CHAPTER 12 CAPITAL STRUCTURE AND LEVERAGE

(Difficulty: E = Easy, M = Medium, and T = Tough)

Business risk 1.

Diff: E

Which of the following factors would affect a company’s business risk? a. b. c. d. e. The level of uncertainty regarding the demand for its product. The degree of operating leverage. The amount of debt in its capital structure. Statements a and b are correct. All of the statements above are correct. Diff: E

Business and financial risk 2. Which of the following statements is most correct?

a. A firm’s business risk is solely determined by the financial characteristics of its industry. b. The factors that affect a firm’s business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors that affect a firm’s business risk are not subject to any degree of managerial control. c. One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much less important. d. The firm’s financial risk may have both market risk and diversifiable risk components. e. None of the statements above is correct. Optimal capital structure 3. Diff: E

From the information below, select the optimal capital structure for Minnow Entertainment Company. a. b. c. d. e. Debt Debt Debt Debt Debt = = = = = 40%; 50%; 60%; 80%; 70%; Equity Equity Equity Equity Equity = = = = = 60%; 50%; 40%; 20%; 30%; EPS EPS EPS EPS EPS = = = = = $2.95; $3.05; $3.18; $3.42; $3.31; Stock Stock Stock Stock Stock price price price price price = = = = = $26.50. $28.90. $31.20. $30.40. $30.00. Diff: E

Optimal capital structure 4.

Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s weighted average cost of capital (WACC). d. Statements a and b are correct. e. Statements b and c are correct.

1

A decrease in the firm’s business risk. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company’s common stock. e. Diff: E Which of the following factors is likely to encourage a corporation to increase the proportion of debt in its capital structure? a. b. and EPS 9. d. Diff: E Capital structure. b. All of the statements above are correct. e. TIE. c. c. The company’s ROA will decline. An increase in the personal tax rate. Which of the following factors is likely to encourage a company to increase its debt ratio? a. ROA. e. An increase in costs incurred when filing for bankruptcy. e. Its assets become less liquid. Diff: E Leverage and capital structure 6. The company currently has no debt in its capital structure. WACC. An increase in the personal tax rate. and ROE 8. d. The company’s ROE will increase. b. Statements b and d are correct. An increase in expected bankruptcy costs. Diff: E Capital structure. An increase in the company’s degree of operating leverage. The capital structure that maximizes stock price is also the capital structure that maximizes earnings per share. All of the statements above are correct. The company’s basic earning power is 15 percent. Both statements a and c are correct. Which of the following would increase the likelihood that a company would increase its debt ratio in its capital structure? a. Ridgefield Enterprises has total assets of $300 million. The company’s basic earning power will decline. An increase in the corporate tax rate. An increase in the personal tax rate. The company’s assets become less liquid.Leverage and capital structure 5. c. d. 2 . An increase in the corporate tax rate. d. If the company proceeds with the recapitali-zation its operating income. The capital structure that maximizes stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio. Which of the following statements is most correct? a. c. total assets. The capital structure that maximizes stock price is also the capital structure that minimizes the weighted average cost of capital (WACC). b. b. and tax rate will remain the same. An increase in the corporate tax rate. c. Which of the following will occur as a result of the recapitalization? a. Statements a and b are correct. Diff: E Leverage and capital structure 7.

None of the statements above is correct. d. At what price must each widget be sold for the company to achieve an EBIT of $95. Financial leverage and ratios Diff: E 10. If corporate tax rates were decreased while other things were held constant. An increase in the personal tax rate would not affect firms’ capital structure decisions. (2) minimizes its WACC. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk. Which of the following statements is most correct? a. and operating leverage. and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct. d.000. e. b.000 widgets next year. Firm U and Firm L each have the same total assets. If corporate tax rates were decreased while other things were held constant. e. The two companies have the same times interest earned (TIE) ratio.d. Variable costs will equal 40 percent of sales. correct. Statements b and c are correct. this would tend to cause corporations to increase their use of debt. c. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt. Firm L has Firm L has Statements Statements a a a b lower lower and b and c ROA ROE are are than Firm U. b. while business risk reflects both the use of debt and such factors as sales variability. Miscellaneous capital structure concepts 12. Which of the following statements is correct? a. and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct. Both firms have positive net income. this would tend to cause corporations to decrease their use of debt. correct. Determining price from EBIT 13. while fixed costs will total $110.000? 3 . Which of the following statements is most correct? a. cost variability. a firm with low operating leverage has a small proportion of its total costs in the form of fixed costs. Diff: M Miscellaneous capital structure concepts 11. e. d. assuming all else equal. Both firms also have a basic earning power of 20 percent. In general. c. while Firm L is financed with 50 percent debt and 50 percent equity. and (3) maximizes its EPS. Firm L’s debt has a before-tax cost of 8 percent. Diff: E Diff: M The Price Company will produce 55. than Firm U. e. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock. Statements a and b are correct. Statements a and b are correct. b. All of the statements above are correct. Firm U is 100 percent equity financed. c.

