Corporate Finance

Part 1

15.2

a) Ð...

b) 0.16

c) 0.16

15.9

a) False.

o Only a change in capital structure

o No effect on market value  MM Proposition 1)

o Stock price remains constant

b) False.

o MM Proposition 2:

A higher debt to equity ratio increases firm's cost of equity. However, firm's cost of capital remains unchanged.

o rs = r0 + (r0 - rB)B/S

 Cost of equity is positively related to firm's debt to equity ratio

15.16

a) $7,375,000

b) 33.90%

c) It depends.

In reality, there is likelihood of financial distress and bankruptcy costs which will increase the cost of debt. Moreover, the percentage of debt use by firms differs by the nature of the industry the firm is in. Thus, without additional information, it is hard to determine whether the amount of debt reflects reality.

15.19

a) 36.25%

b) 19.98%

c) 16.98%, 15.78%

16.13

a) $15,000

b) 1. $15,000

2. $7,500

3. 0.30

4. 0.2

c) 1. It depends.

The value of the firm will increase by the tax shield when using debt since corporations can deduct interest payments but not dividend payments. Thus, corporate leverage lowers tax payments. However, if the value of unlevered firm is higher when there is no corporate tax, the value of the firm will decrease despite the tax shield since the tax shield is not sufficient enough to cover the tax already incurred by the firm.

2. Case 1:

$18,000 (increase in firm's value)

Case 2:

$12,000 (decrease in firm's value)

Part 2

Question 1

Profitable firms tend to use more debt because the firms can use the extra interest to reduce the taxes from its greater earnings. And being more financially secure, profitable firms will find its extra debt increasing the risk of bankruptcy only slightly. In addition, rational investors view debt as a sign of equity. They are likely to infer a higher firm value from a higher debt level. Thus, these investors are likely to bid up a firm's stock price after the firm has issued debt to buy back equity.

However, the static trade-off theory of capital structure involves a trade-off between the tax benefits of debt and the costs of financial distress. Also, the pecking-order theory implies that managers prefer internal to external financing. In view of these, firms pursue conservative policies.

Question