EBK FUNDAMENTALS OF CORPORATE FINANCE
9th Edition
ISBN: 9781260049237
Author: BREALEY
Publisher: MCGRAW HILL BOOK COMPANY
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Chapter 16, Problem 10QP
Leverage and the Cost of Capital. “Increasing financial leverage increases both the cost of debt (rdebt) and the
- a. How much debt does the company now have?
- b. How much equity does it now have?
- c. What is the overall cost of capital?
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“Increasing financial leverage increases both the cost of debt (rdebt) and the cost of equity (requity). So the overall cost of capital cannot stay constant.” This problem is designed to show that the speaker is confused. Buggins Inc. is financed equally by debt and equity, each with a market value of $1 million. The cost of debt is 5%, and the cost of equity is 10%. The company now makes a further $250,000 issue of debt and uses the proceeds to repurchase equity. This causes the cost of debt to rise to 6% and the cost of equity to rise to 12%. Assume the firm pays no taxes.
a. After the debt issue, what percent of the firm is financed with debt? (Do not round intermediate calculations. Enter your answer as a whole percent.)
b. After the debt issue, what percent of the firm is financed with equity? (Do not round intermediate calculations. Enter your answer as a whole percent.)
c. What is the overall cost of capital? (Enter your answer as a percent rounded to 1 decimal…
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Firms with relatively high nonfinancial fixed costs are said to have a high degree of what?
Why is the following statement true? “Other things being the same, firms with relatively stable sales are able to carry relatively high debt ratios.”
MACC Inc. has fixed operating costs of $500,000 and variable costs of $50per unit. If it sells the product for $75 per unit, what is the break-even quantity? show work in excel.
Leverage and the Cost of Capital. “Increasing financial leverage increases both the cost ofdebt (rdebt) and the cost of equity (requity). So the overall cost of capital cannot stay constant.”This problem is designed to show that the speaker is confused. Buggins Inc. is financed equallyby debt and equity, each with a market value of $1 million. The cost of debt is 5%, and the costof equity is 10%. The company now makes a further $250,000 issue of debt and uses theproceeds to repurchase equity. This causes the cost of debt to rise to 6% and the cost of equityto rise to 12%. Assume the firm pays no taxes. (LO16-1)a. How much debt does the company now have?b. How much equity does it now have?c. What is the overall cost of capital?
Chapter 16 Solutions
EBK FUNDAMENTALS OF CORPORATE FINANCE
Ch. 16 - Prob. 1QPCh. 16 - Prob. 2QPCh. 16 - Prob. 3QPCh. 16 - Prob. 4QPCh. 16 - Prob. 5QPCh. 16 - Prob. 6QPCh. 16 - Prob. 7QPCh. 16 - Prob. 8QPCh. 16 - Prob. 9QPCh. 16 - Leverage and the Cost of Capital. Increasing...
