\Chapter 17: Capital Structure:
Limits to the Use of Debt
17.2
a.
The interest payments each year will be:
Interest payment = .12($80,000) = $9,600
This is exactly equal to the EBIT, so no cash is available for shareholders. Under this scenario,
the value of equity will be zero since shareholders will never receive a payment. Since the
market value of the company’s debt is $80,000, and there is no probability of default, the total
value of the company is the market value of debt. This implies the debt to value ratio is 1 (one).
b.
At a 5 percent growth rate, the earnings next year will be:
Earnings next year = $9,600(1.05) = $10,080
So, the cash available for shareholders is:
Payment to shareholders = $10,080 – 9,600 = $480
Since there is no risk, the required return for shareholders is the same as the required return on
the company’s debt. The payments to stockholders will increase at the growth rate of five
percent (a growing perpetuity), so the value of these payments today is:
Value of equity = $480 / (.12 – .05) = $6,857.14
And the debt to value ratio now is:
Debt/Value ratio = $80,000 / ($80,000 + 6,857.14) = 0.921
c.
At a 10 percent growth rate, the earnings next year will be:
Earnings next year = $9,600(1.10) = $10,560
So, the cash available for shareholders is:
Payment to shareholders = $10,560 – 9,600 = $960
Since there is no risk, the required return for shareholders is the same as the required return on
the company’s debt. The payments to stockholders will increase at the growth rate of five
percent (a growing perpetuity), so the value of these payments today is:
Value of equity = $960 / (.12 – .10) = $48,000.00
And the debt to value ratio now is:
Debt/Value ratio = $80,000 / ($80,000 + 48,000) = 0.625
17.4
Modigliani and Miller’s theory with corporate taxes indicates that, since there is a positive tax
advantage of debt, the firm should maximize the amount of debt in its capital structure. In reality,
however, no firm adopts an all–debt financing strategy. MM’s theory ignores both the financial
distress and agency costs of debt. The marginal costs of debt continue to increase with the amount of
Answers to End-of-Chapter Problems
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