Answers To Concepts Review and Critical Thinking Questions

CHAPTER 17 B-1
Answers to Concepts Review and Critical Thinking Questions

1.
Business risk is the equity risk arising from the nature of the firms operating activity, and is directly
related to the systematic risk of the firms assets. Financial risk is the equity risk that is due entirely to
the firms chosen capital structure. As financial leverage, or the use of debt financing, increases, so
does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of
equity if it uses greater leverage
2.
No, it doesnt follow. While it is true that the equity and debt costs are rising, the key thing to
remember is that the cost of debt is still less than the cost of equity. Since we are using more and more
debt, the WACC does not necessarily rise.
3.
Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot
easily be identified or quantified, its practically impossible to determine the precise debt/equity ratio
that maximizes the value of the firm. However, if the firms cost of new debt suddenly becomes much
more expensive, its probably true that the firm is too highly leveraged.
4.
The more capital intensive industries, such as airlines, cable television, and electric utilities,
tend to use greater financial leverage. Also, industries with less predictable future earnings,
such as computers or drugs, tend to use less financial leverage. Such industries also have a
higher concentration of growth and startup firms. Overall, the general tendency is for firms
with identifiable, tangible assets and relatively more predictable future earnings to use more
debt financing. These are typically the firms with the greatest need for external financing
and the greatest likelihood of benefiting from the interest tax shelter.
5.
Its called leverage (or gearing in the UK) because it magnifies gains or losses.
6.
Homemade leverage refers to the use of borrowing on the personal level as opposed to the
corporate level.
7.
One answer is that the right to file for bankruptcy is a valuable asset, and the financial
manager acts in shareholders best interest by managing this asset in ways that maximize its
value. To the extent that a bankruptcy filing prevents a race to the courthouse steps, it
would seem to be a reasonable use of the process.
8.
As in the previous question, it could be argued that using bankruptcy laws as a sword may
simply be the best use of the asset. Creditors are aware at the time a loan is made of the
possibility of bankruptcy, and the interest charged incorporates it.
CHAPTER 17 B-2
9.
One side is that Continental was going to go bankrupt because its costs made it
uncompetitive. The bankruptcy filing enabled Continental to restructure and keep flying.
The other side is that Continental abused the bankruptcy code. Rather than renegotiate labor
agreements, Continental simply abrogated them to the detriment of its employees. In this,
and the last several, questions, an important thing to keep in mind is that the bankruptcy
code is a creation of law, not economics. A strong argument can always be made that making
the best use of the bankruptcy code is no different from, for example, minimizing taxes by
making best use of the tax code. Indeed, a strong case can be made that it is the financial
managers duty to do so. As the case of Continental illustrates, the code can be changed if
socially undesirable outcomes are a problem.
10. The basic goal is to minimize the value of non-marketed claims.

Solutions to Questions and Problems
Basic
1.
a.
b.
22.
EBIT
Interest
NI
EPS
EPS%
$6,000
0
$6,000
$ 2.40
MV $100,000/2,500 shares = $40 per share;

back
$7,800
0
$7,800
$ 3.12
+30
$40,000/$40 = 1,000 shares bought
EBIT
Interest
NI
EPS
EPS%
$2,400
2,000
$ 400
$ 0.27
90
$6,000
2,000
$4,000
$ 2.67
$7,800
2,000
$5,800
$ 3.87
+45
a.
EBIT
Interest
Taxes
NI
EPS
EPS%
$2,400
0
840
$1,560
$0.624
60
$6,000
0
2,100
$3,900
$ 1.56
$7,800
0
2,730
$5,070
$ 2.03
+30
b.
MV $100,000/2,500 shares = $40 per share;

back
EBIT
Interest
Taxes
NI
EPS
EPS%
3.
$2,400
0
$2,400
$ 0.96
60
a.
$2,400
2,000
140
$ 260
$0.173
90
$6,000
2,000
1,400
$2,600
$1.733
$40,000/$40 = 1,000 shares bought

$7,800
2,000
2,030
$3,770
$2.513
+45
market-to-book ratio = 1.0, so TE = MV = $100,000;

ROE
ROE
%
.024
60
.060
ROE = NI/$100,000
.078
+30
CHAPTER 17 B-3
b.
c.
4.
a.
b.
c.
5.
6.
now, TE = $100,000 40,000 = $60,000;

ROE
ROE%
no debt, ROE
ROE%
with
debt,
ROE
ROE%
ROE = NI/$60,000
.0067
60
.0156
60
.0043
.0667
.039
.0433
.0967
+30
.0507
+30
.0628
90
+45
Plan I:
NI = $200K ;
EPS = $200K/100K shares =
$2.00
Plan II:
NI = $200K .10($1.5M) = $50K;
EPS = $50K/50K shares = $1.00
Plan I has the higher EPS when EBIT is $200,000.
Plan I:
NI = $700K;
$7.00
Plan II:
NI = $700K .10($1.5M) = $550K;
$11.00
Plan II has the higher EPS when EBIT is $700,000.
EBIT/100K = [EBIT .10($1.5M)]/50K ; EBIT = $300,000;
P = $1.5M/50K shares bought with debt = $30 per share

