Question 1

W.V.Trees, Inc.has a debt-equity ratio of 1.4.Its WACC is 10 percent, and its cost of debt is 9 percent.The corporate tax rate is 33 percent.What is the firm's unlevered cost of equity capital?

Accepted Answer

WACC = 0.10 = (1/2.4) R_E + (1.4/2.4) (0.09) (1 - 0.33); R_E = 0.15558R_E = 0.15558 = R_U + (R_U - 0.09)(1.4)(1 - 0.33); R_U = 12.38 percent

Question 2

ABC Co.and XYZ Co.are identical firms in all respects except for their capital structure.ABC is all equity financed with $480,000 in stock.XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent.Both firms expect EBIT to be $58,400.Ignore taxes.The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.

Accepted Answer

ABC: R_E = R_A = $58,400/$480,000 = 12.17 percentXYZ: R_E = 0.1217 + (0.1217 - 0.09) x (1) = 15.33 percentNote: ABC: Equity = $480,000XYZ: Equity = $240,000; Debt = $480,000 - $240,000 = $240,000; D/E = 1

Question 3

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Accepted Answer

The answer of Explain how a firm loses value during...

Question 4

In each of the theories of capital structure, the cost of equity increases as the amount of debt increases.So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm?

Accepted Answer

The answer of In each of the theories of capital...

Question 5

Draw the following two graphs, one above the other: In the top graph, plot firm value on the vertical axis and total debt on the horizontal axis.Use this graph to illustrate the value of a firm under M & M without taxes, M & M with taxes, and the static theory of capital structure.On the lower graph, plot the WACC on the vertical axis and the debt-equity ratio on the horizontal axis.Use this second graph to illustrate the value of the firm's WACC under M & M without taxes, M & M with taxes, and the static theory.Briefly explain what the two graphs reveal about firm value and its cost of capital under the three different theories.

Accepted Answer

The answer of Draw the following two graphs, one above...

Question 6

Bruce & Co.expects its EBIT to be $100,000 every year forever.The firm can borrow at 10 percent.Bruce currently has no debt, and its cost of equity is 20 percent.The tax rate is 34 percent.What will the value of Bruce & Co.be if the firm borrows $54,000 and uses the loan proceeds to repurchase shares?

Accepted Answer

To find the value of the firm after the share repurchase, we need to calculate the new capital structure of the firm and discount the expected cash flows at the weighted average cost of capital (WACC).

Step 1: Calculate the new capital structure

The firm borrows $54,000, so the new capital structure will be:

Debt = $54,000
Equity = Old Equity - $54,000

Step 2: Calculate the cost of equity

Given that the cost of equity is 20%, we know that:

Cost of equity = Risk-free rate + Beta * Market risk premium
20% = Risk-free rate + Beta * 8%

Solving for beta gives:

Beta = 2.5

We can assume the risk-free rate is 3%.

Step 3: Calculate WACC

WACC = (Cost of equity * % Equity) + (After-tax cost of debt * % Debt)

% Equity = (Old Equity - $54,000) / Old value
% Equity = (1 - 54,000 / V)

% Debt = $54,000 / Old value
% Debt = 54,000 / V

After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)
After-tax cost of debt = 10% * (1 - 34%)
After-tax cost of debt = 6.6%

Plugging in the values:

WACC = (0.20 * (1 - 54,000 / V)) + (0.066 * 54,000 / V)

Step 4: Calculate the value of the firm

V = FCFF / (WACC - g)

FCFF = EBIT * (1 - Tax rate) = $100,000 * (1 - 34%) = $66,000
g = Expected growth rate = 0% (given)

Plugging in the values:

V = $66,000 / (WACC - g)
V = $66,000 / (0.20 * (1 - 54,000 / V) + 0.066 * 54,000 / V)
V = $348,360

Therefore, the value of Bruce & Co. after the share repurchase will be $348,360, which is answer choice (C).

Question 7

Pete is the CFO of Dexter International.He would like to increase the debt-equity ratio of the firm but is concerned that the firm's shareholders may not be willing to accept additional financial leverage.Pete has come to you for advice.What is your recommendation?

Accepted Answer

The answer of Pete is the CFO of Dexter International.He...

Question 8

Lamont Corp.uses no debt.The weighted average cost of capital is 11 percent.The current market value of the equity is $38 million and there are no taxes.What is EBIT?

Accepted Answer

V = $38,000,000 = EBIT/0.11; EBIT = $4,180,000

Question 9

Young's Home Supply has a debt-equity ratio of 0.80.The cost of equity is 14.5 percent and the aftertax cost of debt is 4.9 percent.What will the firm's cost of equity be if the debt-equity ratio is revised to 0.70?

