37. A venture capital investment group received a proposal from Wireless Solutions to produce a new
smart phone. The variable cost per unit is estimated at $250, the sales price would be set at twice the
VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is
likely to have an operating income of $500,000 or more. What sales volume would be required in
order to meet this profit goal?
a.
4,513
b.
4,750
c.
5,000
d.
5,250
e.
5,513
VC/unit
$250
Price multiple over VC
Price
Fixed costs
Profit target
Volume (units) to meet profit goal = (FC + Profit)/(P − VC) =
Check: Op profit = (P − VC) Units − FC =
38. Firms HD and LD are identical except for their level of debt and the interest rates they pay on
debt⎯HD has more debt and pays a higher interest rate on that debt. Based on the data given below,
what is the difference between the two firms’ ROEs?
Applicable to Both Firms
Firm HD’s Data
Firm LD’s Data
Assets
$200
Debt ratio
50%
Debt ratio
30%
EBIT
$40
Interest rate
12%
Interest rate
10%
Tax rate
35%
a.
2.18%
b.
2.29%
c.
2.41%
d.
2.54%
e.
2.66%
Step 3:
Find the new value of the firm:
39. Morales Publishing’s tax rate is 40%, 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?
a.
1.53%
b.
1.70%
c.
1.87%
d.
2.05%
e.
2.26%
40. Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and
20% common equity, its beta is 1.60, and its tax rate is 35%. However, the CFO thinks the company
has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity.
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?
a.
−5.20%
b.
−5.78%
c.
−6.36%
d.
−6.99%
e.
−7.69%
41. 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, rRF, is 5.0%, the market risk premium, RPM, is
6.0%, and the firm’s tax rate is 40%. Currently, the cost of equity, rs, 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.)
a.
10.95%
b.
11.91%
c.
12.94%
d.
14.07%
e.
15.29%
42. An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is
expected to remain constant in the future. The company pays out all of its earnings, so earnings per
share (EPS) equal dividends per shares (DPS). Its tax rate is 40%.
The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase
stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but
the CFO believes beta would rise to 1.10 if the recapitalization occurs.
Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what
would the price be following the recapitalization?
a.
$65.77
b.
$69.23
c.
$72.69
d.
$76.33
e.
$80.14
43. Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt. It pays out
all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share,
and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt
and 60% equity (based on market values), its investment bankers believe its weighted average cost of
capital would be 10%. What would its stock price be if it changes to the new capital structure?
a.
$40
b.
$48
c.
$52
d.
$54
e.
$60
44. 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, rM − rRF, is 5%. Currently the company’s cost of equity, which is based on the CAPM, is
12% and its tax rate is 40%. What would be Cartwright’s estimated cost of equity if it were to change
its capital structure to 50% debt and 50% equity?
a.
13.00%
b.
13.64%
c.
14.35%
d.
14.72%
e.
15.60%
0.11
10.68%
0.43
10.22
45. LeCompte Learning Solutions is considering making a change to its capital structure in hopes of
increasing its value. 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:
Percent financed
Percent financed
Debt-to-equity
Bond
Before-tax
with debt (wd)
with equity (wc)
ratio (D/S)
Rating
cost of debt
0.10
0.90
0.10/0.90 = 0.11
AAA
7.0%
0.20
0.80
0.20/0.80 = 0.25
AA
7.2
0.30
0.70
0.30/0.70 = 0.43
A
8.0
0.40
0.60
0.40/0.60 = 0.67
BBB
8.8
0.50
0.50
0.50/0.50 = 1.00
BB
9.6
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%. LeCompte 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 LeCompte’s optimal capital structure, and what is the firm’s
cost of capital at this optimal capital structure?
a.
wc = 0.9; wd = 0.1; WACC = 14.96%
b.
wc = 0.8; wd = 0.2; WACC = 10.96%
c.
wc = 0.7; wd = 0.3; WACC = 7.83%
d.
wc = 0.6; wd = 0.4; WACC = 10.15%
e.
wc = 0.5; wd = 0.5; WACC = 10.18%
46. Refer to Exhibit 15.1. PP is considering changing its capital structure to one with 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
47. Refer to Exhibit 15.1. 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 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and
purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share
immediately after issuing the debt but prior to the repurchase?
a.
