You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but thepresident thinks it would be better to hold the percentage of debt in the capital structure (wa) to only 10%. Thecompany is small, so it is not subject to the interest deduction limitation. Other things held constant, and based on thdata below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROEHigher - ROELower? Donot round your intermediate calculations.Operating DataOther DataCapital$4,000Higher wd60%ROIC = EBIT(1 - T)/Capital12.00%Higher interest rate13%%3DTax rate25%Lower wd10%Lower interest rate9%a. 3.75%b. 2.22%C 2.80%d. 2.54%e. 1,87%

The weightage of debt in the capital structure affects the net income of the firm and thus affects…

Answered: You have been hired by a new firm that…

Corporate Fin Focused Approach

5th Edition

ISBN:9781285660516

Author:EHRHARDT

Publisher:EHRHARDT

Chapter15: Capital Structure Decisions

Section: Chapter Questions

Problem 8P

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David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.
A company had WACC (weighted average cost of capital) equal to 8. % If the company pays off mortgage bonds with an interest rate of 4% and issues an equal amount of new stock considered to be relatively risky by the market, which of the following is true? a. residual income will increase. b. ROI will decrease. c. WACC will increase. d. WACC will decrease.
You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Both companies are small, so they are not subject to the interest deduction limitation. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROEHigher - ROELower? Do not round your intermediate calculations. Operating Data Other Data Capital $4,000 Higher wd 60% ROIC = EBIT(1 – T)/Capital 13.00% Higher interest rate 13% Tax rate 25% Lower wd 10% Lower interest rate 9% Group of answer choices 4.68% 4.77% 3.72% 4.18% 3.93%
Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 25%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity? a. −5.40% b. −7.99% c. −6.00% d. −7.26% e. −6.60%
Nelco Inc. has decided in favour of a capital structuring that involvesincreasing its existing $80 million in debt to $125 million. The interestrate on debt is 9% and is not expected to change. The firm currently has 10million shares outstanding and the price per share is $45. If therestructuring is expected to increase the ROE, what is the minimum level ofEBIT that Nelco’s management must be expecting. Ignore taxes in your answer.
Stephens Electronics is considering a change in its target capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRFrRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm s tax rate is 40%. Currently, the cost of equity, rsrs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt?
Vafeas Inc.'s capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 40%. However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity? (Just calculate the change in the cost of equity). A. -5.20% B. -6.36% C. -7.69% D. -6.99% E. -5.65%
You were hired as a consultant to XYZ Company, whose target capital structure is 32% debt, 10% preferred, and 58% common equity. The interest rate on new debt is 8.40%, the yield on the preferred is 5.85%, the cost of common from retained earnings is 13.20%, and the tax rate is 33.00%. The firm will not be issuing any new common stock. What is XYZ's WACC?
You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after - tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 13.00%. The firm will not be issuing any new stock. What is its WACC?9.38% 11.44% 9.19% 7.22% 10.22%
ABC Company is re-evaluating its debt level. Its current capital structure consists of 72% debt and the remaining as common equity, its beta is 1.63, and its tax rate is 35%. However, as its CFO, you think the company has too much debt, and are considering moving to a capital structure with 36% debt and the remaining as common equity. The risk-free rate is 5.0% and the market risk premium is 6.9%. By how much would the capital structure shift change the company's cost of equity, that is, (current cost of equity - new cost of equity)? Round your final answer to two decimal places of percentage (%), but do not enter % in your answer, e.g., x.xx. (Hint: Compute the new beta using the Hamada equation first and then the new cost of equity using the CAPM.)
Demo Inc. currently is financed with 10% debt and 90% equity. However, its CFO has proposed that the firm issue new long-term debt and repurchase some of the firm’s common stock. Its advisers believe that the long-term debt would require a before-tax yield of 10%, while the firm’s basic earning power is 14%. The firm’s operating income and total assets will not be affected. The CFO has told the rest of the management team that he believes this move will increase the firm’s stock price. If Demo Inc. proceeds with the recapitalization, which of the following items are also likely to increase? Check all that apply. Net income Basic earning power (BEP) Cost of equity (rsrs) Cost of debt (rdrd) Return on assets (ROA)

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