On 30 July 2021, you noted that TPW`s closing share price is $11.95 and shares outstanding is 120,452,928 (obtained from Morningstar DatAnalysis database). TPW`s revenues had grown by approximately 70% and 85% in year 2020 and 2021 respectively, driven by higher customer numbers and more revenue per active customer. While the firm`s online home improvement industry is gaining steady competition from smaller retailers, TPW is growing market share and making larger investments in technology and data, brand awareness and private label products.

You also discussed with Michael the current capital market conditions and decided to focus on the assumption that TPW could borrow $250 million at a credit rating of A with a yield of 1.91% in the current market as of 30 July 2021. Under the proposed leveraged recapitalization, TPW would borrow $250 million and use it either to pay an equivalent dividend or to repurchase an equivalent value of shares. You knew that this combination of actions could affect the firm`s share value, cost of capital, EPS, and some other potential areas. Accordingly, you thought to evaluate the effect of the recapitalization on these areas, which are explained in more detail as follows:

(i)

The impact on valuation and share price You recalled that debt increased the value of a firm by means of shielding cash flows from taxes. Thus, the present value of debt tax shields could be added to the value of the underlying unlevered firm to yield the value of the levered enterprise. The marginal tax rate proposed to use was 30%.

(ii)

The impact on the cost of capital You also knew that the maximum value of the firm was achieved when the weighted average cost of capital (WACC) was minimised. Thus, you intended to estimate what the cost of equity and the WACC might be, if TPW pursued this capital structure change. The projected cost of debt (rD) would depend on the assessment of the firm`s debt rating, A given the current capital market rates.

The cost of equity (rE) could be estimated by using a capital asset pricing model (CAPM). RBA cash rate

target of 0.1% (effective 7 July 2021) would be the risk-free return (rf) and the equity market risk premium

of 7%. TPW`s beta would also need to be re-levered to reflect the projected recapitalisation.

(iii)

The impact on reported earnings per share

You intended to estimate the expected effect on earnings per share (EPS) that would occur at different

levels of operating income (EBIT) with a change in leverage. You planned to draw a graph to illustrate this.

(iv)

Other effects

Lastly, you wondered whether your analysis covered everything. Where, for instance, should you consider

potential costs of bankruptcy and distress or the effects of leverage as the signal about future operations?

More leverage would also create certain constraints and incentives for management. Where should those

be reflected in the analysis?

Analysis structure

As you draft a detailed proposal for the recapitalization, you are guided by the above thoughts to lay out

the following questions for consideration.

Question 1: 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 propositions I and II, and TPW as an example to explain this thoroughly.

Tips:

1. Complete the table in Excel spreadsheet Q1.

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 (7) to (17) using debt = $250 million.