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05 - CAPITAL STRUCTURE AND LEVERAGE - PROBLEMS With Answers

The document discusses capital structure and leverage. It provides 4 problems related to calculating unlevered beta using the Hamada equation, determining return on equity for companies with different debt ratios and interest rates, finding the cost of equity for a company considering changing its capital structure, and calculating stock price before and after a company undergoes recapitalization. The solutions explore how return on equity, cost of equity, and stock price are affected by changes in a company's leverage, capital structure, and cost of debt.

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Merr Fe Painagan
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531 views

05 - CAPITAL STRUCTURE AND LEVERAGE - PROBLEMS With Answers

The document discusses capital structure and leverage. It provides 4 problems related to calculating unlevered beta using the Hamada equation, determining return on equity for companies with different debt ratios and interest rates, finding the cost of equity for a company considering changing its capital structure, and calculating stock price before and after a company undergoes recapitalization. The solutions explore how return on equity, cost of equity, and stock price are affected by changes in a company's leverage, capital structure, and cost of debt.

Uploaded by

Merr Fe Painagan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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05_CAPITAL STRUCTURE AND LEVERAGE

PROBLEMS

1. UZI Company has P10 million in assets, which were financed with P2 million of debt and P8 million
in equity. The company’s beta is currently 1.2, and its tax rate is 40%. Using the Hamada equation,
calculate the company’s unlevered beta.

2. HOLLAND Company and LISBON Company are identical except for their leverage ratios and the
interest rates they pay on debt. Each has P20 million in assets, has P4 million of EBIT, and has 40% tax
rate. HOLLAND has a debt ratio of 50% and pays 12% interest on its debt, whereas LISBON has a 30%
debt ratio and pays only 10% interest on its debt.

a. What is the Return on Equity (ROE) of Holland?

b. What is the ROE of Lisbon?

c. Lisbon is thinking of raising the debt ratio from 30% to 60% even though that would increase its
interest rate on all debt to 15%. Calculate the new ROE for Lisbon.

Initially as Leverage increases, ROE also increases ; but interest expense increases when leverage
increases. Thus ROE will reach a maximum level, then inevitably declines.
As Leverage increases, ROE increases up to a point; As risk increases with increased leverage, cost
of debt increases. After ROE peaks, it then begins to fall.
As leverage increases, the measures of risk (standard deviation and coefficient of variation) increase
with each increase in Leverage.

3. LATVIA Company is trying to establish its optimal capital structure. Currently, its capital structure
consists of 25% debt and 75% equity; however, the CEO believes that the company should use more
debt. The risk-free rate is 5%, the market risk premium is 6% and the tax rate is 40%. The company’s
cost of equity is 14% currently determined using the CAPM.

If the company changed its capital structure to 50% debt and 50% equity, what would be its cost of
equity?

4. LITHUANIA currently has assets of P5 million, has zero debt, has 40% tax rate, has a net income
(earnings after tax) of P1 million, and pays out 40% of its earnings as dividends. Net income is expected
to grow at a constant rate of 5% per year, 200,000 shares are outstanding, and the current WACC is
13.40%.

The company is considering recapitalization where it will issue P1 million in debt and use the proceeds
to repurchase stock. Investment bankers have estimated that if the company goes through with its
planned recapitalization, its cost of equity will increase to 14.5% and its before-tax cost of debt will be
11%.

Recapitalization : Change in capital structure


a. Before the recapitalization, what is the company’s current stock price?

b. Following the recapitalization, and assuming that the company maintains the same payout ratio, what
will be its stock price?
FROM 02_COST OF CAPITAL QUIZZER 1

Question 11 through 13 are based on the following information.

C Company currently sells 400,000 bottles of perfume each year. Each unit costs P0.84 to produce and
sells for P1.00. Fixed costs are P28,000 per year. The firm has annual interest expense of P6,000
preferred stock dividends of P2,000 per year, and a 40% tax rate.

11. The degree of operating leverage for C Company is


a. 2.40
b. 1.78
C. 1.35
d. 1.2

12. If C Company did not have preferred stock, the degree of total leverage would
a. Decrease in proportion to a decrease in financial leverage.
b. Increase in proportion to an increase in financial leverage
c. Remain the same
d. Decrease but not be proportional to the decrease in financial leverage.

13. The degree of financial leverage for C Company is


a. 2.4
b. 1.78
c. 1.35
d. 2.30
Should be

= 36,000 / 36,000 – 6,000 – (2,000 / 0.60)

= 36,000 / 26,667

= 1.35

Degree of Total Leverage = DOL x DFL

= 1.78 x 1.35

= 2.403

Or

Degree of Total Leverage = CM / EBIT – I – (Pref Div divided by [1-tax rate])

= 64,000 / 36,000 – 6,000 – (2,000 / 0.60)

= 64,000 / 26,667

= 2.400

12. Assuming C Company DID NOT have preferred stock,

DFL = EBIT / EBIT – I

= 36,000 / 36,000 – 6,000

= 1.20

Decreased from 1.35 to 1.20, or by 0.15, or by 11 %

Therefore,

Degree of Total Leverage = DOL x DFL

= 1.78 x 1.20
= 2.136

Or Degree of Total Leverage = CM / EBIT – I

= 64,000 / 36,000 – 6,000

= 64,000 / 30,000

= 2.133

Decreased from 2.4 to 2.136, or by 0.264, or by 11 %

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