$45.90
b.
$48.12
c.
$51.06
d.
$53.33
e.
$58.75
48. Refer to Exhibit 15.1. 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 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 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?
a.
7,500; $71.49
b.
7,000; $59.57
c.
6,500; $51.06
d.
6,649; $53.33
e.
6,959; $58.78
49. Refer to Exhibit 15.2. If this plan were carried out, what would be VF’s new WACC and its new value
of operations?
WACC Value
a.
9.64% $497,925
b.
9.83% $507,884
c.
10.03% $518,041
d.
10.23% $528,402
e.
10.74% $538,970
Debt/Value =
20%
Interest rate = rd =
Equity/Value =
80%
New cost of equity = rs =
50. Refer to Exhibit 15.2. 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?
Debt/Value =
40%
Value of new debt =
$213,333
Equity/Value =
60%
New WACC =
9.0%
a.
$50.67
b.
$53.33
c.
$56.00
d.
$58.80
Value of equity
Divide by # shares
Price per share
e.
$61.74
51. Refer to Exhibit 15.2. What would the stock price be if VF issued the new debt and immediately used
the proceeds to repurchase stock?
a.
$49.43
b.
$50.70
c.
$52.00
d.
$53.33
e.
$56.00
52. Refer to Exhibit 15.3. 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?
a.
$498,339
b.
$512,188
c.
$525,237
d.
$540,239
e.
$590,718
53. Refer to Exhibit 15.3. Now assume that BB is considering changing from its original capital structure
to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of
capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new
debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share
immediately after issuing the debt but prior to the repurchase?
a.
$14.42
b.
$19.36
c.
$23.91
d.
$28.85
e.
$35.62
54. Refer to Exhibit 15.3. Now assume that BB is considering changing from its original capital structure
to a new capital structure with 45% debt and 55% equity. This results in a weighted average cost of
capital equal to 10.4% and a new value of operations of $576,923. Assume BB raises $259,615 in new
debt and purchases T-bills to hold until it makes the stock repurchase. BB 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?
a.
11,001; $28.85
b.
12,711; $35.62
c.
13,901; $42.57
d.
15,220; $54.31
e.
17,105; $89.67
55. Refer to Exhibit 15.4. What is AJC’s current total market value and weighted average cost of capital?
a.
$600,000; 7.5%
b.
$600,000; 8.0%
c.
$800,000; 7.0%
d.
$800,000; 7.5%
e.
$800,000; 8.0%
56. Refer to Exhibit 15.4. The firm is considering moving to a capital structure that is comprised of 40%
debt and 60% equity, based on market values. The new funds would be used to replace the old debt
and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage
would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity
would rise to 9.5%. If this plan were carried out, what would be AJC’s new WACC and total value?
a.
7.38%; $800,008
b.
7.38%; $813,008
c.
7.50%; $813,008
d.
7.50%; $790,008
e.
7.80%; $790,008
57. Refer to Exhibit 15.4. Now assume that AJC is considering changing from its original capital structure
to a new capital structure with 50% debt and 50% equity. If it makes this change, its resulting market
value would be $820,000. What would be its new stock price per share?
a.
$58
b.
$59
c.
$60
d.
$61
e.
$62
58. Refer to Exhibit 15.4. Now assume that AJC is considering changing from its original capital structure
to a new capital structure that results in a stock price of $64 per share. The resulting capital structure
would have a $336,000 total market value of equity and a $504,000 market value of debt. How many
shares would AJC repurchase in the recapitalization?
a.
4,250
b.
4,500
c.
4,750
d.
5,000
e.
5,250