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Chapter 13: Capital Structure and Leverage
75. El Capitan Foods has a capital structure of 36% debt and 64% equity, its tax rate is 35%, and its beta (leveraged) is
1.40. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?
a.
1.03
b.
1.29
c.
0.80
d.
0.88
e.
1.15
Chapter 13: Capital Structure and Leverage
76. Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are
shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The
money raised would be used to repurchase stock at the current price. 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. If this plan
were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? Do not round your
intermediate calculations.
wd
40%
Orig cost of equity, rs
10.0%
wc
60%
New cost of equity = rs
11.0%
Interest rate new = rd
6.0%
Tax rate
40%
a.
2.29%
b.
1.96%
c.
2.04%
d.
1.65%
e.
2.16%
77. As a consultant to First Responder Inc., you have obtained the following data (dollars in millions). The company plans
to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because
growth is zero. The CFO believes that a move from zero debt to 80.0% debt would cause the cost of equity to increase
from 10.0% to 12.0%, and the interest rate on the new debt would be 9.0%. What would the firm's total market value be if
it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 - T) because no new operating capital is
Chapter 13: Capital Structure and Leverage
needed, and then divide by (WACC - g). Do not round your intermediate calculations.
Oper. income (EBIT)
$800
Tax rate
40.0%
New cost of equity (rs)
12.00%
New wd
80.0%
Interest rate (rd)
9.00%
a.
$7,143
b.
$8,000
c.
$7,357
d.
$5,357
e.
$5,929
78. You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are
about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--
High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower
will High's expected EPS be versus that of Low, i.e., what is EPSHigh – EPSLow? Do not round your intermediate
calculations.
Applicable to Both Firms
Firm High's Data
Firm Low's Data
Chapter 13: Capital Structure and Leverage
Capital
$3,000,000
wd
70%
wd
20%
EBIT
$565,000
Shares
90,000
Shares
240,000
Tax rate
35%
Int. rate
12%
Int. rate
10%
a.
$01.16
b.
$00.67
c.
$01.07
d.
$00.80
e.
$00.89
79. Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus
must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of
Chapter 13: Capital Structure and Leverage
LD, i.e., what is ROEHD - ROELD? Do not round your intermediate calculations.
Applicable to Both Firms
Firm HD's Data
Firm LD's Data
Capital
$3,000,000
wd
70%
wd
20%
EBIT
$595,000
Int. rate
12%
Int. rate
10%
Tax rate
35%
a.
11.31%
b.
13.37%
c.
8.74%
d.
10.28%
e.
10.80%
Chapter 13: Capital Structure and Leverage
80. Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is
not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied
capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Based on the
following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA? Do not round your
intermediate calculations.
Applicable to Both Firms
Firm A's Data
Firm NA's Data
Capital
$210,000
wd
50%
wd
0%
EBIT
$40,000
Int. rate
12%
Int. rate
10%
Tax rate
35%
a.
4.90%
b.
3.71%
c.
4.58%
d.
5.54%
e.
3.76%
Chapter 13: Capital Structure and Leverage
81. Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell
bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital
structure (wc) = 1 – wd. Other things held constant, and based on the data below, if the firm increases the percentage of
debt in its capital structure (wd) to 60.0%, by how much would the ROE change, i.e., what is ROENew - ROEOld? Do not
round your intermediate calculations.
Operating Data
Other Data
Capital
$150,000
Old wd
5%
ROIC = EBIT (1 – T)/Capital
20.00%
Old interest ratio
10%
Tax rate
35%
New wd
60%
New interest rate
12%
a.
14.95%
b.
19.17%
c.
17.59%
d.
21.64%
e.
14.42%
Chapter 13: Capital Structure and Leverage
82. You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the
president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Other things
held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is
ROENew - ROEOld? Do not round your intermediate calculations.
Operating Data
Other Data
Capital
$4,000
Higher wd
60%
ROIC = EBIT(1 – T)/Capital
17.00%
Higher interest rate
13%
Tax rate
35%
Lower wd
10%
Lower interest rate
9%
a.
