520 Part IV Capital Structure and Dividend Policy

5. Business Risk versus Financial Risk Explain what is meant by business and
financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that
Firm A also has a higher cost of equity capital? Explain.
6. MM Propositions How would you answer in the following debate?
Q: Isn’t it true that the riskiness of a firm’s equity will rise if the firm increases its
use of debt financing?
A: Yes, that’s the essence of MM Proposition II.
Q: And isn’t it true that, as a firm increases its use of borrowing, the likelihood of
default increases, thereby increasing the risk of the firm’s debt?
A: Yes.
Q: In other words, increased borrowing increases the risk of the equity and the debt?
A: That’s right.
Q: Well, given that the firm uses only debt and equity financing, and given that
the risks of both are increased by increased borrowing, does it not follow that
increasing debt increases the overall risk of the firm and therefore decreases the
value of the firm?
A: ?
7. Optimal Capital Structure Is there an easily identifiable debt–equity ratio that will
maximize the value of a firm? Why or why not?
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8. Financial Leverage Why is the use of debt financing referred to as financial

“leverage”?
9. Homemade Leverage What is homemade leverage?
10. Capital Structure Goal What is the basic goal of financial management with regard
to capital structure?

Questions and Problems

®
1. EBIT and Leverage Money, Inc., has no debt outstanding and a total market value
of $275,000. Earnings before interest and taxes, EBIT, are projected to be $21,000 if
finance
economic conditions are normal. If there is strong expansion in the economy, then
BASIC (Questions 1−16) EBIT will be 25 percent higher. If there is a recession, then EBIT will be 40 percent
lower. Money is considering a $99,000 debt issue with an interest rate of 8 percent.
The proceeds will be used to repurchase shares of stock. There are currently
5,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic scenarios
before any debt is issued. Also calculate the percentage changes in EPS when the
economy expands or enters a recession.
b. Repeat part (a) assuming that Money goes through with recapitalization. What
do you observe?
2. EBIT, Taxes, and Leverage Repeat parts (a) and (b) in Problem 1 assuming Money
has a tax rate of 35 percent.
3. ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio
of 1.0.
a. Calculate return on equity, ROE, under each of the three economic scenarios
before any debt is issued. Also calculate the percentage changes in ROE for eco-
nomic expansion and recession, assuming no taxes.
Chapter 16 Capital Structure 521

b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of
35 percent.
4. Break-Even EBIT Rolston Corporation is comparing two different capital
structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I,
Rolston would have 265,000 shares of stock outstanding. Under Plan II, there would
be 185,000 shares of stock outstanding and $2.8 million in debt outstanding. The
interest rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,500,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
5. MM and Stock Value In Problem 4, use MM Proposition I to find the price per
share of equity under each of the two proposed plans. What is the value of the firm?
6. Break-Even EBIT and Leverage Kolby Corp. is comparing two different capital
structures. Plan I would result in 900 shares of stock and $65,700 in debt. Plan II
would result in 1,900 shares of stock and $29,200 in debt. The interest rate on the
debt is 10 percent.
a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that
EBIT will be $8,500. The all-equity plan would result in 2,700 shares of stock
outstanding. Which of the three plans has the highest EPS? The lowest?
b. In part (a) what are the break-even levels of EBIT for each plan as compared to

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that for an all-equity plan? Is one higher than the other? Why?
c. Ignoring taxes, when will EPS be identical for Plans I and II?
d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent.
Are the break-even levels of EBIT different from before? Why or why not?
7. Leverage and Stock Value Ignoring taxes in Problem 6, what is the price per share
of equity under Plan I? Plan II? What principle is illustrated by your answers?
8. Homemade Leverage Star, Inc., a prominent consumer products firm, is debating
whether or not to convert its all-equity capital structure to one that is 35 percent
debt. Currently there are 6,000 shares outstanding and the price per share is $58.
EBIT is expected to remain at $33,000 per year forever. The interest rate on new debt
is 8 percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash
flow under the current capital structure, assuming the firm has a dividend payout
rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the
firm? Assume that she keeps all 100 of her shares.
c. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital
structure. Show how she could unlever her shares of stock to recreate the original
capital structure.
d. Using your answer to part (c), explain why Star’s choice of capital structure is
irrelevant.
9. Homemade Leverage and WACC ABC Co. and XYZ Co. are identical firms in all
respects except for their capital structure. ABC is all equity financed with $750,000 in
stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the
interest rate on its debt is 8 percent. Both firms expect EBIT to be $86,000. Ignore taxes.
a. Richard owns $30,000 worth of XYZ’s stock. What rate of return is he expecting?
b. Show how Richard could generate exactly the same cash flows and rate of return
by investing in ABC and using homemade leverage.
c. What is the cost of equity for ABC? What is it for XYZ?
d. What is the WACC for ABC? For XYZ? What principle have you illustrated?
 522 Part IV Capital Structure and Dividend Policy

