chap015solutions - Solutions to Chapter 15 Debt Policy 1 a...

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Solutions to Chapter 15 Debt Policy 1. a.True. b. False. As financial leverage increases, the expected rate of return on equity rises by just enough to compensate for its higher risk. The value of the firm and stockholders’ wealth are unaffected. c.False. The sensitivity of equity returns to business risk, and therefore the cost of equity, increases with leverage even without a change in the risk of financial distress. d. True. 2. While the cost of debt and the cost of equity both increase, the weight applied to debt in the cost of capital formula also increases. Applying a higher weight to the lower- cost source of capital offsets the increase in the cost of debt and the cost of equity. 12. Share price = $10 With no leverage, there are 100,000 shares outstanding: Expected earnings per share = 25 . 1 $ 000 , 100 000 , 125 $ = P/E = $10/$1.25 = 8 With leverage, there are 75,000 shares outstanding: Expected earnings per share = 333 . 1 $ 000 , 75 000 , 100 $ = P/E = $10/$1.333 = 7.5 P/E decreases because the equity is now riskier. Although earnings per share are expected to rise from $1.25 to $1.333, the value of each share of equity is no higher. The increase in risk offsets the increase in expected earnings. 13. After-tax income for all-equity firm: State of the Economy Slump Normal Boom Operating income $75,000 $125,000 $175,000 Tax at 35% $26,250 $ 43,750 $ 61,250 After-tax income $48,750 $ 81,250 $113,750 15-1
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After-tax income assuming $250,000 of debt financing: State of the Economy Slump Normal Boom Operating income $75,000 $125,000 $175,000 Debt interest at 10% 25,000 25,000 25,000 Before-tax income 50,000 100,000 150,000 Tax at 35% 17,500 35,000 52,500 After-tax income 32,500 65,000 97,500 Combined debt & equity income (debt interest + after-tax income) 57,500 90,000 122,500 After-tax income (all-equity case) $48,750 $81,250 $113,750
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