Business Finance: Questions

1612 Words Feb 16th, 2014 7 Pages
Question 1
Reliable Gearing currently is all-equity financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.

a. What will be the debt-to-equity ratio after each possible restructuring?
b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will earnings per share be for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected (i.e., average) EPS under each
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' ' Do you agree? Why or why not? Be sure to fully explain the rationale behind your argument. b. Suppose your firm is going to finance a new project 100% with retained earnings. Your boss claims that since the earnings are already being retained and that since no outside financing is required, the project should be evaluated at the risk-free rate of return. Is this appropriate? Are retained earnings risk-free? Why or why not? c. Considering that issuing debt is cheaper than issuing equity; that debt is a less expensive form of financing; and that debt issues tend to be larger in size, why do firms have secondary equity offerings? Why not just issue debt securities once the IPO is complete? d. In each of the theories of capital structure, the cost of equity rises as the amount of debt increases. So why don 't financial managers use as little debt as possible to keep the cost of equity down? After all, isn 't the goal of the firm to maximize share value (and minimize shareholder costs)?

Solutions

Question 1:

a. Market value of firm is $100  10,000 = $1,000,000.

With the low-debt plan, equity falls by $200,000, so D/E = $200,000/$800,000 = .25, and 8,000 shares remain outstanding. With the high-debt plan, equity falls by $400,000, so D/E = $400,000/$600,000 = .67,

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