One key benefit is that Hensley can lower its wholesale price to its distributors to $1. 75.a. d.000 units e.00 Diff: M New financing 15. b. and it needs to raise $100.60.47 $2. The firm is considering a new bag machine and an automatic carton folder as modifications to its existing production lines. c. Currently. Texas Products Inc. 50 percent equity Diff: M Change in breakeven volume 16.000.00 $4. Hensley Corporation uses breakeven analysis to study the effects of expansion projects it considers. d.82 $3.5. which would increase its fixed costs to $650.33 percent. while its unit price per carton is $1. 80 percent equity 40 percent debt.000 to expand.000 units per year at a price of $7. b. fixed costs would rise to $240. its variable cost is $4. Management feels that an optimal debt ratio would be 16. $2.15 $2. as it will become the lowest cost producer. has a division that makes burlap bags for the citrus industry.00 per unit. what price must the division charge in order to break even? a.67 percent.000 units c. but variable cost would drop to $0.41 per unit. 175. e. 100% equity 100% debt 20 percent debt.37 $6.48 per unit. The Altman Company has a debt ratio of 33.000 units b.00. c. Diff: M Martin Corporation currently sells 180. How should the expansion be financed so as to produce the desired debt ratio? a. If 4 . 0 units Breakeven and expansion 17. e.000 per month. What is the change in the breakeven volume with the proposed project? a.000 bags per month. d.20 per unit.45 $5.000.000 units d. and this would likely more than double its market share.000.20 and its variable unit cost is $0. 200. 60 percent equity 50 percent debt. the firm’s plastic bag business segment has fixed costs of $120. 100. With the expansion.24 $2. Sales are currently $750. If the variable cost per bag is $2. and fixed costs are $400.000 and would increase its variable unit cost to an average of $4. and the total assets turnover is 7.00 $5. $2. b.05 per carton (that is.21 Diff: E Breakeven price 14. e. and it expects to sell 42.000. Martin is considering expanding into two additional states. its selling price). c. The division has fixed costs of $10.

$32. how much will Martin’s breakeven sales dollar level change? a.43 0.333 $ 456.60 0.Martin expands. $ 183. e.70 0.000 units at $7.667 $1.8 5 . Diff: M A consultant has collected the following information regarding Young Publishing: Total assets $3.29 $32. After meeting with investment bankers.72 Diff: T Optimal capital structure and Hamada equation 19. c. however. after the repurchase.20/0. b.0% 7.90 0. the cost of equity will increase to 11 percent. it expects to sell 270.48 $31. b.11 0. In order to estimate the cost of debt.20 0.0 8.556 $ 910. what will be its estimated stock price after the capital structure change? a.70 0.10/0.00 $33.00 Tax rate Debt ratio WACC M/B ratio EPS = DPS 40% 0% 10% 1.67 AA A A BB 7.30 0. c.00× $3. d. The $1. leaving the company with interest expense of $84 million. so the company pays out all of its earnings as dividends (EPS = DPS). Aaron Athletics is trying to determine its optimal capital structure.200.60 = = = = 0.40 0. The repurchase will have no effect on the firm’s EBIT.000 Operating income (EBIT) $800 Interest expense $0 Net income $480 Share price million million million million $32.59 $34.80 0.200 million raised from the debt issue would be used to repurchase stock at $32 per share. The consultant believes that the company would be much better off if it were to change its capital structure to 40 percent debt and 60 percent equity. the company has produced the following table: Debt-to-totalassets ratio (wd) debt Equity-to-totalassets ratio (wc) Debt-to-equity ratio (D/E) Bond rating Before-tax cost of 0.000 By Capital structure and stock price 18. Young’s stock price can be calculated by simply dividing earnings per share by the required return on equity capital. The company’s capital structure consists of debt and common stock.200 million of debt at a before-tax cost of 7 percent.25 0.80 0. e.2 8.90 0.30/0.500 $ 805. which currently equals the WACC because the company has no debt. d.10 0. If the firm follows the consultant’s advice.20 The company has no growth opportunities (g = 0). the consultant concludes that the company could issue $1.00 per unit.40/0.

