Exam 14: Capital Structure and Leverage

Modigliani and Miller (MM),in their second article,took account of taxes,bankruptcy,and other factors that were assumed away in their original article.Once they took account of all these assumptions,they concluded that every firm has a unique optimal capital structure.Moreover,a manager can use the second MM model to determine his or her firm's optimal debt ratio.

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 (w_c)is 1 - w_d.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?

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate.Based on the data given below,how much higher or lower will HD's ROE be versus that of LD,i.e. ,what is ROE_HD - ROE_LD? Do not round your intermediate calculations. Applicable to Both Firms Firm HD's Data Firm LD's Data Capital \ 3,000,000 70\% 20\% EBIT \ 595,000 Int. rate 12\% Int. rate 10\% Tax rate 35\% ?

El Capitan Foods has a capital structure of 36% debt and 64% equity,its tax rate is 35%,and its beta (leveraged)is 1.40.Based on the Hamada equation,what would the firm's beta be if it used no debt,i.e. ,what is its unlevered beta,b_U?

An increase in the debt ratio will generally have no effect on which of these items?

You work for the CEO of a new company that plans to manufacture and sell a new product,a watch that has an embedded TV set and a magnifying glass crystal.The issue now is how to finance the company,with only equity or with a mix of debt and equity.Expected operating income is $510,000.Other data for the firm are shown below.How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity,i.e. ,what is ROE_L - ROE_U? Do not round your intermediate calculations. 0\% Debt, U 60\% Debt, L Oper income (EB IT) \ 510,000 \ 510,000 Required investment \ 2,500,000 \ 2,500,000 \% Debt 0.0\% 600.0\% \ of Debt \ 0.00 \ 1,500,000 \ of Common equity \ 2,500,000 \ 1,000,000 Interest rate 10.00\% Tax rate 35\% 35\% ?

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.However,that article was criticized because it assumed that no taxes existed.MM then revised their original article to include corporate taxes,and this model led to the conclusion that a firm's value would be maximized if it used (almost)100% debt.

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important,and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

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.

Dyson Inc.currently finances with 20.0% debt (i.e. ,w_d = 20%),but its new CFO is considering changing the capital structure so w_d = 36.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (w_c)= 1 - w_d.Given the data shown below,by how much would this recapitalization change the firm's cost of equity? Do not round your intermediate calculations.(Hint: You must unlever the current beta and then use the unlevered beta to solve the problem. ) Risk-free rate, 5.00\% Tax rate, 40\% Market risk prem, RPM 6.00\% Current wd 20\% Current beta, bL1 1.65 Target wd 36.0\% ?

Gator Fabrics Inc.currently has zero debt .It is a zero growth company,and additional firm data are shown below.Now the company is considering using some debt,moving to the new capital structure indicated below.The money raised would be used to repurchase stock at the current price.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat,as indicated below.If this plan were carried out,by how much would the WACC change,i.e. ,what is WACC_Old - WACC_New? Do not round your intermediate calculations. 40\% Orig cost of equity, 10.0\% 60\% New cost of equity = 11.0\% Interest rate new = 6.0\% Tax rate 40\% ?

Firms U and L each have the same amount of assets,investor-supplied capital,and both have a return on investors' capital (ROIC)of 12%.Firm U is unleveraged,i.e. ,it is 100% equity financed,while Firm L is financed with 50% debt and 50% equity.Firm L's debt has an after-tax cost of 8%.Both firms have positive net income and a 35% tax rate.Which of the following statements is CORRECT?

Other things held constant,the lower a firm's tax rate,the more logical it is for the firm to use debt.

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

You were hired as the CFO of a new company that was founded by three professors at your university.The company plans to manufacture and sell a new product,a cell phone that can be worn like a wrist watch.The issue now is how to finance the company,with equity only or with a mix of debt and equity.The price per phone will be $250.00 regardless of how the firm is financed.The expected fixed and variable operating costs,along with other data,are shown below.How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity,i.e. ,what is ROE_L - ROE_U? 0\% Debt, U 60\% Debt, L Expected unit sales (Q) 32,000 32,000 Price per phone (P) \ 250.00 \ 250.00 Fixed costs (F) \ 1,000,000 \ 1,000,000 Variable cost'unit (V) \ 200.00 \ 200.00 Required investment \ 2,500,000 \ 2,500,000 \% Debt 0.00\% 60.00\% Debt, \ \ 0 \ 1,500,000 Equity, \ \ 2,500,000 \ 1,000,000 Interest rate 10.00\% Tax rate 35.00\% 35.00\% ?

According to Modigliani and Miller (MM),in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Which of the following statements is CORRECT?

Your company plans to produce a new product,a wireless computer mouse.Two machines can be used to make the mouse,Machines A and B.The price per mouse will be $25.00 regardless of which machine is used.The fixed and variable costs associated with the two machines are shown below.At the expected sales level of 30,000 units,how much higher or lower will the firm's expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with low fixed costs,i.e. ,what is EBIT_B - EBIT_A ? Machine A Machine B Price per mouse (P) \ 25.00 \ 25.00 Fixed costs (F) \ 100,000 \ 400,000 Variable costinit (V) \ 17.00 \ 11.00 Exp. unit sales (Q) 30,000 30,000 ?

Dye Industries currently uses no debt,but its new CFO is considering changing the capital structure to 49.0% debt (w_d)by issuing bonds and using the proceeds to repurchase and retire some common shares so the percentage of common equity in the capital structure (w_c)= 1 - w_d.Given the data shown below,by how much would this recapitalization change the firm's cost of equity,i.e. ,what is r_L - r_U? Do not round your intermediate calculations. Risk-free rate, 6.00\% Tax rate, 40\% Market risk prem, RPM 3.00\% Current 0\% Current beta, bu 1.30 Target 49.0\% ?

Which of the following would tend to increase a firm's target debt ratio,other things held constant?