CFA Practice Question

CFA Practice Question

A firm currently has a capital structure that is 100% equity. It is considering a 'capital restructuring' in which it will sell debt for cash, and then use all of the cash thus obtained for repurchasing equity. This will move the capital structure to a mix of debt and equity (rather than the current 100% equity). Debt is tax advantaged at the corporate level. Assume other effects of debt like possibly increased bankruptcy costs are minor. At the personal level for tax purposes there is no difference between treatment of debt and equity. Which of the following is correct?
A. Increasing the amount of debt in a capital restructuring increases the cost of equity.
B. Increasing the amount of debt in a capital restructuring decreases the total value of equity (that is the money received from sale of debt plus new discounted cash flows to equity).
C. Increasing the amount of debt in a capital restructuring increases the discounted value of cash flows to equity, that is discounted value of: EBIT - (cash to old and new debt) - taxes.
Explanation: Total value of the firm increases due to the tax shield. Total value of cash flows to equity does not increase. Total Value of equity increases due to the total of discounted value of cash flows to equity plus money received from selling debt exceeds pre-repurchase discounted value of cash flows to equity. Thus value of equity post-repurchase is greater than value of equity pre-repurchase. That is:

1) 'Cash from sale of debt + New value of discounted equity cash flows' is greater than 'Old value of discounted equity cash flows'
2) New value of discounted equity cash flows lesser than Old value of discounted equity cash flows

User Contributed Comments 3

User Comment
Hamad333_1 I dont get it
sshetty2 yea, i still don't get how this translates into the cost of equity
deleeuw I just assumed added debt would make investors require a larger return
You need to log in first to add your comment.