Chapter 15, 21 Solutions

# Chapter 15, 21 Solutions - Chapter 15 Capital Structure...

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Capital Structure Decisions 15-7 a. Here are the steps involved: (1) Determine the variable cost per unit at present, V: Profit = P(Q) - FC - V(Q) \$500,000 = (\$100,000)(50) - \$2,000,000 - V(50) 50(V) = \$2,500,000 V = \$50,000. (2) Determine the new profit level if the change is made: New profit = P 2 (Q 2 ) - FC 2 - V 2 (Q 2 ) = \$95,000(70) - \$2,500,000 - (\$50,000 - \$10,000)(70) = \$1,350,000. (3) Determine the incremental profit: Profit = \$1,350,000 – \$500,000 = \$850,000. (4) Estimate the approximate rate of return on new investment: Return = Profit/Investment = \$850,000/\$4,000,000 = 21.25%. Since the return exceeds the 15 percent cost of equity, this analysis suggests that the firm should go ahead with the change. b. The change would increase the breakeven point: Old: Q BE = = = 40 units. New: Q BE = = 45.45 units. c. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one. We would need information on both the sales probability distribution and the uncertainty about variable input cost in order to make this determination. However, since a higher breakeven point, other things held constant, is more risky. Also the percentage of fixed costs increases: Old: = = 44.44%. New: = = 47.17%. Chapter 15

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The change in breakeven points--and also the higher percentage of fixed costs-- suggests that the new situation is more risky. 15-8 a. Original value of the firm (D = \$0): We are given that the book value of assets is equal to the market value of assets, so the value is \$3,000,000. Alternatively, we can calculate the value as the sum of the debt (which is zero) and the stock (200,000 shares at a price of \$15 per share): V = D + S = 0 + (\$15)(200,000) = \$3,000,000. Original cost of capital: WACC = w d r d (1-T) + w ce r s = 0 + (1.0)(10%) = 10%. With financial leverage (w d =30%): WACC = w d r d (1-T) + w ce r s = (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%. Because growth is zero, FCF is equal to EBIT(1-T). The value of operations is: V op = Increasing the financial leverage by adding \$900,000 of debt results in an increase in the firm’s value from \$3,000,000 to \$3,348,214.286. b.
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## This note was uploaded on 02/27/2012 for the course BUS 510 taught by Professor Mehdi during the Spring '11 term at University of La Verne.

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Chapter 15, 21 Solutions - Chapter 15 Capital Structure...

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