finance ch 13
Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost information: Based on this information, what capital structure (debt/asset ratio) should management accept? Assume the marginal tax rate is 40%.*****
60% has lowest cost of capital
Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:
ANS: A Solution: P0 = 1.00(1.07)/(0.143 - 0.07) = $30.40
Technico has determined that its optimal capital structure is 40% debt, at which point its weighted cost of capital, ka, is 13.7%. Due to financial problems, the firm has decided to raise the proportion of debt to 50%, which will increase its weighted cost of capital to 14.4%. What is the effect on the stock price of Technico? The current dividend is $1.60 and the long-term growth rate of dividends is expected to be 8.5%.
Decrease $3.96
With financial leverage, a change in EBIT results in a change in:
EPS
What is the present value of the tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on perpetual debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%?
PV tax shield = $25 million(0.35) = $8.75 million
Calculate the market value of a firm with total assets of $60 million and a net worth of $35 million. The firm's cost of equity is 15% and the cost of perpetual debt is 8%. The firm has a perpetual net operating income (EBIT) of $4.5 million and a marginal tax rate of 35%.
Solution: Income available to stockholders = ($4.5 - $2.0)(1 - 0.35) = $1.625 Value = $2.0/0.08 + $1.625/0.15 = $35.83 (million)
Calculate the market value of a firm with total assets of $105 million and $50 million of 10% perpetual debt in the capital structure. The firm's cost of equity is 14% on the $55 million in equity in the capital structure. The perpetual EBIT is expected to be $9 million and the marginal tax rate is 40%.
Solution: Income available to stockholders = ($9 - 5)(.6) = $2.4 Value = $2.4/.14 + 5/.10 = $67.1 million
What is the market value of Barings, a firm with total assets of $100 million and $30 million in perpetual debt in its capital structure. Barings' cost of equity is 15% and its cost of debt is 10%. Expected perpetual net operating income (EBIT) will be $17 million and the marginal tax rate is 40%.
Solution: Income available to stockholders = (17 - 3)(1 - .4) = $8.4 Value = $8.4/.15 + 3/.10 = $86 million
Calculate the market value of Lotle Group, a firm with total assets of $80 million and $30 million of perpetual debt in its capital structure. The firm's cost of equity is 14% and the cost of debt is 9%. Lotle expects annual, perpetual net operating income (EBIT) of $9 million and a marginal tax rate of 40%.
Solution: Income available to stockholders= ($9.0 - $2.7)(1 - 0.40) = $3.78 million Value = $2.7/0.09 + $3.78/0.14 = $57 (million)
RoTek has a capital structure of $300,000 in equity and $300,000 in perpetual debt. The firm's cost of equity is 14 percent and its cost of debt is 9 percent. If the firm has an expected, perpetual net operating income of $120,000 and a marginal tax rate of 40 percent, what is the market value of RoTek? Assume all net income is paid out as dividends.
Solution: Interest = $300,000(0.09) = $27,000 Net income = ($120,000 - $27,000)(1 - 0.40) = $55,800 Market value = $55,800/0.14 + $27,000/0.09 = $698,571
What is the present value of the tax shield to a firm that has a capital structure consisting of $100 million of perpetual debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%?
Solution: PV tax shield = $100(0.4) = $40 (million)
The management of Graphicopy is trying to determine how much debt they should have in their capital structure. If they sell $500,000 in perpetual bonds with a 9 percent coupon, what would be the present value of the tax shield? Assume the marginal tax rate is 35%.
Solution: PV tax shield = ($500,000)(0.35) = $175,000
What is the annual tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%?
Solution: Tax shield = 0.085($25 million)(0.35) = $0.744 million
What is the annual tax shield to a firm that has a capital structure consisting of $100 million of debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%?
Solution: Tax shield = 0.09($100)(0.4) = $3.6 (million)
Which of the following statements is (are) true concerning the relationship between the firm's cost of equity and its capital structure (as measured by the debt ratio)? a. The exact relationship between the cost of equity and the debt ratio is difficult to determine. b. The range of debt ratios where the cost of equity begins to increase rapidly varies by firm and industry depending on the firm's age. c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.
a. The exact relationship between the cost of equity and the debt ratio is difficult to determine.
Which of the following statements is true regarding the relationship between the firm's cost of debt and its capital structure (as measured by the debt ratio)? a. The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk. b. The precise relationship between the cost of debt and the debt ratio is simple to determine. c. The relationship is a saucer-shaped curve. d. The relationship is determined by the static tradeoff theory.
a. The range of debt ratios where the cost of debt begins to increase rapidly varies by firm and industry, depending on the level of business risk.
The optimal capital structure is determined by several factors including all of the following except: a. corporate capital gains b. business risk c. potential bankruptcy risk d. agency costs
a. corporate capital gains
perfect capital markets imply that
all investors can borrow and lend at the same rate
The process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit is called:
arbitage
The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based in a(n) _____ process
arbitraging
operating leverage involves the use of
assets having fixed costs
____ refers to the argument that officers and managers have access to information about the expected future earnings of the firm that is not available to outside investors.
asymmetric information
All of the following factors influence a firm's business risk except: a. degree of operating leverage b. variability of interest rates c. variability of operating costs d. variability of selling prices
b. variability of interest rates
The optimal capital structure of a firm is a function of the ____.
