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Exam 15: Capital Structure Decisions

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Question 21

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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?

A) $65.77
B) $69.23
C) $72.69
D) $76.33
E) $80.14

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Question 22

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A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet this profit goal?

A) 4,513
B) 4,750
C) 5,000
D) 5,250
E) 5,513

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Question 23

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

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 return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d. Which of the following statements is CORRECT?

The major contribution of the Miller model is that it demonstrates that

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

VanMannen Foundations, Inc. (VF) 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?

Which of the following statements is CORRECT?

Eccles Inc. Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Inc.What is the firm's cost of equity according to MM with corporate taxes?

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.

Best Bagels, Inc. (BB) 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.

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

Two operationally similar companies, HD and LD, have the same total assets, operating income (EBIT) , tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d. Which of the following statements is CORRECT?

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15%. The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Anson Jackson Court Company (AJC) 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?

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Anson Jackson Court Company (AJC) 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 that results in a stock price of $64 per share. The resulting capital structure would have a $336,000 total market value of equity and a $504,000 market value of debt. How many shares would AJC repurchase in the recapitalization?

LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table: The company uses the CAPM to estimate its cost of common equity, r_s. The risk-free rate is 5% and the market risk premium is 6%. LeCompte estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," b_U, equals 1.0.) The company's tax rate, T, is 40%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?