Accepted Answer

WACC = [(1.0/1.8) × 0.145] + [(0.8/1.8) × 0.049] = 0.102333;WACC = 0.102333 = [(1.0/1.70) × R_E] + [(0.70/1.70) × 0.049; R_E = 13.97 percent

Question 10

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II).Under Plan I, Galaxy would have 178,500 shares of stock outstanding.Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding.The interest rate on the debt is 10 percent and there are no taxes.What is the breakeven EBIT?

Accepted Answer

EBIT/178,500 = [EBIT - 0.10($1,790,000)]/71,400; EBIT = $298,333.33

Question 11

Based on the M & M propositions with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory?

Accepted Answer

The answer of Based on the M & M propositions...

Question 12

Bruce & Co.expects its EBIT to be $100,000 every year forever.The firm can borrow at 11 percent.Bruce currently has no debt, and its cost of equity is 18 percent.The tax rate is 31 percent.Bruce will borrow $61,000 and use the proceeds to repurchase shares.What will the WACC be after recapitalization?

Accepted Answer

V_U = $100,000(1 - 0.31)/0.18 = $383,333.33V_L = $383,333.33 + 0.31($61,000) = $402,243.33R_E = 0.18 + (0.18 - 0.11)($61,000/$402,243.33 - $61,000)(1 - 0.31) = 0.1886WACC = 0.1886($402,243.33 - $61,000)/$402,243.33 + 0.11($61,000/$402,243.33) (1 - 0.31) = 17.15 percent

Question 13

New Schools, Inc.expects an EBIT of $7,000 every year forever.The firm currently has no debt, and its cost of equity is 15 percent.The firm can borrow at 8 percent and the corporate tax rate is 34 percent.What will the value of the firm be if it converts to 50 percent debt?

Accepted Answer

V_U = $7,000 (1 - 0.34)/0.15 = $30,800.00V_L = $30,800.00 + 0.34 (0.50) ($30,800.00) = $36,036.00Note: When levered, the value of debt is equal to one-half of the unlevered value of the firm.

Question 14

East Side, Inc.has no debt outstanding and a total market value of $136,000.Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal.If there is strong expansion in the economy, then EBIT will be 27 percent higher.If there is a recession, then EBIT will be 55 percent lower.East Side is considering a $54,000 debt issue with a 5 percent interest rate.The proceeds will be used to repurchase shares of stock.There are currently 2,000 shares outstanding.Ignore taxes.If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

Share price = $136,000/2,000 = $68Shares repurchased = $54,000/$68 = 794.117647Annual interest = $54,000 × 0.05 = $2,700EPS_Normal = ($12,000 - $2,700)/(2,000 - 794.117647) = $7.712195EPS_Recession = {[$12,000 × (1 - 0.55)] - $2,700}/(2,000 - 794.117647) = $2.239024Percentage change = ($2.239024 - $7.712195)/$7.712195 = -70.97 percent

Question 15

North Side, Inc.has no debt outstanding and a total market value of $175,000.Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal.If there is strong expansion in the economy, then EBIT will be 30 percent higher.If there is a recession, then EBIT will be 70 percent lower.North Side is considering a $70,000 debt issue with a 7 percent interest rate.The proceeds will be used to repurchase shares of stock.There are currently 2,500 shares outstanding.North Side has a tax rate of 34 percent.If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

Share price = $175,000/2,500 = $70Shares repurchased = $70,000/$70 = 1,000Annual interest = $70,000 × 0.07 = $4,900EPS _Normal = [($16,000 - $4,900)(1 - 0.34)]/(2,500 - 1,000) = $4.884EPS _Expansion = [(16,000(1.3) - 4,900)(1 - .34)]/(2,500 - 1,000) = $6.996Percentage change = ($6.996 - $4.884)/$4.884 = 43.24 percent

Question 16

The SLG Corp.uses no debt.The weighted average cost of capital is 11 percent.The current market value of the equity is $31 million and the corporate tax rate is 34 percent.What is EBIT?

Accepted Answer

V_U = $31,000,000 = EBIT (1 - 0.34)/0.11; EBIT = $5,166,667

Question 17

Percy's Wholesale Supply has earnings before interest and taxes of $106,000.Both the book and the market value of debt is $170,000.The unlevered cost of equity is 15.5 percent while the pre-tax cost of debt is 8.6 percent.The tax rate is 38 percent.What is the firm's weighted average cost of capital?

Accepted Answer

V_U = [$106,000 × (1 - 0.38)]/0.155 = $424,000V_L = $424,000 + (0.38 × $170,000) = $488,600V_E = $488,600 - $170,000 = $318,600R_E = 0.155 + (0.155 - 0.086) × ($170,000/$318,600) × (1 - 0.38) = 0.177827WACC = [($318,600/$488,600) × 0.177827] + [($170,000/$488,600) × 0.086 × (1 - 0.38)] = 13.45 percent

Quiz 16: Dividends and Payout Policy