has a debt/equity ratio = 2. The firm has a cost of equity of 12% and a cost of debt of 6%. Calculate the firm’s equity’s beta (β) after the target debt/equity ratio changes to 1.5. Assume that the cost of debt does not change. Ignore

has a debt/equity ratio = 2. The firm has a cost of equity of 12% and a cost of debt of 6%. Calculate the firm’s equity’s beta (β) after the target debt/equity ratio changes to 1.5. Assume that the cost of debt does not change. Ignore

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter15: Capital Structure Decisions

Section: Chapter Questions

Problem 10MC: Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default...

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Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default on its debt. The value of Lius operations is 4 million. The firms debt consists of 1-year, zero coupon bonds with a face value of 2 million. Lius volatility, , is 0.60, and the risk-free rate rRF is 6%. Because Lius debt is risky, its equity is like a call option and can be valued with the Black-Scholes Option Pricing Model (OPM). (See Chapter 8 for details of the OPM.) (1) What are the values of Lius stock and debt? What is the yield on the debt? (2) What are the values of Lius stock and debt for volatilities of 0.40 and 0.80? What are yields on the debt? (3) What incentives might the manager of Liu have if she understands the relationship between equity value and volatility? What might debtholders do in response?
Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of Ls operations is 4 million (the value of its debt plus equity). Assume also that its debt consists of 1-year, zero coupon bonds with a face value of 2 million. Finally, assume that Ls volatility, , is 0.60 and that the risk-free rate rRF is 6%.
If the financial Manager of Evergreen wants to decrease its cost of capital by adding more debt to its capital structure and arrive at a debt-equity ratio of 0.60. If its debt is in the form of a 6% semiannual bond issue outstanding with 15 years to maturity. The bond currently sells for 95% of its face value of $1000. On the other hand, suppose the risk-free rate is 3% and the market portfolio has an expected return of 9% and the company has a beta of 2. If the tax rate is 40%. Question 1 Calculate the company,s after-tax cost of debt. Question 2 Calculate the company,s cost of equity. Question 3 What would be the company’s overall cost of capital (WACC) at the targeted capital structure of debt equity ratio of 0.60? Question 4 If the company achieves this new cost of capital, would your investment decision change regarding the previous two investment opportunities? Explain your answer.
Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and a cost for the risk of default. All general M&M assumptions apply. You have also been provided the following information: Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $ 0 - .80 0 $ 5,000,000 5.5% ? $800,000 $ 7,000,000 7.0% 2 ? What is the market value of the firm? What is the market value of the firm and the market value of the equity if they issue $5,000,000 in debt with a coupon rate of 4.5% and use the proceeds to repurchase shares? What is the new cost of equity? According to CAPM, what is the new beta? What is the market value of the firm if the firm issues $7,000,000 in debt? What would be the PV of financial distress costs if…
Morrison Medical Inc., an all-equity firm, has earnings before interest and taxes of $950,000, an un-levered beta of .80 and a tax rate = 35%. In the market, you observe that Government T-bills are being sold to yield 2% and the S&P/TSX Composite Index is expected to yield 9%. Assume a world with taxes and a cost for the risk of default. All general M&M assumptions apply. You have also been provided the following information: Value of Debt Cost of Debt (Rd) Beta PV of Financial Distress Costs $ 0 - .80 0 $ 5,000,000 5.5% ? $800,000 $ 7,000,000 7.0% 2 ? What is the market value of the firm if the firm issues $7,000,000 in debt? What would be the PV of financial distress costs if the firm issues $7,000,000 in debt?
Larson Corporation has a beta of 1.7 and a marginal tax rate of 35%. The expected return on the market is 12% and the risk-free interest rate is 7%. Estimate the firm's cost of internal equity.
Consider a firm whose debt has a market value of $35 million and whose stock has a market value of $55 million. The firm pays a 7 percent rate of interest on its new debt and has a beta of 1.23. The corporate tax rate is 21%. Assume that the security market line holds, that the risk premium on the market is 10.5 percent, and that the current Treasury bill is rate is 1 percent. Using the pretax cost of debt from Question 7, what is the cost of equity, RS?
Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.19. Its current stock price is $54 per share, with 2.4 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.475 and can borrow at 4.6%, just 20 basis points over the risk-free rate of 4.4%. The expected return of the market is 9.6%, and PKGR's tax rate is 21%. a. This year, PKGR is expected to have free cash flows of $6.2 billion. What constant expected growth rate of free cash flow is consistent with its current stock price? b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.475, it believes its borrowing costs will rise only slightly to 4.9%. If PKGR announces that it will raise its debt-equity ratio to 0.475 through a leveraged recap, determine the increase or decrease in the stock price that would result from the…
The LoLev Corporation's equity has a beta of 1.4. Its debt has a beta of 0.2. Its debt-to-value ratio is 30%. The HiLev Corporation's equity has a beta of 2. Its debt has a beta of zero. HiLev's debt-tovalue ratio is 40%. The riskfree rate is 8%, and the expected return on the market portfolio is 14%. Assuming the CAPM holds, and that there are no taxes or costs of financial distress, answer the following: a) LoLev is thinking of investing in the same line of business that HiLev is engaged in. What discount rate should it use? b) Now suppose the LoLev Corporation has decided to invest in HiLev's line of business. These projects now constitute 50% of the overall value of the LoLev's Corporation. Assuming that its debt-to-value ratio and the beta of its debt remain unchanged, calculate the new value of LoLev's equity beta.
AllCity, Inc., is financed 42% with debt, 5% with preferred stock, and 53% with common stock. Its pretax cost of debt is 5.7%, its preferred stock pays an annual dividend of $2.51 and is priced at $27. It has an equity beta of 1.11. Assume the risk-free rate is 2.2%, the market risk premium is 7.3% and AlICity's tax rate is 25%. What is its after-tax WACC? Note: Assume that the firm will always be able to utilize its full interest tax shield. The WACC is __ % ? (Round to two decimal places.)
Rolex, Inc. has equity with a market value of $20 million and debt with a market value of $10million. Assume the firm has no default risk and can borrow at the risk-free interest rate. Therisk-free interest rate is 5 percent per year, and the expected return on the market portfolio is11 percent. The beta of the company's equity is 1.2. The tax rate is 20%. What is the cost ofcapital for an otherwise identical all-equity firm?
Prokter and Gramble (PKGR) has historically maintained a debt-equity ratio of approximately 0.16. Its current stock price is $45 per share, with 2.3 billion shares outstanding. The firm enjoys very stable demand for its products, and consequently it has a low equity beta of 0.4 and can borrow at 4.0%, just 20 basis points over the risk-free rate of 3.8%. The expected return of the market is 9.6%, and PKGR's tax rate is 22%. a. This year, PKGR is expected to have free cash flows of $5.5 billion. What constant expected growth rate of free cash flow is consistent with its current stock price? b. PKGR believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.4, it believes its borrowing costs will rise only slightly to 4.3%. If PKGR announces that it will raise its debt-equity ratio to 0.4 through a leveraged recap, determine the increase or decrease in the stock price that would result from the anticipated tax savings. a. This…