# ch8solns - Chapter 8 8-1(a Book Value Debt/Equity Ratio =...

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Chapter 8 8-1 (a) Book Value Debt/Equity Ratio = 2,500/2,500 = 100% Market Value of Equity = 50 * 80 = 4,000 Market Value of Debt = .80 * 2500 = 2,000 Debt/Equity Ratio in market value terms = 2,000/4,000 = 50.00% (b) Book Value Debt/(Debt + Equity) = 2,500/(2,500 + 2,500) = 50% Market Value Debt/(Debt + Equity) = 2,000/(2,000+4,000) = 33.33% (c) After-tax Cost of Debt = 12% (1-0.4) = 7.20% (d) Cost of Equity = 8% + 1.2 (5.5%) = 14.60% (e) Cost of Capital = 14.60% (4,000/6,000) + 7.20% (2,000/6,000) = 12.13% 8-2 (a) To assess this project from the equity investors' standpoint, we estimate cash flows to equity and the cost of equity. Initial Equity Investment in Project = 0.6667 (100 million) = \$66.67 million Cash Flows to Equity = Net Income + Depreciation = \$9.60 million + \$5 million = \$14.60 million NPV of CF to Equity = 14.60/.1460 - 66.67 = \$33.33 million (b) From the firm's standpoint, the cash flows to the firm have to be estimated. Initial Investment in Project = \$ 100 million Cash Flows to Firm = EBIT (1 - tax rate) + Depreciation = \$20 million (1-0.4) + \$5 million = \$17 million NPV of CF to Firm = \$17/.1213 million - \$100 million = \$40.15 million (c) The cost of equity should be used as the discount rate if the cash flows being discounted are cash flows to equity. (d) The cost of capital should be used as the discount rate if the cash flows being discounted are cash flows to the firm. (e) Even if this project is financed entirely with debt, it should be analyzed using the same costs of equity and capital as the analysis above. 8-3 (a), (b) and (c) Unlevered Beta = Levered Beta/(1+(1-t)(D/E)) = 1.2/(1+0.6*0.5) = 0.92 D/E Ratio Beta Cost of Equity Cost of Debt WACC

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Option 1 20.00% 1.03 13.69% 6.60% 12.51% Option 2 100.00% 1.48 16.12% 7.80% 11.96% Option 3 500.00% 3.69 28.31% 10.80% 13.72% (d) Δ Firm Value New Firm Value Debt Equity Stock Price Option 1 (\$180) \$5,820 \$1,000 \$4,820 \$75.68 Option 2 \$86 \$6,086 \$3,000 \$3,086 \$81.72 Option 3 (\$693) \$5,307 \$5,000 \$307 \$66.14 Note: The change in firm value will mean that the debt ratios computed above will also change. (e) From a cost of capital standpoint, option 2 is the best one. (f) If Plastico's income is more volatile, the firm should be more cautious in adding debt. (g) If the new debt or equity is used to take projects, the analysis would change for three reasons: (1) the projects may have a different risk profile than the firm's risk profile. (2) the NPV of the projects has to be added to the value change calculated. (3) the firm value itself will increase as the new debt and equity is issued. (h) I would factor in the firm's need for flexibility into the analysis - the greater the need for flexibility the less likely it is that I would add on debt. Further, I would look at how responsive managers are to stockholders; if they are not, I would be more likely to add debt. (i) The higher rating in option 1 lowers the cost of debt, but it is accomplished by replacing debt with more expensive equity. 8-4 (a) Intuitively, I would expect Plastico to have a higher debt ratio than its competitors because: (1) its earnings are less volatile than those of its competitors (2) it has higher cash flows as a percent of firm value than its competitors.
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