Fin 3322
Capital Structure Homework
1.
If a firm permanently borrows $50 million at an interest rate of 8%, how much is
firm value increased over an un-levered firm? Assume a 35% tax rate..
2.
Firm U and firm L are identical except for their capital structure. U is all equityfinanced and its equity is worth $1,000, while firm L has a D/E ratio of 1.5. Assume
all debts is risk-free. Investor Bob owns $100 of firm L’s stock. Ignore taxes.
a) What is the alternative investment strategy in U’s stock and risk-free bonds that
generate identical cash flows for Bob? (Specify exactly what strategy you use)
(b) Show that the cash flows from both strategies are the same.
3.
Sparky’s Inc. currently has an equity beta of 2.84, is financed with 10% debt and
has a total firm value of $10 million. Sparky’s CEO thinks that they should
increase the firm’s leverage by issuing $2 million of debt and buying back $2
million of equity. This debt will be perpetual and have a yield of 7%. Sparky’s
has a 35% tax rate. What is the value of Sparky’s after the swap, and how much
of that value will be equity?
4.
Skim and Cream are identical firms except that Skim is more leveraged than
Cream. The probability of a recession is equal to the probability of an expansion.
If an expansion occurs, each firm will have EBIT of $2 million next year. If a
recession occurs, each firm will have EBIT of $ 1 million next year. Cream’s
debt obligation requires the firm to make $1 million in payments. Because Skim
carries more debt, its debt payment obligations are $1.5 million. Assume that all
of the firm’s cash flows are discounted at 15%, the firm exists for one period and
there are no taxes. Use the provided data to calculate:
a. The value of equity for each firm
b. The value of debt for each firm
c. The total value of the firms. Do they have the same value? Briefly explain.
d. Is investing in Skim’s equity more or less risky than investing in Cream’s
equity? Briefly explain.
5.
Anderson’s Furniture Outlet has an un-levered cost of capital of 10%, a tax rate of
34%, and expected earnings before interest and taxes of $1,600. The company has
$3,000 in bonds outstanding that have an 8% coupon and pay interest annually.
The bonds are selling at par value. What is the cost of equity?
6.
A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of
debt is 8%. If the corporate tax rate is 25%, what would its cost of equity be if the
debt-to-equity ratio were 0?
Use the following to answer questions 7 & 8
Earn and Learn Company is financed entirely by common stock, which is priced
to offer a 20% expected rate of return. The stock price is $60 and the earnings per
share are $12.
7.
If the company repurchases 50% of the stock and substitutes an equal value of
debt yielding 8%, what is the expected earnings per share value after refinancing?
8.
Suppose that before refinancing, an investor owned 100 shares of Earn and Learn
common stock. What should he do if he wishes to ensure that risk and expected
return on his investment are unaffected by refinancing? Assume that share price
doesn’t change.
9.
Given the following information, leverage will add how much value to the
unlevered firm per dollar of debt?
Corporate tax rate: 34%
Personal tax rate on income from bonds: 40%
Personal tax rate on income from stocks: 40%