Exam 13: Capital Structure

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions). The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 8.0%. What would the firm's total market value be if it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed, and then divide by (WACC - g).

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs?

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC) is 15%, and it currently has no debt in its capital structure . The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 40.0% debt (wd) by issuing bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 - wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity, i.e., what is rL - rU?

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU?

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)?

Which of the following statements is CORRECT?

Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS), and its tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

Which of the following statements is CORRECT?

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Which of the following statements is CORRECT?

Some people--including the current chairman of the Federal Reserve Board of Governors (Ben Bernanke)--have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms.

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.