business risk of the firm and the tax structure
____ represents the permanent sources of the firm's financing.
capital structure
the amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm defines the firm's
capital structure
due to both financial distress and agency costs, a firm should have a capital structure that
contains both debt and equity
the optimal capital structure is a function of
corporate income taxes, financial distress costs, and agency costs
The greater the variability of costs, the greater the business risk of the firm. This is reflected in the:
cost of inputs used to produce a firm's output
Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place restrictions on which of the following activities? a. the sale of assets b. payment of dividends c. the issuance of additional debt d. all of the above are typical protective covenants
d. all of the above are typical protective covenants
The managerial implications of capital structure theory include all of the following except: a. capital structure changes transmit important information to investors b. changes in capital structure result in changes in the market value of the firm's equity c. optimal capital structure is influenced heavily by the business risk facing the firm d. tax shield benefits from equity lead to increased firm value
d. tax shield benefits from equity lead to increased firm value
In considering a firm's capital structure, the firm should increase its ____ which will maximize its value.
debt
The amount of debt in a firm's optimal capital structure is often referred to as the firm's:
debt capacity
According to the "pecking order theory," firms prefer to issue ____ securities first and then issue ____ securities as a last resort.
debt, equity
In analyzing the value of the firm as a function of capital structure, the present value of the tax shield benefit is to offset by the present value of the expected ______, resulting in an interior optimal capital structure
financial distress costs and agency costs
the use of fixed-cost financing sources is referred to as the use of
financial leverage
The increased variability in earnings per share due to the firm's use of debt is a definition of ____.
financial risk
the use of fixed costs source of funds, such as debt and preferred stock affect a firm's
financial risk
a firm with high liquid assets plus unused debt capacity is said to have
financial slack
the airline industry is extremely price competitive, as well as having huge fixed costs and very low variable costs. This is an example of:
high operating leverage
As the proportion of debt in the capital structure increases, investors require a ____ return and the value of existing debt will ____.
higher, decrease
Holding all other things equal, as the relative amount of debt in the capital structure increases, the cost of equity capital will
increase
A firm accepts the risk of fixed-cost financing is to:
increase possible returns to stockholders
Investors' required returns and the cost of equity capital ____ as the relative amount of dent used to finance the firm _____
increase, increases
Modigliani and Miller show that the value of a firm is ____ capital structure given perfect capital markets and no corporate income taxes.
independent
In considering the arbitrage process in perfect capital markets with no income taxes, the market value of a firm is _________________.
independent of its capital structure
as more debt is added to the capital structure of a firm, the cost of debt capital
initially rises slowly, then increases rapidly beyond some point
What is optimal capital structure?
it is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firm's employed capital
Seduak has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:******
k10 = 0.10(0.054) + 0.90(0.133) = 0.1251 k20 = 0.20(0.054) + 0.80(0.138) = 0.1212 k30 = 0.30(0.058) + 0.70(0.144) = 0.1182 k40 = 0.40(0.063) + 0.60(0.152) = 0.1164 k50 = 0.50(0.07) + 0.50(0.16) = 0.115 k60 = 0.60(0.082) + 0.40(0.17) = 0.1172
Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:*****
k35 = 0.35(0.054) + 0.65(0.138) = 0.1086 k40 = 0.40(0.056) + 0.60(0.140) = 0.1064 k45 = 0.45(0.059) + 0.55(0.143) = 0.1052 k50 = 0.50(0.064) + 0.50(0.147) = 0.1055
In determining the capital structure for an international firm, the managerial objective is to
minimize the overall cost of capital
The less a firm's business risk, the ____ the amount of ____ that will be used in the optimal capital structure, holding constant all other relevant factors.
more; financial leverage
one of the primary assumptions of capital structure analysis is that the level and variability of _____ is not expected to change as changes in capital structure are contemplated
operating income
The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the firm is known as the
optimal capital structure
with an optimal capital structure
overall capital costs are minimized
The market value of a levered firm can be represented by the following equation: Market value of levered firm = Market value of unlevered firm ____ Present value of tax shield ____ Present value of financial distress costs ____ Present value of agency costs
plus; minus; minus
Studies of capital structure changes have found that actions that increase leverage have generally been associated with ____ stock returns and actions that decrease leverage are associated with ____ stock returns.
positive, negative
agency costs
reduce the market value of the levered firm
financial leverage benefits shareholders when the
return on assets is greater than the cost of debt
Arbitrage transactions are
risk-free
the objective of capital structure management is to find the capital mix that leads to
shareholder wealth maximization
Generally the ______ a firm's business risk, the _____ the amount of financial leverage that will be used in the optimal capital structure
smaller, less
The tax deductibility of interest payments provides the firm with a:
tax shield
The capital structure decision attempts to minimize ____ which maximizes the value of the firm.
the cost of capital
A survey of Fortune 500 firms indicate that they prefer internal financing (retained earnings) to external financing. This preference is known as ____.
the pecking order theory
the tax deductibility of the interest payments on corporate debt is known as
the tax shield
two prominent finance researchers (Modigliani and Miller) showed that
the value of a firm is independent of its capital structure in perfect capital markets with no income taxes
Triad Labs has total assets of $120 million and $40 million of debt in its capital structure. Its current cost of equity is 13% and its cost of debt is 8.5%. Triad is considering increasing its debt to $70 million and purchasing its own stock with proceeds from the sale of $30 million in debt with a cost of 9.5%, reducing equity to $50 million. The cost of equity will increase to 14.5%. Net operating income (EBIT) will remain at $12 million. If Triad has a marginal tax rate of 40%, should the firm increase its debt? Assume that both debt and EBIT are perpetual.
yes, the value of the firm increases $14.1 million Solution: Income available = (12 - 3.4)(.6) = $5.16 Value = $5.16/.13 + 3.4/.085 = $79.7 million Income available (after new debt) = (12 - 3.4 - 2.85)(.6) = $3.45 Value = 3.45/.145 + 3.4/.085 + 2.85/.095 = $93.8 million
