Solutions Manual

CHAPTER 24 ASSESSING LONG-TERM DEBT, EQUITY AND CAPITAL STRUCTURE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions 1. Capital structure is the composition of a firms financing, which consists of its permanent sources of capital. 2. The financial managers objective in making capital structure decisions is to find the financing mix that maximizes the market value of the firm. This structure is called the optimal capital structure. . !nder idealized conditions with no income taxes, the traditional approach to capital structure suggests that there is an optimal capital structure which simultaneousl" maximizes the firms market value and minimizes its weighted average cost of capital. !nder idealized conditions with no income taxes, the Modigliani and Miller model implies that the total market value and cost of capital are independent of a firms capital structure. !nder idealized conditions with corporate income taxes, the Modigliani and Miller model concludes that leverage affects value, and that firms should be financed with virtuall" all debt. !nder relaxed assumptions, the contemporary approach suggests that there is an optimal range for the capital structure of the firm. #f the firm finances outside this range, the value of the firm will decline. $. %hoosing an optimal or target capital structure involves tradeoff among opposing benefits and costs and re&uires the use of both anal"tical techni&ues and informed judgment. '. ( firm can anal"ze its capital structure b" performing an )*#T + ),anal"sis. assessing risk associated with various capital structures. computing debt management ratios and comparing them with industr" standards. and seeking the opinion of lenders, investment anal"sts, and investment bankers. )*#T + ),- anal"sis is useful for evaluating the sensitivit" of ),- to changes in )*#T under various financing plans.

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Assessing Long-term Debt, Equity and Capital Structure

/. The indifference point is the )*#T level at which ),- is e&ual under alternate financing plans. This point ma" be found either graphicall" or mathematicall". 0. )*#T + ),- anal"sis ma" be criticized because it does not directl" consider the long1run financial conse&uences of financing alternatives and concentrates on earnings maximization rather than wealth maximization. 2. %apital structure decisions are tempered b" such considerations as cash flow, market conditions, profitabilit" and stabilit", control, management preferences, financial flexibilit", and business risk. II. Multiple Choice Questions 1. 2. . 3 3 ( $. '. /. * * 3 0. 2. 5. 3 % ( 14. 3

III. Problems P"o%l!& ' 6or the following problem, assume that7
kd # ks 9 ka )*#T 8 8 8 8 8 8 %ost of debt #nterest %ost of e&uit" :arket value of the firm ;eighted average cost of capital )arnings before interest and taxes

<a= -ubstituting kd 8 4.42 and # 8 ,24,444 and solving for 3, the market
value of debt is7
4.42 8 3 8 8 ,24,444 3 ,24,444 4.42 ,1,444,444

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Assessing Long-term Debt, Equity and Capital Structure

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-ubstituting )*#T 8 ,244,444, # 8 ,24,444, and k s 8 4.12, the market value of e&uit" is7
- 8 8 8 ,244,444 > ,24,444 4.12 ,024,444 4.12 ,/,444,444

-ubstituting 3 8 ,1,444,444 and - 8 ,/,444,444, the total market value of the firm is7
9 8 ,1,444,444 ? ,/,444,444 8 ,0,444,444

<b= -ubstituting )*#T 8 ,244,444 and 9 8 ,0,444,444, the weighted average cost of capital is7
ka 8 ,244,444 ,0,444,444

8 4.11$ or 11.$ @

P"o%l!& #

<a= -ubstituting kd 8 4.42 and # 8 ,244,444 and solving for 3, the market
value of debt is7
4.42 8 3 8 8 ,244,444 3 ,244,444 4.42 ,2,'44,444

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Assessing Long-term Debt, Equity and Capital Structure

-ubstituting )*#T 8 ,244,444, # 8 ,244,444, and k s 8 4.12', the market value of e&uit" is7
- 8 8 8 ,244,444 > ,244,444 4.12' ,/44,444 4.12' ,$,244,444

-ubstituting 3 8 ,2,'44,444 and - 8 ,$,244,444, the total market value of the firm is7
9 8 ,2,'44,444 ? ,$,244,444 8 ,0, 44,444

<b= -ubstituting )*#T 8 ,244,444 and 9 8 ,0, 44,444, the weighted average cost of capital is7
ka 8 ,244,444 ,0, 44,444

