1

Chapter 16
Capital Structure Policy

Learning Objectives

1. Describe the two Modigliani and Miller propositions, the key assumptions underlying

them, and their relevance to capital structure decisions.

M&M Proposition 1 states that the value of a firm is unaffected by its capital structure if

the following three conditions hold: (1) there are no taxes; (2) there are no information or

transaction costs; and (3) capital structure decisions do affect the real investment policies

of the firm. This proposition tells us the three reasons that capital structure choices affect

firm value.

M&M Proposition 2 states that the expected return on a firm’s equity increases with

the amount of debt in its capital structure. This proposition also shows that the expected

return on equity can be separated into two parts—a part that reflects the risk of the underlying

assets of the firm and a part that reflects the risk associated with the financial leverage used

by the firm. This proposition helps managers understand the implications of financial

leverage for the cost of the equity that they use to finance the firm’s investments.

2. Discuss the benefits and costs of using debt financing.

Using debt financing involves several benefits. A major benefit is the deductibility of interest

payments. Since interest payments are tax deductible and dividend payments are not,
 2

distributing cash to security holders through interest payments can increase the value of a

firm. Debt is also less expensive to issue than equity. Finally, debt can benefit stockholders in

certain situations by providing managers with incentives to maximize the cash flows

produced by the firm and by reducing their ability to invest in negative-NPV projects.

The costs of debt include bankruptcy and agency costs. Bankruptcy costs arise

because financial leverage increases the probability that a firm will get into financial

distress. Direct bankruptcy costs are the out-of-pocket costs that a firm incurs when it gets

into financial distress, while indirect bankruptcy costs are associated with actions the

people who deal with the firm take to protect their own interests when the firm is in

financial distress. Agency costs are costs associated with actions taken by managers and

stockholders who are acting in their own interests rather than in the best interests of the

firm. When a firm uses financial leverage, managers have incentives to take actions that

benefit themselves at the expense of stockholders, and stockholders have incentives to

take actions that benefit themselves at the expense of lenders. To the extent that these

actions reduce the value of lenders’ claims, the expected losses will be reflected in the

interest rates that lenders require.

3. Describe the trade-off and pecking order theories of capital structure choice, and

explain what the empirical evidence tells us about these theories.

The trade-off theory says that managers balance, or trade off, the benefits of debt against

the costs of debt when choosing a firm’s capital structure in an effort to maximize the

value of the firm. The pecking order theory states that managers raise capital as they need
 3

it in the least expensive way available, starting with internally generated funds, then

moving to debt, then to the sale of equity. In contrast to the trade-off theory, the pecking

order theory does not imply that managers have a particular target capital structure. There

is empirical evidence that supports both theories, suggesting that each helps explain the

capital structure choices made by managers.

4. Discuss some of the practical considerations that managers are concerned with when

they choose a firm’s capital structure.

Practical considerations that concern managers when they choose a firm’s capital structure

include the impact of the capital structure on financial flexibility, risk, net income, and control of

the firm. Financial flexibility involves having the necessary financial resources to take advantage

of unforeseen opportunities and to overcome unforeseen problems. Risk refers to the possibility

that normal fluctuations in operating profits will lead to financial distress. Managers are also

concerned with the impact that financial leverage has on their reported net income, especially on

a per-share basis. Finally, the impact of capital structure decisions on who controls the firm also

affects capital structure decisions.

I. True or False Questions

1. Increasing a firm’s outstanding equity will increase firm leverage.

a. True

b. False
 4

2. Minimizing the cost of a firm’s financing activities also maximizes the total value of the

firm.

a. True

b. False

3. When calculating free cash flow, it is important to include interest and principal

payments.

a. True

b. False

4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not

affect real investment policy.

a. True

b. False

5. The enterprise value of a firm is the value of equity minus the value of debt.

a. True

b. False

6. A financial restructuring can change the value of a firm’s real assets, such as plant and

equipment.

a. True

b. False
 5

7. M&M Proposition 2 states that the required rate of return on a firm’s stock is related to

the debt-to-equity ratio.

a. True

b. False

8. M&M Proposition 1 states that the capital structure of a firm does not affect the required

rate of return on a firm’s assets, while M&M Proposition 2 shows that the required rate of

return on firm’s equity does change with capital structure decisions.

a. True

b. False

9. If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt

outstanding times the tax rate.

a. True

b. False

10. Under the M&M assumptions with taxes, the value of the firm with debt is the value of

the firm without debt plus the present value of the interest tax shield.

