Protos Inc Has No Debt Outstanding And A Total Market ✓ Solved

Questions1 Protos Inc Has No Debt Outstanding And A Total Market V

Questions 1. Protos, Inc., has no debt outstanding and a total market value of $300,000. Earnings before interest and taxes, EBIT, are projected to be $25,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will be 50 percent lower.

Money is considering a $100,000 debt issue with an interest rate of 6 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem. a) Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession. b) Repeat part (a) assuming that Protos goes through with recapitalization.

What do you observe? 2. Repeat parts (a) and (b) in Problem 1 assuming Protos has a tax rate of 25 percent. 3.- The company with the common equity accounts shown here has declared a stock dividend of 15 percent when the market value of its stock is $45 per share. What effects on the equity accounts will the distribution of the stock dividend have? 4.- Sangria Corporation has a target capital structure of 65 percent common stock and 35 percent debt.

Its cost of equity is 16 percent, and the cost of debt is 6 percent. The relevant tax rate is 25 percent. What is Sangria's WACC? 5.- Given the following information for Telefonica Co., find the WACC. Assume the company's tax rate is 15 percent.

Debt: 5,000 bonds outstanding, 5 percent coupon, $1,000 par value, 10 years to maturity, selling for 105 percent of par; the bonds make semiannual payments. Common stock: 185,000 shares outstanding, selling for $60 per share; the beta is 1.20. Market: 8 percent market risk premium and 4 percent risk-free rate.

Sample Paper For Above instruction

The financial decision-making processes of firms are critically influenced by their capital structure, which balances debt and equity financing to optimize value and minimize cost. Understanding the implications of leveraging, stock dividends, and weighted average cost of capital (WACC) calculations are essential components in corporate finance. This paper analyzes various scenarios involving these elements to illustrate their impact on firm valuation and shareholder wealth.

Part 1: Impact of Debt and Economic Scenarios on Earnings Per Share (EPS) in Protos, Inc.

Protos, Inc. initially has no debt and a market value of $300,000. Its projected EBIT is $25,000 under normal economic conditions, with potential fluctuations during expansion or recession. The firm’s current share count is 5,000. Under no-debt conditions, EPS is straightforwardly calculated by dividing net income (which equals EBIT, as taxes are ignored here) by the number of shares.

In the normal scenario, EPS equals $25,000 divided by 5,000, resulting in an EPS of $5. During an economic expansion, EBIT increases by 25%, raising EBIT to $31,250, which results in an EPS of $6.25 when divided by identical shares. Conversely, in a recession, EBIT drops by 50% to $12,500, producing an EPS of $2.5. The percentage change in EPS during expansion is 25% increase, and a 50% decrease during recession, illustrating sensitivity to economic shifts.

When the firm considers recapitalization with a $100,000 debt at a 6% interest rate, the analysis becomes more complex. Post-recapitalization, the firm has fixed interest expenses of $6,000 annually, reducing net income but also shifting the financial risk profile. Because taxes are ignored in this scenario, net income equals EBIT minus interest for debt-financed cases.

Under leverage, EBIT remains the same, but net income varies due to interest payments, affecting EPS as the number of shares repurchased increases with debt proceeds. Investors should note the increased risk and potential return consequences associated with leveraging, as the EPS variability tends to magnify during economic fluctuations.

Part 2: Effect of Taxation on Earnings and Capital Structure Decisions

Introducing a tax rate of 25% alters the financial landscape significantly. Tax shield benefits from debt reduce the effective cost of borrowing, thus increasing net income attributable to shareholders. Calculations incorporating taxes show that the interest expense reduces taxable income, yielding tax savings that enhance firm value, as per the Modigliani-Miller theorem with corporate taxes.

For instance, post-tax EBIT becomes EBIT minus taxes, which is EBIT times (1 - tax rate). The EPS calculations are adjusted accordingly, revealing that leverage with tax shields generally increases EPS and firm value, incentivizing firms to utilize debt financing up to an optimal level to balance tax benefits against financial distress costs.

Part 3: Effects of Stock Dividends on Equity Accounts

A stock dividend of 15% increases the number of outstanding shares accordingly, diluting earnings per share but strengthening shareholder equity in a different manner. The total equity remains unchanged in nominal terms, but the composition shifts as retained earnings are redistributed into additional shares. At $45 per share, the stock dividend signals the company's confidence and can influence market perceptions, potentially affecting stock price and investor behavior.

Part 4: Calculating WACC for Sangria Corporation

Sangria’s target capital structure comprises 65% equity and 35% debt. The cost of equity is 16%, and the cost of debt is 6%, with a tax rate of 25%. The WACC is computed by weighting the costs of equity and debt according to their proportion in the capital structure and adjusting the latter for tax deductibility.

Using the formula: WACC = (E/V) Re + (D/V) Rd * (1 - Tc), where E/V = 0.65, D/V = 0.35, Re = 16%, Rd = 6%, and Tc = 25%, the WACC calculates to approximately 12.54%. This blended rate reflects the firm's cost of capital considering its leverage and tax environment.

Part 5: WACC Calculation for Telefonica Co.

The company has $5,000 bonds with semiannual payments, a coupon rate of 5%, and a current market price of 105% of par value. The bonds' yield to maturity (YTM) must be estimated to determine the after-tax cost of debt. With 10 years to maturity, and semiannual coupons, YTM can be derived via the present value formula for bonds.

The equity component includes 185,000 shares at $60 each, with a beta of 1.20, indicating higher systematic risk. Using the Capital Asset Pricing Model (CAPM), the cost of equity is calculated: Re = Rf + Beta Market Risk Premium, which yields Re = 4% + 1.20 8% = 13.60%. The WACC then combines these costs weighted by their capital structure shares, adjusted for the company's tax rate of 15%, resulting in a comprehensive cost of capital reflecting debt and equity contribution.

Conclusion

Overall, the strategic use of debt, dividend policies, and cost of capital calculations are critical in shaping a company's financial strategy, impacting valuation, risk, and shareholder wealth. Companies must balance these elements carefully to maximize value in varying economic and market conditions, leveraging theoretical models like the dividend irrelevance theory, the capital asset pricing model, and the weighted average cost of capital to inform decision-making.

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