Chapter 17 - Does Debt Policy Matter?CHAPTER 17Does Debt Policy Matter?Answers to Problem Sets1.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.55.5.Er%= 12.5%;Er= 20%b.12.5%c.E/P = 20%; P/E = 5d.$50e..5 XE+ .5 X 0 = 1.0;E= 2.0.3.Expected return on assets is rA= .08 X 30/80 + .16 X 50/80 = .13. The new returnon equity will be rE= .13 + (20/60)(.13 - .08) = .147.4.a.b.EDAEDEEDD17-1

Chapter 17 - Does Debt Policy Matter?.8 = (.25 x 0) + (.75 x βE)βE= 1.075.a.Trueb.True (as long as the return earned by the company is greater than theinterest payment, earnings per share increase, but the PyE falls to reflectthe higher risk).c.False (the cost of equity increases with the ratio D/E).d.False (the formula rE= rA+ (D/E)(rA- rD) does not require rDto beconstant).e.False (debt amplifies variations in equity income).f.False (value increases only if clientele is not satisfied).6.a.rA= .15, rE= .175b.βA= .6 (unchanged), βD= .3, βE= .9.7.See Figure 17.3.8.Currently rA= rE= .14, or 14%. From proposition 2 the leverage causes rEtoincrease to rE= rA+ (rA– rD)(D/E) = .14 + (.14 - .095) X (45/55) = .1768, or17.68%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 anamount equal to:0.01(DA- DB) = 0.002VThis investment requires a net cash outlay of (0.007V) and provides a netcash return of:(0.01Profits) – (0.003rfV)where rfis the risk-free rate of interest on debt.Thus, the two investmentsare identical.17-2

Chapter 17 - Does Debt Policy Matter?b.Guildenstern could buy two percent of Company A’s equity and lend anamount equal to:0.02(DA- DB) = 0.004VThis investment requires a net cash outlay of (0.018V) and provides a netcash return of:(0.02Profits) – (0.002rfV)Thus the two investments are identical.c.The expected dollar return to Rosencrantz’ original investment in A is:(0.01C) – (0.003rfVA)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 bethe expected cash flow for Firm B.The dollar return to Rosencrantz’alternative strategy is:(0.01C) – (0.003rfVB)Also, the cost of the original strategy is (0.007VA) while the cost of thealternative strategy is (0.007VB).If VAis less than VB, then the original strategy of investing in Company Awould provide a larger dollar return at the same time that it would cost lessthan the alternative.Thus, no rational investor would invest in Company Bif the value of Company A were less than that of Company B.10.When a firm issues debt, it shifts its cash flow into two streams.MM’sProposition I states that this does not affect firm value if the investor canreconstitute a firm’s cash flow stream by creating personal leverage or byundoing the effect of the firm’s leverage by investing in both debt and equity.

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