a. True

b. False
 6

11. With no debt, the WACC is the cost of equity plus the required rate of return on the

firm’s underlying assets.

a. True

b. False

12. Issuing debt is less expensive than issuing stock.

a. True

b. False

13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital

structure.

a. True

b. False

14. Direct-bankruptcy costs are considered transactions costs and occur when a firm must

navigate the bankruptcy process.

a. True

b. False

15. When a firm gets closer to financial distress causing expected bankruptcy costs to

increase, lenders will often charge the firm a lower interest rate in order to reduce the

chance of an actual bankruptcy occurring.

a. True
 7

b. False

16. Direct bankruptcy costs are considered small when compared to indirect costs.

a. True

b. False

17. Indirect bankruptcy costs include changes in customer and supplier behavior that

negatively affect the firm.

a. True

b. False

18. Unlike direct bankruptcy costs, indirect costs are not considered transactions costs.

a. True

b. False

19. Indirect bankruptcy costs will often increase when a firm is in financial stress and may

even push the company into bankruptcy.

a. True

b. False

20. More debt in the capital structure provides managers with an incentive to maximize cash

flows, but also makes them want to take on negative NPV projects.

a. True
 8

b. False

21. Dividends reduce the value of lender claims, and this is why bondholders often limit the

firm’s ability to distribute cash to equity holders.

a. True

b. False

22. Borrowing money and paying out a special dividend to shareholders is an example of the

asset substitution problem.

a. True

b. False

23. When a firm is in financial distress, stockholders would like to overinvest in positive

NPV projects.

a. True

b. False

24. Without debt in the capital structure, there are no asset substitution or underinvestment

problems.

a. True

b. False
 9

25. The trade-off theory of capital structure states that leverage is increased until the

marginal cost of debt is equal to the marginal benefit.

a. True

b. False

26. Under the pecking order theory, debt is factually the cheapest source of funds due to the

interest tax shield.

a. True

b. False

27. Firms have a difficult time selling equity when in financial distress.

a. True

b. False

28. Industries with large amounts of tangible assets often use little debt.

a. True

b. False

29. More profitable firms have less debt, which supports the trade-off theory.

a. True

b. False
 10

30. Managers often focus on cash flows, but reported accounting earnings are a better

indicator of the firm’s economic health.

a. True

b. False
 11

II. Multiple-Choice Questions and Problems

31. A firm’s capital structure is the mix of financial securities used to finance its activities

and can include all of the following except

a. stock.

b. bonds.

c. equity options.

d. preferred stock.

32. The optimal capital structure of a firm

a. minimizes the cost of financing a firm’s projects.

b. minimizes interest payments to creditors.

c. maximizes firm value.

d. both a and c.

33. M&M Proposition 1 assumes all of the following except that

a. there are no taxes.

b. there are no costs to acquiring information.

c. there are no transactions costs.

d. the real investment policy of the firm is affected by its capital structure decisions.

34. A firm’s enterprise value is given by

a. the value of equity plus the value of debt.

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b. the value of equity minus the value of debt.

c. the value of equity minus the value of debt plus the value of future projects.

d. none of the above.

35. A financial restructuring

a. will not change the value of a firm’s real assets under M&M Proposition 1.

b. includes financial transactions that change the capital structure of the firm.

c. means that a firm has issued equity to retire debt.

d. both a and b.

36. The weighted average cost of capital (WACC) includes

a. the required return on equity and required return on underlying firm assets.

b. the cost of any debt and the cost of equity.

c. the cost of any debt and required return on underlying firm assets.

d. none of the above.

37. M&M Proposition 2 states that the cost of a firm’s common stock is related to

a. the debt-to-equity ratio.

b. the required rate of return on the firm’s underlying assets.

c. the return of the market index.

d. a and b.

38. According to M&M Proposition 2, the cost of a firm’s equity

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a. increases with the debt-to-equity ratio.

b. decreases with the debt-to-equity ratio.

c. increases and then falls with the debt-to-equity ratio.

d. decreases and then increases with the debt-to-equity ratio.

39. Financial risk

a. refers to the effect that a firm’s financing decisions has on the riskiness to cash flows

that investors will receive.

b. increases a firm’s business risk.

c. decreases a firm’s business risk.

d. is related to how debt affects the business decisions of a firm.

