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Homework Questions for Lecture 5 ~ Taxes QL. Please read the following article: Heard on the Street Philip Morris's Big Holders Press for Buyback, But Many Analysts Doubt It Would Help Stock -- By Eben Shapiro The Wall Street Journal PAGE C2 (Copyright (¢) 1993, Dow Jones & Co., Inc.) NEW YORK -- Large sharcholders are clamoring for Philip Morris to announce a big share-buyback program, which they hope will prompt a rebound in the company's battered stock. Don't bet on the rebound. Even if the share buyback does come to pass, a big bounce back by the stock isn't likely anytime soon. During the past seven months, Philip Morris shares -- once a favorite of growth-stock investors -- have experienced an ignominious plunge. Since September, shares of the tobacco and food giant are off 47%, trading yesterday at 45 5/8 on the New York Stock Exchange. With the stock down sharply, a buyback might seem like a smart move. But Philip Morris is quietly casting doubts on the idea in talks with some Wall Street analysts. It says outright that it won't announce any kind of stepped-up buyback at today's annual shareholder meeting in Richmond, Va. Even if the company relents, some analysts doubt a big buyback would help the stock price that much because Philip Morris has fundamental problems. Some believe the stock may go lower. Philip Morris outperformed the stock market for most of the past decade by virtue of its high profit margin tobacco business and its aggressive price boosts in food and cigarettes. But the days of heady growth seem to be over. Philip Morris “is clearly less attractive now than at any point in the last 10 years," says Gary Langbaum, director of research for Kemper Financial Services in Chicago. Much of Philip Morris's stock-market decline was self-inflicted. The stock tanked by more than 14 points, or 23%, on April 2, when the company announced that it would cut prices on Marlboro cigarettes. The price cut, which is expected to carve $2 billion out of the company's profit this year, was prompted by Marlboro's loss of market share to discount cigarettes.

Analysts say it now makes sense for Philip Morris to borrow a pile of money to buy back shares. The company's cost of short-term funds after taxes is only about 4% -- less than the 5.5% yield it now has to pay on its dividend. Philip Morris could borrow $2 billion, at an annual interest cost of perhaps $80 million, and use it to retire 40 million shares -- wiping out $100 million in yearly dividend payments. Even before the stock plunged on April 2, the company had been furiously scooping up its own shares. In the first quarter alone, the company spent $1.2 billion to buy back 17.3 million shares at an average price of $69 a piece. That doesn't look so smart now, but the next round could be more of a bargain, Philip Morris, which had 883 million shares outstanding as of March 31, has $1.2 billion left to spend from an carlier buyback program. But investors say the company would have to spend at least $2 billion over a 12-month period to have a tangible impact. At the current stock price, $2 billion would buy 41 million shares, equal to 4.6% of its stock. A buyback of that magnitude, combined with Philip Morris's 5.5% dividend yield, could result in a return to shareholders in the next year of about 10%. "That's a pretty nice return,” says Larry Weissman, a portfolio manager for College Retirement Equities Fund, a large holder of Philip Morris shares. Mr. Weissman says he has let Philip Morris know that he views a major share buyback program as the best use of the company's massive cash flow. Mr. Wiessman's hopes are clearly shared by others on Wall Street. Investors have begun loading up on Philip Morris call options in a gamble that a big buyback, or that some other upbeat development, will help the stock. "Speculative optimism in Philip Morris is fairly high, suggesting that traders are looking for a sharp recovery in the stock," says Steve Shobin, a technical analyst at Merrill Lynch & Co. But Ronald Morrow, an analyst with Smith Barney, believes a buyback is unlikely at a time when Philip Morris -- until now one of the most profitable marketers in the world -- is faced with the likelihood of lower earnings over the next four quarters compared with year-earlier results. Many analysts believe the strategy to cut Marlboro prices is flawed, thus obviating the benefits of any possible buyback. A price reduction may only cheapen the value of the brand and permanently lower profit margins, they say. And a jump in the federal cigarette tax also looms. "We feel there's one more shoe to drop,” says Lawrence Adelman of Dean Witter, who recommends that investors sell the stock. The stock price "might go up a couple of points" on a buyback, adds Gary D. Black, an analyst with Sanford C. Bernstein & Co. "But it doesn't change my fundamental outlook." --- Philip Morris (NYSE symbol: MO}

Business: Tobacco and food Year ended Dec. 31, 1992: Revenue: $59.13 billion Net income: $4.94 billion; $5.45 a share First quarter, March 31, 1993: Per-share earnings: $1.38 vs. $1.20 Average daily trading volume: 4,036,117 shares Common shares outstanding: 883 miltion Please answer the following questions based on the above article. You can assume initially: « there are no costs of financial distress « existing Philip Morris debt is riskless + and that t* = 0.21. (a) Suppose that Philip Morris borrows $2.6 billion to buy back stock as suggested in the article. What is the impact of the buyback on Philip Morris' stock price? (b) How many shares would you be able to buy back with $2.6 billion? {c) How would your answer to a) change had I told you that Philip Morris debt is risky? (A qualitative answer is all that it is needed here.) (d) Do you agree with Mr. Wiessman's opinion about the best use of the company's cash flow? Why? Q2. Assume that the real riskless interest rate is zero and the corporate tax rate is 33 percent. IGWT Industries can borrow at the riskless interest rate. It will have an inflation- adjusted EBIT next year of $200 million. It would like to borrow $50 million today. Its only deductions will be interest payments (if any). a. What are its interest payments, taxable income, tax payments, and income left for shareholders in a no-inflation environment? b. Suppose there is inflation of 10 percent per year, but the real interest rate stays at zero, This means that investors now will require a sure payment of $1.10 next year for each $1.00 loaned today. Repeat part a, assuming that EBIT grows with the inflation rate. ¢.In which environment is the inflation -- adjusted income left for shareholders higher? Why? Q3. WYSIWYG Corporation is 100% equity financed. It is expected to earn $10 per share in pretax profit every year in perpetuity. Profits after tax are paid out annually as dividends. There are 1 million shares outstanding. The corporation tax rate is 35%. The required return on WYSIWYG equity (and hence its assets) is 11%. Ignore any taxes paid at the personal level.

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(a) What is WYSIWYG Corporation’s annual net income (net of taxes and interest)? ‘What will be the market capitalization of WYSIWIG's equity and the value of the firm? {b) Now suppose WYSIWYG decides to undertake a leveraged recapitalization by issuing $12 million in perpetual debt at the market expected rate of return for such debt of 7% per year and using the proceeds to buy back shares of equity. Assume that the firm’s operations do not change. What is annual net income now? What is the present value of the tax shield from the interest on WYSIWYG’s debt? () What must be the firm’s total (debt plus equity) market capitalization after the recapitalization? What is the value of the firm’s debt and the value of its equity? What is the net gain to the equity shareholders of the firm? (d) How many shares had to be bought back to accomplish the recapitalization and what is the new share price?