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11-1
Chapter 11
Answers to Review Problems
Finance For Executives – 4th Edition
1. EBIT–EPS analysis.
a.
The following tables show the calculations of Chloroline’s EPS and return on investment as a function of
the firm’s EBIT, without debt and with debt.
Current Capital Structure: No Debt and Two Million Shares Outstanding
Recession Expected Expansion
Earnings before interest and tax (EBIT) $5.0 million $15.0 million $20.0 million
Less interest expenses $0 $0 $0
Proposed Capital Structure: Borrow $50 million at 8 percent and use the cash to repurchase 1 million
shares at $50 per share
Recession Expected Expansion
Earnings before interest and tax (EBIT) $5.0 million $15.0 million $20.0 million
Less interest expenses on debt ($4.0 million) ($4.0 million) ($4.0 million)
b.
The analysis shows that a substitution of debt for equity will increase Chloroline’s EPS and return on
investment in the expected and expansion scenarios, but will decrease EPS and return on investment in
the recession scenario. These results, however, are insufficient to make a recommendation on whether the
firm should recapitalize for the following reasons:
11-2
2. Firm value and capital structure in the absence of tax.
This statement is false. An increase in debt financing has two consequences: (1) an increase in risk for
3. Homemade leverage.
a.
Currently, Alberton does not have any debt outstanding and it does pay any tax. Therefore, its earnings
after tax are equal to its earnings before interest and tax, which is $4 million. Since the payout ratio is 100
b.
Under the proposed capital structure, the number of shares outstanding will be reduced since the proceeds
of the debt issue will be used to buy back shares.
Currently
1. Number of shares outstanding
1 million
3. Market value of Alberton’s assets (line 1 × line 2)
$60 million
Under the new capital structure
1. Debt-to-assets ratio
30 %
2. Amount of debt issued (line 4 line 3)
$18 million
3. Number of shares repurchased (line 5/line 2)
300,000
4. Number of shares outstanding (line 1 – line 6)
700,000
11-3
c.
Mr. Robert will receive less cash under the new capital structure than under the current one ($440,000
versus $560,000). This is because the interest rate on the debt, 10 percent, is higher than Alberton’s return
on assets, 6.67 percent ($4 million of EBIT divided by $60 million of assets).
Mr. Robert can keep receiving $560,000 from his investment in Alberton if he does the following:
1. Number of shares outstanding
700,000
2. Number of shares owned by Mr. Robert
98,000
3. Distributable earnings (see line 8 above)
$2.2 million
4. Amount of dividend to be received by Mr. Robert (line 3 line 2)/line 1)
$308,000
4. Cost of debt versus cost of equity.
The argument is irrelevant. Using more debt relative to equity makes the firm riskier for both
shareholders and bondholders, thus increasing the return expected by them from investing in the firm.
Both the cost of debt and the cost of equity increase with more debt financing, especially the latter since
5. Changes in capital structure and the cost of capital.
a.
In the absence of debt, the cost of equity of Starline is equal to the return from its assets because the
shareholders are the only claimants to the cash flows generated by these assets. Thus, Starline’s return on
11-4
where:
L
E
k
= cost of equity
rA = return on assets = 14%
kD = cost of debt = 8%
Tc = corporate tax rate = 40%
D/E = debt-to-equity ratio
D/E 0 25% 50% 75% 100%
kD 0.08 0.08 0.08 0.08 0.08
L
E
k
0.14 0.149 0.158 0.167 0.176
WACC 0.14 0.129 0.121 0.116 0.112
b.
L
E
k
11-5
c.
According to the above analysis, you would be tempted to recommend that Starline increase its
indebtedness as much as possible because the higher the level of debt, the lower the weighted average
6. The cost of equity, the weighted average cost of capital, and financial leverage.
a.
From equation 11.2:
E
D
)kr(rk DAA
L
E−+=
where:
L
E
k
= cost of equity
rA = expected return on the firm’s assets
kD = cost of debt
D/E = debt-to-equity ratio
b.
From equation 11.7:
E
D
)T)(kr(rk cDAA
L
E−−+= 1
where:
11-6
When the target debt ratio is 1:
L
E
k
= 12% + (12% – 8%) (1 – .40) 1 = 14.4%
and WACC = 14.4% .50 + 8% (1 – .40) .50 = 9.6%
7. The value of the interest tax shield.
a.
The annual tax savings, or interest tax shield (ITS), is:
ITS = Tax rate Interest rate Amount of debt
= .35 .08 $25,000,000 = $700,000
Note that the value of the tax shield would represent 8.75 percent of the market value of the firm, since
the firm has currently no debt and its market value is $100,000,000.
11-7
b.
If the interest rate increases immediately after the debt is issued:
PV(ITS)permanent =
000,700$
= $7,777,778
8. Industry influence on the capital structure.
The probability that an electric utility goes bankrupt is quite small because (1) it is usually a local
monopoly and (2) most of its valuable assets are tangible ones. It should exhibit the highest debt ratio
among the three firms. At the opposite, a biotechnology firm’s most valuable assets are intangible and its
9. Board of directors and management.
It is in the interest of the managers to maintain a low debt-to-equity ratio when the board of directors
exercise little power on them. By keeping financial leverage low, they reduce the probability of the firm
10. Agency costs.
Shareholders expropriate wealth from bondholders when they induce management to (1) make
investments which are riskier than anticipated by bondholders, (2) increase debt at a higher level than
