Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
CHAPTER 16 – ASSESSING LONG-TERM DEBT, EQUITY, AND CAPITAL
STRUCTURE
Questions
LG1 1. How will passive and active capital structure changes differ?
Active capital structure changes will be initiated immediately, regardless of whether
LG2 2. Why is debt often referred to as leverage in finance?
LG3 3. In M&M’s perfect world, will the debt holders ever bear any of the risk of the firm?
LG4 4. Why does allowing for the existence of corporate taxation cause firms to prefer the
maximum amount of debt possible?
LG5 5. If a firm increased the amount of debt in its capital structure, but a shareholder
wanted to switch back to the mixture of expected return and risk she had before the
LG5 6. If an investor wanted to reduce the risk of a levered stock in their portfolio, how
LG6 7. Suppose you were the financial manager for a firm and were considering a
proposed increase in the amount of debt in the firm’s capital structure. If you thought the
firm was going to consistently earn a level of EBIT above its break-even level of EBIT
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Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
LG7 8. Explain why, in a world with both corporate taxes and the chance of bankruptcy, a
LG7 9. If the U.S. government completely eliminated taxation at the corporate level, how
LG8 10. Would you expect a utility company to have high or low debt levels? Why?
problems
basic problems
LG3 0-1 Capital Structure Weights Suppose that Lil John Industries’ equity is currently
selling for $37 per share and that there are 2 million shares outstanding. If the firm also
has 30 thousand bonds outstanding, which are selling at 103 percent of par, what are the
firm’s current capital structure weights?
2,000, 000 $37 70.54%
2,000, 000 $37 30, 000 $1,000 1.03
30, 000 $1,000 1.03 29.46%
2,000, 000 $37 30, 000 $1,000 1.03
E
E D
D
E D
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= =
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= =
+ ´ + ´ ´
LG3 0-2 Capital Structure Weights Suppose that Papa Bell, Inc.’s, equity is currently
selling for $55 per share, with 4 million shares outstanding. If the firm also has 17
thousand bonds outstanding, which are selling at 94 percent of par, what are the firm’s
current capital structure weights?
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Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
4,000,000 $55 93.23%
4,000,000 $55 17,000 $1,000 0.94
17,000 $1,000 0.94 6.77%
4,000,000 $55 17,000 $1,000 0.94
E
E D
D
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+ ´ + ´ ´
´ ´
= =
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LG1 0-3 Restructuring Strategy Suppose that Lil John Industries’ equity is currently selling
for $27 per share and that there are 2 million shares outstanding. The firm also has 50
thousand bonds outstanding, which are selling at 103 percent of par. If Lil John was
considering an active change to their capital structure so that the firm would have a D/E of
1.4, which type of security (stocks or bonds) would they need to sell to accomplish this,
and how much would they have to sell?
Using the capital structure weights formulas from Chapter 11, the current capital weights
are:
2,000, 000 $27 0.5118 or 51.18%
2,000,000 $27 50,000 $1,000 1.03
50,000 $1,000 1.03 0.4882 or 48.82%
2,000,000 $27 50,000 $1,000 1.03
E
E D
D
E D
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= =
+ ´ + ´ ´
´ ´
= =
+ ´ + ´ ´
The current D/E ratio is 0.4882 / 0.5118 = 0.9537, so Lil John would be contemplating
increasing the D/E ratio. To do so, they would have to change their debt ratio to 1.4 / 2.4 =
0.5833, which would require issuing (0.5833 – 0.4882) × [($2,000,000 × $27) + (50,000 ×
LG1 0-4 Capital Structure Weights Suppose that Papa Bell, Inc.’s, equity is currently
selling for $45 per share, with 4 million shares outstanding. The firm also has seven
thousand bonds outstanding, which are selling at 94 percent of par. If Papa Bell was
considering an active change to their capital structure so as to have a D/E of 0.4, which
type of security (stocks or bonds) would they need to sell to accomplish this, and how
much would they have to sell?
Using the capital structure weights formulas from Chapter 11, the current capital weights
are:
4, 000, 000 $45 96.47%
4,000, 000 $45 7, 000 $1, 000 0.94
7,000 $1,000 0.94 3.53%
4,000, 000 $45 7, 000 $1, 000 0.94
E
E D
D
E D
´
= =
+ ´ + ´ ´
´ ´
= =
+ ´ + ´ ´
The current D/E ratio is 0.0353 / 0.9647 = 0.0366, so Lil John would be contemplating
increasing the D/E ratio. To do so, they would have to change their debt ratio to 0.4 / 1.4 =
16-3
intermediate problems
LG3 0-5 Expected EPS after Leveraging Daddi Mac, Inc., doesn’t face any taxes and has
$290 million in assets, currently financed entirely with equity. Equity is worth $37 per
share, and book value of equity is equal to market value of equity. Also, let’s assume that
the firm’s expected values for EBIT depend upon which state of the economy occurs this
year, with the possible values of EBIT and their associated probabilities shown as follows:
STATE RECESSION AVERAGE BOOM
Probability of state 0.25 0.55 0.20
Expected EBIT in state $5 million $10 million $17 million
The firm is considering switching to a 20 percent debt capital structure, and has determined
that they would have to pay an 8 percent yield on perpetual debt in either event. What will
be the level of expected EPS if they switch to the proposed capital structure?