8 4.145/ or 14.5/@

<c= The market value of the firm <9= has increased and the weighted average cost of capital <ka= has decreased with the use of additional debt. Thus, the firm is operating in a world as viewed b" the traditionalists. P"o%l!& ( <a= (ccording to the :: approach, the market value of the firm remains unchanged at ,0,444,444 with increased leverage. <b= (ccording to the :: approach, the weighted average cost of capital remains unchanged at 11.$ percent with increased leverage. <c= -ubstituting 9 8 ,0,444,444 and 3 8 ,2,'44,444 and solving for -, the market value of ordinar" e&uit" share outstanding is7 ,0,444,444 8 ,2,'44,444 ? - 8 ,0,444,444 > ,2,'44,444 8 ,$,'44,444
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-ubstituting )*#T 8 ,244,444, # 8 ,244,444, and - 8 ,$,'44,444, the cost of e&uit" is7
ks 8 ,244,444 > ,244,444 ,$,'44,444 or 1 . @

8 4.1

P"o%l!& $ <a= -ince the firm has no debt, the market value of the firm is found b" multipl"ing the ordinar" e&uit" share selling price per share b" the number of shares outstanding7 - 8 <,2'= <$44,444= 8 ,14,444,444 <b= -ubstituting )*#T 8 ,1,'44,444 and - 8 ,14,444,444, the cost of e&uit" is7 ,1,'44,444
ks 8 ,14,444,444 8 4.1'44 or 1'.44@

P"o%l!& ) <a= ;eighted (verage %osts of %apital %omputation

Source o Capital 3ebt )&uit" Total A <4. 4 x 4.42= <4.04 x 4.1$= 8 2$@ 8 5.2@ 12.2@ ! <4./4 x 4.14= <4.$4 x 4.12= 8 8 /@ 0.2@ 1 .2@

<b= %apital -tructure ( is less costl".

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Assessing Long-term Debt, Equity and Capital Structure

P"o%l!& * <a= The value of Aock" Aoad %orporation with no leverage is7
9alue of the firm with 8 no leverage 8 <,0'4,444= <1> 4. $= 4.1' ,$5',444 4.1'

8 , , 44,444

<b= 1. The value of Aock" Aoad %orporation with ,1,444,444 in debt is7
9alue of the firm with 8 , , 44,444 ? <4. $= <,1,444,444= leverage 8 , ,/$4,444

2. The total market value with ,2,444,444 in debt is7

9alue of the firm with 8 , , 44,444 ? <4. $= <,2,444,444= leverage 8 , ,524,444

3ue to the tax shelter, the firm is able to increase its value in a linear manner with more debt. P"o%l!& + <a= The market value of the firm under each capital structure is7
Ca ital St"u,tu"! ( * % 3 ) 6 Vu ,$4,444,444 ,$4,444,444 ,$4,444,444 ,$4,444,444 ,$4,444,444 ,$4,444,444 NTD , /44,444 ,1,244,444 ,2,$44,444 , ,/44,444 ,$,244,444 ,',$44,444 -D > > > > > > , 4 , 144,444 , 2'4,444 , 244,444 ,2,444,444 ,',444,444 8 8 8 8 8 8 V' ,$4,/44,444 ,$1,144,444 ,$2,1'4,444 ,$2,244,444 ,$2,244,444 ,$4,$44,444

? ? ? ? ? ?

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%apital -tructure 3 is preferred because it provides the greatest market value of the firm. <b= The major problem in using the contemporar" approach is estimating the various inputs. This approach is relativel" eas" to appl" in theor" but difficult to use in practice. P"o%l!& . <a= -ubstituting # 8 ,024,444 <4.45 x ,2,444,444=, the financial break1even point under ,lan ( is7 ,lan ( 6b 8 ,024,444

!nder ,lan *, the firm does not have an" fixed financial costs <interest or preferred share dividends=. Thus the financial breakeven point under ,lan * is7 ,lan * 6b 8 , 4

<b= The )*#T + ),- indifference point is7

),- <debt= 8 <)*#TB + ,024= <1 > 4. $= + , 4 '44 4.// )*#TB + ,$0'.24 '44 %ross multipl"ing7 <0'4= <4.// )*#TB + ,$0'.24= $5' )*#TB + , '/,$44 1/' )*#TB )*#TB 8 8 8 8 <'44= <4.// )*#TB= 4 )*#TB , '/,$44 ,2,1/4 <in thousands= or ,2,1/4,444 8 8 ),- <ordinar" e&uit" share= <)*#TB + , 4= <1 > 4. $= + , 4 0'4 4.// )*#TB 0'4

