MindTap Finance, 2 terms (12 months) Printed Access Card for Brigham/Houston's Fundamentals of Financial Management, 14th (Finance Titles in the Brigham Family)
14th Edition
ISBN: 9781305403826
Author: Eugene F. Brigham, Joel F. Houston
Publisher: Cengage Learning
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Chapter 14, Problem 2P
Summary Introduction
To identify: The optimal capital structure of Company J and debt-to-capital to minimize WACC of company.
Optimal Capital Structure:
Optimal capital structure refers to a satisfactory debt-to-equity ratio through which the cost of capital of a firm can be minimized.
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Chapter 14 Solutions
MindTap Finance, 2 terms (12 months) Printed Access Card for Brigham/Houston's Fundamentals of Financial Management, 14th (Finance Titles in the Brigham Family)
Ch. 14 - Changes in sales cause changes in profits. Would...Ch. 14 - Would each of the following increase, decrease, or...Ch. 14 - Discuss the following statement: All else equal,...Ch. 14 - Prob. 4QCh. 14 - Prob. 5QCh. 14 - Why do public utilities generally use different...Ch. 14 - Why is EBIT generally considered independent of...Ch. 14 - Is the dept level that maximizes a firms expected...Ch. 14 - If a firm goes from zero dept to successively...Ch. 14 - Prob. 10Q
Ch. 14 - A firm is about to double its assets to serve its...Ch. 14 - Prob. 1PCh. 14 - Prob. 2PCh. 14 - Prob. 3PCh. 14 - UNLEVERED BETA Harley Motors has 10 million in...Ch. 14 - FINANCIAL LEVERAGE EFFECTS Firms HL and LL are...Ch. 14 - BREAK-EVEN ANALYSIS The Weaver Watch Company sells...Ch. 14 - Prob. 7PCh. 14 - HAMADA EQUATION Cyclone Software Co. is trying to...Ch. 14 - RECAPITALIZATION Tapley Inc. currently has total...Ch. 14 - BREAKEVEN AND OPERATING LEVERAGE a. Given the...Ch. 14 - RECAPITALIZATION Currently, Bloom Flowers Inc. has...Ch. 14 - BREAKEVEN AND LEVERAGE Wingler Communications...Ch. 14 - FINANCING ALTERNATIVES The Severn Company plans to...Ch. 14 - WACC AND OPTIMAL CAPITAL STRUCTURE Elliott...Ch. 14 - OPTIMAL CAPITAL STRUCTURE Assume that you have...Ch. 14 - Prob. 1TCLCh. 14 - Exploring the Capital Structures for Four...
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- Optimal Capital Structure with Hamada Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero-growth firm and pays out all of its earnings as dividends. The firm’s EBIT is $14,933 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt level to a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.0. What is BEA’s unlevered beta? Use market value D/S (which is the same as wd/ws when unlevering. What are BEA’s new beta and cost of equity if it has 40% debt? What are BEA’s WACC and total value of the firm with 40% debt?arrow_forwardAs a first step, we need to estimate what percentage of MMMs capital comes from debt, preferred stock, and common equity. This information can be found on the firms latest annual balance sheet. (As of year end 2014, MMM had no preferred stock.) Total debt includes all interest-bearing debt and is the sum of short-term debt and long-term debt. a. Recall that the weights used in the WACC are based on the companys target capital structure. If we assume that the company wants to maintain the same mix of capital that it currently has on its balance sheet, what weights should you use to estimate the WACC for MMM? b. Find MMMs market capitalization, which is the market value of its common equity. Using the sum of its short-term debt and long-term debt from the balance sheet (we assume that the market value of its debt equals its book value) and its market capitalization, recalculate the firms debt and common equity weights to be used in the WACC equation. These weights are approximations of market-value weights. Be sure not to include accruals in the debt calculation.arrow_forwardCOST OF CAPITAL Coleman Technologies is considering a major expansion program that has been proposed by the companys information technology group. Before proceeding with the expansion, the company must estimate its cost of capital. Suppose you are an assistant to Jerry Lehman, the financial vice president. Your first task is to estimate Colemans cost of capital Lehman has provided you with the following data, which he believes may be relevant to your task. The firms tax rate is 25%. The current price of Colemans 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity, is 1.153.72. Coleman does not use short-term, interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost. The current price of the firms 10%, 100.00 par value, quarterly dividend, perpetual preferred stock is 111.10. Colemans common stock is currently selling for 50.00 per share. Its last dividend (D0) was 4.19, and dividends are expected to grow at a constant annual rate of 5% in the foreseeable future. Colemans beta is 1.2, the yield on T-bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus-risk-premium approach, the firm uses a risk premium of 4%. Colemans target capital structure is 30% debt, 10% preferred stock, and 60% common equity. To structure the task somewhat, Lehman has asked you to answer the following questions: a. 1. What sources of capital should be included when you estimate Colemans WACC? 2. Should the component costs be figured on a before-tax or an a after-tax basis? 3. Should the costs be historical (embedded) costs or new (marginal) costs? b. What is the market interest rate on Colemans debt and its component cost of debt? c. 1. What is the firms cost of preferred stock? 2. Colemans preferred stock is riskier to investors than its debt, yet the preferreds yield to investors is lower than the yield to maturity on the debt Does this suggest that you have made a mistake? (Hint: Think about taxes) d. 1. Why is there a cost associated with retained earnings? 2. What is Colemans estimated cost of common equity using the CAPM approach? e. What is the estimated cost of common equity using the DCF approach? f. What is the bond-yield-plus-risk-premium estimate for Colemans cost of common equity? g. What is your final estimate for rs? h. Explain in words why new common stock has a higher cost than retained earnings. i. 1. What are two approaches that can be used to adjust for flotation costs? 2. Coleman estimates that if it issues new common stock, the flotation cost will be 15%. Coleman incorporates the flotation costs into the DCF approach. What is the estimated cost of newly issued common stock, considering the flotation cost? j. What is Colemans overall, or weighted average, cost of capital (WACC)? Ignore flotation costs. k. What factors influence Colemans composite WACC? l. Should the company use the composite WACC as the hurdle rate for each of its projects? Explain.arrow_forward
- WACC AND OPTIMAL CAPITAL STRUCTURE Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firms debt cost at different debt levels: Elliott uses the CAPM to estimate its cost of common equity. rs and estimates that the risk free rate is 5%, the market risk premium is 6%, and its tax rate is 25%. Elliott estimates that if it had no debt, its unleveled beta, bU, would be 1.2. a. What is the firms optimal capital structure, and what would be its WACC at the optimal capital structure? b. If Elliotts managers anticipate that the companys business risk will increase in the future, what effect would this likely have on the firms target capital structure? c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliotts target capital structure? d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/capital ratio and (2) the debt/equity ratio.arrow_forwardCALCULATING 3Ms COST OF CAPITAL In this chapter, we described how to estimate a companys WACC, which is the weighted average of its costs of debt, preferred stock, and common equity. Most of the data we need to do this can be found from various data sources on the Internet. Here we walk through the steps used to calculate Minnesota Mining Manufacturings (MMM) WACC. 3. Next, we need to calculate MMMs cost of debt. We can use different approaches to estimate it. One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at close to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the companys home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Remember that you need the after-tax cost of debt to calculate a firms WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?arrow_forwardWACC Estimation On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s present market value capital structure, shown here, is considered to be optimal. There is no short-term debt. New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 40%. In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC? Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.arrow_forward
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