Chapter 17 Solutions

# Chapter 17 Solutions - \Chapter 17: Capital Structure:...

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\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 B- 252

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debt in the firm’s capital structure so that, at some point, the marginal costs of additional debt will outweigh its marginal tax benefits. Therefore, there is an optimal level of debt for every firm at the point where the marginal tax benefits of the debt equal the marginal increase in financial distress and agency costs. 17.6 a. If there is a recession, Good Time will generate a cash flow of \$110 million. Since the bondholder’s have the right to the first \$162 million which is lower than that the firm can generate, Good Time’ bondholders will receive only \$110 if there is a recession. b.
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## This note was uploaded on 06/10/2010 for the course ACTSC 372 taught by Professor Maryhardy during the Winter '09 term at Waterloo.

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Chapter 17 Solutions - \Chapter 17: Capital Structure:...

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