40. Which of the following is a reason financial policy might matter?

a. Firms must pay corporate income taxes.

b. Capital structure choices can affect investment decisions, such as R&D and PP&E.

c. Issuing equity is expensive.

d. All of the above.

41. The interest tax shield

a. does not affect the WACC.

b. makes it less costly to distribute cash to the security holder through interest payments

than through dividends.

c. is given by D × (1 – t).
 14

d. b and c.

42. In order to calculate the present value of debt tax savings, the _______ is used as the

discount rate.

a. WACC

b. risk-free rate

c. required rate of return on debt

d. none of the above

43. Academic studies have estimated that the tax benefit of debt realized by firms is

approximately

a. 10% of firm value.

b. a 10% reduction in WACC.

c. a 10% reduction in the cost of debt

d. 10% of debt value.

44. The use of debt financing

a. may cause a manager to take on riskier projects in order to make interest payments.

b. is more expensive than issuing equity due to the use of covenants.

c. allows managers to make discretionary interest payments.

d. limits the ability of managers to waste stockholder money.

45. Which of these statements about direct bankruptcy costs is not true?
 15

a. Direct bankruptcy costs include the hiring of additional accountants, lawyers, and

consultants.

b. Direct bankruptcy costs are less than indirect costs.

c. Suppliers requiring cash on delivery is part of a firm’s direct bankruptcy costs.

d. Negotiating with lenders may help a firm reduce direct bankruptcy costs.

46. Which of these is not an example of indirect bankruptcy costs?

a. A firm’s customers become concerned about whether or not warranties will be

honored.

b. Employees begin to leave the firm.

c. New accountants are brought in to help with the bankruptcy process.

d. A bankruptcy judge orders new projects to be halted.

47. The use of debt financing

a. reduces agency costs between the stockholders and management by increasing the

amount of risk the managers take.

b. increases agency costs between the stockholders and management by limiting the

amount of risk the managers take.

c. increases agency costs since managers prefer to keep more retained earnings rather

than pay a dividend.

d. b and c.

48. The asset substitution problem occurs when

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a. managers substitute riskier assets for less risky ones to the detriment of bondholders.

b. managers substitute less risky assets for riskier ones to the detriment of bondholders.

c. managers substitute riskier assets for less risky ones to the detriment of equity

holders.

d. managers substitute less risky assets for riskier ones to the detriment of equity

holders.

49. The underinvestment problem occurs in a financially distressed firm when

a. the value of investing in a positive-NPV project is likely to go to debt holders instead

of equity holders.

b. the value of investing in a positive-NPV project is likely to go to equity holders

instead of debt holders.

c. management invests in negative-NPV projects to reduce their own risk.

d. issuing equity becomes difficult due to increased risk.

50 Which of the following supports the trade-off theory of capital structure?

a. Firms use cash on hand first, since issuing equity and debt is expensive.

b. A firm’s capital structure is the result of past equity and debt issuance decisions.

c. Firms have a target capital structure.

d. a and b.

Use the following information for Questions 51–57.

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Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The

company is currently financed with 75 percent equity and 25 percent debt. Your analysis

tells you that the appropriate discount rates are 10 percent for the cash flows, and 7

percent for the debt. You currently own 10 percent of the stock.

51. M&M Proposition 1: How much is Dynamo worth today?

a. $1,765

b. $1,500

c. $2,143

d. None of the above.

52. M&M Proposition 1: How much are your cash flows today?

a. $12.38

b. $15

c. $4.50

d. $150

53. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75 percent

to 60 percent equity and use the debt proceeds to pay a special dividend to shareholders,

how much debt should they issue?

a. $321

b. $375

c. $600
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d. $225

54. M&M Proposition 1: How much does Dynamo currently pay in interest, and how much

will it have to pay after the restructuring in the prior problem, assuming that the cost of

debt is constant?

a. $42 and $26.25

b. $26.25 and $42

c. $160 and $37.50

d. $37.50 and $60

55. M&M Proposition 1: How much of the special dividend do you receive, and how much

do you receive in regular dividends per annum after the restructuring?

a. $15 and $60

b. $60 and $15

c. $10.80 and $22.50

d. $22.50 and $10.80

56. M&M Proposition 1: According to M&M Proposition 1, what transaction do you need

to take in order to undo the restructuring?

a. Sell $22.50 of stock.

b. Sell $10.80 worth of stock.

c. Buy $22.50 worth of debt.

d. Buy $10.80 worth of debt.

