Principles of Corporate Finance
13th Edition
ISBN: 9781260465099
Author: BREALEY, Richard
Publisher: MCGRAW-HILL HIGHER EDUCATION
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Chapter 17, Problem 12PS
MM proposition 2. “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?
- d. What is the percentage increase in earnings per share after the refinancing?
- e. What is the new price-earnings multiple? (Hint: Has anything happened to the stock price?)
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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 5.5% and the cost of equity to rise to 10.83%. Assume the firm pays no taxes.
How much debt does the company now have?
How much equity does it now have?
What is the overall cost of capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)
What is the percentage increase in earnings per share after the refinancing? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)
What is the new…
“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…
2. Business and financial risk
The impact of financial leverage on return on equity and earnings per share
Consider the following case of Purple Panda Importers:
Suppose Purple Panda Importers is considering a project that will require $350,000 in assets.
• The company is small, so it is exempt from the interest deduction limitation under the new tax law.
• The project is expected to produce earnings before interest and taxes (EBIT) of $60,000.
• Common equity outstanding will be 25,000 shares.
• The company incurs a tax rate of 25%.
If the project is financed using 100% equity capital, then Purple Panda Importers's return on equity (ROE) on the project will be
addition, Purple Panda's earnings per share (EPS) will be
Alternatively, Purple Panda Importers's CFO is also considering financing the project with 50% debt and 50% equity capital. The
company's debt will be 10%. Because the company will finance only 50% of the project with equity, it will have only 12,500 shar
Panda…
Chapter 17 Solutions
Principles of Corporate Finance
Ch. 17 - Homemade leverage Ms. Kraft owns 50,000 shares of...Ch. 17 - Homemade leverage Companies A and B differ only in...Ch. 17 - Corporate leverage Suppose that Macbeth Spot...Ch. 17 - Corporate leverage Reliable Gearing currently is...Ch. 17 - MMs propositions True or false? a. MMs...Ch. 17 - MMs propositions What is wrong with the following...Ch. 17 - Prob. 7PSCh. 17 - MM proposition 1 Executive Cheese has issued debt...Ch. 17 - Prob. 9PSCh. 17 - Prob. 10PS
Ch. 17 - MM proposition 2 Spam Corp. is financed entirely...Ch. 17 - MM proposition 2. Increasing financial leverage...Ch. 17 - Prob. 13PSCh. 17 - MM proposition 2 Look back to Section 17-1....Ch. 17 - MM proposition 2 Hubbards Pet Foods is financed...Ch. 17 - MM proposition 2 Imagine a firm that is expected...Ch. 17 - MM proposition 2 Archimedes Levers is financed by...Ch. 17 - MM proposition 2 Look back to Problem 17. Suppose...Ch. 17 - Prob. 19PSCh. 17 - After-tax WACC Gaucho Services starts life with...Ch. 17 - After-tax WACC Omega Corporation has 10 million...Ch. 17 - After-tax WACC Gamma Airlines has an asset beta of...Ch. 17 - Prob. 23PSCh. 17 - Investor choice People often convey the idea...Ch. 17 - Investor choice Suppose that new security designs...
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