Chapter 14, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 14

ASSESSING LONG-TERM DEBT, EQUITY, AND CAPITAL STRUCTURE

Questions LG1 1. How will passive and active capital structure changes differ? Active capital structure changes will be initiated immediately, regardless of whether the firm has any capital budgeting needs; passive capital structure changes will be accommodated in the course of financing future capital budgeting needs, with the firm raising money for such new projects in the form (debt or equity) they wish to increase in the capital structure. LG2 2. Why is debt often referred to as leverage in finance? Debt magnifies both the potential returns and the risk to equityholders. LG3 3. In M&Ms perfect world, will the debtholders ever bear any of the risk of the firm? No. If theres no chance of bankruptcy, theres no chance that the debtholders wont get paid back everything theyre owed. LG4 4. Why does allowing for the existence of corporate taxation cause firms to prefer the maximum amount of debt possible? Since interest paid on corporate debt is tax-deductible, debt is cheap, in the sense that the incremental cost to the firm is iD(1 TC), so the firm will use as much of it as it feasibly can. LG5 5. If a firm increased the amount of debt in its capital structure, but a shareholder wanted to switch back to the mixture of expected return and risk she had before the switch, how would she go about doing so? She would unleverage by lending a portion of her wealth equivalent to the percentage of the firms capital structure that was shifted from equity to debt. LG5 6. If an investor wanted to reduce the risk of a levered stock in their portfolio, how could they go about doing so while still retaining shares in the company? They could sell some of their shares and use the proceeds to buy the firms bonds. LG6 7. Suppose you were the financial manager for a firm and were considering a proposed increase in the amount of debt in the firms capital structure. If you thought the firm was going to consistently earn a level of EBIT above its break-even level of EBIT (based on the current and proposed new capital structures) would this cause you to prefer leveraging the firm up or staying at your current capital structure?

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Chapter 14, Solutions

Cornett, Adair, and Nofsinger

Leveraging increases the EPS above the break-even level of EBIT, so you would prefer leveraging the firm up. LG7 8. Explain why, in a world with both corporate taxes and the chance of bankruptcy, a small firm with volatile EBIT is unlikely to have much debt. In such a firm, debt would greatly increase both the chance of the firm going bankrupt and the expected associated costs of financial distress. LG7 9. If the U.S. government completely eliminated taxation at the corporate level, how would this influence the capital structures of firms in a world with bankruptcy? Since debt would no longer enjoy a tax advantage compared to equity, we would expect to see lower debt levels, everything else held constant. LG8 10. Would you expect a utility company to have high or low debt levels? Why? Most utility companies have high and stable earnings streams, which allows them to support a relatively large amount of debt. Problems Basic Problems LG3 14-1 Suppose that Lil John Industries equity is currently selling for $37 per share and that there are 2 million shares outstanding. If the firm also has 50 thousand bonds outstanding, which are selling at 103 percent of par, what are the firms current capital structure weights? Using the capital structure weights in equation 11-1:
E E D E D D 2, 000, 000 2, 000, 000 $37 $37 $1, 000 1.03 0.4104 0.5896

50, 000

50, 000 2, 000, 000 $37

$1, 000 1.03 50, 000 $1, 000 1.03

LG3

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Daddi Mac, Inc., doesnt face any taxes and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, lets assume that the firms expected values for EBIT are dependent upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Recession Average Boom

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Chapter 14, Solutions

Cornett, Adair, and Nofsinger

Probability of State

.25

.55

.20

Expect EBIT in State $5 million $10 million $17 million The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt regardless of whether they change their capital structure. What will be the standard deviation in EPS if they switch to the proposed capital structure? The EPS in each state of nature will be as shown:

The expected EPS will be equal to (.25 -0.08) + (.55 0.58) + (.20 1.51) = 0.60, so the standard deviation in EPS will be equal to:
.25 0.5290 .08 0.60
2

EPS

.55 0.58

0.60

.20 1.51

0.60

LG6

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Continuing the previous problem, what will be the break-even level of EBIT?
E P S 20% E B IT $5, 600, 000 7, 567, 568 . E B IT $5, 600, 000 1
D ebt

E P S A ll

equity

E B IT 1

9,459,459 E B IT 9,459,459 7, 567, 5 68 E B IT $52, 972, 97 2, 972, 973.00 $28,000, 000

7, 567, 568 9,459,459 $52, 972, 972, 972, 973.00 1, 891, 891.89 E B IT E B IT

LG3

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HiLo, Inc., doesnt face any taxes and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, lets assume that the firms expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below:

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Chapter 14, Solutions

Cornett, Adair, and Nofsinger

State Probability of State Expect EBIT in State

Pessimistic .45 $5 million

Optimistic .55 $19 million

The firm is considering switching to a 40-percent debt capital structure, and has determined that they would have to pay a 12 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? The EPS in each state of nature will be as shown:

The expected EPS will be equal to (.45 0.02) + (.55 1.66) = 0.92 LG3 14-5 HiLo, Inc., doesnt face any taxes and has $100 million in assets, currently financed entirely with equity. Equity is worth $7 per share, and book value of equity is equal to market value of equity. Also, lets assume that the firms expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Probability of State Expect EBIT in State Pessimistic .45 $5 million Optimistic .55 $19 million

The firm is considering switching to a 40-percent debt capital structure, and has determined that they would have to pay a 12 percent yield on perpetual debt in either event. What will be the standard deviation in EPS if they switch to the proposed capital structure? The EPS in each state of nature will be as shown:

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Chapter 14, Solutions

Cornett, Adair, and Nofsinger

The expected EPS will be equal to (.45 0.02) + (.55 1.66) = 0.92, so the standard deviation in EPS will be equal to:
.45 0.02 0.8126 0.92
2

EPS

.55 1.66

0.92

LG6

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Continuing the previous problem, what will be the break-even level of EBIT?
E P S 40% E B IT $4, 800, 000 14, 285, 714 . E B IT $4, 800, 000 1
D ebt

E P S A ll

equity

E B IT 1

8, 571, 429 E B IT 8, 571, 429 14, 285, 7 14 E B IT $68, 571, 428, 571, 428.60 $12,000, 000

14, 285, 714 8, 571, 429 E B IT $68, 571, 428, 571, 428.60 5, 714, 285.71 E B IT E B IT

Advanced Problems LG4 14-7 NoNuns Cos. has a 25 percent tax rate and has $350 million in assets, currently financed entirely with equity. Equity is worth $37 per share, and book value of equity is equal to market value of equity. Also, lets assume that the firms expected values for EBIT depend upon which state of the economy occurs this year, with the possible values of EBIT and their associated probabilities as shown below: State Probability of State Recession .25 Average .55 Boom .20

Expect EBIT in State $5 million $10 million $17 million

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Chapter 14, Solutions

Cornett, Adair, and Nofsinger

The firm is considering switching to a 20-percent debt capital structure, and has determined that they would have to pay an 8 percent yield on perpetual debt in either event. What will be the level of expected EPS if they switch to the proposed capital structure? The EPS in each state of nature will be as shown:

The expected EPS will be equal to (.25 -0.06) + (.55 0.44) + (.20 1.13) = 0.45

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