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Exam 16: Capital Structure Decisions

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Question 21

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Laramie Trucking's CEO is considering a change to the company's capital structure,which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt,but the CEO is reluctant to increase the debt ratio.The risk-free rate,r_RF,is 5.0%,the market risk premium,RP_M,is 6.0%,and the firm's tax rate is 40%.Currently,the cost of equity,r_s,is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

A) 10.95%
B) 11.91%
C) 12.94%
D) 14.07%
E) 15.29%

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Question 22

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Blueline Publishers is considering a recapitalization plan.It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock.The recapitalization would not change the company's total assets,nor would it affect the firm's basic earning power,which is currently 15%.The CFO believes that this recapitalization would reduce the WACC and increase stock price.Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

A) The company's earnings per share would decline.
B) The company's cost of equity would increase.
C) The company's ROA would increase.
D) The company's ROE would decline.
E) The company's net income would increase.

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Question 23

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Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now,Cartwright has a capital structure that consists of 20% debt and 80% equity,based on market values.(Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium,r_M − r_RF,is 5%.Currently the company's cost of equity,which is based on the CAPM,is 12% and its tax rate is 40%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Hernandez Corporation expects to have the following data during the coming year.What is Hernandez's expected ROE? $\begin{array} { l c } \text { Assets } & \$ 200,000 \text { Interest rate } &8\%\\\mathrm { D } / \mathrm { A } & 65 \% \text { Tax rate }&\%40 \\\text { EB IT } & \$ 25,000\end{array}$

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt?HD has more debt and pays a higher interest rate on that debt.Based on the data given below,what is the difference between the two firms' ROEs? $\text {Applicable to Both Firms}$ $\quad$ $\quad$$\text {Firm HD's Data}$$\quad$$\text {Firm LD's Data}$ $\begin{array}{lcl}\text { Assets } & \$ 200 D \text { Debtratio } & 50 \% \text { Debt ratio }&30\% \\\text { EBIT } & \$ 40 \text { Interest rate } & 12 \% \text { Interest rate } &10\%\\\text { Tax rate } & 35 \% &\end{array}$

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Exhibit 16.2 VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. $\begin{array} { l c } \text { EBIT } = & \$ 80,000 \mathrm { New } \text { Debt } / \text { Value } =&20\% \\\text { Growth } = & 0 \% \text { New Equity/Value } =&80\% \\\text { Orig cost of equity, } r _ { s } = & 10.0 \% \text { No. of shares } =&10,000 \\\text { New cost of equity } = r _ { s } = & 11.0 \% \text { Price per share } =&\$48.00 \\\text { Tax rate } = & 40 \% \text { Interest rate } = r _ { d } =&7.0\%\end{array}$ -Refer to Exhibit 16.2.If this plan were carried out,what would be VF's new WACC and its new value of operations? WACC Value a. $9.64 \% \quad \$ 497,925$ b. $9.83 \% \quad \$ 507,884$ c. $10.03 \% \quad \$ 518,041$ d. $10.23 \% \quad \$ 528,402$ e. $10.74 \% \quad \$ 538,970$

Which of the following statements is CORRECT?

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage,other things held constant.

Provided a firm does not use an extreme amount of debt,financial leverage typically affects both EPS and EBIT,while operating leverage only affects EBIT.

An all-equity firm with 200,000 shares outstanding,Antwerther Inc.,has $2,000,000 of EBIT,which is expected to remain constant in the future.The company pays out all of its earnings,so earnings per share (EPS) equal dividends per shares (DPS) .Its tax rate is 40%. The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock.The risk-free rate is 6.5%,the market risk premium is 5.0%,and the beta is currently 0.90,but the CFO believes beta would rise to 1.10 if the recapitalization occurs. Assuming that the shares can be repurchased at the price that existed prior to the recapitalization,what would the price be following the recapitalization?

Two operationally similar companies,HD and LD,have identical amounts of assets,operating income (EBIT) ,tax rates,and business risk.Company HD,however,has a much higher debt ratio than LD.Company HD's basic earning power ratio (BEP) exceeds its cost of debt (r_d) .Which of the following statements is CORRECT?

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000,its variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's breakeven point,i.e.,at what unit sales volume would income equal costs?

Exhibit 16.1 Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to Exhibit 16.1.PP is considering changing its capital structure to one with 30% debt and 70% equity,based on market values.The debt would have an interest rate of 8%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%.If this plan were carried out,what would be PP's new value of operations?

If a firm utilizes debt financing,an X% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than X.

A firm's capital structure does not affect its calculated free cash flows,because FCF reflects only operating cash flows.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output,this will

Exhibit 16.2 VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. $\begin{array} { l c } \text { EBIT } = & \$ 80,000 \mathrm { New } \text { Debt } / \text { Value } =&20\% \\\text { Growth } = & 0 \% \text { New Equity/Value } =&80\% \\\text { Orig cost of equity, } r _ { s } = & 10.0 \% \text { No. of shares } =&10,000 \\\text { New cost of equity } = r _ { s } = & 11.0 \% \text { Price per share } =&\$48.00 \\\text { Tax rate } = & 40 \% \text { Interest rate } = r _ { d } =&7.0\%\end{array}$ -Refer to Exhibit 16.2.What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?