1.

If u can borrow all the money u need for a project at 6%, doesnt it follow that 6% is ur cost of capital for the project? No. The cost of capital depends on the risk of the project, not the source of the money. 2. Why do we use an aftertax figure for cost of debt but not for cost of equity? Interest expense is tax-deductible. There is no difference betn pretax & aftertax equity costs. 3. If u use the stock beta & the security market line to compute the discount rate for a project, what assumptions r u implicitly making? u are assuming that the new projects risk is the same as the risk of the firm as a whole, & that the firm is financed entirely with equity. 6. Suppose Tom, president of B Inc., has hired u to determine the firms cost of debt and cost of equity capital. a. The stock currently sells for $50 per share, & the dividend per share will probably be about $5. Tom argues, It will cost us $5 per share to use the stockholders money this yr, so cost of equity = 10% (=$550). Whats wr ong with this conclusion? This only considers the dividend yield component of the required return on equity. b. B total liabilities are $8 million. Total interest expense for the coming year will be $1 million. Tom reasons, We owe $8 million, & we will pay $1 million interest. Our cost of debt is obviously $1 million/8 million = 12.5%. Whats wrong with this conclusion? This is current yield only, not the promised yield to maturity. Its based on book value of liability, it ignores taxes. c. Based on his own analysis, Tom is recommending that company increase its use of equity financing because, debt costs 12.5%, but equity only costs 10 percent; thus equity is cheaper. Ignoring all other issues, what do u think about conclusion that cost of equity is less than cost of debt? Equity is inherently riskier than debt (except, perhaps, in the unusual case where a firms assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt. 9. Consider a levered firms projects that have similar risks to the firm as a whole. Is the discount rate for the projects higher or lower than the rate computed using the security market line? Why? The discount rate for the projects should be lower that the rate implied by the security market line. The security market line is used to calculate the cost of equity. The appropriate discount rate for projects is the firms weighted average cost of capital. Since the firms cost of debt is generally less that the firms cost of equity, the rate implied by the security market line will be too high.

10. Beta What factors determine the beta of a stock? Define and describe each. Beta measures the responsiveness of a security's returns to movements in the market. Beta is determined by the cyclicality of a firm's revenues. This cyclicality is magnified by the firm's operating and financial leverage. The following three factors will impact the firms beta. (1) Revenues. The cyclicality of a firm's sales is an important factor in determining beta. In general, stock prices will rise when the economy expands and will fall when the economy contracts. As we said above, beta measures the responsiveness of a security's returns to movements in the market. Therefore, firms whose revenues are more responsive to movements in the economy will generally have higher betas than firms with less-cyclical revenues. (2) Operating leverage. Operating leverage is the percentage change in earnings before interest and taxes (EBIT) for a percentage change in sales. A firm with high operating leverage will have greater fluctuations in EBIT for a change in sales than a firm with low operating leverage. In this way, operating leverage magnifies the cyclicality of a firm's revenues, leading to a higher beta. (3) Financial leverage. Financial leverage arises from the use of debt in the firm's capital structure. A levered firm must make fixed interest payments regardless of its revenues. The effect of financial leverage on beta is analogous to the effect of operating leverage on beta. Fixed interest payments cause the percentage change in net income to be greater than the percentage change in EBIT, magnifying the cyclicality of a firm's revenues. Thus, returns on highly-levered stocks should be more responsive to movements in the market than the returns on stocks with little or no debt in their capital structure. 9. Finding Capital Structure: Famas has WACC = 9.8%. Companys cost of equity is 15%, & cost of debt is 7.5%. Tax rate = 35%. What is Famas debtequity ratio?
Soln:

WACC = ( 0.098 = ( ( ( ( )

) )

( ( ) (

)( )(

) ) )( )( ) ) 1.0558 )

Here, WACC = 9.8% Cost of equity, Ke = 15% Cost of debt Tc = 35% debtequity ratio, Now we must realize that: = 7.5%

( (

10. Book Value vs Market Value: Filer has 7.5 million shares of common stock outstanding. Current share price = $49 & the book value per share = $4. Filer has two bond issues outstanding. The 1st bond issue has a face value of $60 million & a 7% coupon & sells for 93% of par. The 2nd issue has a face value of $50 million & a 6.5% coupon & sells for 96.5% of par. The 1st issue matures in 10 years, the 2nd in 6 years. a. What are Filers capital structure weights on a book value basis? Soln: Book value of equity = book value per share x no. of shares, & the book value of debt = face value of companys debt, so: BVE = 7,500,000($4) = $30,000,000 BVD = $60,000,000 + 50,000,000 = $110,000,000 So, the total value , V = $30,000,000 + 110,000,000 = $140,000,000 & the book value weights of equity & debt are: = 0.2143 ( )

b. What are Filers capital structure weights on a market value basis? Soln: MV of equity = share price x no. of shares, so: MVE = 7,500,000($49) = $367,500,000 Total MV of debt =price quote x par value of bond, MV of debt: MVD = 0.93($60,000,000) + 0.965($50,000,000) = $104,050,000 Total market value , V = $367,500,000 + 104,050,000 = $471,550,000 & MV weights of equity & debt are: = 0.7793 ( )

c. Which are more relevant, the book or MV weights? Why? The market value weights are more relevant. 11. Calculating WACC: In prblm 10, suppose companys stock has = 1.2. Risk-free rate is 5.2% & market risk premium = 7%. Assume, overall cost of debt is the weighted average implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35%. What is the companys WACC? Soln:Solving for cost of equity using CAPM, ( For Bond 1:
After tax,

