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Exam 15: Capital Structure Decisions

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Question 41

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Powell Plastics, Inc. (PP) currently has zero debt. Its earnings before interest and taxes (EBIT) are $80,000, and it is a zero growth company. 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. -PP is considering moving to a capital structure that is comprised of 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?

A) $484,359
B) $487,805
C) $521,173
D) $560,748
E) $584,653

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

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Question 42

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A consultant has collected the following information regarding Young Publishing: The company has no growth opportunities (g = 0) , so the company pays out all of its earnings as dividends (EPS = DPS) . The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?

A) $3,200
B) $3,600
C) $4,000
D) $4,200
E) $4,800
Medium/Hard:

F) None of the above
G) A) and B)

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Question 43

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Volunteer Fabricators, Inc. (VF) currently has zero debt. It is a zero growth company, 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. $\begin{array}{l}\begin{array}{lll}\text { EBIT = } & \$ 80,000 \\\text { Growth }= &0\%\\\text { Orig cost of equity, } r= &10.0 \% \\\text { New cost of equity }=r,= & 11.0 \%\\\text { Tax rate }=&40 \%\end{array}\begin{array}{lll} \text { New Debt/Value = } &20 \\ \text {New Equity/Value = } &80 \\ \text { No. of shares = } &10,00 \\ \text {Price per share = } &\$ 48.00\\ \text { Interest rate = } {r}_{d}= &7.0\%\end{array}\end{array}$ -If this plan were carried out, what would be VF's new WACC and its new value of operations? $\begin{array}{lll} &\underline { \text { WACC } }& \underline {\text { Value }} \\\text { a. } & 9.64 \% & \$ 497,925 \\\text { b. } & 9.83 \% & \$ 507,884 \\\text { c. } & 10.03 \% & \$ 518,041 \\\text { d. } & 10.23 \% & \$ 528,402 \\\text { e. } & 10.74 \% & \$ 538,970\end{array}$

Aaron Athletics is trying to determine its optimal capital structure. 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, rs. The risk-free rate is 5% and the market risk premium is 6%. Aaron estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 40%. On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal Capital structure?

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

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

Vu Enterprises expects to have the following data during the coming year. What is Vu's expected ROE?

Ang Enterprises has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Ang's beta be if it used no debt, i.e., what is its unlevered beta?

Barnes Baskets, 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. -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?