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1. Why is it that, for a given firm, that the required rate of return on equity is always greater than the required rate of return on its debt? 2. The Mountaineer Airline Company has consulted with its investment bankers and determined that they could issue new debt with a yield of 8%. If Mountaineer ' marginal tax rate is 39%, what is the after-tax cost of debt to Mountaineer? 3. The Blue Dog Company has common stock outstanding that has a current price of $20 per share and a $0.5 dividend. Blue Dogs dividends are expected to grow at a rate of 3% per year, forever. The expected risk-free rate of interest is 2.5%, whereas the expected market premium is 5%. The beta on Blue Dogs stock is 1.2. a. What is the cost of equity for Blue Dog using the dividend valuation model? b. What is the cost of equity for Blue Dog using the capital asset pricing model? 4. Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. In consultation with investment bankers, Gaggle expects to be able to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Gaggle is currently selling for $20.00 a share. Gaggle expects to pay a dividend of $1.50 per share next year. Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year. Gaggle' marginal tax rate is 35%. a. If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Gaggle's cost of capital? b. If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Gaggles cost of capital?
2. The Mountaineer Airline Company has consulted with its investment bankers and determined that they could issue new debt with a yield of 8%. If Mountaineer ' marginal tax rate is 39%, what is the after-tax cost of debt to Mountaineer? rd* = 0.08 (1 0.39) = 0.0488 or 4.88% 3. The Blue Dog Company has common stock outstanding that has a current price of $20 per share and a $0.5 dividend. Blue Dogs dividends are expected to grow at a rate of 3% per year, forever. The expected risk-free rate of interest is 2.5%, whereas the expected market premium is 5%. The beta on Blue Dogs stock is 1.2. a. What is the cost of equity for Blue Dog using the dividend valuation model? re = {[$0.50(1 + 0.03)] /$20} + 0.03 = 0.05575 or 5.575% b. What is the cost of equity for Blue Dog using the capital asset pricing model? re = 0.025 + (0.05) 1.2 = 0.025 + 0.06 = 8.5% 4. Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. In consultation with investment bankers, Gaggle expects to be able to issue new debt at par with a coupon rate of 8% and to issue new preferred stock with a $2.50 per share dividend at $25 a share. The common stock of Gaggle is currently selling for $20.00 a share. Gaggle expects to pay a dividend of $1.50 per share next year. Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year. Gaggle' marginal tax rate is 35%. rd* = 0.08 (1 0.35) = 0.52 or 5.2% rp = $2.50 / $25 = 10% re = $1.50 / $20 + 5% = 7.5% + 5% = 12.5% a. If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common stock, what is Gaggle's cost of capital? WACC = [0.45 (0.052)] + [0.05 ( 0.10)] + [0.50 (0.125)] WACC = 0.0234 + 0.005 + 0.0625 = 0.0909 = 9.09% b. If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common stock, what is Gaggles cost of capital? WACC = [0.30 (0.052)] + [0.05 ( 0.10)] + [0.65 (0.125)] WACC = 0.0156 + 0.005 + 0.08125 = 0.10185 = 10.185%
Assume that the tax rate is 0%. Calculate the capitalization rate for earnings for each firm and for each alternative financing arrangement. In addition, calculate the value of equity and debt in each case. 3. Explain why interest deductibility would encourage companies to use debt financing. 4. Explain a. b. c. d. how each of the following affects the capital structure decision: Interest deductibility Likelihood of bankruptcy Limited liability Net operating loss carryovers
5. The ABC Company has a current capital structure consisting of $100,000 of 10% coupon debt and $300,000 of equity. ABC wants to raise $100,000 of capital by either selling additional shares of stock or issuing debt. There is currently 30,000 shares of stock outstanding and ABC expects to pay 10% interest per year. ABC expects operating earnings of $30,000 in the following year. a. What is ABCs debt ratio under each of the two financing alternatives? b. If interest on debt is not deductible by ABC, what is the distribution of next years $30,000 among claimants? c. If interest on debt is deductible by ABC, and ABC has a tax rate of 30%, what is the distribution of next years $30,000 among claimants (including the government)? d. Suppose ABCs probability distribution of next years earnings is as follows:
Scenario Good Normal Bad Probability 25% 50% 25% Operating earnings $50,000 $30,000 $0
What is ABCs expected earnings to owners and standard deviation of earnings to owners under the two alternatives? Assume that there are no taxes.
0.10+[(0.10-0.05)(1)] = 0.15 0.12+[(0.12-0.08)0.04(1.5)] =0.18 $500 $500 $1,000 $1,000.00 666.67 $1,666.67
3. Interest deductibility lowers the cost of using debt vis--vis equity financing. Therefore, companies have an incentive to use debt because its cost is much lower than that of equity. 4. a. Interest deductibility: makes the use of debt more attractive by lowering the cost of debt to the company.
b. Likelihood of bankruptcy: the greater the probability of bankruptcy, the less debt that a company would want to take on. c. Limited liability: The fact the owners bear only a fixed amount of the risk on the downside of investments creates an incentive to take on riskier projects. This limit on the owners liability encourages creditors to require a premium for bearing this risk.
d. Net operating loss carryovers: If a company cannot use all of its tax benefits from interest, then the cost of debt is not as low as it could be if they could use these benefits; hence, the lack of profitability negates the benefits from interest deductibility. Therefore, companies that are not generating profits for tax purposes do not benefit from the tax deductibility of interest.
5. a. b.
Alternative 1 Income to claimants $30,000 Alternative 2 $30,000
$10,000 $20,000
$20,000 $10,000
c.
Alternative 1 Income to claimants $14,000 Alternative 2 $7,000
d.
pn (x n -E(x)) $126,562,500 $3,125,000 $189,062,500 $318,750,000 $17,854 1.020 $126,562,500 $3,125,000 $189,062,500 $318,750,000 $17,854 2.380
$50,000 $30,000 $0
With taxes Alternative 1 Net income Operating Interest after earnings on debt taxes Probability $50,000 $10,000 $28,000 25% $30,000 $10,000 $14,000 50% $0 $10,000 ($7,000) 25% E(x) =
pn (x n -E(x)) $62,015,625 $1,531,250 $92,640,625 $156,187,500 $12,497 1.020 $62,015,625 $1,531,250 $92,640,625 $156,187,500 $12,497 2.380
$50,000 $30,000 $0