SOLUTIONS TO END-OF-CHAPTER PROBLEMS

16-1

QBE = F/(P

16-3

If the company had no debt, its required return would be:

rs,U = rRF + bU RPM = 5.5% + 1.0(6%) = 11.5%.
With debt, the required return is:
rs,L = rRF + bL RPM = 5.5% + 1.6(6%) = 15.1%.
Therefore, the extra premium required for financial risk is 15.1% - 11.5% = 3.6%.

16-2

V) = $500,000/($75 - $50) = 20,000.

If wd = 0.2, then wce = 1 0.2 = 0.8. So D/S = wd/we = 0.2/0.8.

bU = b/[1 + (1-T)(D/S)]
= 1.15/[1 + (1-0.40)(0.2/0.8)] = 1.0.

16-4

S = (1

16-5

S = (1 wd)(Vop) = (1 1/3)($900) = $600 million.

P = [S + (D D0)] / n0 = [$600 + ($300 $0)]/30 = $30.

16-6

n = n0

16-7

a. Here are the steps involved:

(1)

(2)

wd)(Vop) = (1

(D/P) = 60

0.4)($500) = $300 million.

($150/$7.5) = 60 20 = 40 million.

Determine the variable cost per unit at present, V:

Profit
$500,000
50(V)
V

= P(Q) - FC - V(Q)
= ($100,000)(50) - $2,000,000 - V(50)
= $2,500,000
= $50,000.

Determine the new profit level if the change is made:

New profit = P2(Q2) - FC2 - V2(Q2)
= $95,000(70) - $2,500,000 - ($50,000 - $10,000)(70)
= $1,350,000.

(3)

Determine the incremental profit:

Profit = $1,350,000 $500,000 = $850,000.

Answers and Solutions: 16 - 3

(4)

Estimate the approximate rate of return on new investment:

Return = Profit/Investment = $850,000/$4,000,000 = 21.25%.

Since the return exceeds the 15 percent cost of equity, this analysis suggests that the
firm should go ahead with the change.
b. The change would increase the breakeven point:
Old:

QBE =

New: QBE =

P V

$2,000,000
= 40 units.
$100,000 $50,000

$2,500,000
= 45.45 units.
$95,000 $40,000

c. It is impossible to state unequivocally whether the new situation would have more or
less business risk than the old one. We would need information on both the sales
probability distribution and the uncertainty about variable input cost in order to make
this determination. However, since a higher breakeven point, other things held
constant, is more risky. Also the percentage of fixed costs increases:
Old:

FC
$2,000 ,000
=
= 44.44%.
FC V(Q)
$2,000 ,000 $2,500 ,000

New:

FC2
$2,500,000
=
= 47.17%.
FC2 V2 (Q 2 )
$2,500,000 $2,800,000

The change in breakeven points--and also the higher percentage of fixed costs-suggests that the new situation is more risky.

Answers and Solutions: 16 - 4

16-8

a. Expected ROE for Firm C:

ROEC = (0.1)(-5.0%) + (0.2)(5.0%) + (0.4)(15.0%)
+ (0.2)(25.0%) + (0.1)(35.0%) = 15.0%.
Note: The distribution of ROEC is symmetrical. Thus, the answer to this problem
could have been obtained by simple inspection.
Standard deviation of ROE for Firm C (for convenience, we express returns in
percentage form rather than in decimal form):
C

0.1( 5.0 15.0) 2

0.2(25.0 15.0) 2
0.1( 20) 2

0.2(5.0 15.0) 2

0.1(35.0 15.0) 2

0.2( 10 ) 2

40 20 0 20 40

0.4(0) 2
120

0.4(15.0 15.0) 2

0.2(10) 2

11.0%.

0.1( 20) 2

b. According to the standard deviations of ROE, Firm A is the least risky, while C is the
most risky. However, this analysis does not take into account portfolio effects-c.

its apparent riskiness would be reduced.

= BEP = 5.5%. Therefore, Firm A uses no financial leverage and has

no financial risk. Firm B and Firm C have ROE > BEP, and hence both use leverage.
Firm C uses the most leverage because it has the highest ROE - BEP = measure of
ROE

Answers and Solutions: 16 - 5

16-9

a. Original value of the firm (D = $0):

We are given that the book value of asset is equal to the market value of assets, so the
value is $3,000,000. Alternatively, we can calculate the value as the sum of the debt
(which is zero) and the stock (200,000 shares at a price of $15 per share):
V = D + S = 0 + ($15)(200,000) = $3,000,000.
Original cost of capital:
WACC = wd rd(1-T) + wcers
= 0 + (1.0)(10%) = 10%.
With financial leverage (wd=30%):
WACC = wd rd(1-T) + wcers
= (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%.
Because growth is zero, FCF is equal to EBIT(1-T). The value of operations is:
Vop =