5. The company uses the CAPM to estimate its cost of common equity.00 ks 15.7. and EBIT is expected to remain constant over time.00 3. the bonds would have an estimated yield to maturity of 8 percent. 0.” bU. Aaron estimates that if it had no debt its beta would be 1. is 40 percent. so its earnings per share equals its dividends per share.1.5.0. The company’s EBIT is $2.000 worth of bonds and using the proceeds for a stock repurchase.000.14 $ 74. The company pays out all of its earnings each year. (Its “unlevered beta. 0.50 0. what is the company’s optimal capital structure.75 4.000. d.6. ks.2 if it proceeded with the recapitalization. The risk-free rate is 5 percent and the market risk premium is also 5 percent. b. e. Debt/Total Assets = 30% c.9. c. The company is considering issuing $800. 0. Debt/Total Assets = 20% b. WACC WACC WACC WACC WACC = = = = = 14.0% 15. The risk-free rate is 5 percent and the market risk premium is 6 percent. but its investment bankers estimate that the company’s beta would rise to 1.50 3.0.6 The company’s tax rate. The company’s stock price is currently $80 a share.18% Diff: T Capital structure and stock price 20.0.40 6 . 0. b.0 18. equals 1.67 $102. 0.50 = 1. The company’s beta is currently 1. wd wd wd wd wd = = = = = 0. c. e. The company retains 30 percent of its earnings to fund future growth. 0.000 shares outstanding.96% 10. d. Diff: T Lascheid Enterprises is an all-equity firm with 175. T. $106.) On the basis of this information.0. What is the optimal capital structure for ZPC? Debt/Total Assets 20% 30 40 50 70 a. If issued.15% 10.25 3.5 16. ZPC’s expected EPS (EPS1) and ks for various capital structures are given below.50/0. 0.0 17.2.8. Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent.50 0.63 $ 77.67 $ 70.0 Capital structure and stock price 21.3. wc wc wc wc wc = = = = = 0.83% 10.4.96% 7. The firm’s tax rate is 30 percent.00 B 9. Debt/Total Assets = 40% Expected EPS $2. 0. and what is the firm’s weighted average cost of capital (WACC) at this optimal capital structure? a. What would be the company’s stock price following the repurchase transaction? a.

23 $2.54 Debt/Total Assets = 50% Debt/Total Assets = 70% (The following information applies to the next three problems. the Fotopoulos Corporation is considering a recapitalization. the company has determined the following information: • • • • • The The The The The company estimates that its before-tax cost of debt is 7.1. 11. risk-free rate is 5 percent.52 $5.5 percent.26 $4. e. the Fotopoulos Corporation’s balance sheet is as follows: Assets Total assets $5 billion $5 billion Debt $1 billion Common equity 4 billion Total debt & common equity $5 billion The book value of the company (both debt and common equity) equals its market value (both debt and common equity). Assume the stock price remains unchanged by the transaction. and the company’s tax rate is 34 percent.Capital structure and EPS 22. market risk premium. company’s tax rate is 40 percent. The proposed plan is to issue $1 billion worth of debt and to use the money to repurchase $1 billion worth of common stock. 10. d. d. 9. is 6 percent.6 million (before any recapitalization).88% c. The company’s stock trades at $40 a share. company estimates that its levered beta is 1.78% e. e. What is Fotopoulos’ recapitalization)? a. $2.38% Hamada equation and unlevered beta 24. As a result of this recapitalization. 5. if it proceeds with the recapitalization? a. the firm’s size will not change. What will be the company’s earnings per share. b. kM – kRF. where it will issue $10 million worth of debt at a yield to maturity of 10 percent and use the proceeds to repurchase common stock. Capital structure and WACC 23. The company currently has 900. 10. Diff: T Buchanan Brothers anticipates that its net income at the end of the year will be $3.45 $3.92% b. c. The company is considering a recapitalization.18% d.) Currently. In addition. Furthermore.000 shares of common stock outstanding and has no debt. What is Fotopoulos’ recapitalization)? current unlevered beta (before the Diff: E proposed current WACC (before the Diff: E proposed 7 .