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Assessing Long-term Debt, Equity and Capital Structure

<c= The ),- are calculated as follows7

Plan A" Debt )*#T Cess7 #nterest on new debt )arnings before taxes Cess7 #ncome taxes < $@= Det income Erdinar" e&uit" shares )arnings per share ,2,0'4,444 024,444 2,4 4,444 /54,244 ,1, 5,244 '44,444 ,2./2 Plan !" #rdinary Equity Share ,2,0'4,444 4 2,0'4,444 5 ',444 ,1,21',444 0'4,444 ,2.$2

<d= 9aldez -porting Foods should adopt ,lan ( if it can be reasonabl" sure that the )*#T will not drop below the indifference point. (lthough ,lan ( results in a higher ),- than ,lan *, debt financing involves greater risk than ordinar" e&uit" share financing. P"o%l!& / <a= The interest on existing debt is ,2,244,444 <4.11 x ,24,444,444= and the interest on the new debt is ,1,444,444 <4.14 x ,14,444,444=. -ubstituting #1 8 , ,244,444, #2 8 ,2,244,444, ,3 8 ,'2',444 <,'.2' x 144,444=, T 8 4. $, n1 8 2,444,444, and n2 8 2,'44,444 <with thousands of pesos omitted=, the )*#T + ),- indifference point is7
),- <debt= 8 <)*#TB + , ,244= <1 > 4. $= + ,'2' 8 2,444 4.// )*#TB + ,2,112 + ,'2' 8 2,444 %ross multipl"ing7 <2,'44= <4.// )*#TB + ,2,/ 0= 1,/'4 )*#TB + ,/,'52,'44 4 )*#TB )*#TB 8 8 8 8 <2,444= <4.// )*#TB + ,1,500= 1, 24 )*#TB + ,5'$,444 ,2,/ 2,'44 ,0,55'.$'' <in thousands= or ,0,55',$'' ),- <ordinar" e&uit" share= <)*#TB + ,2,244= <1 > 4. $= + ,'2' 2,'44 4.// )*#TB + ,1,$'2 + ,'2' 2,'44

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Assessing Long-term Debt, Equity and Capital Structure

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<b= Do. The difference point onl" identifies the level of )*#T where the ),of two financing alternatives are e&ual. The risk associated with the financing alternatives is not reflected b" the indifference point. <c= !sing the maximization of ),- as the criterion, ordinar" e&uit" share financing would be favored below ,0,55',$'' and debt financing above ,0,55',$''. <d= -ubstituting ri 8 ,0,55',$'', 8 ,5,'44,444, and G 8 ,1,'44,444, the z value is7
z 8 8 8 ,0,55',$'' + ,5,'44,444 ,1,'44,444 + ,1,'4$,'$' ,1,'44,444 + 1.44 <rounded=

The area under the normal curve with a z 8 + 1.44 is 4. $1 . The probabilit" that )*#T will be below the indifference point of ,0,55',$'' is 4.1'20 <4.'444 + 4. $1 =, or 1'.20 percent. <e= The ),- are calculated as follows7
Plan $" Debt )*#T Cess7 #nterest on existing debt #nterest on new debt )arnings before taxes Cess7 #ncome taxes < $@= Det income Cess7 ,referred share dividends )arnings available to ordinar" e&uit" shareholders Erdinar" e&uit" shares )arnings per share ,5,'44,444 2,244,444 1,444,444 /, 44,444 2,1$2,444 $,1'2,444 '2',444 , ,/ ,444 Plan %" #rdinary Equity Share ,5,'44,444 2,244,444 4 0, 44,444 2,$22,444 $,212,444 '2',444 ,$,25 ,444 2,'44,444 ,1.02

2,444,444 ,1.22

<f= #f the expected )*#T is ,5,'44,444, debt financing should be recommended because it provides a higher ),- than ordinar" e&uit" share financing with an acceptable level of risk. There is a 1'.20 percent probabilit" that the indifference point will not be reached.
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