Subject:

Strategic Corporate Finance

Course instructor:

Ma'am Shama Noreen

Course code:

MGT- 603

Topic:

Financial Leverage and Capital Structure Policy

Submitted by:

Noshaba Maqsood

Semester:

Mphil 1st

Management & Administrative Sciences

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CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL
STRUCTURE POLICY

Answers to Concepts Review and Critical Thinking Questions

1. Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly
related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely
to the firm’s 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 doesn’t 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, it’s practically impossible to determine the precise debt-equity
ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes
much more expensive, it’s 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. It’s 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.
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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 manager’s 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.

8. a. The earnings per share are:

EPS = $32,000/8,000 shares

EPS = $4.00

So, the cash flow for the company is:

Cash flow = $4.00(100 shares)

Cash flow = $400

b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under
the proposed capital structure. The market value of the firm is:

V = $55(8,000)
V = $440,000

Under the proposed capital structure, the firm will raise new debt in the amount of:

D = 0.35($440,000)
D = $154,000

in debt. This means the number of shares repurchased will be:

Shares repurchased = $154,000/$55

Shares repurchased = 2,800

Under the new capital structure, the company will have to make an interest payment on the new
debt. The net income with the interest payment will be:

NI = $32,000 – .08($154,000)
NI = $19,680

This means the EPS under the new capital structure will be:

EPS = $19,680/(8,000 – 2,800) shares

EPS = $3.7846

Since all earnings are paid as dividends, the shareholder will receive:
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Shareholder cash flow = $3.7846(100 shares)

Shareholder cash flow = $378.46

c. To replicate the proposed capital structure, the shareholder should sell 35 percent of their
shares, or 35 shares, and lend the proceeds at 8 percent. The shareholder will have an interest
cash flow of:

Interest cash flow = 35($55)(.08)

Interest cash flow = $154
The shareholder will receive dividend payments on the remaining 65 shares, so the dividends
received will be:

Dividends received = $3.7846(65

shares) Dividends received = $246

The total cash flow for the shareholder under these assumptions will be:

Total cash flow = $154 + 246

Total cash flow = $400

This is the same cash flow we calculated in part a.

d. 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.

9. a. The rate of return earned will be the dividend yield. The company has debt, so it must make an
interest payment. The net income for the company is:

NI = $80,000 – .08($300,000)
NI = $56,000

The investor will receive dividends in proportion to the percentage of the company’s share they
own. The total dividends received by the shareholder will be:

Dividends received = $56,000($30,000/$300,000)

Dividends received = $5,600

So the return the shareholder expects is:

R = $5,600/$30,000
R = .1867 or 18.67%

b. To generate exactly the same cash flows in the other company, the shareholder needs to match
the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net
$30,000. The shareholder should then borrow $30,000. This will create an interest cash flow of:

Interest cash flow = .08(–$30,000)

Interest cash flow = –$2,400
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The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC.
The investor will receive dividends in proportion to the percentage of the company’s share they
own. The total dividends received by the shareholder will be:

Dividends received = $80,000($60,000/$600,000)

Dividends received = $8,000
The total cash flow for the shareholder will be:

Total cash flow = $8,000 – 2,400

Total cash flow = $5,600

The shareholders return in this case will be:

R = $5,600/$30,000
R = .1867 or 18.67%

c. ABC is an all equity company, so:

RE = RA = $80,000/$600,000
RE = .1333 or 13.33%

To find the cost of equity for XYZ we need to use M&M Proposition II, so:

RE = RA + (RA – RD)(D/E)(1 – tC)

RE = .1333 + (.1333 – .08)(1)(1) R E
= .1867 or 18.67%

d. To find the WACC for each company we need to use the WACC equation:

WACC = (E/V)RE + (D/V)RD(1 – tC)

So, for ABC, the WACC is:

WACC = (1)(.1333) + (0)(.08)

WACC = .1333 or 13.33%

And for XYZ, the WACC is:

WACC = (1/2)(.1867) + (1/2)(.08)

WACC = .1333 or 13.33%

When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital
structure; this is M&M Proposition II without taxes.

14. a. The value of the unlevered firm is:

VU = EBIT(1 – tC)/RU
VU = $92,000(1 – .35)/.15
VU = $398,666.67

b. The value of the levered firm is:

)
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VU = VU + tCD
VU = $398,666.67 + .35($60,000)
VU = $419,666.67

15. We can find the cost of equity using M&M Proposition II with taxes. Doing so, we find:

RE = RU + (RU – RD)(D/E)(1 – t)
RE = .15 + (.15 – .09)($60,000/$398,667)(1 – .35)
RE = .1565 or 15.65%

Using this cost of equity, the WACC for the firm after recapitalization is:

WACC = (E/V)RE + (D/V)RD(1 – tC)

WACC = .1565($398,667/$419,667) + .09(1 – .35)($60,000/$419,667)
WACC = .1425 or 14.25%

When there are corporate taxes, the overall cost of capital for the firm declines the more highly
leveraged is the firm’s capital structure. This is M&M Proposition I with taxes.