Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 21, Problem 5MC
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s 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
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Mini CaseDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s 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 average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Assume that Firms U and L are in the same risk class and that both have EBIT=$500,000. Firm U uses no debt financing, and its cost of equity is rsU=14%. Firm L has $1 million of debt outstanding at a cost of rd=8%. There are no taxes. Assume that the MM assumptions hold.
Find V, S, rs, and WACC for Firms U and L.
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s 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 average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Suppose the expected free cash flow for Year 1 is $250,000 but it is expected to grow unevenly over 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 $80,000, 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 $95,000, at Year 3 it will be $120,000, and it will grow at 7% thereafter. What is the estimated horizon unlevered…
After discussions with Josh, Carrington and Genevieve agree that they would like to try to increase the value of the company stock. Like many small business owners, they want to retain control of the company and do not want to sell stock to outside investors. They also feel that the company's debt is at a manageable level and do not want to borrow more money, What steps can they take to increase the price of the stock? Are there any condi- tions under which this strategy would not increase the stock price?
Chapter 21 Solutions
Financial Management: Theory & Practice
Ch. 21 - Prob. 1QCh. 21 - Modigliani and Miller assumed that firms do not...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 - Prob. 3PCh. 21 - Prob. 4PCh. 21 - A company’s most recent free cash flow to equity...Ch. 21 - Air Tampa has just been incorporated, and its...Ch. 21 - Companies U and L are identical in every respect...Ch. 21 - Schwarzentraub Corporation’s expected free cash...
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- 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: Now assume that Firms L and U are both subject to a 25% corporate tax rate. Using the data given in part b, repeat the analysis called for in parts b(1) and b(2) using assumptions from the MM model with taxes.arrow_forwardDavid 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: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.arrow_forwardKaren Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy in light of a recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was ultimately renewed, the scare has forced Johnson to examine carefully each component of RR’s working capital to make sure it is needed, with the goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well aware that reducing working capital will improve free cash flow. Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnson’s efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about the cash and securities balances. However, with the recent credit scare, this resistance has become unacceptable and Johnson has undertaken a company-wide examination of cash, marketable securities, inventory, and accounts receivable levels. Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, and free cash flow would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stockouts and loss of sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Johnson has begun her investigation by collecting the ratios shown here. (The partial cash budget shown after the ratios is used later in this mini case.) Johnson plans to use the preceding ratios as the starting point for discussions with RR’s operating team. Based on the data, does RR seem to be following a relaxed, moderate, or restricted current asset usage policy?arrow_forward
- The Rivoli Company has no debt outstanding, and its financial position is given by the following data: What is Rivoli’s intrinsic value of operations (i.e., its unlevered value)? What is its intrinsic stock price? Its earnings per share? Rivoli is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 12% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Based on the new capital structure, what is the new weighted average cost of capital? What is the levered value of the firm? What is the amount of debt? Based on the new capital structure, what is the new stock price? What is the remaining number of shares? What is the new earnings per share?arrow_forwardYou have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Both companies are small, so they are not subject to the interest deduction limitation. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROEHigher - ROELower? Do not round your intermediate calculations. Operating Data Other Data Capital $4,000 Higher wd 60% ROIC = EBIT(1 – T)/Capital 13.00% Higher interest rate 13% Tax rate 25% Lower wd 10% Lower interest rate 9% Group of answer choices 4.68% 4.77% 3.72% 4.18% 3.93%arrow_forwardA company needs to raise $9 million and issues bonds for that amount rather than additional capital stock. Which of the following is not a likely reason the company chose debt financing? A. Management hopes to increase profits by using financial leveraging. B. The cost of borrowing is reduced because interest expense is tax deductible. C. Adding new owners increases the possibility of bankruptcy if economic conditions get worse. D. If money becomes available, the company can rid itself of debts.arrow_forward
- The following statements were included in a report prepared by a financial manager of a company to explain current capital rationing matters in the company:1. The owners wish to remain in control, and hence do not want to issue any more shares2. The directors only wish to use retained earnings for finance investment3. Investors are unable or not willing to invest more equity finance4. The covenants on existing loans prevent the company from taking out any more loans.Required:Which of the above statements are examples of soft capital rationing? (Provide explanation)arrow_forwardTaggart Technologies is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? a. The times-interest-earned ratio will decrease. b. Net income will decrease. c. Taxable income will decline. d. The ROA will decline. e. The tax bill will increase.arrow_forwardKaren Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy considering a recent scare she faced when RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of credit. Had the line of credit not been renewed, RR would not have been able to make payroll, potentially forcing the company out of business. Although the line of credit was ultimately renewed, the scare has forced Johnson to examine carefully each component of RR’s working capital to make sure it is needed, with the goal of determining whether the line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need for a line of credit, Johnson is well aware that reducing working capital can also add value to a company by improving its EVA (Economic Value Added). In her corporate finance course Johnson learned that EVA is calculated by taking net operating profit after taxes (NOPAT) and then…arrow_forward
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