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# The pecking order theory of capital structure posits

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67. The Pecking Order Theory of capital structure posits that firms will only issue equity as a last resort. Reasons include the cost of equity financing and the negative signaling that can accompany stock offerings due to investors’ suspicion about firm’s issuing stock when it is overvalued. Finale, Inc. has 30M (M = million) shares outstanding at \$20 per share. Finale announces a new offering of 10M new shares at \$19 per share. Its issue costs are 10% of the offering value and that the announcement of a stock offering causes its outstanding stock value to fall 4%. How much of the fall in price can be explained by issue costs? a. about 75.12% b. about 79.13% c. about 85.23% d. about 87.11% [ ANSWER: Acme will raise \$19(10M new shares) = \$190M. The issue costs are 0.1(\$190M) = \$19M. This cost will be spread out over 30M outstanding shares. The cost per share = \$19M / 30M = \$0.6333 per share. The stock price should fall to \$20 - \$0.6333 = \$19.3667 or about \$19.37 based on issue costs alone. The market response causes the shares to fall 4% or 0.04(\$20) = \$0.80. Thus, \$0.63333 / \$0.80 = 0.79125 or about 79.13% of the fall can be explained by issue costs .] c 68. Acme, Inc. attempts to capture the impact of all the relevant dimensions connected with debt financing by using the net-benefit-to-leverage factor (T*). T* is assumed to be derived from a linear approximation to the actual net-benefit-to-leverage relationship over some relevant range of values for the leverage ratio L. Acme’s unleveraged value (V U ) is \$100M (M = million) and it estimates T* to be 0.2. It issues \$20M in debt. According to the corporate tax view of capital structure, what is its leveraged firm value (V L ) and gain to leverage (G L )? [ = V U + G L = \$100M + \$4M = \$104M .]

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x 69. Acme, Inc. attempts to capture the impact of all the relevant dimensions connected with debt financing by using the net-benefit-to-leverage factor (T*). T* is assumed to be derived from a linear approximation to the actual net-benefit-to-leverage relationship over some relevant range of values for the leverage ratio L. Acme’s unleveraged value (V U ) is \$100M (M = million) and it estimates T* to be 0.2. It issues \$20M in debt. According to the corporate tax view of capital structure, what is its WACC if its unleveraged cost of capital is 12%? [ D / V L = \$20M / \$104M = 0.1923. The weighted average cost of capital is: WACC = r(1 – [T*L]) = 0.12(1 – [0.2]0.1923) = 0.12(0.9615384) = 0.1153846 or about 11.538% .] IV. Longer Problems 70. The corporate tax view of capital structure model asserts that the gain to leverage (G L ) is the corporate tax rate (T) multiplied by debt value (D). The equation is: G L = TD where D = CPN / r d , CPN is the perpetual cash flow for debt owners, and r d is the required rate of return for debt or cost of debt (r d is traditionally viewed as the riskless rate). Answer the below questions using this equation.
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• Spring '10
• Mr.Cula

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