8962 0.a. What will be the company’s new cost of common equity if it proceeds with the recapitalization? (Hint: Be sure that the beta you use is carried out to 4 decimal places.62% 13. b. c.9565 1. d.) a.74% 11.03% 8 . 0. 10.2700 Diff: M Hamada equation and cost of common equity 25. b. d. e.62% 12.0041 1.27% 12. e.6213 0. c.

3. Statements a and b are correct. then this will tend to increase its debt ratio. 5. 4. Since statements a and b are correct. all the other statements are false. 7. Since interest is tax deductible. Business and financial risk Optimal capital structure Optimal capital structure Leverage and capital structure Answer: d Answer: c Answer: e Answer: a Diff: E Diff: E Diff: E Diff: E Statement a is correct. is related to the financial risk of the firm. it would hurt the company’s financial position. Increasing operating leverage would discourage a company from increasing debt. An increase in the personal tax rate decreases the after-tax return that investors will receive. Business risk Answer: d Diff: E The correct answer is statement d. so firms will not increase their debt ratios. An increase in the corporate tax rate would mean that firms would get larger tax breaks for interest payments. Firms will have to issue debt at higher interest rates in order to provide investors with the same after-tax returns they used to receive. Both relate directly to the business side of the firm. so they will increase their debt ratios. Therefore. Leverage and capital structure Answer: e Diff: E If the costs incurred when filing for bankruptcy increased. on the other hand. the correct choice is statement e. If a company’s assets become less liquid. If a firm’s business risk decreases. Therefore. If corporate tax rates increase. Therefore. Therefore. 2. Interest received by individual investors is not tax exempt. it would make sense to increase debt if the corporate tax rate rises. they would reduce debt levels to help avoid bankruptcy risk. in order to reduce taxes. then companies get a larger tax advantage from debt in their capital structure. which will increase their WACCs. 6. Since both statements b and d are true. An increase in expected bankruptcy costs would encourage a company to use less debt. so statement b is true. making it less likely that the firm could make interest payments when necessary. firms would be penalized more if they filed for bankruptcy and would be less willing to take that risk. they will increase their debt ratios. statement c is false. so statement a is false. Therefore. statement d is true.CHAPTER 12 ANSWERS AND SOLUTIONS 1. statement d is the correct choice. If personal taxes 9 . This will raise firms’ costs of debt. Statement c. so an increase in the personal tax rate would not encourage a firm to increase its debt level in the capital structure. firms have an incentive to increase interest payments. Leverage and capital structure Answer: a Diff: E The correct answer is statement a.

Firm L will have a lower ROA than Firm U. BEP = EBIT/TA. statement d is the appropriate choice. ROA = NI/TA. Since BEP is 20 percent and kd is 8 percent. corporations would decrease their use of debt 10 . 9. therefore. If the personal tax rate were increased. Therefore. The firm could maximize its TIE by having no debt (that is zero interest payments). and ROE Answer: d Diff: E Statements a and b are correct. If total assets remain the same. Therefore.) This makes the debt more expensive and makes companies less likely to increase their debt ratios. but not as much in comparison to the amount that common equity will fall because BEP > kd. Miscellaneous capital structure concepts Answer: c Diff: M If corporate tax rates were decreased while other things were held constant. the other statements are false. ROA. The capital structure that maximizes the firm’s stock price generally calls for a debt ratio that is lower than the one that maximizes EPS. Therefore. then they must have the same EBIT. k = k* + IP + DRP + MRP + LP. 2. therefore. BEP will remain the same. Leverage will increase ROE if BEP > k d.increase. Therefore. so its net income will be lower than Firm U. ROA will decrease. (Remember. investors would prefer to receive less of their income as interest--implying firms would substitute equity for debt. 8. leverage will increase Firm L’s ROE. LP increases. an increase in the personal tax rate will not encourage corporations to increase their debt ratios. the other statements are false. Since Firm U has no debt in its capital structure. but NI decreases (because of the new interest payment). If their assets become less liquid. Capital structure. this capital structure would probably not maximize the firm’s stock price. If the two companies have the same EBIT. companies will have to pay a higher interest rate on their bonds. Miscellaneous capital structure concepts Answer: a Diff: M Statement a is true. 1. Therefore. where TA and EBIT remain the same (which was given in the problem). The TIE ratio is EBIT/Int. Since ROA is equal to NI/TA. which makes debt more expensive. Firms L and U have the same EBIT. statement c is false. But. statement b is true. but Firm L has a higher interest expense. firms with high business risk would use less debt. will have a higher TIE. 0. TIE. High business risk is associated with high operating leverage. and if the MM tax-adjusted tradeoff theory of capital structure were correct. If both firms have the same BEP ratio and same total assets. Financial leverage and ratios Answer: b Diff: E BEP = EBIT/TA. statement a is false. If assets are less liquid. NI will fall. and the two firms have the same total assets. companies will need to pay higher interest rates. Capital structure. thus ROE = NI/CE will rise. bondholders will pay more taxes and will demand a higher rate of return from companies to compensate them. Firm U will have higher net income than Firm L because U has no interest expense and L does. the one with the lower interest expense (Firm U). WACC. and EPS Answer: a Diff: E Statement a is correct.