V1 = $30(100K shares) = $3M; V2 = $30(50K shares) + $1.5M debt = $3M
a.
I
EBIT
Interest
NI
EPS
$8,000
900
$7,100
$8.875
II
$8,000
1,350
$6,650
$ 9.50
all-equity
$8,000
0
$8,000
$ 8.00
Plan II has the highest EPS; the all-equity plan has the lowest EPS.
b.
Plan I vs. all-equity: EBIT/1,000 = [EBIT .10($9,000)]/800; EBIT = $4,500

Plan II vs. all-equity: EBIT/1,000 = [EBIT .10($13,500)]/700; EBIT = $4,500
The break-even levels of EBIT are the same because of M&M Proposition I.
c.
[EBIT .10($9,000)]/800 = [EBIT .10($13,500)]/700 ; EBIT = $4,500

This break-even level of EBIT is the same as in part (b) again because of M&M
Proposition I.
d.
I
EBIT
Interest
Taxes
NI
EPS
$8,000
900
2,840
$4,260
$5.325
II
$8,000
1,350
2,660
$3,990
$ 5.70
all-equity
$8,000
0
3,200
$4,800
$ 4.80
Plan II still has the highest EPS; the all-equity plan still has the lowest EPS.
Plan I vs. all-equity: EBIT(.60)/1,000 = [EBIT .10($9,000)](.60)/800; EBIT =
$4,500
Plan II vs. all-equity: EBIT(.60)/1,000 = [EBIT .10($13,500)](.60)/700; EBIT =
$4,500
[EBIT .10($9,000)](.60)/800 = [EBIT .10($13,500)](.60)/700 ; EBIT = $4,500
CHAPTER 17 B-4
The break-even levels of EBIT do not change because the addition of taxes reduces the
income of all three plans by the same percentage; therefore, they do not change relative
to one another.
CHAPTER 17 B-5
7.
I: P = $9,000/200 shares bought with debt = $45 per share; II: P = $13,500/300 shares = $45
This shows that when there are no corporate taxes, the stockholder does not care about the capital
structure decision of the firm. This is M&M Proposition I without taxes.
8.
a.
b.
c.
d.
9.
a.
b.
c.
d.
EPS = $7,000/1,000 shares = $7.00; cash flow = $7.00(100 shares) = $700

V = $70(1,000) = $70,000; D = 0.40($70,000) = $28,000
$28,000/$70 = 400 shares are bought; NI = $7,000 .07($28,000) = $5,040
EPS = $5,040/600 shares = $8.40; cash flow = $8.40(100 shares) = $840
Sell 40 shares of stock and lend the proceeds at 7%: interest cash flow = 40($70)(.07)
= $196
cash flow from shares held = $8.40(60 shares) = $504; total cash flow = $700.
The capital structure is irrelevant because shareholders can create their own leverage or
unlever the stock to create the payoff they desire, regardless of the capital structure the
firm actually chooses.
EBIT = $85,000 .10($300K) = $55K; cash flow = $55K($45K/$300K) = $8,250
R = $8,250/$45,000 = 18.33%
Sell all XYZ shares: nets $45,000. Borrow $45,000 at 10%: interest cash flow =
$4,500
Use the proceeds from selling shares and the borrowed funds to buy ABC shares:
cash flow from ABC = $85,000($90K/$600K) = $12,750.
total cash flow = $8,250
R = $8,250/$45,000 net investment = 18.33%
RE = RU + (RU RD)(D/E)(1 t)
ABC: RE = RU = $85,000/$600,000 = .1417 ; XYZ: RE = .1417 + (.1417 .10)(1)(1)
= .1833
WACC = (E/V)RE + (D/V)RD(1 t)
ABC: WACC = (1)(.1417) + (0)(.10) = .1417
XYZ: WACC = (1/2)(.1833) + (1/2)(.10) = .1417
When there are no corporate taxes, the cost of capital for the firm is unaffected by the
capital structure; this is M&M Proposition I without taxes.
10. V = EBIT/WACC; EBIT = .14($40M) = $5.6M

11.
V = VU + TCD; V = EBIT(.65)/.14 + 0 ; EBIT = $8,615,384.62, WACC = 14%

Due to taxes, EBIT for an all-equity firm would have to be higher for the firm to still be worth $40M.
12. a.
b.
c.
WACC = .11 = (1/3)RE + (2/3)(.11)(.65); RE = .1870

.1870 = RU + (RU .11)(2)(.65) ; RU = .1435
.11 = (1/2.5)RE + (1.5/2.5)(.11)(.65); RE = .1678;
.11 = (1/2)RE + (1/2)(.11)(.65);
RE = .1485;
.11 = (1)RE + (0)(.12)(.65);
RE = WACC = .11
13. a.
b.
c.
d.
all-equity financed: WACC = RU = RE = .15

