Suppose you are the president of a large corporation located in Seattle, Washington. How do you think the stockholders will react if you decide to increase the proportion of the company’s assets that is financed with debt from 35 percent to 50 percent? In other words, what if the firm used much more debt to finance its assets?

Suppose you are the president of a large corporation located in Seattle, Washington. How do you think the stockholders will react if you decide to increase the proportion of the company’s assets that is financed with debt from 35 percent to 50 percent? In other words, what if the firm used much more debt to finance its assets?

EBK CFIN

6th Edition

ISBN:9781337671743

Author:BESLEY

Publisher:BESLEY

Chapter1: An Overview Of Managerial Finance

Section: Chapter Questions

Problem 8PROB

See similar textbooks

Similar questions

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The companys EBIT was 120 million last year and is not expected to grow. PizzaPalace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. If the company were to recapitalize, then debt would be issued, and the funds received would be used to repurchase stock. As a first step, assume that you obtained from the firms investment banker the following estimated costs of debt for the firm at different capital structures: a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.
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.
Consider the following thoughts of a manager at the end of the companys third quarter: If I can increase my reported profit by 2 million, the actual earnings per share will exceed analysts expectations, and stock prices will increase. The stock options that I am holding will become more valuable. The extra income will also make me eligible to receive a significant bonus. With a son headed to college, it would be good if I could cash in some of these options to help pay his expenses. However, my vice president of finance indicates that such an increase is unlikely. The projected profit for the fourth quarter will just about meet the expected earnings per share. There may be ways, though, that I can achieve the desired outcome. First, I can instruct all divisional managers that their preventive maintenance budgets are reduced by 25 percent for the fourth quarter. That should reduce maintenance expenses by approximately 1 million. Second, I can increase the estimated life of the existing equipment, producing a reduction of depreciation by another 500,000. Third, I can reduce the salary increases for those being promoted by 50 percent. And that should easily put us over the needed increase of 2 million. Required: Comment on the ethical content of the earnings management being considered by the manager. Is there an ethical dilemma? What is the right choice for the manager to make? Is there any way to redesign the accounting reporting system to discourage the type of behavior the manager is contemplating?
You are leading a role of Chief Financial Officer of a Cement Company in Oman. Your company has huge current profit of RO 10 million and presently having a plan to capital investment of RO 8 million in the next financial year. The company is willing to continue capital structure of debt 25% and Equity 75% in the future. How much of the RO 10 million should your company pay out as dividends? And what would be the dividend payout ratio of your company?
A privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. If the founders must issue stock to finance the growth of the firm, what would you recommend they do to protect their controlling interest for at least a few years after the IPO?
A privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. The founders now hold all of the company’s stock: 8 million shares. If the company issues 8 million shares, what proportion of the stock will the founders own after the IPO?
The company’s EBIT was $150 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 20 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures: % Financed With Debt rd 0% --- 20 9.0% 30 9.5 40 11.0 55 13.0 If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Gary’s Guacamole is in the 25 percent state-plus-federal corporate tax bracket, its beta is 1.35 the risk-free rate is 5 percent, and the market risk premium is 8.5…
Corporations often distribute profits to their shareholders in the form of dividends, which are simply checks mailed out to shareholders. Suppose that you have the chance to buy a share in a fashion company called Rogue Designs for $35 and that the company will pay dividends of $2 per year on that share every year. What is the annual percentage rate of return? Next, suppose that you and other investors could get a 12 percent per year rate of return by owning the stocks of other very similar fashion companies. If investors care only about rates of return, what should happen to the share price of Rogue Designs? (Hint: This is an arbitrage situation.)
As president of Young's of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company's dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following: (1) The company follows a residual dividend policy. (2) The total capital budget for next year is likely to be one of three amounts, depending on the results of capital budgeting studies that are currently under way. The capital expenditure amounts are $2 million, $3 million, and $4million. (3) The forecasted level of potential retained earnings next year is $2 million. (4) The target or optimal capital structure is a debt ratio of 40%. You have decided to respond by sending the stockholder the best information available to you. a. Compute the amount of the…
An investor is considering starting a new business. The company would require $475,000 of assets, and itwould be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business? Please show work in excel
An investor is considering starting a new business. The company would require $500,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 15.0% return on the invested capital, which means that the firm must have an ROE of 15.0%. How much net income must be expected to warrant starting the business?
You have been asked to value Brilliant Enterprises, a publicly traded IT services firm, and have collected the following information: After-tax operating income last year = $100 million Net income last year = $82.5 million Book value of equity at start of this year = $750 million Book value of debt at start of this year = $250 million Capital expenditure last year = $80 million Depreciation last year = $30 million Increase in non-cash working capital last year = $10 million a) Assuming that Brilliant Enterprises will maintain its return on capital and reinvestment rate from last year for the next 3 years, estimate the free cash flow for the company for each of the next 3 years. b) After year 3, Brilliant expects its growth rate to decline to 3% and the return on capital to be 9% in perpetuity. Assuming that its cost of capital is 8%, estimate the terminal value at the end of the third year. c) Assuming that Brilliant has a cost of capital of 10% for the next 3…