Budgeting Ac 2023

Capital structure
Seminar Questions
1. Define each of the following terms:

a. Capital structure; business risk; financial risk
b. Operating leverage; financial leverage, break-even point
c. Reserve borrowing capacity
2. What term refers to the uncertainty inherent in projections of future ROIC?
3. Firms with relatively high nonfinancial fixed costs are said to have a high degree of what?
4. “One type of leverage affects both EBIT and EPS. The other type affects only EPS.” Explain
this statement.
5. Why is the following statement true? “Other things being the same, firms with relatively stable
sales are able to carry relatively high debt ratios.”
6. Why do public utility companies usually have capital structures that are different from those of
retail firms?
7. Why is EBIT generally considered being independent of financial leverage? Why might EBIT
actually be influenced by financial leverage at high debt levels?
8. If a firm went from zero debt to successively higher levels of debt, why would you expect its
stock price to first rise, then hit a peak, and then begin to decline?
9. The Rogers Company is currently in this situation: (1) EBIT = $4.7 million; (2) tax rate, T =
40%; (3) value of debt, D = $2 million; (4) rd = 10%; (5) rs = 15%; (6) shares of stock
outstanding, n0 = 600,000; and stock price, P0 = $30. The firm’s market is stable, and it expects
no growth, so all earnings are paid out as dividends. The debt consists of perpetual bonds.
a. What is the total market value of the firm’s stock, S, and the firm’s total market value, V?
b. What is the firm’s weighted average cost of capital?
c. Suppose the firm can increase its debt so that its capital structure has 50% debt, based on
market values (it will issue debt and buy back stock). At this level of debt, its cost of equity
rises to 18.5% and its interest rate on all debt will rise to 12% (it will have to call and
refund the old debt). What is the WACC under this capital structure? What is the total
value? How much debt will it issue, and what is the stock price after the repurchase? How
many shares will remain outstanding after the repurchase?
10. Lighter Industrial Corporation (LIC) is considering a large-scale recapitalization. Currently,

LIC is financed with 25% debt and 75% equity. LIC is considering increasing its level of debt
until it is financed with 60% debt and 40% equity. The beta on its common stock at the current
level of debt is 1.5, the risk-free rate is 6%, the market risk premium is 4%, and LIC faces a 40%
federal- plus-state tax rate.
a. What is LIC’s current cost of equity?
b. What is LIC’s unlevered beta?
c. What will be the new beta and new cost of equity if LIC recapitalizes?
11. The Rivoli Company has no debt outstanding, and its financial position is given by the
following data:
Assets (book = market) $3,000,000

EBIT $500,000
Cost of equity, rs 10%
Stock price, P0 $15
Shares outstanding, n0 200,000
Tax rate, T (federal-plus-40%
state)
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it
moves to a capital structure with 30% debt based on market values, its cost of equity, rs, will
increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 7%. Rivoli is a
no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are
expectationally constant over time.
a. What effect would this use of leverage have on the value of the firm?
b. What would be the price of Rivoli’s stock?
c. What happens to the firm’s earnings per share after the recapitalization?
d. The $500,000 EBIT given previously is actually the expected value from the following
probability distribution:
Probability EBIT
0.10 ($ 100,000)
0.20 200,000
0.40 500,000
0.20 800,000
0.10 1,100,000
Determine the times-interest-earned ratio for each probability. What is the probability of not
covering the interest payment at the 30% debt level?
13. Pettit Printing Company has a total market value of $100 million, consisting of 1 million
shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The
company’s EBIT is $13.24 million, and its tax rate is 15%. Pettit can change its capital structure
by either increasing its debt to 70% (based on market values) or decreasing it to 30%. If it
decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12%
coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with
new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price
to complete the capital structure change.
The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current
cost of equity, rs, is 14%. If it increases leverage, rs will be 16%. If it decreases leverage, rs will
be 13%. What is the firm’s WACC and total corporate value under each capital structure?
14. Beckman Engineering and Associates (BEA) is considering a change in its capital structure.
BEA currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share
with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as
dividends. EBIT is $14.933 million, and BEA faces a 40% federal-plus-state tax rate. The
market risk premium is 4%, and the risk-free rate is 6%. BEA is considering increasing its debt
level to a capital structure with 40% debt, based on market values, and repurchasing shares with
the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt,
and the rate on the new debt will be 9%. BEA has a beta of 1.0.
a. What is BEA’s unlevered beta? Use market value D/S when unlevering.
b. What are BEA’s new beta and cost of equity if it has 40% debt?
c. What are BEA’s WACC and total value of the firm with 40% debt?
15. Elliott Athletics is trying to determine its optimal capital structure, which now consists of
only debt and common equity. The firm does not currently use pre- ferred stock in its capital
structure, and it does not plan to do so in the future. To estimate how much its debt would cost at
different debt levels, the company’s treasury staff has consulted with investment bankers and, on
the basis of those discussions, has created the following table:
Market Market Equity-Market Debt- Before-Tax Cost

Debt- to-to-Value to-Equity Bond of Debt (rd)
Value Ratio (wce) Ratio (D/S) Rating
Ratio (wd)
0.0 1.0 0.00 A 7.0%
0.2 0.8 0.25 BBB 8.0
0.4 0.6 0.67 BB 10.0
0.6 0.4 1.50 C 12.0
0.8 0.2 4.00 D 15.0
Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the
risk-free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that
if it had no debt, its “unlevered” beta, bU, would be 1.2.
a) Based on this information, what is the firm’s optimal capital structure, and what would
the weighted average cost of capital be at the optimal capital structure?
b) Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus the
debt/value ratio.

Budgeting Ac 2023

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Capital structure

1. Define each of the following terms:

10. Lighter Industrial Corporation (LIC) is considering a large-scale recapitalization. Currently,

Assets (book = market) $3,000,000

Market Market Equity-Market Debt- Before-Tax Cost

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