= 1.2, Tc = 35% RFR = 5.2% Rm-RFR = 7%

)

0 .052 + 1.2 x 0.07 = 0.136 or 13.6%

or 8% (

For Bond 2:
After tax, (

or 7.2% )

To find weighted average after tax cost of debt, we need the weight of each bond as a % of the total debt. We find: Weight of Debt 1 =
( )

= 0.536

; Weight of Debt 2 =

=0.464

Weighted average cost of debt = (.052) (0.536) + (.047) (.464) = 0.0497 or 4.97% WACC =( ) ( ) 0.7793(0.136) + 0.2207(0.0497) = 0.117 or 11.7%

16. Calculating Flotation Cost: Suppose ur company needs $20 million to build a new assembly line. Your target debt equity ratio = 0.75. The flotation cost for new equity is 8%, but flotation cost for debt = 5%. Your boss has decided to fund the project by borrowing money bcoz the flotation costs are lower & the needed funds are relatively small. a. What is rationale behind borrowing entire amount? He should look at weighted average flotation cost, not just debt cost. b. What is your companys weighted average flotation cost, assuming all equity is raised externally? Soln: The weighted average flotation cost is the weighted average of the flotation costs for debt & equity, so: fT = ( ) ( )
; V = D + E = 0.75 + 1 = 1.75

c. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt? Soln: The total cost of the equipment including flotation costs is: Amount raised (1 0.0671) = $20,000,000 Amount raised = (
)

Even if specific funds r actually being raised completely from debt, flotation costs & hence true investment cost, should be valued as if the firms target capital structure is used.

Chapter 16 : Capital Structure: Basic Concepts

MM proposition I (without taxes): According to MM in a real world without any corporate tax A firm
cant change the value of its outstanding securities by changing its capital structure. VL = VU

MM proposition II (without taxes): According to MM in a real world without any corporate tax the cost
of equity capital is a linear fn of debt to equity ratio. RS = R0 + (B/S) (R0 RB)

MM proposition I (with taxes): According to MM in a real world with corporate tax the value of levered
firm is the value of an all equity firm plus the tax rate times the value of the debt. VL = VU +TCB

MM proposition II (with taxes): According to MM in a real world with corporate tax value is positively
related to leverage. The value of (1-TC) is always less than 1, so the required return on equity RS, does not increase as fast as it increases in the no taxes condition. RS = R0 + (B/S) (R0 RB)(1-TC) 1. List the 3 assumptions that lie behind the MM theory in a world without taxes. r they reasonable in real world? Explain. Assumptions of the Modigliani-Miller theory in a world without taxes: 1) Individuals & corporations borrow at same interest rate. Since investors can purchase securities on margin, an individuals effective interest rate is probably no higher than that for a firm. So, this is reasonable when applying to the real world 2) There are no taxes. In the real world, firms do pay taxes.

3) There are no costs of financial distress. In the real world, costs of financial distress can be substantial. 2. In a world with no taxes, no transaction costs, & no costs of financial distress, is the following statement true, false, or uncertain? If a firm issues equity to repurchase some of its debt, the price per share of the firms stock will rise because the shares are less risky. False. A reduction in leverage will decrease both the risk of the stock and its expected return. Modigliani and Miller state that, in the absence of taxes, these two effects exactly cancel each other out and leave the price of the stock and the overall value of the firm unchanged. 3. In a world with no taxes, no transaction costs, & no costs of financial distress, is the following statement true, false, or uncertain? Moderate borrowing will not increase the required return on a firms equity. Explain . False. M-M Proposition II (No Taxes) states that required return on a firms equity is positively related to the firms debt-equity ratio. Therefore, any increase in the amount of debt in a firms capital structure will increase the required return on the firms equity. 4. What is the quirk in the tax code that makes a levered firm more valuable than an otherwise identical unlevered firm? Interest payments are tax deductible, where payments to shareholders (dividends) are not tax deductible. 5. Explain what is meant by business & 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? Business risk is the equity risk arising from the nature of the firms operating activity, and is directly related to the systematic risk of the firms assets. Financial risk is the equity risk that is due entirely to the firms chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage. 7. Optimal Capital Structure Is there an easily identifiable debtequity ratio that will maximize the value of a firm? Why or why not? Bcoz many relevant factors such as bankruptcy costs, tax asymmetries, & agency costs cannot easily be identified or quantified, it is practically impossible to determine the precise debt/equity ratio that maximizes the value of firm. However, if the firms cost of new debt suddenly becomes much more expensive, its probably true that the firm is too highly leveraged. 8. Why is the use of debt financing referred to as financial leverage? Its called leverage bcoz it magnifies gains or losses. 9. Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level. 10. Basic goal of financial mgt with regard to capital structure: To minimize the value of non-marketed claims.

