# 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