Practice Problems – Chapter 17
Note:
all problems assume perfect capital markets.
1)
A levered firm has a debt-to-value ratio of 15%.
The firm’s cost of equity is 14.5%, and its weighted average cost of
capital is 13%.
a)
What is the firm’s cost of debt?
b) What would the firm’s cost of capital be if the firm was unlevered?
2)
A levered firm has a debt-equity ratio of 90%.
The firm’s cost of equity is 15.6%, and the required return on its debt
is 12%.
a)
What is the firm’s weighted average cost of capital?
b) If the firm’s debt-equity ratio falls to 2/3, what is the new WACC?
3)
A levered firm has a debt-to-value ratio of 45%.
The cost of equity is 18%, and its weighted average cost of capital is
12%.
a)
What is the firm’s cost of debt?
b)
If the firm increases its debt ratio to 60% the required return on its
debt would increase by one-fifth. At
this debt ratio, what would be the firm’s weighted average cost of capital and
its cost of equity?
4)
Shop-or-Rob’s debt has a market value of $800,000.
If the firm had no debt, the required return on its equity would be 11%,
and its expected cashflows would be $220,000 each year forever.
The required return on the debt is 6%.
Assuming perfect capital markets, what is the value of the firm, the
value of equity, the required return on its equity, and its weighted average
cost of capital?
5)
Myopic Microwaves Inc. has a total market value of $25 million, $8
million of which is the market value of its debt.
The required return on the firm’s debt is 11.5%.
The required return on equity is 16.5%.
a)
What is MMI’s required return on assets?
b)
What would their required return on equity be if the debt-to-value ratio fell to
20%, and the required return on debt fell to 10%?
6)
Tom’s Turkeys has annual expected cashflows forever of $1,250,000.
It has issued perpetual debt with annual interest payments of $300,000.
The required return on the debt is 6%.
The required return on the firm’s assets is 9.625%.
a)
What is the value of the TT’s equity?
b)
What is the required return on their equity?
7)
An all equity firm has 1,000 shares outstanding; the stock price on
Monday is $60 per share. On Tuesday
morning, the firm announces that:
i) On Wednesday, the firm
will issue $15,000 of debt
ii) On Thursday, it will pay a dividend of $17,000.
a)
What is the value of the firm when the market closes on Tuesday, Wednesday and
Thursday?
b)
What is the stock price when the market closes on Tuesday and Thursday.
c)
What is the increase in stockholders’ wealth due to this transaction?
8)
Mark the following statements with a T or an F to indicate
whether they are true or false (no explanations required or considered):
a)
When making capital structure decisions, managers can maximize either the
stock price or the value of the firm; stockholder wealth is maximized either
way.
b)
When a firm makes a pure capital structure change, the proceeds from
issuing new debt must be paid out to stockholders.
c)
An investor who is more risk averse prefers to invest in the equity of
the unlevered firm.
d)
Given an unlevered firm U and an otherwise identical levered firm L,
buying 2% of U’s equity or buying 1% of L’s equity and 1% of L’s debt
yields identical investments
e)
Borrowing money to buy shares of the unlevered firm has the same effect
as buying shares in the levered firm.
f)
In perfect capital markets, capital structure is irrelevant because
investors are indifferent between dividends and capital gains.
g)
In perfect capital markets, as a firm increases its debt ratio, the cost
of debt and the weighted average cost of capital both stay constant.
h)
If the cost of debt was always less than the cost of equity, a firm would
be able to reduce its WACC just by using more debt and less equity.
i) In PCM maximizing firm value is the same as minimizing WACC, but this is not necessarily true in the real world because capital structure decisions can affect the cashflows generated by assets.