16. MM I: Levered, & Unlevered r identical except their capital structures. Each company expects to earn $65 million before interest per yr in perpetuity, with each company distributing all its earnings as dividends. Levereds perpetual debt has a MV= $185 million & costs 8% per year. Levered has 3.4 million shares outstanding, worth $100 per share. Unlevered has no debt & 7 million shares outstanding, worth $80 per share. no taxes. Is Levereds stock a better buy than Unlevereds stock? Soln: Value of Unlevered: VU = 7,000,000($80) = $560,000,000 & MV of Levereds equity, VL = 3,400,000($100) = $340,000,000 The current market value of Levered is: VL = B + S = $185,000,000 + 340,000,000 = $525,000,000 . The MV of Levereds equity needs to be $375 million, $35 million higher than its current MV of $340 million, for MM Proposition I to hold. Since Levereds MV is less than Unlevereds MV, Levered is relatively underpriced & an investor should buy shares of the firms stock. 8. Homemade Leverage: Star, Inc., is debating whether or not to convert its all-equity capital structure to one that is 40% debt. Currently there are 5,000 shares outstanding & price per share = $65. EBIT is expected to remain at $37,500 per yr forever. The interest rate on new debt is 8%, & there r no taxes. a. Ms. B, a shareholder of the firm, owns 100 shares of stock. What is her CF under the current capital structure, assuming the firm has a dividend payout rate = 100%? EPS = = $7.50

Cash flow = $7.50 x 100 shares = $750

b. What will Ms. Bs CF be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares. Market value of the firm is: V = $65(5,000) = $325,000 Under the proposed capital structure, the firm will raise new debt, D = 40% of 325,000 = $130,000 no. of shares repurchased will be = = 2,000 (share sell )(& now its a levered firm)

Under the new capital structure, the company will have to make an interest payment on the new debt. The NI with the interest payment will be: NI = EBIT 130,000 x 8% = $37,500 $130,000 x 0.08 = $27,100 This means the EPS under the new capital structure will be: EPS = = $9.03

Since all earnings are paid as dividends: Shareholder CF (income) = $9.03(100 shares) = $903.33 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. To replicate the proposed capital structure, the shareholder should sell 40% of their shares, & lend the proceeds at 8%. The shareholder will have Interest cash flow = 40 x $65 @8% = $208 The shareholder will receive div payments on remaining 60 shares, so Dividends received = $9.03(60 shares) = $542 Total CF = I + D =208 + 542 = $750. This is the same CF we calculated in part a. d. Using ans to part (c), explain why Stars choice of capital structure is irrelevant. bcoz shareholders can create their own leverage or unlever the stock to create the payoff they desire, regardless of the capital structure the firm actually chooses.

9. Homemade Leverage & WACC: ABC Co. & XYZ Co. r identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock & perpetual debt; its stock is worth $400,000 & the interest rate on its debt is 10%. Both firms expect EBIT to be $95,000. Ignore taxes. a. Richard owns $30,000 worth of XYZs stock. What rate of return is he expecting? ABC (u) Stock Bond EBIT -I 95,000 0 800,000 XYZ (L) 400,000 400,000 95,000 40,000 The investor will receive dividends in proportion to the % of the companys shares they own. The total dividends received by the shareholder will be: Dividends received = $55,000 So the return shareholder expects is: R = = $4,125 =0.1375 or 13.75%

b. Show how Richard could generate exactly the same CFs & rate of return by investing in ABC & using homemade leverage. To generate exactly the same CFs in the other company, the shareholder needs to match the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net $30,000. The shareholder should then borrow $30,000. This will create an interest CF of = 0.10($30,000) = $3,000 The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive div. in proportion to the % of the companys share they own. Dividends received = $95,000 x = $7,125

Total CF for the shareholder = $7,300 3,000 = $4,125 ; Shareholders return , R = $4,125/$30,000 = .1375 or 13.75% c. What is the cost of equity for ABC? What is it for XYZ? ABC is an all equity company, so: RE = RA = = .1188 or 11.88%

To find cost of equity for XYZ, we use M&M Proposition II, RE=RA + (RA RD)( )(1 tC)=.1188 + (.1188 .10)(1)(1)= .1375 or
13.75%

d. What is the WACC for ABC? For XYZ? What principle have you illustrated? WACC = ( )RE + ( )RD(1 tC) So, for ABC, WACC = (1)(.1188) + (0)(.10) = .1188 or 11.88% & for XYZ, WACC = (1/2)(.1375) + (1/2)(.10) = .1188 or 11.88% . When there r no corp taxes, cost of capital for the firm is unaffected by capital structure; this is M&M Proposition I without taxes.

14. MM: B Co. expects its EBIT be $140,000 every yr forever. Firm can borrow at 9%. B currently has no debt & its cost of

equity = 17%. Tax rate=35%, what is value of firm? What will value be if B borrows $135,000 & uses proceeds to repurchase shares? The value of the unlevered firm is: V =
( )

= $535,294.12

The value of the levered firm is: V = VU + tCB = $535,294.12 + .35($135,000) = $582,544.12