Capital Structure and Leverage 16

Capital Structure and Leverage 16 - $75.00 E. $85.00 25....

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Old Exam Questions - Capital Structure and Leverage Page 16 of 31 Pages 24. Assume that an all-equity firm has $1,000 of assets and faces the possible states of nature listed in the table below. Now assume that the firm plans to issue $500 of debt and use the proceeds to repurchase $500 of its own stock (capital structure would then be equal to $500 of debt and $500 of equity). Determine how much interest expense the firm can pay before the expected ROE begins to decrease. (Hint: think about at what interest rate it is beneficial, at least in terms of expected ROE, for a firm to issue debt.) Firm A Unlevered Bad Average Good Probability 20% 40% 40% EBIT $125.00 $150.00 $175.00 Interest $0.00 $0.00 $0.00 EBT $125.00 $150.00 $175.00 Taxes (40%) -$50.00 -$60.00 -$70.00 Net Income $75.00 $90.00 $105.00 Expected BEP 12.5% 15.0% 17.5% 15.5% ROA 7.5% 9.0% 10.5% 9.3% ROE 7.5% 9.0% 10.5% 9.3% Economy A. $80.00 B. $77.50 C. $82.50 D.
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Unformatted text preview: $75.00 E. $85.00 25. Your company has collected the following information: Item Value Total Assets (BV) $3,000 million Operating Income (EBIT) $800 million Interest Expense $0 Net Income $480 million Share Price (MV Common) $32.00 Tax Rate 40% Debt Ratio 0% WACC 10% EPS = DPS $3.20 The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS) and expects to make no additional investment in net operating working capital or gross fixed assets and has zero depreciation expense (you should now be able to calculate FCF). A consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 8 percent (you should now be able to calculate WACC)....
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