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# practicefinal - Practice Final MBA 730 Problem 1 Aaron...

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Practice Final MBA 730 Problem 1. Aaron Athletics is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of capital, the company has produced the following table: Debt-to-total assets ratio (w d ) Equity-to-total assets ratio (w c ) Debt-to-equity ratio (D/E) Bond Rating Before-tax cost of debt (k d ) 0.10 0.90 0.10/0.90=0.11 AA 7.0% 0.20 0.80 0.25 A 7.2% 0.30 0.70 0.43 A 8.0% 0.40 0.60 0.67 BB 8.8% 0.50 0.50 1.00 B 9.6% The company’s tax rate is 40%. The company uses the CAPM to estimate its cost of equity, k s . The risk-free rate is 5% and the market risk premium (k m -k rf ) is 6%. Aaron estimates that if it had no debt its beta would be 1.0 (Its unlevered beta = 1.0.) On the basis of this information, what is the company’s optimal capital structure, and what is the firm’s WACC at this optimal capital structure? Levered Beta Ks Ws Kd(1-T) Wd WACC 1(1+ (.6).11)=1.066 11.40% .90 (7.0% * .6) = 4.2% .10 10.68 1(1+(.6).25)=1.15 11.90% .80 (7.2% * .6) = 4.32% .20 10.384 1(1+ (.6).43)=1.258 12.548% .70 (8.0% * .6) = 4.8% .30 10.22 1(1+ (.6).67)=1.402 13.412% .60 (8.8% * .6) = 5.28% .40 10.16*** 1(1+(.6)1)=1.60 14.60% .50 (9.6% * .6) = 5.76% .50 10.18 *** = optimal capital structure

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Problem 2 The A.J. Croft Company (AJC) currently has \$100,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are \$150,000, and it is a zero-growth company. AJC’s current cost of equity is 11%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding. Please answer the following questions about AJC. a. What is AJC’s current total market value? Market value = value of debt + value of common stock 100,000 + [EBIT – I](1-T) / .11 or 785,454 = \$885,454 total Mkt Val. b. What is AJC’s current stock price? Current Stock Price = Value of equity / # shares = 785,454 / 10,000 = \$78.55 c. The firm is considering recalling the 6% debt and issuing \$400,000 of new debt. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would increase to 12%. If this plan were carried out, what would be AJC’s new stock price? The increase in debt will cause interest to be .07 * 400,000 = 28,000 per year. The amount available to the original 10,000 shares a) the new value of the equity and b) 300,000 of the new debt (the other 100,000 replaces the original debt outstanding). New value of the equity = [150,000 – 28,000] .6 / .12 = 610,000 New price per share (the equilibrium price in the situation) = 610,000 + 300,000 / 10,000 = \$91.
Problem 3. A company forecasts the following free cash flows.

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practicefinal - Practice Final MBA 730 Problem 1 Aaron...

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