CHAPTER 16—CAPITAL STRUCTURE DECISIONS
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Debt’s effect on ROE
TYPE: Multiple Choice: Problem
48. After an intensive research and development effort, two methods for producing playing cards have been identified by
the Turner Company. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per
deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater
variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what
level of output will the two methods produce the same net operating income (EBIT)?
a.
b.
c.
d.
e.
Difficulty: Moderate
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
TYPE: Multiple Choice: Problem
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
49. Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is
40%. What would Bailey’s beta be if it used no debt, i.e., what is its unlevered beta?
a.
0.64
b.
0.67
c.
0.71
d.
0.75
e.
0.79
e
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Calculating the unlevered beta
TYPE: Multiple Choice: Problem
50. The following information has been presented to you about the Gibson Corporation.
Total assets
$3,000 million
Tax rate
40%
Operating income (EBIT)
$800 million
Debt ratio
0%
Interest expense
$0 million
WACC
10%
Net income
$480 million
M/B ratio
1.00×
Share price
$32.00
EPS = DPS
$3.20
The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS).
The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based
on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company
makes this change, what would be the total market value (in millions) of the firm?
a.
$3,200
b.
$3,600
c.
$4,000
d.
$4,200
e.
$4,800
e
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
51. 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
c
52. 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?
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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%
c
Difficulty: Challenging
INTE.GENE.16.105 – LO: 16-2
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Differences in ROE
TYPE: Multiple Choice: Problem
53. 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%
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
54. 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%
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
55. 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%
e
Difficulty: Challenging
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Cost of equity–unlevering and relevering betas
TYPE: Multiple Choice: Problem
56. 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%.
United States – OH – Default City – TBA
Calculating levered beta and cost of equity
TYPE: Multiple Choice: Problem
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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
Recapitalization
57. 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
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
c.
$52
d.
$54
e.
$60
58. 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%
c
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
59. 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%
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
e.
wc = 0.5; wd = 0.5; WACC = 10.18%
Difficulty: Challenging
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Opt cap struc, Hamada equation–nonalgorithmic
TYPE: Multiple Choice: Problem
Exhibit 16.1
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.
60. Refer to Exhibit 16.1. 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
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
c.
$521,173
d.
$560,748
e.
$584,653
61. Refer to Exhibit 16.1. 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
c
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
62. Refer to Exhibit 16.1. 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
Difficulty: Moderate
INTE.GENE.16.108 – LO: 16-6
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Stock price, recapitalization–nonalgorithmic
TYPE: Multiple Choice: Multi-part
Exhibit 16.2
VanMannen Foundations, Inc. (VF) is a zero-growth company that currently has zero debt, and it has the data shown
TYPE: Multiple Choice: Multi-part
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
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
New cost of equity = rs =
11.0%
Price per share =
$48.00
Tax rate =
40%
Interest rate = rd =
7.0%
63. Refer to Exhibit 16.2. 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
a
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
WACC and recapitalization
TYPE: Multiple Choice: Multi-part
The problems referring to Exhibit 16.2 MUST be kept together.
64. Refer to Exhibit 16.2. 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
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
d.
$58.80
e.
$61.74
65. Refer to Exhibit 16.2. 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
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
Exhibit 16.3
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.
66. Refer to Exhibit 16.3. 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
a
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
WACC and recapitalization–nonalgorithmic
TYPE: Multiple Choice: Multi-part
The problems referring to Exhibit 16.3 MUST be kept together, and they cannot be changed
67. Refer to Exhibit 16.3. 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
United States – OH – Default City – TBA
Stock price, recapitalization
TYPE: Multiple Choice: Multi-part
The problems referring to Exhibit 16.2 MUST be kept together.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
e.
17,105; $89.67
a
Difficulty: Moderate
INTE.GENE.16.108 – LO: 16-6
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Stock price, recapitalization–nonalgorithmic
TYPE: Multiple Choice: Multi-part
68. Refer to Exhibit 16.3. 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
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
Difficulty: Moderate
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Market value and WACC–nonalgorithmic
TYPE: Multiple Choice: Multi-part
The problems referring to Exhibit 16.4 MUST be kept together, and they cannot be changed
Exhibit 16.4
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 Exhibit 16.4. 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%
Difficulty: Moderate
INTE.GENE.16.108 – LO: 16-6
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
Stock price, recapitalization–nonalgorithmic
TYPE: Multiple Choice: Multi-part
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
70. Refer to Exhibit 16.4. 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
Difficulty: Challenging
INTE.GENE.16.107 – LO: 16-5
United States – BUSPROG: Analytic
United States – AK – DISC: Capital structure
United States – OH – Default City – TBA
WACC and recapitalization–nonalgorithmic
TYPE: Multiple Choice: Multi-part
71. Refer to Exhibit 16.4. 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
c
Difficulty: Challenging
INTE.GENE.16.108 – LO: 16-6
algorithmically.
CHAPTER 16—CAPITAL STRUCTURE DECISIONS
72. Refer to Exhibit 16.4. 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