3333.000) .20 New QBE = $240. thus the firm should finance with 100 percent equity.000 + $100. New TA = $100.000. $0.5.1667.000P $6. Change in breakeven volume Calculate the old and new projections: Old QBE = $120.000 = $1.000) . 5.000 = $2.556.64 = 375. Business risk is the riskiness of the firm’s operations if it uses no debt.6)(55.000 $205. 1 .1667) = $33.200.000/$0.67% of total assets following the expansion.000 $205. Price = $94. = = = = = PQ .000 units.00 Price/unit Sales = $400. 6.24.(0. Answer: a Diff: M Sales = 7.000/($1.00 11 . TA $750.20 = VC = 111$7.000 units. New debt ratio = 0. Answer: a Diff: E Answer: e Diff: E Breakeven price Total costs = $10.000/42. 11 .05 Change in breakeven volume 7.21.000 + $2(42. 3.000.000 $4.60 = 200.64 $7.4)P(55.60) = $120.333 represents approximately 16.000 $650.333. New financing Old debt ratio = 0.000 (0.000(0.000.000) = $33.000)P 33. Altman’s current debt of $33.000. = 375.48 = = = $1.000.000) = $94. The optimal capital structure does not maximize EPS.$110.000 .000/$0.000 = 175.000 TA = = $100.0. New Debt = $200.FC P(55.000/($1.000 FC VC/unit = $4.0.000 units.60 Calculate the new breakeven volume in sales dollars: New SBE $650.VQ .3333($100.because the tax shelter benefit would not be as great as when tax rates are high. Breakeven and expansion Calculate the initial breakeven volume in dollars: Old SBE Answer: b Diff: M breakeven volumes using the old data and new $0. Answer: c Diff: M FC $400.000 = $200. 7.41) = $240.000 P 4.333. and the degree of total leverage shows how a given change in sales will affect earnings per share.805.5 Debt = 0. Determining price from EBIT EBIT $95.

