PRIN.OF CORPORATE FINANCE >BI<
12th Edition
ISBN: 9781260431230
Author: BREALEY
Publisher: MCG CUSTOM
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Question
Chapter 32, Problem 2PS
Summary Introduction
To determine: Whether the statements are true or false.
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During a restructuring, what could happen to the balance sheet of a company? (select all that apply)
The existing debtholders create new debt and new equity; existing equity holders are wiped out
The existing debtholders lose their stake and equity holders seek new debt
Assets are sold off to pay delinquent debts
Preferred equity holders are converted to debtholders on a 2:1 basis
Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?
a.
An increase in the corporate tax rate.
b.
An increase in the personal tax rate.
c.
The Federal Reserve tightens interest rates in an effort to fight inflation.
d.
The company's stock price hits a new low.
e.
An increase in costs incurred when filing for bankruptcy.
Explain your answer
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.
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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: 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_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: 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: 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.arrow_forward
- 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: Who were Modigliani and Miller (MM), and what assumptions are embedded in the MM and Miller models?arrow_forwardA company with a poor credit rating needs to raise funds for expansion, but the bank will not give them a loan. In addition, their common stock prices are already low, so they do not want to issue more shares of common stock. What would be the best way for this company to raise funds for the expansion? Sell secured bonds. Sell callable bonds. Sell convertible bonds. Sell unsecured bonds.arrow_forwardThe major function of investment banks is to help firms to finance via issuing debt or equity. Assume that there are no other costs and expenses. 1) An investment bank agrees to underwrite a $50 million, 10-year, 8 percent coupon par bond issue for a company on a firm commitment basis. The investment bank pays the company on Monday and plans to begin a public sale on Tuesday. If interest rates rise by 0.25 percent, overnight, what will be the impact on the profits of the investment bank?arrow_forward
- Match the following: Group of answer choices A. One of the largest buyers of U.S. subprime securities B. Filed for bankruptcy due to a short-term liquidity crisis C. Losses that rise unexpectedly due to unforeseen risks in a bank’s portfolio D. The federal reserve bought long-term bonds and sold an equivalent amount of short-term bonds to prop up the economy E. Places primary responsibility of accurate financial reports on CEOs and CFOs F. Established a hedging program to protect against market volatility Merck - SOX - Operation Twist - Lehman Brothers - Dark Side -…arrow_forwardQuestion A According to an international survey of CFOs of publicly traded firms, which of the following was NOT considered to be an important factor in determining the optimal amounts of debt in a firm's capital structure? A) Credit ratings B) Corporate tax shield C) Financial distress cost D) All of the above were considered to be important. Full explain this question and text typing work only We should answer our question within 2 hours takes more time then we will reduce Rating Dont ignore this linearrow_forwardQuestion 1 Indicate whether each of the following actions will increase or decrease a bond’s yield tomaturity: a. A bond’s price increase. b. The company’s bonds are downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondholders to receivepayments in the event a firm declares bankruptcy. d. The economy enters a recession. Question 2 .If a company’s beta were to double, would it expected return double? Question 3.Are there conditions under which a firm might be better off if it were to choose a machine with arapid payback rather than one with a larger NPV?arrow_forward
- 2. What is the primary reason for the higher cost of finance from shareholders than debt? a. Shareholders receive dividends every year, so the company has to factor this in, whereas interest payments on loans are optional. b. The assumption in the question is incorrect - banks always charge businesses more than shareholders. c. Shareholders are greedy d. Shareholders take on more risk and therefore require a higher return on their investmentarrow_forwardWhich of the following would likely encourage a firm to increase the debt in its capital structure? a. The corporate tax rate increases. b. The personal tax rate increases. c. Due to market changes, the firm’s assets become less liquid. d. Changes in the bankruptcy code make bankruptcy less costly to the firm. e. The firm’s sales and earnings become more volatile.arrow_forwardA. Stockholders can transfer wealth from bondholders. As a finance analyst, you are required to explain how the following actions by stockholders transfer wealth from bondholders. Again, in what ways can the bondholders protect themselves against these actions?i. An increase in dividendsii. A leveraged buyoutiii. Acquiring a risky business B. Why might the two (2) disciplinary mechanisms of shareholders against managers not work? C. Union Pacific Rail road reported net income of $770million after interest expenses of $320 million in a recent financial year. The corporate tax rate was 36%. It reported depreciation of $960 million in that year, and capital spending of $1.2billion. The firm also had $4billion in debt outstanding on the books, was rated AA (carrying a yield to maturity of 8%), and was trading at par (up from $3.8 billion at the end of the previous year). The beta of the stock is 1.05, and there were 200 million shares outstanding (trading at $60 per share), with a book…arrow_forward
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