Capital structure

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Exercises on Capital Structure 1. (RWJ, exercise 12.9) The following table lists possible rates of return on Compton Technology’s stock and debt, and on the market portfolio. The corporate tax rate is 35 percent. The corresponding probabilities are also listed.

State 1 2 3 4

Probability 0.1 0.3 0.4 0.2

Return on Equity 3% 8 20 15

Return on Debt 8% 8 10 10

Return on the Market 5% 1015 20

a. What is the beta of Compton Technology debt? b. What is the beta of Compton Technology stock? c. If the debt-to-equity ratio of Compton Technology is 0.5, what is the asset beta of the company? 2. (RWJ, exercise 12.10) Is the discount rate for the projects of a levered firm higher or lower than the cost of equity computed using the security market line? Why? (Consider only projectsthat have similar risk to that of the firm.)

3. (RWJ, exercise 12.13) Calculate the weighted average cost of capital for the Luxury Porcelain Company. The book value of Luxury’s outstanding debt is $60 million. Currently, the debt is trading at 120 percent of book value and is priced to yield 12 percent. The 5 million outstanding shares of Luxury stock are selling for $20 a share. The requiredreturn on Luxury stock is 18 percent. The tax rate is 25 percent.

4. (RWJ, exercise 12.15) Calgary Industries, Inc. is considering a new project that costs $25 million. The project will generate after-tax (year-end) cash flows of $7 million for five years. The firm has a debt-to-equity ratio of 0.75. The cost of equity is 15 percent and the cost of debt is 9 percent. The corporate tax rate is 35percent. It appears that the project has the same risk of the overall firm. Should Calgary take on the project?

5. (RWJ, exercise 15.4) Levered, Inc. and Unlevered, Inc. are identical companies with identical business risk. Their earnings are perfectly correlated. Each company is expected to earn $96 million per year in perpetuity, and each company distributes all its earnings. Levered’s debthas a market value of $275 million and provides a return of 8%. Levered’s stock sells for $100 a share, and there are 4.5 million outstanding shares. Unlevered has only 10 million shares outstanding worth $80 each. Unlevered has no debt. There are no taxes. Which stock is a better investment? (RWJ, exercise 15.7) Strom, Inc has 250,000 outstanding shares of stock that sell for $20 per share. Strom,Inc. currently has no debt. The appropriate discount rate for the firm is 15 percent. Strom’s earnings last year were $750,000. The management expects that if no

changes affect the assets of the firm, the earnings will remain $750,000 in perpetuity. Strom pays no taxes. Strom plans to buy out a competitor’s business at a cost of $300,000. Once added to Strom’s current business, thecompetitor’s facilities will generate earnings of $120,000 in perpetuity. The competitor has the same risk as Strom, Inc. a. Construct the market-value balance sheet for Strom before the announcement of the buyout is made. b. Suppose Strom uses equity to fund the buyout. i. According to the efficient markets hypothesis, what will happen to Strom’s stock price? ii. Construct the market value balance sheet asit will look after the announcement. iii. How many shares did Strom sell? iv. Once Strom sells the new share of stock, how will its accounts look? v. After the purchase is finalized, how will the market-value balance sheet look like? vi. What is the return to Strom’s shareholders? c. Suppose Strom uses 10-percent debt to fund the buyout. i. Construct the market value balance sheet as it will lookafter the announcement ii. Once Strom sells the bonds, how will its accounts look? iii. What is the cost of equity? iv. Explain any difference in the cost of equity between the two plans. v. Use MM Proposition II to verify your answer in iii.

6. (RWJ, exercise 15.13) The market value of a company with $500,000 debt is $1,700,000. EBIT are expected to be a perpetuity. The pretax interest rate...
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