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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
Proposed Capital Structure: Borrow $50 million at 8 percent and use the cash to repurchase 1 million
shares at $50 per share
Recession Expected
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:
11-1
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
both shareholders and debt holders and (2) an increase in the firm’s expected earnings before interest.
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
Currently
Under the new capital structure
c.
Mr. Robert will receive less cash under the new capital structure than under the current one ($440,000
Mr. Robert can keep receiving $560,000 from his investment in Alberton if he does the following:
11-2
Tender a percentage of its shares equal to the percentage of shares that Alberton will buy back, that is
Subscribe to Alberton’s debt issue up to $2.52 million. From then on, Mr. Robert will receive
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.
According to the capital asset pricing model, a higher debt-to-equity ratio increases the equity beta
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
E
D
..k L
E03614
From equation 11.8, we have:
DE
D
)T(k
DE
E
kWACC cD
L
E
1
E
D
E
D
)T(k
E
D
kcD
L
E
1
1
1
1
D/E0 25% 50% 75% 100%
b.
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
Conclusion: You should not recommend an increase in debt on the basis of this analysis alone.
11-4
WACC
kd
L
E
k
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
At the current target capital structure of 80 percent equity and 20 percent debt (D/E=.25):
L
E
Since the return on assets does not depend upon the way the assets are financed, the equation is still
applicable if the target capital structure changes to 50 percent equity, 50 percent debt (D/E = 1). Then, we
have:
L
E
Albarval’s return on assets accrues to both its shareholders and debt holders in proportion to their
respective investments in the firm. Since a firm’s weighted average cost of capital (WACC) is equal to the
sum of the shareholders’ and bondholders’ expected returns in proportion to their respective investments
b.
From equation 11.7:
E
D
)T)(kr(rk cDAA
L
E 1
where:
Tc = corporate tax rate
When the target debt-to-equity ratio is .25, the cost of equity is:
L
And, from equation 11.8, the weighted average cost of capital is:
ED
D
)T(k
DE
E
kWACC cD
L
E
1
11-5
When the target debt ratio is 1:
L
and
Although the return on assets is still not affected by changes in the capital structure, the weighted average
cost of capital is because the interest payments are tax deductible. The 8 percent interest rate required by
Albarval’s debt holders changes to 4.8 percent [8% (1 – .40)] when the corporate tax rate is 40 percent.
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
If the debt is permanent, the present value of the interest tax shield is equal to the present value of a
perpetual annuity of $700,000 at 8 percent:
rateInterest
ITS
08.
000,700$
Note that the value of the tax shield would represent 8.75 percent of the market value of the firm, since
If the debt matures in five years, the present value of the interest tax shield is equal to the present value of
a five-year annuity of $700,000 at 8 percent:
000,700$
000,700$
000,700$
000,700$
000,700$
000,700$
000,700$
000,700$
000,700$
000,700$
