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Ch 15 Capital Structure Decisions
63. 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
Ch 15 Capital Structure Decisions
64. 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%
Ch 15 Capital Structure Decisions
65. 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%
Ch 15 Capital Structure Decisions
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 40%. The firm has 10,000 shares of
common stock outstanding selling at a price per share of $48.00.
Ch 15 Capital Structure Decisions
66. Refer to the data for Pennewell Publishing Inc. (PP). 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
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. Now the company is considering using some debt, moving to the market value capital structure indicated below.
The money raised 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 somewhat, as indicated below.
EBIT =
$80,000
New Debt/Value =
20%
Growth =
0%
New Equity/Value =
80%
Orig cost of equity, rs =
10.0%
No. of shares =
10,000
Ch 15 Capital Structure Decisions
New cost of equity = rs =
11.0%
Price per share =
$48.00
Tax rate =
40%
Interest rate = rd =
7.0%
67. Refer to the data for VanMannen Foundations, Inc. (VF). 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
Best Bagels, Inc. (BB)
Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero
growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock
outstanding selling at a price per share of $23.08.
Ch 15 Capital Structure Decisions
68. Refer to the data for Best Bagels, Inc. (BB). 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
Anson Jackson Court Company (AJC)
The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt
outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero
growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common
stock outstanding selling at a price per share of $60.00.
69. Refer to the data for the Anson Jackson Court Company (AJC). What is AJC's current total market value and weighted
average cost of capital?
a.
$600,000; 7.5%
b.
$600,000; 8.0%
Ch 15 Capital Structure Decisions
c.
$800,000; 7.0%
d.
$800,000; 7.5%
e.
$800,000; 8.0%
70. Refer to the data for the Anson Jackson Court Company (AJC). 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
Ch 15 Capital Structure Decisions
71. Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.
The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO
thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS).
Assuming the CFO's estimates are correct, which of the following statements is CORRECT?
a.
If the plan reduces the WACC, the stock price is also likely to decline.
b.
Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
c.
If the plan does increase the EPS, the stock price will automatically increase at the same rate.
d.
Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the
interest rate on the currently outstanding bonds.
e.
Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if
EPS increases.
Ch 15 Capital Structure Decisions
72. Which of the following statements is CORRECT?
a.
The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per
share.
b.
The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times
interest earned (TIE) ratio.
c.
Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing;
however, this still may raise the company's WACC.
d.
If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate,
this would encourage companies to increase their debt ratios.
e.
The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted
average cost of capital (WACC).
73. 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
Ch 15 Capital Structure Decisions
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
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 40%. The firm has 10,000 shares of
common stock outstanding selling at a price per share of $48.00.
74. 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
Ch 15 Capital Structure Decisions
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
75. 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 9.4% 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
