Capital Structure Questions:

Problem 1, page 80 in the class packet.

1. Briefly explain the terms, "capital structure" and "optimal capital structure".
Answer:
Capital Structure: The mix (or proportions) of long-term financing sources: debt, preferred stock and common
stock.
Optimal Capital Structure: The capital structure that maximizes firm value. (or, maximizes shareholder wealth)
2. The current, market value balance sheet for the ABC Corp. is shown below. Currently, the cost of equity (re) is
12%, and the cost of debt (rd) is 4%. (Assume "perfect markets" conditions)
Assets
Claims
Debt
200
TA
800 Equity
600
800
800
2a. Create the market value balance sheet for the ABC Corp., assuming the following changes: ABC issues
$100 in debt. ABC uses the $100 to repurchase (and retire) equity.
Assets
TA

Answer:
Claims
Debt
800 Equity
800

300
500
800

2b. ABC's cost of debt (rd) for the capital structure found in part 2a is 5.0%. Find ABC's
cost of equity (re) for the capital structure found in part 2a.
Answer:
Original: WACC = wd(rd) + we(re) = .25(4%) + .75(12%) = 10%
Because of the "perfect markets" assumption, we know that firm value, share price,
and WACC all are constant, regardless of capital structure.
Restructured: WACC = wd(rd) + we(re) = 10% = .375(5%) +.625(re), re= 13%
2c. (5 points) Carefully explain why ABC's cost of equity (re) changes when ABC changes its capital structure.
Answer:
An increase in financial leverage results in an increase in the risk and required return of equity.
Increased financial leverage increases the risk of equity because debt is the priority claim; as the amount
of debt increases, any risk in the cash flows produced by the firm's assets is concentrated on a smaller
and smaller equity claim, making the risk larger and larger.
3. Carefully explain how the existence of "bankruptcy costs" can affect a firm's optimal capital
structure.
Answer: Even the threat of bankruptcy can have large effects on the value of a company,
such as lost sales, or the loss of valuable employees. Because the threat of bankruptcy
increases with financial leverage, companies with large bankruptcy costs tend to have less
debt in their optimal capital structure.
4. The assets of firm A are expected to provide cash flows that are more risky than the cash flows
expected from the assets of firm B. Does this mean that the required rate of return on equity is
higher for firm A than for firm B? Carefully explain why or why not.
Answer: Not necessarilyIf firm B uses more financial leverage, then the additional financial risk may
sufficiently increase the risk and required rate of return on firm Bs equity so that it is higher than that of firm As
equity.
Working Capital Questions

Problem 1, 2 and 3, pages 84 - 86 in the class packet.

1. Total assets of the Prey Company are expected to vary from a minimum of $100 to a maximum of $145 over the coming
year. The Prey Company currently has $110 in long-term financing (bonds and equity). If the Prey Company wanted to
change to a more conservative working capital strategy, it would need to:
a.
increase its long-term financing, and decrease its seasonal short-term financing *****
b.
decrease its long term financing, and increase its seasonal short-term financing
c.
increase both its long-term financing and its seasonal short-term financing
d.
decrease both its long-term financing and its seasonal short-term financing
2. The following information is available for the Better Value Store:
Sales are 40% for cash, 60% on credit.
Of the credit sales, 75% are collected in the first month following the sale and 25% in the second month
following the sale.
Gross profit margin on sales averages 20%.
A basic inventory of $10,000 (cost) is constantly maintained, and the store follows the policy of purchasing
enough additional inventory each month to cover the following month's sales.
Inventory purchases as made on the 15th of the month, and paid on the 25th of the month.
A minimum cash balance of $2,000 is to be maintained by the store.
Any additional financing needed will be short-term debt, in multiples of $1,000
The average age of inventory (AAI) is estimated to be 38 days.
2a. Estimate the cash conversion cycle (CCC) for the Better Value Store.
Answer:
CCC = AAI + ACP APP
AAI = 38 days (given)
APP = 10 days (they pay for their purchases in 10 days)
ACP = weighted average of time necessary to collect on sales:
ACP = .40(0) + .60(.75)(30 days) + .60(.25)(60 days) = 22.5 days
CCC = 38 days + 22.5 days 10 days = 50.5 days
2b. Carefully explain what this number means.
The cash conversion cycle is an estimate of how long the company must have additional financing to support
their current assets (in addition to the spontaneous financing from A/P).
3. Carefully explain why an aggressive seasonal working capital strategy is more profitable, and more risky than a
conservative seasonal working capital strategy.
Answer: An aggressive seasonal working capital strategy will use relatively less long-term financing and
relatively more seasonal short-term financing. This is more risky since the firm must be able to convert its seasonal
current assets into cash in order to repay its short-term financing. This is more profitable for two reasons. First,
short-term financing is generally less expensive than long-term financing. And second, the firm does not need to
have unused financing during those times during the year when seasonal current assets are low.
4. To shorten the cash conversion cycle (CCC) a company could:
a. take longer to pay its accounts payable ***** correct answer
b. allow customers longer to pay their bills
c. decrease the inventory turnover
d. increase short-term bank loans and decrease long-term debt
e. decrease short-term bank loans and increase long-term debt
5. Identify and briefly explain 1 cost and 1 benefits of relaxing credit terms to allow customers longer to pay for purchases.
Answer:
Benefit: the increased profit from increased sales
Cost: the increased financing costs associated from the increased level of accounts receivable.