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57. M&M Proposition 1: What are the interest payments that you receive after you undo the

restructuring, and what are your total cash flows?

a. $1.57 and $12.38

b. $23.55 and $75

c. $1.125 and $12.38

d. None of the above.

58. M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40%

debt and 60% equity. If the firm’s cost of equity is 12%, the cost of debt is 8%, and the

risk-free rate is 3%, what is the appropriate WACC?

a. 8.4%

b. 9.6%

c. 10.4%

d. 9.2%

59. M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If the

firm’s cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC?

a. 9%

b. 10%

c. 11%

d. None of the above.

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60. M&M Proposition 2: Swirlpool, Inc., has a WACC of 11%, a cost of debt of 8%, and a

cost of equity of 12%. What must the debt-to-equity ratio be?

a. 1/2

b. 1/4

c. 1/6

d. None of the above.

61. M&M Proposition 2: Melba’s Toast has a capital structure with 30% debt and 70%

equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm’s marginal

corporate income tax rate is 35%. What is the appropriate WACC?

a. 8.17%

b. 6.35%

c. 8.80%

d. 7.44%

62. M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in

outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the

appropriate WACC?

a. 6%

b. 8%

c. 9%

d. 10%
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63. M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost

of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the

firm is financed with equity?

a. 50%

b. 60%

c. 70%

d. None of the above

64. M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12%

and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required

rate of return on their equity?

a. 12.15%

b. 13.15%

c. 14.15%

d. None of the above

65. M&M Proposition 2: Using the information for Bellamee from Question 64, what is its

required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the

required rate of return on their debt to 7%?

a. 14%

b. 14.25%

c. 14.50%

d. 15%
 22

Use the following information for Questions 66–68.

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of

$400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-

free rate is 5%. Assume that the COGS only includes the marginal costs of selling a

computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and

a YTM of 7.9% to its capital structure.

66. M&M Proposition 2: What percent of the firm’s costs are fixed, and what percent are

variable with the debt and without the change in leverage?

a. 27.9% and 72.1%

b. 72.1% and 27.9%

c. 25.23 and 74.77%

d. 74.77% and 25.23%

67. M&M Proposition 2: What is the net income of Banana without and with the debt?

a. $500 and $484.2

b. $484.2 and $500

c. $500 and $465

d. $490 and $500

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68. M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in net

income with and without the debt? Assume that the total variable productions costs

remain the same.

a. 64.5% and 60%

b. 60% and 64.5%

c. 59.2% and 40.8%

d. 40.8% and 59.2%

69. M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the

YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current

required rate of return on its assets and equity if the D/E is changed to 1/3?

a. 11.35% and 13.25%

b. 11.35% and 8.25%

c. 13.25% and 11.35%

d. None of the above.

70. The benefits of debt: Packman Corporation has a reported EBIT of $500, which is

expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be

6.5% and its coupon rate will be 8%. If the company’s marginal tax rate is 30% and its

average tax rate is 20%, what are its after-tax earnings?

a. $238

b. $272

c. $259
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d. None of the above.

71. The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm’s marginal corporate tax rate is 25%, while its

average tax rate is 15%. By how much will this debt issuance reduce the firm’s annual

tax liability?

a. $13,500

b. $22,500

c. $32,500

d. None of the above.

72. The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm’s marginal corporate tax rate is 35%. What is the

present value of the tax savings in perpetuity?

a. $11,025

b. $20,475

c. $350,000

d. $227,500

Use the following information for Questions 73–74.

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax

bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a

$1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders.
 25

73. The cost of equity: What is its value without debt in the capital structure?

a. $350

b. $650

c. $2,917

d. $5,417

74. The cost of equity: What is Millennium’s value after the debt issuance?

a. $5,417

b. $5,942

c. $6,392

d. None of the above.

Use the following information for Questions 75–78.

Suppose that UBM Corp has $100mm invested in 8% risk-free bonds that mature in one-

year. The firm also has $80mm in debt outstanding that will also mature in a year. UBM

shareholders are considering selling the $100mm in debt and investing in a project that

has a 60% chance of returning $200mm and a 40% chance of returning $2mm.

75. Agency costs: What will the equity value of UBM be in one-year without shareholders

taking on the project?

a. $100mm

b. $80mm
 26

c. $28mm

d. $8mm

76. Agency costs: What is the expected value of the bonds if the stockholders sell the debt?

a. $100mm

b. $88.8mm

c. $48.8mm

d. None of the above.

