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Exam 15: Capital Structure Decisions

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Question 31

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Which of the following statements is CORRECT?

A) The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.Unfortunately, these factors are generally beyond the control of the firm's management.
B) One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.
C) A firm's financial risk can be minimized by diversification.
D) The amount of debt in its capital structure can under no circumstances affect a company's business risk.
E) A firm's business risk is determined solely by the financial characteristics of its industry.

F) A) and D)
G) B) and D)

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Question 32

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As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

A) True
B) False

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Question 33

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Which of the following statements is CORRECT?

Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc.is $500 million and the face value of its 1-year coupon debt is $200 million.The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%.Assume that N(d₁) = 0.9720 and N(d₂) = 0.9050. ​ -Refer to the data for Wilson Dover Inc.What is the value (in millions) of Wilson Dover's debt if its equity is viewed as an option?

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

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

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?

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. $\begin{array}{lr}\text { EBIT }= & \$ 80,000 \\\text { Growth }= & 0 \% \\\text { Orig cost of equity, } \mathrm{r}_{\mathrm{s}}= & 10.0 \% \\\text { No. of shares }= & 10,000 \\\text { Price per share } & \$ 60.00 \\\text { Tax rate }= & 25 \%\end{array}$ ​ -Refer to the data for VanMannen Foundations, Inc.(VF) .Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt.This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations.Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase? $\begin{array}{llr}\text { Debt } / \text { Value }= & 40 \% \text { Value of new debt }= & \$ 280,702 \\\text { Equity } / \text { Value }= & 60 \% \mathrm{New} \text { W } \mathrm{ACC}= & 8.55 \%\end{array}$

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.

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

Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%.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 Incorporated.What is the firm's cost of equity according to MM with corporate taxes?

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values.(Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, r_M − r_RF, is 5%.Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.The risk-free rate, r_RF, is 5.0%, the market risk premium, RP_M, is 6.0%, and the firm's tax rate is 25%.Currently, the cost of equity, r_s, is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

Morales Publishing's tax rate is 25%, its beta is 1.10, and it uses no debt.However, the CFO is considering moving to a capital structure with 30% debt and 70% equity.If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?

Hernandez Corporation expects to have the following data during the coming year.What is Hernandez's expected ROE? $\begin{array}{lc}\text { Assets } & \$ 200,000 \text { Interest rate }&8\% \\\text { D/A } & 65 \% \text { Tax rate } &25\%\\\text { EB IT } & \$ 25,000\end{array}$

Pennewell Publishing Inc.(PP) Pennewell Publishing Inc.(PP) is a zero growth company.It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000.PP's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to the data for Pennewell Publishing Inc.(PP) .Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity.This results in a weighted average cost of capital equal to 9.125% and a new value of operations of $657,534.Assume PP raises $230,137 in new debt and purchases T-bills to hold until it makes the stock repurchase.PP then sells the T-bills and uses the proceeds to repurchase stock.How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase? Remaining Shares; P Post

Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets.Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity.Firm L's debt has an after-tax cost of 4.8%.Both firms have positive net income.Which of the following statements is CORRECT?

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.