Ch. 16 - Prob. 11QPCh. 16 - Prob. 12QPCh. 16 - Prob. 13QPCh. 16 - Prob. 14QPCh. 16 - Prob. 15QPCh. 16 - Prob. 16QPCh. 16 - Tax Shields. Establishment Industries borrows 800...Ch. 16 - Prob. 18QPCh. 16 - Prob. 19QPCh. 16 - Prob. 20QPCh. 16 - Prob. 21QPCh. 16 - Prob. 22QPCh. 16 - Prob. 23QPCh. 16 - Prob. 24QPCh. 16 - Prob. 25QPCh. 16 - Prob. 26QPCh. 16 - Prob. 27QPCh. 16 - Prob. 28QPCh. 16 - Prob. 29QPCh. 16 - Prob. 30QPCh. 16 - Prob. 31QPCh. 16 - Prob. 32QPCh. 16 - Prob. 33QPCh. 16 - Prob. 34QPCh. 16 - Prob. 35QPCh. 16 - Prob. 36QPCh. 16 - Prob. 37QP
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- The cost of equity rises as the quantity of debt rises in each of the capital structure theories. So, why don't financial managers employ as little debt as feasible to keep equity costs low? After all, aren't finance managers expected to increase a company's value?arrow_forwarda) 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?b) Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?arrow_forwardAll computations must be done and shown in detail. 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? b) Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?arrow_forward
- Please critically comment on the following sentence (with a maximum of 500 words):“Weighted Average Cost of Capital (WACC) is too complicated and not useful forfinancial management as we should only calculate the cost of borrowing/debt since we donot have to pay our shareholders any dividends if we choose to.”arrow_forwardHorford Co. has no debt. Its cost of capital is 10 percent. Suppose the company converts to a debt-equity ratio of 1. The interest rate on the debt is 7.1 percent. Ignore taxes for this problem. a.What is the company’s new cost of equity? b.What is its new WACC?arrow_forwardIn each of the theories of capital structure the cost of equity risesas the amount of debt increases. So why don’t financial managers useas 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 minimizeshareholder costs?b) Country Markets has an unlevered cost of capital of 12 percent, a taxrate of 38 percent, and expected earnings before interest and taxesof $15,700. The company has $12,000 in bonds outstanding that have aISSUED BY THE CI, MGMT3048 ON JUNE 11, 2023 36 percent coupon and pay interest annually. The bonds are selling atpar value. What is the cost of equity?arrow_forward
- According to Modigliani & Miller Theory (M&M), WACC of the firm is not affected by the capital structure. Changes of capital structure weights is offset by the change in the cost of equity, given the following information, Required return on assets = 16% Cost of debt = 10% Percent of debt = 45% Calculate: Cost of equity. The debt-to-equity ratio. Suppose the cost of equity is 25%. Percent of equity in the firm.arrow_forwardWhich of the following statements is most likely correct? 0.000 I. II. III. The higher the cost of equity and debt, the higher the cost of capital (WACC), with all else constant. The higher the cost of capital (WACC), the lower the value of the company, with all else constant. A lower corporate tax rate will incentivize firms to issue more debt than equity to reduce the cost of capital (WACC), with all else constant. I only Il only I and III I and IIarrow_forwardKyma Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCold - WACCNew? New Debt/Assets 35% Orig. cost of equity, rs 10.0% New Equity/Assets 65% New cost of equity = rs 11.0% Interest rate new = rd 7.0% Tax rate 40.0% O1.72% O2.06% 1.38% 1.04%arrow_forward
- Companies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Universal Exports Inc. is a small company and is considering a project that will require $650,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 25%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $140,000? 16.15% 12.11% 11.30% 13.73% Determine what the project’s ROE will be if its EBIT is –$40,000. When calculating the tax effects, assume that Universal Exports Inc. as a whole will have a large, positive income this year. -5.06% -4.37% -4.6% -4.14% Universal Exports Inc. is also considering financing the project with 50% equity and 50% debt. The interest rate on the…arrow_forwardCan you please assist me and not just copy and give me answers that have already been answered. a) In each of the theories of capital structure the cost of equity risesas the amount of debt increases. So why don’t financial managers useas 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 minimizeshareholder costs?b) Country Markets has an unlevered cost of capital of 12 percent, a taxrate of 38 percent, and expected earnings before interest and taxesof $15,700. The company has $12,000 in bonds outstanding that have aISSUED BY THE CI, MGMT3048 ON JUNE 11, 2023 36 percent coupon and pay interest annually. The bonds are selling atpar value. What is the cost of equity?arrow_forwardYou noticed that your firm’s debt has an overall lower cost of capital of 5% compared to equity of 15%. Therefore, you suggested to the financial manager of your firms that they should increase it’s debt component in capital structure from 30% to 70% while reducing its equity component from 70% to 30% instead. To back your justifications, under this new arrangement, your firm’s cost of equity would be 20%. i) Calculate, what would be the new cost of debt? ii) With this new arrangement, did you managed to reduce the overall cost of capital?arrow_forward
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