77. Agency costs: What is the expected value of the equity if the stockholders sell the debt?

a. $175mm

b. $97.5mm

c. $51mm

d. None of the above.

78. Agency costs: Given the payoffs of the project, what does the percent chance of success

need to be in order for the expected value of equity with the project to be equal to the

expected value of equity without the project?

a. 1/3

b. 1/4

c. 1/5

d. 7/30
 27

79. Agency costs: Suppose that JMK, Inc., has debt with a face value of $100mm and assets

worth $70mm. Firm management has just identified a project that will require an initial

outlay of $10mm and will return a NPV of $16mm, risk-free. The firm currently has no

cash. What would be the net return to shareholders if they took on this project?

a. $–10mm

b. $0mm

c. $26mm

d. $70mm

80. The pecking order theory: A firm wishes to undertake a project that costs $150mm. It

currently has $10mm in cash on hand and believes that it can raise $75mm in debt and

$100mm in equity if needed. According to the pecking order theory of the capital

structure, what percent of the project will be financed by debt?

a. 0%

b. 26.67%

c. 50%

d. None of the above

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III. Essay Questions

81. One of the conditions that the M&M Propositions required was for there to be no taxes.

Briefly discuss whether the introduction of taxes decreases or increases the value of the

firm.

Answer: The relaxation of the no-tax assumptions actually increases the value of the firm

by an amount equal to the present value of the tax shield on the firm’s debt obligations. If

we consider the debt to be infinitely outstanding, then we can approximate the present

value of the tax shield by multiplying the amount of the debt by the tax rate.

82. Briefly explain how an increase in the amount of debt that a firm has outstanding may

actually decrease the agency costs caused by the conflict between managers and

stockholders.

Answer: The manager-stockholder agency conflict is caused by a misalignment of

interests between the two parties. When a firm has excess cash available for managers to

waste—which is bad for stockholders—then an increase in debt, and consequently the

level of interest service required of that debt, will make less cash available for the

manager to waste. This has the effect of reducing manager-stockholder agency cost.
 29

83. The pecking order theory of capital structure suggests that managers will choose to utilize

retained earnings before issuing additional debt when financing new projects. Does that

imply anything about the flotation costs of issuing new securities?

Answer: The answer to the question is no. It implies that managers perceive there to be a

higher cost of issuing new debt versus stockholder’s equity. It is a perception because even after

considering flotation costs, new debt is still much cheaper than retained earnings, which belongs

to stockholders.
 30

IV. Answers to True or False Questions

1. False

2. True

3. False

4. True

5. False

6. False

7. True

8. True

9. True

10. True

11. False

12. True

13. True

14. True

15. False

16. True

17. True

18. False

19. True

20. False

21. True

22. False
 31

23. False

24. True

25. True

26. False

27. True

28. False

29. False

30. False
 32

V. Answers to Multiple-Choice Questions

31. c

32. d

33. d

34. a

35. d

36. b

37. d

38. a

39. a

40. d

41. b

42. c

43. a

44. d

45. c

46. c

47. d

48. a

49. a

50. c

51. b

52. a
 33

53. d

54. b

55. d

56. c

57. a

58. c

59. c

60. d

61. a

62. d

63. b

64. b

65. a

66. c

67. c

68. b

69. d

70. a

71. b

72. c

73. d

74. b

75. c
 34

76. c

77. d

78. d

79. a

80. c
 35

VI. Solutions to Multiple-Choice Problems

51. Solution:

CF $150
V Firm

i

0.1
 $1,500

52. Solution:

Cash flows to shareholders = Cash flows – Interest payments

= $150 – ($1,500) × (0.25) × (0.07) = $123.75

Therefore, your 10% share = $123.75 × 0.1 = $12.375

53. Solution:

Debt today = 0.25 × $1,500 = $375

Debt after restructuring = 0.40 × $1,500 = $600

Total debt issuance = $600 – $375 = $225

54. Solution:

Debt today = 0.25 × $1500 = $375

Interest payment on debt before restructuring = $375 × 0.07 = $26.25

Total debt after restructuring =0 .4 × $1,500 = $600

Interest payment on debt after restructuring = 0.07 × $600 = $42

55. Solution:

Portion of special dividend received = 0.10 × $225 = $22.50

Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80

 36

Note: $42 = Interest payment on debt after restructuring

56. Solution:

M&M Proposition 1 says to take your portion of the special dividend (found in Question

55) and buy that much of the new debt issuance.

