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Exam 13: Capital Structure and Leverage

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Question 21

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Which of the following statements is CORRECT?

A) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
B) There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
C) A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
D) If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
E) Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

F) A) and C)
G) A) and D)

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Question 22

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Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

A) Its sales are projected to become less stable in the future.
B) The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
C) Management believes that the firm's stock is currently overvalued.
D) The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
E) The corporate tax rate is increased.

F) C) and D)
G) A) and D)

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Question 23

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Which of the following statements is CORRECT, holding other things constant?

Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd) . Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA ? ROENA? $\begin{array}{c}\begin{array}{lr}\underline{\text { Applicable to Both Firms }}\\ \text { Capital } \quad \$ 150,000 \\\text { EBIT } \quad \$40,000 \\\text { Tax rate } \quad 35 \%\end{array}\begin{array}{lll}\underline{\text { Firm A's Data }}\\ \mathrm{w}_{\mathrm{d}} \quad\quad\quad\quad 50 \% \\\text { Int. rate } \quad 12 \% \\\\\end{array}\begin{array}{lll}\underline{\text { Firm NA's Data }} \\\mathrm{w}_{\mathrm{d}} \quad\quad\quad\quad 0 \% \\\text { Int. rate } \quad 10 \%\\ \\\end{array}\end{array}$

Gator Fabrics Inc. currently has zero debt . It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld ? WACCNew? $\begin{array} { l c l r } \mathrm { w} _ { \mathrm { d } } & 55 \% & \text { Orig. cost of equity, } \mathrm { r } _ { \mathrm { S } } & 10.0 \% \\\mathrm { w } _ { \mathrm { C } } & 45 \% & \text { New cost of equity } = \mathrm { r } _ { \mathrm { S } } & 11.0 \% \\\text { Interest rate new } = \mathrm { r } _ { \mathrm { d } } & 7.0 \% & \text { Tax rate } & 40 \%\end{array}$

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL ? ROEU? $\begin{array}{lrr}&\underline{0 \% \text { Debt, } \mathrm{U} }& \underline{60 \% \text { Debt. }}\\\text { Expected unit sales (Q) } & 28,500 & 28,500 \\\text { Price per phone (P) } & \$ 250.00 & \$ 250.00 \\\text { Fixed costs (F) } & \$ 1,000,000 & \$ 1,000,000 \\\text { Variable cost/unit (V) } & \$ 200.00 & \$ 200.00 \\\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \\\% \text { Debt } & 0.00 \% & 60.00 \% \\\text { Debt, \$ } & \$ 0 & \$ 1,500,000 \\\text { Equity, \$ } & \$ 2,500,000 & \$ 1,000,000 \\& & \\\text { Interest rate } & \mathrm{NA} & 10.00 \% \\\text { Tax rate } & 35.00 \% & 35.00 \%\end{array}$

The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions) . The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 8.0%. What would the firm's total market value be if it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 ? T) because no new operating capital is needed, and then divide by (WACC ? g) . $\begin{array} { l r c r } \text { Oper. income } ( \text { EBTT) } & \$ 800 & \text { Tax rate } & 40.0 \% \\\text { New cost of equity } \left( \mathrm { r } _ { \mathrm { S } } \right) & 12.00 \% & \text { New } \mathrm { w } _ { \mathrm { d } } & 20.0 \% \\\text { Interest rate } \left( \mathrm { r } _ { \mathrm { d } } \right) & 8.00 \% & &\end{array}$

Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

A major contribution of the Miller model is that it demonstrates, other things held constant, that

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the break-even formula, but include the required profit in the numerator.)

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL ? EPSU? $\begin{array}{lrr}&\underline{0 \% \text { Debt, U }} &\underline{60 \% \text { Debt, }}\\\text { Expected unit sales } & 225,000 & 225,000 \\\text { Price per unit } & \$ 10.00 & \$ 10.00 \\\text { Fixed costs } & \$ 1,000,000 & \$ 1,000,000 \\\text { Variable cost/unit } & \$ 3.50 & \$ 3.50 \\\text { Required investment } & & \\\text { Shares issued at } \$ 10 / \text { share } & \$ 2,500,000 & \$ 2,500,000 \\\text { \% Debt } & 250,000 & 100,000 \\\text { Debt, \$ } & 0.00 \% & 60.00 \% \\\text { Equity, \$ } & \$ 0 & \$ 1,500,000 \\\text { Interest rate } & \$ 2,500,000 & \$ 1,000,000 \\\text { Tax rate } & \text { NA } & 10.00 \% \\& 35.00 \% & 35.00 \%\end{array}$

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs?

The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.