4 - 16 - Capital Structure

Chapter 16
Questions:
1. True/False
a. In a world with no taxes, no transaction costs, and no costs of financial distress, if
a firm issues equity to repurchase some of its debt, the price per share of the
firm’s stock will rise because the shares are less risky. Explain.
b. The riskiness of a firm’s equity will rise if the firm increases its use of debt
financing.
c. If a firm increases its use of borrowing, the likelihood of default increases,
thereby increasing the risk of the firm’s debt.
d. Given that the firm uses only debt and equity financing, and given that the risks of
both are increased by increased borrowing, so that increasing debt increases the
overall risk of the firm and therefore decreases the value of the firm.
2. Why is the use of debt financing referred to as financial “leverage”?
Problems:
1. EBIT and Leverage Music City, Inc., has no debt outstanding and a total market
value of $295,000. Earnings before interest and taxes, EBIT, are projected to be
$23,000 if economic conditions are normal. If there is strong expansion in the
economy, then EBIT will be 25 percent higher. If there is a recession, then EBIT will
be 40 percent lower. The company is considering an $88,500 debt issue with an
interest rate of 8 percent. The proceeds will be used to repurchase shares of stock.
There are currently 5,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios
before any debt is issued. Also calculate the percentage changes in EPS when the
economy expands or enters a recession.
b. Repeat part (a) if the company goes through with recapitalization. What do you
observe?
2. Break-Even EBIT Franklin Corporation is comparing two different capital structures,
an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company
would have 315,000 shares of stock outstanding. Under Plan II, there would be
225,000 shares of stock outstanding and $4.14 million in debt outstanding. The interest
rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,750,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
3. Homemade Leverage Star, Inc., a prominent consumer products firm, is debating
whether to convert its all-equity capital structure to one that is 35 percent debt.
Currently there are 6,000 shares outstanding and the price per share is $58. EBIT is
expected to remain at $39,600 per year forever. The interest rate on new debt is 7
percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash
flow under the current capital structure, assuming the firm has a dividend payout
rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the
firm? Assume that she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all-equity
capital structure. Show how she could unlever her shares of stock to recreate the
original capital structure.
d. Using your answer to part (c), explain why the company’s choice of capital
structure is irrelevant.
4. Scarlett Corp. uses no debt. The weighted average cost of capital is 8.4 percent. If the
current market value of the equity is $43 million and there are no taxes, what is EBIT?
5. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is
10.5 percent, and its cost of debt is 6 percent. The corporate tax rate is 35 percent.
a. What is the company’s cost of equity capital?
b. What is the company’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio were 2? What if it were
1.0? What if it were zero?
6. Firm Value Cavo Corporation expects an EBIT of $26,850 every year forever. The
company currently has no debt, and its cost of equity is 14 percent. The tax rate is 35
percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 8 percent. What will the value of the
company be if it takes on debt equal to 50 percent of its unlevered value?
7. MM Proposition I with Taxes The Dart Company is financed entirely with equity.
The company is considering a loan of $2.6 million. The loan will be repaid in equal
installments over the next two years, and it has an interest rate of 8 percent. The
company’s tax rate is 35 percent. According to MM Proposition I with taxes, what
would be the increase in the value of the company after the loan?
8. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are
identical in every way except their capital structures. Alpha Corporation, an all-equity
firm, has 18,000 shares of stock outstanding, currently worth $35 per share. Beta
Corporation uses leverage in its capital structure. The market value of Beta’s debt is
$85,000, and its cost of debt is 9 percent. Each firm is expected to have earnings
before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every
investor can borrow at 9 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to
each position in part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent of
Alpha’s equity and replicates both the cost and dollar return of purchasing 20
percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.
9. Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of
debt equals the risk-free rate, Rf. Define 𝛽𝐴 as the firm’s asset beta—that is, the
systematic risk of the firm’s assets. Define 𝛽𝐸 to be the beta of the firm’s equity. Use
the capital asset pricing model, CAPM, along with MM Proposition II to show that
𝐷 𝐷
𝛽𝐸 = 𝛽𝐴 × (1 + 𝐸 ), where 𝐸 is the debt–equity ratio. Assume the tax rate is zero.

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