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Exam 16: Capital Structure Decisions

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Question 31

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The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to the data for the Anson Jackson Court Company (AJC) . Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share?

A) $58
B) $59
C) $60
D) $61
E) $62

F) B) and D)
G) A) and C)

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Question 32

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Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.

A) stock price.
B) cost of equity.
C) cost of debt.
D) cost of preferred stock.
E) earnings per share (eps) .

F) A) and D)
G) A) and C)

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Question 33

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Which of the following statements is CORRECT?

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

The firm's target capital structure should be consistent with which of the following statements?

Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 4.8%. Both firms have positive net income. Which of the following statements is CORRECT?

Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Refer to the data for Best Bagels, Inc. (BB) . BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 7%. The new funds 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 to 14%. If this plan were carried out, what would BB's new value of operations be?

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

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, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, 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.)

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. -Refer to the data for VanMannen Foundations, Inc. (VF) . Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase? $\begin{array} { l l r } \text { Debt/Value } = & 40 \% \text { Value of new debt } = & \$ 213,333 \\\text { Equity } / \text { alue } = & 60 \% \text { New WACC } = & 9.0 \%\end{array}$

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to the data for the Anson Jackson Court Company (AJC) . The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be AJC's new WACC and total value?

Which of these items will not generally be affected by an increase in the debt ratio?

Whenever a firm borrows money, it is using financial leverage.

Firms HD and LD are identical except for their level of debt and the interest rates they pay on debtσHD 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? $\begin{array}{lcll}{\text { Applicable to Both Firms }} & {\text { Firm HD's Data }} & \text { Firm LD's Data } \\\text { Assets } & \$ 200 \text { Debt ratio } & 50 \% \text { Debt ratio } & 30 \% \\\text { EBIT } & \$ 40 \text { Interest rate } & 12 \% \text { Interest rate } & 10 \% \\\text { Tax rate } & 35 \% & &\end{array}$

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. -Refer to the data for VanMannen Foundations, Inc. (VF).  If this plan were carried out, what would be VF's new WACC and its new value of operations?

Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08. -Refer to the data for Best Bagels, Inc. (BB) . Now assume that BB is considering changing from its original capital structure to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

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. -Refer to the data for VanMannen Foundations, Inc. (VF) .What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?