ans-odd-problems-ch16 - CHAPTER 16 CAPITAL STRUCTURE LIMITS...

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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:
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Debt/Value ratio = $80,000 / ($80,000 + 6,857.14) = 0.921
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This note was uploaded on 02/14/2011 for the course FINANCE 620 taught by Professor Halstead during the Fall '09 term at UMBC.

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ans-odd-problems-ch16 - CHAPTER 16 CAPITAL STRUCTURE LIMITS...

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