Capital Structure and Leverage - Solutions2

Capital Structure and Leverage - Solutions2 - 1 Your...

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Old Exam Questions - Capital Structure and Leverage - Solutions Page 6 of 59 Pages 1. Your company is financed entirely by common stock that is priced to offer a 15% expected/required return. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Assume that you are in a Modigliani and Miller world without taxes.) A. 24% * B. 18% C. 15% D. 12% E. None of the above In this sort of M&M world, the average cost of capital will not change. Therefore, 15% = (.25)(.06) + (.75)(K e ) K e = (.15 - .015)/(.75) = 18% 2. Your company is financed entirely by common stock that is priced to offer a 20% expected/required return. Assume now that the company repurchases 30% of the common stock and substitutes an equal value of debt. If the cost of equity increases to 25.14%, then what is the interest rate on the debt? (Assume that you are in a Modigliani and Miller world without taxes.) * A. 8% B. 10% C. 12% D. 14% E. None of the above. Since this is an M&M world without taxes, we know that the average cost of capital will remain at 20%. Therefore, .20 = (.30)(K D ) + (.70)(.2514) K D = [.20 - (.70)(.2514)] / [.30] K D = 0.08 3. The beta of an all equity firm is 1.0. If the firm changes its capital structure to 50% debt and 50% equity, using 8% debt financing, and if the tax rate is 40%, then what will be the beta of the equity of the levered firm? (You may assume that the beta for debt is zero.) A. 1.2 B. 1.4
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Old Exam Questions - Capital Structure and Leverage - Solutions Page 7 of 59 Pages * C. 1.6 D. 1.8 E. None of the above. Levered Beta = 1.0 + (1.0)(.50/.50)(1 - .40) = 1.6 4. You are given the following information. Using the same procedure demonstrated in our last class (price changes in anticipation of the new level of debt), calculate by how much the price of this firm's stock will increase if it moves to $10,000 of debt and uses the proceeds to repurchase its equity. Assets
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This note was uploaded on 07/13/2011 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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Capital Structure and Leverage - Solutions2 - 1 Your...

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