10. MM Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If the
current market value of the equity is $37 million and there are no taxes, what is EBIT?
11. MM and Taxes In the previous question, suppose the corporate tax rate is
35 percent. What is EBIT in this case? What is the WACC? Explain.
12. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is
11 percent, and its cost of debt is 7 percent. The corporate tax rate is 35 percent.
a. What is Weston’s cost of equity capital?
b. What is Weston’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio were 2? What if it were
1.0? What if it were zero?
13. Calculating WACC Shadow Corp. has no debt but can borrow at 8 percent. The
firm’s WACC is currently 11 percent, and the tax rate is 35 percent.
a. What is Shadow’s cost of equity?
b. If the firm converts to 25 percent debt, what will its cost of equity be?
c. If the firm converts to 50 percent debt, what will its cost of equity be?
d. What is Shadow’s WACC in part (b)? In part (c)?
14. MM and Taxes Bruce & Co. expects its EBIT to be $185,000 every year forever.
The firm can borrow at 9 percent. Bruce currently has no debt, and its cost of equity
is 16 percent. If the tax rate is 35 percent, what is the value of the firm? What will
the value be if Bruce borrows $135,000 and uses the proceeds to repurchase shares?
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15. MM and Taxes In Problem 14, what is the cost of equity after recapitalization? What
is the WACC? What are the implications for the firm’s capital structure decision?
16. MM Proposition I Levered, Inc., and Unlevered, Inc., are identical in every way
except their capital structures. Each company expects to earn $29 million before
interest per year in perpetuity, with each company distributing all its earnings as
dividends. Levered’s perpetual debt has a market value of $91 million and costs
8 percent per year. Levered has 2.3 million shares outstanding, currently worth
$105 per share. Unlevered has no debt and 4.5 million shares outstanding, currently
worth $80 per share. Neither firm pays taxes. Is Levered’s stock a better buy than
Unlevered’s stock?
INTERMEDIATE 17. MM Tool Manufacturing has an expected EBIT of $57,000 in perpetuity and a
(Questions 17−25)
tax rate of 35 percent. The firm has $90,000 in outstanding debt at an interest rate
of 8 percent, and its unlevered cost of capital is 15 percent. What is the value of the
firm according to MM Proposition I with taxes? Should Tool change its debt–equity
ratio if the goal is to maximize the value of the firm? Explain.
18. Firm Value Cavo Corporation expects an EBIT of $19,750 every year forever. The
company currently has no debt, and its cost of equity is 15 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 10 percent. If the corporate tax rate is
35 percent, what will the value of the firm be if the company takes on debt equal
to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent
of its unlevered value?
c. What will the value of the firm be if the company takes on debt equal to 50 per-
cent of its levered value? What if the company takes on debt equal to 100 percent
of its levered value?
19. MM Proposition I with Taxes The Maxwell Company is financed entirely with
equity. The company is considering a loan of $1.8 million. The loan will be repaid
in equal installments over the next two years, and it has an interest rate of 8 percent.
The company’s tax rate is 35 percent. According to MM Proposition I with taxes,
what would be the increase in the value of the company after the loan?
Chapter 16 Capital Structure 523

20. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are
identical in every way except their capital structures. Alpha Corporation, an all-
equity firm, has 15,000 shares of stock outstanding, currently worth $30 per share.
Beta Corporation uses leverage in its capital structure. The market value of Beta’s
debt is $65,000, and its cost of debt is 9 percent. Each firm is expected to have
earnings before interest of $75,000 in perpetuity. Neither firm pays taxes. Assume
that every investor can borrow at 9 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
d. How much will it cost to purchase 20 percent of each firm’s equity?
e. Assuming each firm meets its earnings estimates, what will be the dollar return to
each position in part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent
of Alpha’s equity and replicates both the cost and dollar return of purchasing
20 percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.
21. Cost of Capital Acetate, Inc., has equity with a market value of $23 million and
debt with a market value of $7 million. Treasury bills that mature in one year yield
5 percent per year, and the expected return on the market portfolio is 12 percent. The
beta of Acetate’s equity is 1.15. The firm pays no taxes.
a. What is Acetate’s debt–equity ratio?

