CHAPTER 16
CAPITAL STRUCTURE:
LIMITS TO
THE USE OF DEBT
Solutions to Odd-Numbered Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are
included in this solutions manual, rounding may appear to have occurred. However, the final
answer for each problem is found without rounding during any step in the problem.
Basic
1.
a.
V
L
= [EBIT(1 –
t
C
)/R
0
] +
t
C
B
V
L
= [$750,000(1 – .35)/.15] + .35($1,500,000)
V
L
= $3,775,000
b
.
The CFO may be correct. The value calculated in part
a
does not include the costs of
any non-marketed claims, such as bankruptcy or agency costs.
3.
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: