Coporate Finance Case Study

Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.

The firm has decided to increase the debt finance component portion from 20% to 30% which is a good decision since the interest payments are 100% tax deductible. The appropriate capital structure would be to

What are the advantages of leveraging this company? The disadvantages? How would leveraging up affect the company’s taxes? How would the capital markets react to a decision by the company to increase the use of debt in its capital structure?

The tax rate is estimated from case Exhibit 2 as Income Taxes ($496 million) divided by Earnings Before Taxes, Non-controlling Interest and Goodwill Amortization ($990 million). Note that, in 2001, interest on the company’s total debt is approximately 3.8%: $317 million of interest / $8,361 million of debt. However, this calculation is misleading since the 2000 debt is much larger than the 1999 debt of $2,270 (not in the case). You should ask yourself…should you use current yields or historical yields when calculating the cost of debt? Current yield figures should be used because Telus is considering

Aside from the two aforementioned proposals the company can raise its leverage in other ways. By conducting DuPont analysis and understanding operating leverage we see that purchasing fixed assets and decreasing stockholder’s equity will raise the equity multiplier and the firm’s operating leverage. In this instance we recommend against this approach as the firm already has a large amount of excess cash above what they require to fund new positive NPV projects and purchase new assets. Investors would rather see their capital returned to them in the form of share repurchases and dividends as it is evident by the company’s cash stockpile that they can

* Determine the investment’s value without leverage, VU, by discounting its free cash flows at the

Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.

Furthermore, we choose to use cash as the “plug” for a few reasons. First, the amount of debt Staples holds has been decreasing for the last six years, and the debt-to-equity ratio also has decreased. Meanwhile, as we discussed in the previous Project, Staples tries to maintain its debt-to-equity ratio at a lower level. In this case, we assume that it is not the optimal choice to use debt as the plug, since it will automatically increase the leverage. Second, cash and equivalents owns by Staples is very volatile in the past ten years, so it is not guaranteed that the company will have the ability to pay down more debt if debt is used as the “plug”. Third, as the “plug”, when the company generates more cash, the cash cumulates each year in the

Target Corporation is having a very stable financial policy and dividend policy. From the historical financial data, Target had debt $11,044M, $11,202M, $10,599M, $17,471M, and $19,882M in the year of 2005,2006,2007,2008, and 2009 respectively. The long-term debt/equity ratio rises from 69.34% to 108%.

Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner: BL = BU[1 + (1 − T)D/E], where BU is the firm’s beta without leverage, T is the corporate income tax rate, D is the market value of debt, and E is the market value of equity.

Although the increased leverage decreases the amount of earnings available to stock holders from 496.9 million to 451.7 million for a total of 45.2 million dollars, it has a positive affect for the company’s tax structure. It actually reduces the company’s tax liability by 83 million dollars! Without the debt they have to pay 952.5 million dollars in taxes. However after an increase of 30% leverage, the new tax liability is 869.5 million dollars.

There are two ways of increasing capital, (1) using debt and (2) issuing new shares. For profitable companies sometimes it is cheaper to use debt instead of issuing new shares since cost of debt is tax shielded. In this case company didn’t have any debt in past which means less default risk, it will affect total value in a positive way. It will decrease the taxes paid and increase net income, accordingly share values.

The advantage of debt financing is that interests paid on such debt are tax deductible. If a company has the intention of maintaining a permanent debt, the present value of the tax shield can be obtained by discounting them by the expected rate of return demanded by the investors who hold the debt (this is a perpetuity, where in reality would be the maximum possible present value for the tax shield). This tax shield value reduces the tax bill and increases the cash payment to investors, increasing the value of their investments.

The change in incremental cash flow can be examined through looking at the factors causing change

West Company's cost structure will include a larger proportion of variable costs than East Company's cost structure. A firm's operating leverage factor, at a particular sales volume, is defined as its total contribution margin divided by its net income. Since East Company has proportionately higher fixed costs, it will have a proportionately higher total contribution margin. Therefore, East Company's operating leverage factor will be higher.