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CF - Questions and Practice Problems - Chapter 16

This document contains sample questions and practice problems from a corporate finance textbook chapter on capital structure. Question 3 discusses how a firm's required rate of return on equity increases as the debt-to-equity ratio increases, since more debt leads to higher financial risk. Question 4 notes that interest payments are tax deductible, unlike dividend payments. Several practice problems calculate financial metrics like net income, earnings per share, and firm value under different capital structures to demonstrate the effects of leverage and taxes on the cost of capital. Other questions determine the weighted average cost of capital for firms with varying amounts of debt.

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169 views2 pages

CF - Questions and Practice Problems - Chapter 16

This document contains sample questions and practice problems from a corporate finance textbook chapter on capital structure. Question 3 discusses how a firm's required rate of return on equity increases as the debt-to-equity ratio increases, since more debt leads to higher financial risk. Question 4 notes that interest payments are tax deductible, unlike dividend payments. Several practice problems calculate financial metrics like net income, earnings per share, and firm value under different capital structures to demonstrate the effects of leverage and taxes on the cost of capital. Other questions determine the weighted average cost of capital for firms with varying amounts of debt.

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Lâm Thanh Huyền Nguyễn
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© © All Rights Reserved
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Corporate Finance

Questions and Practice problems_Chapter 16

Chapter 16:
Concept questions (page 519 textbook): 3, 4
Q3: Required rate on a firm's equity is positively related to the firm's debt-to-equity ratio [Rs =
Ro + (B/S)(Ro -Rb)]. Therefore, any increase in the amount of debt in a firm's capital structure
will increase the required return on the firm's equity
Q4: Interest payments are tax deductible, where payments to shareholders (dividends)
are not tax deductible
Questions and Problems (page 520 textbook): 4, 5, 10, 11, 13, 14, 15
Q4:
Under Plan I, the unlevered company, net income is the same as EBIT with no
corporate tax. The EPS under this capitalization will be
EPS = $750,000 / 265,000 shares = $2.83
Under Plan II, the levered company, EBIT will be reduced by the interest payment. The
interest payment is the amount of debt times the interest rate, so
NI = $750,000 – .10($2,800,000) = $470,000
And the EPS will be: EPS = $470,000 / 185,000 shares= $2.54
b, Under Plan I, the net income is $1,500,000 and the EPS is EPS = $1,500,000 /
265,000 shares = $5.66
Under Plan II, the net income is: NI = $1,500,000 – .10($2,800,000) = $1,220,000
And the EPS is: EPS = $1,220,000 / 185,000 shares = $6.59
c, to find the breakeven EBIT for two different capital structures, we simply set the
equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is
EBIT / 265,000 = [EBIT – .10($2,800,000)] / 185,000
 EBIT = $927,500
 EBIT > break-even EBIT (plan II- LEVERED FIRM has a higher EPS)
 EBIT < break-even EBIT (plan I- UNLEVERED FIRM has a higher EPS)

Q5:
We can find the price per share by dividing the amount of debt used to repurchase
shares by the number of shares repurchased. Doing so, we find the share price is: 
Share price = $2,800,000 / (265,000 – 185,000) = $35.00 per share 
The value of the company under the unlevered plan is: 
V= $35(265,000 shares) = $9,275,000  
And the value of the company under the levered plan is: 
V= $35(185,000 shares) + $2,800,000 debt = $9,275,000

Q10:
V = $37,000,000 = EBIT/0.09
 EBIT = $3,330,000

Q11:
If there are corporate taxes, the value of an unlevered firm is:
V = EBIT(1 - T)/R0

Using this relationship, we can find EBIT as:


$37,000,000 = EBIT(1 - .35)/.09
EBIT = $5,123,076.92

The WACC remains at 9 percent. Due to taxes, EBIT for an all-equity firm would have to
be higher for the firm to still be worth $37 million

Q13:
a. For an all-equity financed company:
WACC = 11%
b. To find the cost of equity for the company with leverage we need to
use M&M Proposition II with taxes, so:
RS = R0 + (B/S)×(1-TC)×(R0 - RB) = 0.11 + (0.25/0.75)(.65)(0.11-0.08)
=> RS = 11.65%
c. RS = R0 + (B/S)×(1-TC)×(R0 - RB) = 0.11 + (0.5/0.5)(.65)(0.11-0.08)
=> RS = 12.95%
d. The WACC with 25 percent debt is:
WACC = (S/V)RS + (B/V)RB(1 - T)
WACC = 0.75(0.11) + 0.25(0.08)(1 - 0.35)
WACC = 9.55%
And the WACC with 50 percent debt is:
WACC = (S/V)RS + (B/V)RB(1 - T)
WACC = 0.5(0.11) + 0.5(0.08)(1 - 0.35)
WACC = 8.1%

Q14:
VU=$185,000(1-0.35)/0.16=$751,562.5
VL = $751,562.5 + 0.35($135,000) = $798,812.5

Q15:
135,000
RE¿ 0.16+ 663,812.5 × ( 1−0.35 ) × ( 0.16−0.09 ) =0.1693=16.93 %
135,000 663,812.5
WACC¿ 798,812.5 ×0.09 × ( 1−0.35 ) + 798,812.5 ×0.1693=0.1506=15.06 %

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