Business Finance: Questions
Question 1
Reliable Gearing currently is all-equity financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.
a. What will be the debt-to-equity ratio after each possible restructuring?
b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will earnings per share be for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected (i.e., average) EPS under each financing mix? Is the high-debt mix preferable?
c. Suppose that EBIT is $100,000. What is EPS under each financing mix? Why are they the same in this particular case?
Question 2
Margo Corporation is a major producer of lawn care products. Margo stock currently sells for $80 per share; there are 10.5 million shares outstanding. Margo also has debt outstanding with an aggregate book value of $400 million. The bonds issued by Margo are currently yielding 10%, and are trading at 90% of face value. The risk-free rate if 8%, the market risk premium is 9%, and Margo has a equal to 2. The corporate tax rate is 34%.
a. Margo is considering expansion of its facilities. Use the SML approach to determine the cost of equity capital for Margo.
b. Compute the weighted average cost of capital for Margo.
c. The project under consideration requires an outlay of $1,000,000. The expansion will produce incremental after-tax cash inflows of $350,000 per year for the next five years. Compute the net present value of the investment, assuming the project has the same risk as Margo’s other projects.
d. Flotation costs are 5% of the amount of common stock issued and 2% of the amount of debt issued. Using the same data, compute the weighted average
Reliable Gearing currently is all-equity financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10%. The firm pays no taxes.
a. What will be the debt-to-equity ratio after each possible restructuring?
b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will earnings per share be for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected (i.e., average) EPS under each financing mix? Is the high-debt mix preferable?
c. Suppose that EBIT is $100,000. What is EPS under each financing mix? Why are they the same in this particular case?
Question 2
Margo Corporation is a major producer of lawn care products. Margo stock currently sells for $80 per share; there are 10.5 million shares outstanding. Margo also has debt outstanding with an aggregate book value of $400 million. The bonds issued by Margo are currently yielding 10%, and are trading at 90% of face value. The risk-free rate if 8%, the market risk premium is 9%, and Margo has a equal to 2. The corporate tax rate is 34%.
a. Margo is considering expansion of its facilities. Use the SML approach to determine the cost of equity capital for Margo.
b. Compute the weighted average cost of capital for Margo.
c. The project under consideration requires an outlay of $1,000,000. The expansion will produce incremental after-tax cash inflows of $350,000 per year for the next five years. Compute the net present value of the investment, assuming the project has the same risk as Margo’s other projects.
d. Flotation costs are 5% of the amount of common stock issued and 2% of the amount of debt issued. Using the same data, compute the weighted average