FCF
WACC

( EBIT )(1 T)
WACC

($500,000 )(1 0.40)

$3,348,214 .286 .
0.0896

Increasing the financial leverage by adding $900,000 of debt results in an increase in

b. Using its target capital structure of 30% debt, the company must have debt of:
D = wd V = 0.30($3,348,214.286) = $1,004,464.286.
Therefore, its value of equity is:
S = V D = $2,343,750.
Alternatively, S = (1-wd)V = 0.7($3,348,214.286) = $2,343,750.
The new price per share, P, is:
P = [S + (D D0)]/n0 = [$2,343,750 + ($1,004,464.286
= $16.741.

Answers and Solutions: 16 - 6

0)]/200,000

c. The number of shares repurchased, X, is:

X = (D D0)/P = $1,004,464.286 / $16.741 = 60,000.256

60,000.

The number of remaining shares, n, is:

n = 200,000

60,000 = 140,000.

Initial position:
EPS = NI/n0
= [(EBIT Int.)(1-T)] / n0
= [($500,000 0)(1-0.40)] / 200,000 = $1.50.

With financial leverage:

EPS = [($500,000 0.07($1,004,464.286))(1-0.40)] / 140,000
= [($500,000 $70,312.5)(1-0.40)] / 140,000
= $257,812.5 / 140,000 = $1.842.
Thus, by adding debt, the firm increased its EPS by $0.342.

d. 30% debt:

TIE =

EBIT
EBIT
=
.
I
$70,312 .5

Probability
0.10
0.20
0.40
0.20
0.10

TIE
( 1.42)
2.84
7.11
11.38
15.64

The interest payment is not covered when TIE < 1.0.

occurring is 0.10, or 10 percent.

The probability of this

Answers and Solutions: 16 - 7

16-10 a. Present situation (50% debt):

WACC = wd rd(1-T) + wcers
= (0.5)(10%)(1-0.15) + (0.5)(14%) = 11.25%.
V=

FCF
WACC

70 percent debt:

( EBIT )(1 T ) ($13.24)(1 0.15)

= $100 million.
WACC
0.1125

WACC = wd rd(1-T) + wcers

= (0.7)(12%)(1-0.15) + (0.3)(16%) = 11.94%.
V=

FCF
WACC

( EBIT )(1 T ) ($13.24)(1 0.15)

= $94.255 million.
WACC
0.1194

30 percent debt:
WACC = wd rd(1-T) + wcers
= (0.3)(8%)(1-0.15) + (0.7)(13%) = 11.14%.
V=

FCF
WACC

( EBIT )(1 T )
WACC

16-11 a.

($13 .24 )(1 0.15)

= $101.023 million.
0.1114

U=b/(1+

(1-T)(D/S))=1.0/(1+(1-0.40)(20/80)) = 0.870.

b. b = bU (1 + (1-T)(D/S)).
At 40 percent debt: bL = 0.87 (1 + 0.6(40%/60%)) = 1.218.
rS = 6 + 1.218(4) = 10.872%
c. WACC = wd rd(1-T) + wcers
= (0.4)(9%)(1-0.4) + (0.6)(10.872%) = 8.683%.
V=

FCF
WACC

( EBIT )(1 T) ($14.933)(1 0.4)

= $103.188 million.
WACC
0.08683

Answers and Solutions: 16 - 8

16-12 Tax rate = 40%

bU = 1.2

rRF = 5.0%
rM rRF = 6.0%

From data given in the problem and table we can develop the following table:
0.00
0.20
0.40
0.60
0.80

D/A

E/A

1.00
0.80
0.60
0.40
0.20

0.0000
0.2500
0.6667
1.5000
4.0000

D/E

7.00%
8.00
10.00
12.00
15.00

rd

4.20%
4.80
6.00
7.20
9.00

rd(1

T)

1.20
1.38
1.68
2.28
4.08

Levered
betaa
12.20%
13.28
15.08
18.68
29.48

Notes:
These beta estimates were calculated using the Hamada equation,
b = bU[1 + (1 T)(D/E)].
b
These rs estimates were calculated using the CAPM, rs = rRF + (rM rRF)b.
c
These WACC estimates were calculated with the following equation:
WACC = wd(rd)(1 T) + (wce)(rs).

rsb
12.20%
11.58
11.45
11.79
13.10

Answers and Solutions: 16 - 9