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Financial Management: Theory and Practice

Eugene F. Brigham, Michael C. Ehrhardt

Chapter 16

Capital Structure Decisions: The Basics - all with Video Answers

Educators

Chapter Questions

05:46

Problem 1

Shapland Inc. has fixed operating costs of $\$ 500,000$ and variable costs of $\$ 50$ per unit. If it sells the product for $\$ 75$ per unit, what is the break-even quantity?

Karla Conrey
Karla Conrey
Numerade Educator
04:53

Problem 2

Counts Accounting has a beta of $1.15 .$ The tax rate is $40 \%$ and Counts is financed with $45 \%$ debt. What is Counts's unlevered beta?

Puneet Prajapati
Puneet Prajapati
Numerade Educator
01:03

Problem 3

Ethier Enterprise has an unlevered beta of $1.0 .$ Ethier is financed with $50 \%$ debt and has a levered beta of $1.6 .$ If the risk-free rate is $5.5 \%$ and the market risk premium is $6 \%,$ how much is the additional premium that Ethier's shareholders require to be compensated for financial risk?

Breanna Ollech
Breanna Ollech
Numerade Educator
02:25

Problem 4

Nichols Corporation's value of operations is equal to $\$ 500$ million after a recapitalization (the firm had no debt before the recap). It raised $\$ 200$ million in new debt and used this to buy back stock. Nichols had no short-term investments before or after the recap. After the recap, $w_{d}=0.4 .$ What is $S$ (the value of equity after the recap)?

Riham Bassal
Riham Bassal
Numerade Educator
02:25

Problem 5

Lee Manufacturing's value of operations is equal to $\$ 900$ million after a recapitalization (the firm had no debt before the recap). Lee raised $\$ 300$ million in new debt and used this to buy back stock. Lee had no short-term investments before or after the recap. After the recap, $\mathrm{w}_{\mathrm{d}}=1 / 3$ The firm had 30 million shares before the recap. What is $1^{2}$ (the stuck price after the recap)?

Riham Bassal
Riham Bassal
Numerade Educator
01:14

Problem 6

Dye Trucking raised $\$ 150$ million in new debt and used this to buy back stock. After the recap, Dye's stuck price is $\$ 7.5 .$ If Dye had 60 million shares of stock before the recap, how many shares does it have after the recap?

Kristen Karbon
Kristen Karbon
Numerade Educator
01:56

Problem 7

Schweser Satellites Inc. produces satellite earth stations that sell for $\$ 100,000$ each. The firm's fixed costs, $\mathrm{F}$, are $\$ 2$ million; 50 earth stations are produced and sold each year; profits total $\$ 500,000 ;$ and the firm's assets (all equity financed) are $\$ 5$ million. The firm estimates that it can change its production process, adding $\$ 4$ million to investment and $\$ 500,000$ to fixed operating costs. This change will (1) reduce variable costs per unit by $\$ 10,000$ and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowered to $\$ 95,000$ to permit sales of the additional output. The firm has tax loss carry forwards that cause its tax rate to be zero, its cost of equity is $16 \%,$ and it uses no debt.
a. What is the incremental profit? To get a rough idea of the project's profitability, what is the project's expected rate of return for the next year (defined as the incremental profit divided by the investment)? Should the firm make the investment?
b. Would the firm's break-even point increase or decrease if it made the change?
c. Would the new situation expose the firm to more or less business risk than the old one?

Jacquelyn Trost
Jacquelyn Trost
Numerade Educator
01:08

Problem 8

Here are the estimated ROE distributions for Firms A, B, and C:
a. Calculate the expected value and standard deviation for Firm C's ROE. ROE $_{\mathrm{A}}=$ $10.0 \%, \sigma_{\mathrm{A}}=5.5 \% ; \mathrm{ROE}_{\mathrm{B}}=12.0 \%, \sigma_{\mathrm{B}}=7.7 \%$
b. Discuss the relative riskiness of the three firms' returns. (Assume that these distributions are expected to remain constant over time.
c. Now suppose all three firms have the same standard deviation of basic earning power (EBIT/Total assets), $\sigma_{\mathrm{A}}=\sigma_{\mathrm{B}}=\sigma_{\mathrm{C}}=5.5 \% .$ What can we tell about the financial risk of each firm?

Hossam Mohamed
Hossam Mohamed
Numerade Educator
03:54

Problem 9

The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with $30 \%$ debt based on market values, its cost of equity, $r_{s},$ will increase to $11 \%$ to reflect the increased risk. Bonds can be sold at a cost, $\mathrm{r}_{\mathrm{d}}$, of $7 \% .$ Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are expectationally constant over time.
a. What effect would this use of leverage have on the value of the firm?
b. What would be the price of Rivoli's stock?
c. What happens to the firm's earnings per share after the recapitalization?
d. The $\$ 500,000$ EBIT given previously is actually the expected value from the following probability distribution:
Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the $30 \%$ debt level?

Nick Johnson
Nick Johnson
Numerade Educator
02:08

Problem 10

Pettit Printing Company has a total market value of $\$ 100$ million, consisting of 1 million shares selling for $\$ 50$ per share and $\$ 50$ million of $10 \%$ perpetual bonds now selling at par. The company's EBIT is $\$ 13.24$ million, and its tax rate is $15 \%$ Pettit can change its capital structure by either increasing its debt to $70 \%$ (based on market values) or decreasing it to $30 \% .$ If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a $12 \%$ coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new $8 \%$ coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, $r_{s}$, is $14 \% .$ If it increases leverage, $r_{s}$ will be $16 \% .$ If it decreases leverage, $r_{s}$ will be $13 \% .$ What is the firm's WACC and total corporate value under each capital structure?

Dale Sanford
Dale Sanford
Numerade Educator
01:52

Problem 11

Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $\$ 20$ million in debt carrying a rate of $8 \%$, and its stock price is $\$ 40$ per share with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. EBIT is $\$ 14.933 \mathrm{mil}$ lion, and BEA faces a $40 \%$ federal-plus-state tax rate. The market risk premium is $4 \%,$ and the risk-free rate is $6 \% .$ BEA is considering increasing its debt level to a capital structure with $40 \%$ debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be $9 \% .$ BEA has a beta of 1.0.
a. What is BEA's unlevered beta? Use market value D/S when unlevering.
b. What are BEA's new beta and cost of equity if it has $40 \%$ debt?
c. What are BEA's WACC and total value of the firm with $40 \%$ debt?

Adriano Chikande
Adriano Chikande
Numerade Educator
01:52

Problem 12

Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:
Elliott uses the CAPM to estimate its cost of common equity, $\mathrm{r}_{\mathrm{s}}$. The company estimates that the risk-free rate is $5 \%$, the market risk premium is $6 \%$, and its tax rate is $40 \% .$ Elliott estimates that if it had no debt, its "unlevered" beta, by, would be $1.2 .$ Based on this information, what is the firm's optimal capital structure, and what would the weighted average cost of capital be at the optimal capital structure?

Adriano Chikande
Adriano Chikande
Numerade Educator
02:41

Problem 13

Start with the partial model in the file $F M 12$ Ch 16 P13 Build a Model.xls from the textbook's Web site. Rework Problem $16-12$ using a spreadsheet model. After completing the problem as it appears, answer the following related questions.
a. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus the debt/value ratio.
b. Would the optimal capital structure change it the unlevered beta changed? 10 answer this question, do a sensitivity analysis of WACC on $b_{U}$ for different levels of $b_{U}$

Srikar Katta
Srikar Katta
Numerade Educator