57. Solution:

Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 =

$1.57 in interest payments. You also know from Question 55 that you will receive $10.80

in dividends after the restructuring, so your total cash flows are $1.58 + $10.80 = $12.38,

the same as before the restructuring!

58. Solution:

WACC = xDebt kDebt + xEquity kEquity = (0.40 ×.08) + (0.60 × 0.12) = 0.104

59. Solution:

Using the debt-to-equity ratio, you can solve for the percentage of the capital structure

that is debt and the percentage that is equity. If D/E = 0.5, then let’s assume that D = 1

and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity

percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2/3) × 0.13

= 0.11.

60. Solution:
 37

WACC = xDebt kDebt + xEquity kEquity

= xDebt × 0.08 + xEquity × 0.12 = 11%

Also, D + E = 1 by definition. Therefore, substituting gives you:

xDebt × 0.8 + (1 – xDebt) × 0.12 = 0.11.

Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E is

1/3.

61. Solution:

WACC with taxes = xDebt kDebt pretax (1 – t) + xEquity kEquity

= 0.30 ×.06×(1 – 0.35) + 0.70 × 0.10 = 0.0817

62. Solution:

WACC = xDebt kDebt + xEquity kEquity

= (300/1200) × 0.07 + (900/1200) × 0.11 = 0.10

63. Solution:

WACC = 0.085 = (1 – xEquity)kDebt (1 – t) + xEquity kEquity

= (1 – xEquity) × 0.05 × (1 – 0.35) + xEquity × 0.12

Solving for xEquity gives you 0.60

64. Solution:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (1/5)(0.12 – 0.0625) = 0.1315

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65. Solution:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (2/5)(0.12 – .07) = 0.14

66. Solution:

With the debt, fixed cost percentage is

(SG&A + Interest payments)/(SG&A + Interest payments + CGS) =

($100 + ($700)(0.05)) / ($100 + ($700)(0.05) + $400) = 25.23%.

Therefore, variable costs are $400 / ($100 + ($200)(0.05) + $400) or 74.77%.

67. Solution:

Without debt, net income is

$1000 – $400 – $100 = $500

With debt, net income is

$1000 – $400 – $100 – $35 = $165

68. Solution:

Without debt, the new net income is

$700 – $400 – $100 = $200

Therefore, the percent change is

($500 – $200) / $500 = 60%

With debt, the new net income is

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$700 – $400 – $100 – $35 = $165

Therefore, the percent change is

($465 – $165) / $465 = 64.5%

69. Solution:

kcs = kAssets + (D/E)(kAssets – kDebt)

12% = kAssets + (1/6)( kAssets – 7.5%)

Then, kAssets= 11.4%.

Note that if D/E changes, kAssets does not change.

The new cost of equity is then given by

kcs = 11.4% + (1/3)(11.4% – 7.5%) = 12.7%

70. Solution:

After-tax earnings = (Earnings – Interest payments)×(1 – t)

= ($500 – $160) × (1 –.3)

= $238

71. Solution:

Tax shield = D × kDebt × t

= $1,000,000 × 0.09 × 0.25

= $22,500

72. Solution:
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VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

73. Solution:

VFirm = [ CF × (1-t)] /i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417

74. Solution:

PV of tax shield = $1,500 × 0.35 = $525

VFirm = VNo leverage+ PV of the tax shield = $5,417 + $525 = $5,942

75. Solution:

Value of risk-free debt owner – Value of bonds maturing = $20mm

76. Solution:

E[VBonds] = (0.60 × $80mm) × + (0.40 × $2mm) = $48.8mm

77. Solution:

E[VEquity] = ((0.60 × $200mm) – $80mm) + (0.40 × $0mm) = $40mm

78. Solution:

E[VEquity] = (PSuccess × [$200mm – $80mm]) + ((1 – PSuccess) × $0) = $20mm

(PSuccess × [$200mm – $80mm]) = $20mm

Therefore, PSuccess must be 1/6.

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79. Solution:

If they take on the project, the firm will receive its $10mm back, along with the $16mm.

This gives them assets worth $96mm, which is still less than the value of outstanding

debt. Therefore, the shareholders would be out the $10mm of equity that they had to sell

in order to take on the project.

80. Solution:

According to the pecking order theory, the firm will first use its available cash, which is

$10mm. Next, the firm will turn to debt. Since the amount of debt it can raise plus the

amount of cash on hand is less than the project cost, their entire line of credit will be

used. Therefore, $75mm/$150mm = 50%.