Exam 16: Assessing Long-Term Debt, Equity, and Capital Structure

A firm faces a 30 percent tax rate and has $500m in assets, currently financed entirely with equity. Equity is worth $100 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected EBIT is $70m. The firm is considering switching to an 18 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt. How much will ROE change if they switch to the proposed capital structure?

A firm faces a 25 percent tax rate and has $6m in assets, currently financed entirely with equity. Equity is worth $200 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected EBIT is $50m. The firm is considering switching to a 50 percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt. How much will ROE change if they switch to the proposed capital structure?

Suppose that a company's equity is currently selling for $45 per share and that there are 1 million shares outstanding. If the firm also has 7 thousand bonds outstanding, which are selling at 97 percent of par ($1,000), what are the firm's current capital structure weights for equity and debt respectively?

Suppose that a company's equity is currently selling for $55 per share and that there are 1 million shares outstanding. If the firm also has 50 thousand bonds outstanding, which are selling at 95 percent of par ($1,000), what are the firm's current capital structure weights for equity and debt respectively?

Daddi Mac, Inc., doesn't face any taxes and has $250 million in assets, currently financed entirely with equity. Equity is worth $20 per share, and book value of equity is equal to market value of equity. Also, let's assume that the firm's expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities shown as follows: The firm is considering switching to a 30 percent debt capital structure, and has determined that they would have to pay a 10 percent yield on perpetual debt. What will be the level of expected EPS if they switch to the proposed capital structure?

Suppose that Papa Bell Inc.'s equity is currently selling for $30 per share, with 4 million shares outstanding. If the firm also has 70 thousand bonds outstanding, which are selling at 95 percent of par ($1,000), what are the firm's current capital structure weights?

We use the term leverage to describe the use of debt in the firm's capital structure because: