1.Tax Shield Value

Tom’s Trucking, Inc. (TTI) is currently all-equity financed, with r_E = 10%. They are considering adding $25 million in debt. They anticipate a cost of debt of 5%.

Calculate the present value of the tax shield associated with this debt financing under the following assumptions:

• Debt will be kept outstanding at a fixed level perpetually, t_c = 35%, ignore personal taxes.
• Debt will be kept outstanding perpetually, but TTI will adjust their debt level to maintain their current D/V ratio, t_c= 35%, ignore personal taxes.
• Debt will be kept outstanding at a fixed level for only 10 years, t_c = 35%, ignore personal taxes.
• Debt will be kept outstanding at a fixed level perpetually, t_c = 35%, t_i = 35%, t_e = 15%.
• Debt will be kept outstanding at a fixed level for only 10 years, t_c = 35%, t_i = 35%, t_e = 15%.

2.Tax Adjusted WACC

Tom’s Trucking, Inc. (TTI) currently has a D/V ratio of 10% and is considering increasing it to 30%. At its current capital structure, r_E = 12% and r_D = 5%. For simplicity, assume that r_D will be roughly the same at the new leverage level. TTI faces a corporate tax rate of 35%.

Calculate the after-tax WACC before and after the recapitalization under the following assumptions:

• TTI will adjust their debt level going forward to maintain a 30% D/V ratio.
• After the debt issue, TTI will keep their debt at a fixed level going forward (i.e. it has a fixed level of debt both before and after).

3.Leveraged Recapitalization at Home Depot

Below is an abbreviated balance sheet for Home Depot (numbers in $millions). They currently have 1,507 million shares outstanding at a price of $60 per share.

Management is considering issuing an additional $7 billion in debt and using the proceeds to repurchase shares in the open market. Answer the questions below using the following assumptions:

The new debt will be kept outstanding at a fixed level perpetually.

Home Depot’s effective corporate tax rate in recent years is 36%

• Complete the book value balance sheet below, both before (currently) and after the whole transaction (including debt issuance and share repurchase) is completed.
• Complete the market value balance sheet below, both before (currently) and after the whole transaction (including debt issuance and share repurchase) is completed. Assume the market is not currently aware of the planned recapitalization.
• Calculate the anticipated new share price after the transaction is completed. How many shares will the firm repurchase?

Before: After:

Before: After:

4.Credit Ratings

You have the following information for US Tobacco Co. (UST) in 2004:

UST is currently all equity financed, but is considering issuing $1 billion in debt, using the proceeds to repurchase shares. Estimate the impact on UST’s credit rating (that is, what credit rating UST will have after the whole transaction that includes both debt issuance and share repurchase) based on the following financial ratios:

• EBITDA interest coverage
• EBIT interest coverage
• Debt / EBITDA
• Debt / (Debt + Market capitalization)

Note: You need to use the spreadsheet “Q4_CreditRating_Projections.xlsx” posted on Canvas to find the ranges of financial ratios for each rating. Please also feel free to use this spreadsheet to project UST’s credit rating.