RE = RU + (RU RD)(D/E)(1 t) = .15 + (.15 .09)(.25/.75)(.65) = .163
RE = RU + (RU RD)(D/E)(1 t) = .15 + (.15 .09)(.50/.50)(.65) = .189
WACCB = (E/V)RE + (D/V)RD(1 t) = .75(.163) + .25(.09)(.65) = .1369
WACCC = (E/V)RE + (D/V)RD(1 t) = .50(.189) + .50(.09)(.65) = .1238
CHAPTER 17 B-6
14. a.
b.
V = VU = $80,000(.65)/.25 = $208,000
V = VU + TCD = $208,000 + .35($50,000) = $225,500
15. RE = RU + (RU RD)(D/E)(1 t) = .25 + (.25 .14)($50,000/$175,500)(.65) = .2704

WACC = .2704($175,500/$225,500) + .14(.65)($50,000/$225,500) = .2306
When there are corporate taxes, the overall cost of capital for the firm declines the more highly
leveraged is the firms capital structure. This is M&M Proposition I with taxes.
Intermediate
16. WACC = .12 = (100/160)RE + (60/160)(.08)(.65) ; RE = .1608
RE = .1608 = RU + (RU .08)(.6)(.65) ; RU = .1381
VL = EBIT(1 t)/WACC = ($26,000)(.65)/.12 = $140,833.33
VU = EBIT(1 t)/RU = ($26,000)(.65)/.1381 = $122,348.96
VL = VU + TCD
$140,833.33 = $122,348.96 + .35D
$18,484.37 = .35D
D = $52,812.49
Applying M&M Proposition I with taxes, the firm has increased its value by issuing debt. As long as
M&M Proposition I holds, that is, there are no bankruptcy costs and so forth, then the company
should continue to increase its debt/equity ratio to maximize the value of the firm.
17. no debt:
50% debt:
100% debt:
V = VU = $6,000(.65)/.16 = $24,375
V = $24,375 + .35($24,375/2); V = $28,640.63
V = $24,375 + .35($24,375);
V = $32,906.25
Challenge
18. RE = RU + (RU RD)(D/E)(1 t)
WACC
= (E/V)RE + (D/V)RD(1 t) = (E/V)[RU + (RU RD)(D/E)(1 t)] + (D/V)RD(1 t)
= RU[(E/V) + (E/V)(D/E)(1 t)] + RD(1 t)[(D/V) (E/V)(D/E)]
= RU[(E/V) + (D/V)(1 t)] = RU[{(E+D)/V} t(D/V)] = RU[1 t(D/V)]
19. RE = (EBIT RDD)(1 t)/E = [EBIT(1 t)/E] [RD(D/E)(1 t)]
= RUVU/E [RD(D/E)(1 t)] = RU(VL tD)/E {RD(D/E)(1 t)}
= RU(E + D tD)/E {RD(D/E)(1 t)} = RU + (RU RD)(D/E)(1 t)
20. M&M Proposition II, with RD = Rf :
RE = RA + (RA Rf)(D/E)
CAPM: RE = E(RM Rf) + Rf ; RA = A(RM Rf) + Rf ;
RE = E(RM Rf) + Rf = {1 + (D/E)}[A(RM Rf) + Rf ] Rf(D/E)
E = A[1 + D/E]
CHAPTER 17 B-7
21. E = A(1 + D/E) ; E = 1.0, 2.0, 6.0, 21.0
The equity risk to the shareholder is composed of both business and financial risk. Even if the assets
of the firm are not very risky, the risk to the shareholder can still be large if the financial leverage is
high. These higher levels of risk will be reflected in the shareholders required rate of return R E,
which will increase with higher debt/equity ratios.

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CHAPTER 17 B-1

Answers to Concepts Review and Critical Thinking Questions

10. The basic goal is to minimize the value of non-marketed claims.

MV $100,000/2,500 shares = $40 per share;

$40,000/$40 = 1,000 shares bought

MV $100,000/2,500 shares = $40 per share;

$40,000/$40 = 1,000 shares bought

market-to-book ratio = 1.0, so TE = MV = $100,000;

now, TE = $100,000 40,000 = $60,000;

P = $1.5M/50K shares bought with debt = $30 per share

Plan I vs. all-equity: EBIT/1,000 = [EBIT .10($9,000)]/800; EBIT = $4,500

[EBIT .10($9,000)]/800 = [EBIT .10($13,500)]/700 ; EBIT = $4,500

EPS = $7,000/1,000 shares = $7.00; cash flow = $7.00(100 shares) = $700

10. V = EBIT/WACC; EBIT = .14($40M) = $5.6M

V = VU + TCD; V = EBIT(.65)/.14 + 0 ; EBIT = $8,615,384.62, WACC = 14%

WACC = .11 = (1/3)RE + (2/3)(.11)(.65); RE = .1870

all-equity financed: WACC = RU = RE = .15

V = VU + TCD = $208,000 + .35($50,000) = $225,500

15. RE = RU + (RU RD)(D/E)(1 t) = .25 + (.25 .14)($50,000/$175,500)(.65) = .2704

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