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CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL
STRUCTURE POLICY
Answers to Concepts Review and Critical Thinking Questions
1. Business risk is the equity risk arising from the nature of the firm’s operating activity and is directly
4. The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to
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9. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. a. A table outlining the income statement for the three possible states of the economy is shown
b. If the company undergoes the proposed recapitalization, it will repurchase:
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The interest payment each year under all three scenarios will be:
2. a. A table outlining the income statement with taxes for the three possible states of the economy is
b. A table outlining the income statement with taxes for the three possible states of the economy
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3. a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the
b. If the company undertakes the proposed recapitalization, the new equity value will be:
c. If there are corporate taxes and the company maintains its current capital structure, the ROE is:
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Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest
b. Under Plan I, the net income is $750,000 and the EPS is:
c. To find the breakeven EBIT for two different capital structures, we simply set the equations for
5. We can find the price per share by dividing the amount of debt used to repurchase shares by the number
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6. a. The income statement for each capitalization plan is:
b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The
EPS is calculated as:
c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT,
we get:
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d. The income statement for each capitalization plan with corporate income taxes is:
This is similar to the equation we used before, except now we need to account for taxes. Again,
7. To find the value per share of the stock under each capitalization plan, we can calculate the price as
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8. a. The earnings per share are:
b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under
the proposed capital structure. The market value of the firm is:
This means the EPS under the new capital structure will be:
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d. The capital structure is irrelevant because shareholders can create their own leverage or unlever
the stock to create the payoff they desire, regardless of the capital structure the firm actually
chooses.
9. a. The rate of return earned will be the dividend yield. The company has debt, so it must make an
interest payment. The net income for the company is:
b. To generate exactly the same cash flows in the other company, the shareholder needs to match
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The total cash flow for the shareholder will be:
c. ABC is an all equity company, so:
To find the cost of equity for XYZ we need to use M&M Proposition II, so:
d. To find the WACC for each company we need to use the WACC equation:
10. With no taxes, the value of an unlevered firm is the EBIT divided by the unlevered cost of equity, so:
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11. If there are corporate taxes, the value of an unlevered firm is:
12. a. With the information provided, we can use the equation for calculating WACC to find the cost
of equity. The equation for WACC is:
b. To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:
c. To find the cost of equity under different capital structures, we can again use M&M Proposition
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13. a. For an all-equity financed company:
c. Using M&M Proposition II with taxes again, we get:
d. The WACC with 25 percent debt is:
14. a. The value of the unlevered firm is:
b. The value of the levered firm is:
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15. We can find the cost of equity using M&M Proposition II with taxes. Doing so, we find:
Intermediate
16. To find the value of the levered firm we first need to find the value of an unlevered firm. So, the value
of the unlevered firm is:
17. a. With no debt, we are finding the value of an unlevered firm, so:
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c. According to M&M Proposition I with taxes:
18. a. To purchase 5 percent of Knight’s equity, the investor would need:
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Challenge
19. M&M Proposition II states:
20. The return on equity is net income divided by equity. Net income can be expressed as:
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Now we can rearrange and substitute as follows to arrive at M&M Proposition II with taxes:
21. M&M Proposition II, with no taxes is:
22. Using the equation we derived in Problem 21:
