Old Exam Questions - Capital Structure and Leverage - Solutions
Page 21 of 59 Pages
Units
600,000.00
Units
500,000.00
Sales
$3,000,000.00
Sales
$2,250,000.00
Variable Costs -$2,400,000.00
Variable Costs -$1,500,000.00
Fixed Costs
-$500,000.00
Fixed Costs
-$600,000.00
EBIT
$100,000.00
EBIT
$150,000.00
Interest
-$100,000.00
Interest
-$150,000.00
EBT
$0.00
EBT
$0.00
Taxes (40%)
$0.00
Taxes (40%)
$0.00
Net Income
$0.00
Net Income
$0.00
21.
Your company is financed entirely by common stock that is priced to offer a 10%
annual expected/required rate of return. If the company repurchases 40% of its
common stock and substitutes an equal value of debt, its levered cost of equity will
increase to 14.0%. Assuming that we are in a Modigliani and Miller world without
taxes, where the value of the firm remains constant at all levels of debt, what must be
the firm’s cost of debt?
A.
4.6%
B.
4.4%
C.
4.2%
*
D.
4.0%
E.
3.8%
In this sort of M&M world, the average cost of capital will not change. Therefore,
WACC = 10% = (.40)(K
D
) + (.60)(.14)
K
D
= (.10 - .084)/(.40) = 4.0%
22.
You are given the information indicated below. Using the same procedure
demonstrated in 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 $20,000 of debt
and uses the proceeds to repurchase its equity.
Assets
Starting Values
Current Assets
$20,000
Net Fixed Assets
$20,000
Total
$40,000
Liabilities & Net Worth
Starting Values
Debt
$0
Equity (4,000 Shares)
$40,000
Total
$40,000