Interest in all states will be equal to 0.08 × (0.20 × $290,000,000) = $4,640,000, and the
LG3 0-6 Expected EPS after Leveraging HiLo, Inc., doesn’t face any taxes and has $150
million in assets, currently financed entirely with equity. Equity is worth $7 per share, and
book value of equity is equal to market value of equity. Also, let’s assume that the firm’s
expected values for EBIT depend upon which state of the economy occurs this year, with
the possible values of EBIT and their associated probabilities shown as follows:
STATE PESSIMISTIC OPTIMISTIC
Probability of state 0.45 0.55
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Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
Expected EBIT in state $5 million $19 million
The firm is considering switching to a 40 percent debt capital structure, and has determined
that they would have to pay a 12 percent yield on perpetual debt in either event. What will
be the level of expected EPS if they switch to the proposed capital structure?
Interest in all states will be equal to 0.12 × (0.40 × $150,000,000) = $7,200,000, and the
LG3 0-7 Standard Deviation in EPS after Leveraging Daddi Mac, Inc., doesn’t face any
taxes and has $350 million in assets, currently financed entirely with equity. Equity is
worth $37 per share, and book value of equity is equal to market value of equity. Also, let’s
assume that the firm’s expected values for EBIT are dependent upon which state of the
economy occurs this year, with the possible values of EBIT and their associated
probabilities shown as follows:
STATE RECESSION AVERAGE BOOM
Probability of state 0.25 0.55 0.20
Expected EBIT in state $5 million $10 million $17 million
The firm is considering switching to a 20 percent debt capital structure, and has determined
that they would have to pay an 8 percent yield on perpetual debt regardless of whether they
change their capital structure. What will be the standard deviation in EPS if they switch to
the proposed capital structure?
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advanced problems
LG4 0-9 Expected EPS after Leveraging with Taxes NoNuns Cos. has a 25 percent tax rate
and has $350 million in assets, currently financed entirely with equity. Equity is worth $37
per share, and book value of equity is equal to market value of equity. Also, let’s assume
that the firm’s expected values for EBIT depend upon which state of the economy occurs
this year, with the possible values of EBIT and their associated probabilities shown as
follows:
STATE RECESSION AVERAGE BOOM
Probability of state 0.25 0.55 0.20
Expected EBIT in state $5 million $10 million $17 million
The firm is considering switching to a 20 percent debt capital structure, and has determined
that they would have to pay an 8 percent yield on perpetual debt in either event. What will
be the level of expected EPS if they switch to the proposed capital structure?
Interest in all states will be equal to 0.08 × (0.20 × $350,000,000) = $5,600,000, and the
LG4 0-10 Expected EPS after Leveraging with Taxes GTB, Inc., has a 34 percent tax rate
and has $100 million in assets, currently financed entirely with equity. Equity is worth $7
per share, and book value of equity is equal to market value of equity. Also, let’s assume
that the firm’s expected values for EBIT depend upon which state of the economy occurs
this year, with the possible values of EBIT and their associated probabilities shown as
follows:
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Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
STATE PESSIMISTIC OPTIMISTIC
Probability of state 0.45 0.55
Expected EBIT in state $5 million $19 million
The firm is considering switching to a 40 percent debt capital structure, and has determined
that they would have to pay a 12 percent yield on perpetual debt in either event. What will
be the level of expected EPS if they switch to the proposed capital structure?
LG4 0-11 Standard Deviation in EPS after Leveraging with Taxes NoNuns Cos. has
a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity.
Equity is worth $37 per share, and book value of equity is equal to market value of equity.
Also, let’s assume that the firm’s expected values for EBIT depend upon which state of the
economy occurs this year, with the possible values of EBIT and their associated
probabilities shown as follows:
STATE RECESSION AVERAGE BOOM
Probability of state 0.25 0.55 0.20
Expected EBIT in state $5 million $10 million $17 million
The firm is considering switching to a 20 percent debt capital structure, and has determined
that they would have to pay an 8 percent yield on perpetual debt in either event. What will
be the standard deviation in EPS if they switch to the proposed capital structure?
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Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
Chapter 16 – Assessing Long-Term Debt, Equity, and Capital Structure
Expected EBIT in state $5 million $19 million
The firm is considering switching to a 40 percent debt capital structure, and has determined
that they would have to pay a 12 percent yield on perpetual debt in either event. What will
be the break-even level of EBIT?