10.31%
b.
11.59%
c.
10.43%
d.
9.15%
e.
10.54%
Chapter 13: Capital Structure and Leverage
83. Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but
she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or
with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed
and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's
expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU? Do not round your intermediate
calculations.
0% Debt, U
60% Debt, L
Expected unit sales
290,000
290,000
Price per unit
$10.00
$10.00
Fixed costs
$1,000,000
$1,000,000
Variable cost/unit
$3.50
$3.50
Required investment
$2,500,000
$2,500,000
Shares issued at $10/share
250,000
100,000
% Debt
0.00%
60.00%
Debt, $
$0
$1,500,000
Equity, $
$2,500,000
$1,000,000
Interest rate
NA
10.00%
Tax rate
35.00%
35.00%
a.
$02.48
Chapter 13: Capital Structure and Leverage
b.
$02.35
c.
$03.10
d.
$02.85
e.
$02.60
Chapter 13: Capital Structure and Leverage
84. Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs
for this operation are $300,000, and annual sales are 75,000 packs. The unit variable cost consists of a $4.00 royalty
payment, VR , per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The
book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's
managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a
10% profit margin on course packs, other things held constant? Do not round your intermediate calculations.
a.
$2.50
b.
$1.88
c.
$2.78
d.
$2.25
e.
$2.00
Chapter 13: Capital Structure and Leverage
85. Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 49.0% debt
(wd) by issuing bonds and using the proceeds to repurchase and retire some common shares so the percentage of common
equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this recapitalization
change the firm's cost of equity, i.e., what is rL - rU? Do not round your intermediate calculations.
Risk-free rate, rRF
6.00%
Tax rate, T
40%
Market risk prem, RPM
3.00%
Current wd
0%
Current beta, bU
1.30
Target wd
49.0%
a.
2.59%
b.
1.91%
c.
2.92%
d.
1.57%
e.
2.25%
Chapter 13: Capital Structure and Leverage
86. Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%), but its new CFO is considering changing the capital
structure so wd = 36.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the
percentage of common equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this
recapitalization change the firm's cost of equity? Do not round your intermediate calculations. (Hint: You must unlever
the current beta and then use the unlevered beta to solve the problem.)
Risk-free rate, rRF
5.00%
Tax rate, T
40%
Market risk prem, RPM
6.00%
Current wd
20%
Current beta, bL1
1.65
Target wd
36.0%
a.
1.61%
b.
1.66%
c.
1.24%
d.
1.68%
e.
1.69%
Chapter 13: Capital Structure and Leverage
87. Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to
remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per
share (DPS), and its tax rate is 40%. The company is considering issuing $4,500,000 of 9.00% bonds and using the
proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently
1.10. However, the CFO believes the beta would rise to 1.30 if the recapitalization occurs. Assuming the shares could be
repurchased at the price that existed prior to the recapitalization, what would the price per share be following the
recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)
a.
$34.52
b.
$27.84
c.
$21.44
d.
$28.12
e.
$29.51
Chapter 13: Capital Structure and Leverage
88. You were hired as the CFO of a new company that was founded by three professors at your university. The company
plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to
finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of
how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How
much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL -
ROEU?
0% Debt, U
60% Debt, L
Expected unit sales (Q)
32,000
32,000
Price per phone (P)
$250.00
$250.00
Fixed costs (F)
$1,000,000
$1,000,000
Variable cost/unit (V)
$200.00
$200.00
Required investment
$2,500,000
$2,500,000
% Debt
0.00%
60.00%
Debt, $
$0
$1,500,000
Equity, $
$2,500,000
$1,000,000
Interest rate
NA
10.00%
Tax rate
35.00%
35.00%
a.
16.52%
b.
13.65%
c.
11.33%
d.
15.70%
e.
12.56%
Chapter 13: Capital Structure and Leverage