T) + wcks = (0. Then. (D/E) WACC b = bU[1 + (1 .kRF)b = 5% + 6%(1.75/(15% .8 9.40%) = 10.556.kRF)b wc kd wd 0.0[1 + (1 . D 1 = $2.5 million shares. use each of these betas with the CAPM to find the ks for that capital structure.43 0.22 0.0.38 0.4000% 11.70 = $2.4) + (0.T) + wcks.0% 7. if the D/E is 0.5429 13.7%) or $21. when the debt ratio is 40%.71.9000 12. Capital structure and stock price Step 1: Step 2: Answer: e Diff: M Find the current number of shares outstanding: Shares = NI/EPS = $480 million/$3.The increase in SB = $1.50.T)(D/E)] = 1.75.6]/112.kRF = 6%.00 × 0. ks = kRF + (kM . Find the new EPS after the repurchase: EPS = [(EBIT – INT)(1 . the expected dividend per share D1 is $2. The weights are given at 0.00 1.0 8. and the kd for that capital structure is given as 7 percent. You need to use the D/E ratio given for each capital structure to find the levered beta using the Hamada equation. Optimal capital structure and Hamada equation kRF = 5%.2 8.6 0.5 7. respectively.1 for equity and debt.0667 1.10/(15.72.kRF)b. Find the new stock price: Stock price = EPS/New WACC = $3.818667/0.2 10. kM .00 and expected D 1 is $3. WACC = wdkd(1 .88.2571 1.1 10.50 × 0.11: b = 1. which is 10.25 0.$1. expected EPS is $2.7%) = $24.15 0.4000 1. Similarly.818667.4)(0. WACC = wdkd(1 .000.5 = $3. The optimal capital structure is the one that minimizes the WACC.0667.70 = $1.6 0. 20.67 1.5 10.1)(7%)(1 . When the debt ratio is 20%.11 0.68%.1500 1. Answer: d Diff: T Step 3: Step 4: 9.200/$32 = 150 – 37.68% 0. The stock price P0 is $1.000 = $805.9)(11. The stock price P 0 is $2.7 0. Use this ks and kd for each capital structure to find the WACC.556 .0.275 and P0 = 12 .40%. Given the firm’s policy of retaining 30% of earnings. ks = kRF + (kM .6000 0. 8.18 For example.9 and 0.4000 14.805.15%.20 = 150 million shares. expected EPS is $3. Capital structure and stock price Answer: d Diff: T The optimal capital structure maximizes the firm’s stock price.0667) = 11. Find the number of shares after the repurchase: New shares = 150 – $1. Do the same calculation for each of the capital structures and find each WACC.11 = $34.8 0.3 10.5 = 112.6000 11.10.5% .9 0.4 10.T)(D/E)] ks = kRF + (kM .T)]/New shares = [($800 – $84) × 0.0[1 + (1 . When the debt ratio is 30%. Therefore. the optimal capital structure is 40% debt and 60% equity.1111)] = 1. The optimal capital structure is the one that minimizes the WACC.

Finally.454.1 bU 25.8)(11. The new NI figure will be $4.4) + (0.355.2)(7.1 ks = 11.000.355. we will calculate the cost of common equity and then use that to solve for the WACC.34) = $2.25. 24. using the unlevered beta calculated in the previous problem.454.1 1. bL = bU[1 + (1 .15] 0. First. 23.000/650.200/165.2 = 11%.545.545.T) + wcks WACC = (0.000 = $4.6 million.67. EPS = $2.$1.545.000 shares outstanding.T)(D/E)] bU[1 + (1 . we must find the levered beta after the recapitalization.000. the company can repurchase $10. Thus.625 and P0 = $26.000.000/$40 = 250.0.0.18%.940.000. New net income: ($2. D1 = $2.45. When the debt ratio is 70%.0. Answer: e Diff: M Hamada equation and cost of common equity First.9565[1 + (1 .600.000 in interest after issuing the debt so the new EBT will be $5. Capital structure and stock price Answer: d Diff: T The bonds used in the repurchase will create a new interest expense for the company.21/11% = $74. When the debt ratio is 50%.000 = 165.000 .45. New dividends per share: $1. D1 = $2. Dividends per share will change because net income changes and the number of shares outstanding changes.45 .10. New stock price: $8.000 .0.4)(2/3)] 13 .545. New interest expense: $800.0. we must use the Hamada equation. New shares outstanding: 175. Shares repurchased: $800.4)(1/4)] bU[1.52 after the recapitalization.2133.000/80 = 10.454. Capital structure and WACC Answer: c Diff: E 22. This will change net income. = = = = bU[1 + (1 .000 shares.T)(D/E)] bL = 0.000 = EBIT(1 .000 shares.6%. substituting the known values. WACC = wdkd(1 .000 = $4.000.34) or EBIT = $5.000)(1 . The stock price is highest when the debt ratio is 50%.$64.28. The company will pay $1. Capital structure and EPS Answer: d Diff: T After issuing the debt.200. ks = kRF + (kM . Hamada equation and unlevered beta Answer: c Diff: E To unlever the beta.000.454.9565.$25.80 and P0 = $25.kRF)b ks = 5% + (6%)1.000 shares leaving 650.3) = $1.45.0.5%)(1 .6%) WACC = 10.940. 2.45(1 .000 × 8% = $64. We still need to find the expected NI after issuing the debt. We’re given the anticipated NI is $3. bL 1. We must also calculate a new cost of equity: 5% + (5%)1. the EBIT (before the debt issue) can be found as follows: $3.000 = $8.

9565[1. 14 .4] bL = 1.03%.3391 ks = 13. ks = kRF + (kM – kRF)bL ks = 5% + (6%)1.bL = 0.3391.

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