88.
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure.
ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt;
its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect
EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ
it is ______ percent.
89.
Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The
current market value of the equity is $38 million and there are no taxes. What is EBIT?
90.
The SLG Corp. uses no debt. The weighted average cost of capital is 11 percent. The
current market value of the equity is $31 million and the corporate tax rate is 34 percent.
What is EBIT?
91.
W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its cost of debt
is 9 percent. The corporate tax rate is 33 percent. What is the firm’s unlevered cost of
equity capital?
92.
Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 10
percent. Bruce currently has no debt, and its cost of equity is 20 percent. The tax rate is 34
percent. What will the value of Bruce & Co. be if the firm borrows $54,000 and uses the
loan proceeds to repurchase shares?
93.
Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11
percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31
percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will
the WACC be after recapitalization?
94.
New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no
debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the
corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50
percent debt?
Essay Questions
95.
Draw the following two graphs, one above the other: In the top graph, plot firm value on
the vertical axis and total debt on the horizontal axis. Use this graph to illustrate the value
of a firm under M & M without taxes, M & M with taxes, and the static theory of capital
structure. On the lower graph, plot the WACC on the vertical axis and the debt-equity ratio
on the horizontal axis. Use this second graph to illustrate the value of the firm’s WACC
under M & M without taxes, M & M with taxes, and the static theory. Briefly explain what
the two graphs reveal about firm value and its cost of capital under the three different
theories.
96.
Based on the M & M propositions with and without taxes, how much time should a
financial manager spend analyzing the capital structure of a firm? What if the analysis is
based on the static theory?
97.
Pete is the CFO of Dexter International. He would like to increase the debt-equity ratio of
the firm but is concerned that the firm’s shareholders may not be willing to accept
additional financial leverage. Pete has come to you for advice. What is your
recommendation?
98.
In each of the theories of capital structure, the cost of equity increases as the amount of
debt increases. So why don’t financial managers use as little debt as possible to keep the
cost of equity down? After all, aren’t financial managers supposed to maximize the value
of a firm?
99.
Explain how a firm loses value during the bankruptcy process from both a creditors and a
shareholders perspective.