWJ company: Capital Structure, Valuation, and Cost of Capital All values are in milions except for share price and percentages All values are in millions except for share price and percentages a. Interest tax shieid New debt (in million $ s) PV(Int Tax Shiolds) in million \$s b. Effect of additional debt on the value of WWJ and price per share Consolidated Balance Sheet 11.S. Traseuru vinld raspus