CHAPTER 13
Does Debt Policy Matter?
Answers to Problem Sets
1.
Note the market value of Copperhead is far in excess of its book value:
Ms. Kraft owns .625% of the firm, which proposes to increase common
stock to $17 million and cut short-term debt. Ms. Kraft can offset this by (a)
borrowing .00625 X 1,000,000 = $6,250, and (b) buying that much more
Copperhead stock.
2.
a.
%
= 12.5%; = 20%
b.
12.5%
c.
E/P = 20%; P/E = 5
d.
$50
e.
.5 X
+ .5 X 0 = 1.0; = 2.0.
3.
Expected return on assets is r
A
= .08 X 30/80 + .16 X 50/80 = .13. The
new return on equity will be r
E
= .13 + (20/60)(.13 - .08) = .147.
4.
a.
b.

.8 = (.25 x 0) + (.75 x β
E
)
β
E
= 1.07
5.
a.
True
b.
True (as long as the return earned by the company is greater than
the interest payment, earnings per share increase, but the PyE falls
to reflect
the higher risk).
c.
False (the cost of equity increases with the ratio D/E).
d.
False (the formula r
E
= r
A
+ (D/E)(r
A
- r
D
) does not require r
D
to be
constant).
e.
False (debt amplifies variations in equity income).
f.
False (value increases only if clientele is not satisfied).
6.
a.
r
A
= .15, r
E
= .175
b.
β
A
= .6 (unchanged), β
D
= .3, β
E
= .9.
7.
See Figure 13.3.
8.
Currently r
A
= r
E
= .14, or 14%. From proposition 2 the leverage causes r
E
to
increase to r
E
= r
A
+ (r
A
– r
D
)(D/E) = .14 + (.14 - .095) X (45/55) = .1768, or
17.68%
After-tax WACC = .095 X (1 - .40) X .45 + .1768 X .55 = .1229, or 12.29%.
9.
a.
The two firms have equal value; let V represent the total value of
the firm.
Rosencrantz could buy one percent of Company B’s
equity and borrow an amount equal to:
0.01 (D
A
- D
B
) = 0.002V
This investment requires a net cash outlay of (0.007V) and provides
a net cash return of:
(0.01 Profits) – (0.003 r
f
V)
where r
f
is the risk-free rate of interest on debt.
Thus, the two
investments are identical.

b.
Guildenstern could buy two percent of Company A’s equity and lend
an amount equal to:
0.02 (D
A
- D
B
) = 0.004V
This investment requires a net cash outlay of (0.018V) and provides
a net cash return of:
(0.02 Profits) – (0.002 r
f
V)
Thus the two investments are identical.
c.
The expected dollar return to Rosencrantz’ original investment in A
is:
(0.01 C) – (0.003 r
f
V
A
)
where C is the expected profit (cash flow) generated by the firm’s
assets.
Since the firms are the same except for capital structure, C
must also be the expected cash flow for Firm B.
The dollar return
to Rosencrantz’ alternative strategy is:
(0.01 C) – (0.003 r
f
V
B
)
Also, the cost of the original strategy is (0.007V
A
) while the cost of
the alternative strategy is (0.007V
B
).
If V
A
is less than V
B
, then the original strategy of investing in
Company A would provide a larger dollar return at the same time
that it would cost less than the alternative.
Thus, no rational
investor would invest in Company B if the value of Company A were
less than that of Company B.