1) What should a firm's target capital structure do?
a) Maximize earnings per share
b) Minimize the cost of debt
c) Minimize the cost of equity
d) Shift value from creditors to stockholders
e) Minimize the weighted average cost of capital
f) Other, specify
2) Better Home and Garden (BHG) expects an EBIT of $160,000 every year forever. The company currently has no debt, and its unlevered cost of capital is 12%. Its average tax rate is 34%. Capital markets are perfect. The company wants to borrow $352,000 to repurchase shares. The debt will have an interest rate of 8% and will be kept constant forever. What is the approximate value of the firm with debt?
a) 900,000
b) 1,000,000
c) 1,100,000
d) 1,200,000
e) 1,300,000
f) Other, Specify.
3) When a company takes on more and more debt, _____.
a) the value of the firm will decrease consistently
b) the cost of financial distress will eventually be offset by the benefits of debt
c) the value of the firm will increase consistently
d) the benefits of debt will eventually be offset by the cost of financial distress
e) the cost of equity increases while the cost of debt decreases
f) Other, specify
4) A new firm (with no other assets or liabilities) makes an initial investment of $500 and expects to generate a before-tax gross return of $570 after one year. The firm is partially financed with $200 of debt at an expected return of 5%. The appropriate unlevered after-tax cost of capital is 13% and the marginal income tax rate is 21%. What is the approximate adjusted present value of the firm?
a) $350
b) $400
c) $450
d) $500
e) $550
f) Other, specify.
Algebraic Problem (3 points - show your work on the back of this sheet)
5) The large, consistently profitable firm you work for is considering a small project. Your firm is financed by 60% equity and 40% debt. Its cost of equity is 10%. Its cost of debt is 5%. The risk free rate is 5%. Corporate taxes are 40%. The expected rate of return on the market is 11%. Assume CAPM is correct and the project is just as risky as your firm. Recall equation 18-5:
BETA(unlevered firm) = (Equity / ((Equity) + (1 - tax rate)*(DEBT))) * BETA(levered firm)
The project will cost $1000 at time 0, and is expected to produce $1250 at time 1, and no other cashflows. The firm is considering $600 debt at 6% and $400 equity to finance it.
a) What is the cost of equity for the project?,
What is the WACC of the project?, What is the NPV using WACC?
b) What is the APV of the project, including the tax shield (show both calculations)?
c) Explain for what kinds of projects would it make most sense to use WACC vs. APV.
d) Why might it matter that the firm is large and consistently profitable?