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b. What is the firm’s weighted average cost of capital?
c. What is the cost of capital for an otherwise identical all-equity firm?
22. Homemade Leverage The Veblen Company and the Knight Company are identical
in every respect except that Veblen is not levered. The market value of Knight
Company’s 6 percent bonds is $1.4 million. Financial information for the two firms
appears here. All earnings streams are perpetuities. Neither firm pays taxes. Both
firms distribute all earnings available to common stockholders immediately.

Veblen Knight

Projected operating income $ 550,000 $ 550,000

Year-end interest on debt — 84,000
Market value of stock 4,300,000 3,140,000
Market value of debt — 1,400,000

a. An investor who can borrow at 6 percent per year wishes to purchase 5 percent
of Knight’s equity. Can he increase his dollar return by purchasing 5 percent of
Veblen’s equity if he borrows so that the initial net costs of the two strategies are
the same?
b. Given the two investment strategies in (a), which will investors choose? When will
this process cease?
23. MM Propositions Locomotive Corporation is planning to repurchase part of its
common stock by issuing corporate debt. As a result, the firm’s debt–equity ratio is
expected to rise from 35 percent to 50 percent. The firm currently has $3.6 million worth
of debt outstanding. The cost of this debt is 8 percent per year. Locomotive expects to
have an EBIT of $1.35 million per year in perpetuity. Locomotive pays no taxes.
a. What is the market value of Locomotive Corporation before and after the repur-
chase announcement?
b. What is the expected return on the firm’s equity before the announcement of the
stock repurchase plan?
 524 Part IV Capital Structure and Dividend Policy

c. What is the expected return on the equity of an otherwise identical all-equity firm?
d. What is the expected return on the firm’s equity after the announcement of the
stock repurchase plan?
24. Stock Value and Leverage Green Manufacturing, Inc., plans to announce that
it will issue $2 million of perpetual debt and use the proceeds to repurchase
common stock. The bonds will sell at par with a coupon rate of 6 percent. Green
is currently an all-equity firm worth $6.3 million with 400,000 shares of common
stock outstanding. After the sale of the bonds, Green will maintain the new
capital structure indefinitely. Green currently generates annual pretax earnings of
$1.5 million. This level of earnings is expected to remain constant in perpetuity.
Green is subject to a corporate tax rate of 40 percent.
a. What is the expected return on Green’s equity before the announcement of the
debt issue?
b. Construct Green’s market value balance sheet before the announcement of the
debt issue. What is the price per share of the firm’s equity?
c. Construct Green’s market value balance sheet immediately after the announce-
ment of the debt issue.
d. What is Green’s stock price per share immediately after the repurchase
announcement?
e. How many shares will Green repurchase as a result of the debt issue? How many
shares of common stock will remain after the repurchase?
f. Construct the market value balance sheet after the restructuring.
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g. What is the required return on Green’s equity after the restructuring?

25. MM with Taxes Williamson, Inc., has a debt–equity ratio of 2.5. The firm’s
weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent.
Williamson is subject to a corporate tax rate of 35 percent.
a. What is Williamson’s cost of equity capital?
b. What is Williamson’s unlevered cost of equity capital?
c. What would Williamson’s weighted average cost of capital be if the firm’s debt–
equity ratio were .75? What if it were 1.5?
CHALLENGE 26. Weighted Average Cost of Capital In a world of corporate taxes only, show that the
(Questions 26−30)
R WACC can be written as R WACC 5 R0 3 [1 2 tC (ByV )].
27. Cost of Equity and Leverage Assuming a world of corporate taxes only, show
that the cost of equity, RS , is as given in the chapter by MM Proposition II with
corporate taxes.
28. Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of
debt equals the risk-free rate, Rf . Define bA as the firm’s asset beta—that is, the
systematic risk of the firm’s assets. Define bS to be the beta of the firm’s equity. Use
the capital asset pricing model, CAPM, along with MM Proposition II to show that
bS 5 bA 3 (1 1 ByS), where ByS is the debt–equity ratio. Assume the tax rate is zero.
29. Stockholder Risk Suppose a firm’s business operations mirror movements in the
economy as a whole very closely—that is, the firm’s asset beta is 1.0. Use the result of
previous problem to find the equity beta for this firm for debt–equity ratios of 0, 1, 5,
and 20. What does this tell you about the relationship between capital structure and
shareholder risk? How is the shareholders’ required return on equity affected? Explain.
30. Unlevered Cost of Equity Beginning with the cost of capital equation—that is:
S B
RWACC = ______ ______
B + S RS + B + S RB
show that the cost of equity capital for a levered firm can be written as follows:
RS = R0 + B S (R0 − RB)