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Problem 16-13
Current Asset Usage Policy
Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $2 million of fixed assets and intends to keep its debt ratio at its historical level of 45%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 13% of sales. Payne’s tax rate is 35%.
a. What is the expected return on equity under each current asset level? Round your answers to two decimal places.

Tight policy

 %

Moderate policy

 %

Relaxed policy

 %

b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?
I. The current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
II. The current asset policies followed by the firm mainly influence the level of fixed assets.
III. Yes, this assumption would probably be valid in a real world situation. A firm’s current asset policies have no significant effect on sales.
IV. Sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
V. No, this assumption would probably not be valid in a real world situation. A firm’s current asset policies may have a significant effect on sales.

Why or why not?
The input in the box below will not be graded, but may be reviewed and considered by your instructor.

c. How would the overall risk of the firm vary under each policy?
The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Capital Structure Decisions: Introduction

Up to this point when we calculated a firm’s weighted average cost of capital (WACC), we assumed that the firm had a specific target capital structure. However, target capital structures often change over time, these changes affect the risk and cost of each type of capital, and thus impact the firm’s WACC. In addition, changes in a firm’s WACC impact its capital budgeting decisions and its stock price. Many factors influence capital structure decisions and determining the firm’s optimal capital structure is not an exact science. In fact, even firms in the same industry often have dramatically different capital structures.
Capital refers to investor-supplied funds—debt, preferred stock, common stock, and retained earnings. A firm’s capital structure is the mix of debt, preferred stock, and common equity used to finance the firm’s assets. Capital structure theory suggests that some optimal capital structure exists that simultaneously  a firm’s stock price and  its cost of capital. The optimal capital structure strikes a balance between risk and return. A firm’s target capital structure is generally set equal to the estimated optimal capital structure. However, the target may change over time as conditions change, but at any given moment, a well-managed firm’s management has a specific structure in mind; and financing decisions are made so as to be consistent with this target capital structure.
Actual capital structures also change over time for two different reasons: as a result of deliberate actions or as a result of market actions. First, if a firm is not currently at its target, it may deliberately raise funds in a manner that moves the actual capital structure toward its target. Second, the firm could incur high profits or losses that lead to significant changes in book value equity as shown on the balance sheet and to a decline in its stock price. Similarly interest rate changes due to changes in the general level of rates and/or changes in the firm’s default risk could cause significant changes in its debt’s market value. Both of these changes could result in large changes in its measured capital structure.

Give the correct response to the following question.

Which of the following is/are not investor-supplied fund(s)?

Capital Structure and Leverage: Capital Structure Theory

Modern capital structure theory began in 1958 when Professors Modigliani and Miller (MM) published a paper that proved under a restrictive set of assumptions that a firm’s value is unaffected by its capital structure. By indicating the conditions under which capital structure is irrelevant, they provided clues about what is required to make capital structure relevant and impact a firm’s value. In 1963 they wrote a paper that included the impact of corporate taxes on capital structure. With the tax deductibility of  payments, but not  payments, and if all their other assumptions held, they concluded that an optimal capital structure consisted of % debt. This paper was then modified when Merton Miller brought in the effects of personal taxes. Bond interest income is taxed at  rates than income from stocks (received as dividends and capital gains). Consequently, investors are willing to accept relatively low before-tax returns on stock as compared to the before-tax return on bonds. Most observers believe that interest deductibility has a  effect than the favorable tax treatment of income from stocks, so the U.S. tax system favors the corporate use of .
MM assumed there are no bankruptcy costs but firms do go bankrupt and bankruptcy costs are high. Bankruptcy-related problems are likely to increase the more debt a firm has in its capital structure. Therefore, bankruptcy costs discourage firms from using debt in excessive levels. This led to the development of the Trade-Off Theory, which states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy.
MM assumed that investors and managers have the same information about a firm’s prospects, which is known as  information. However, managers have better information than investors, which is known as  information.  theory recognizes that investors and managers do not have the same information regarding a firm’s prospects. We would expect a firm with very favorable prospects to avoid selling stock, and to instead raise any required new capital by using new debt, even if this moved its debt ratio beyond its target level. The announcement of a stock offering is generally taken as a signal that the firm’s prospects as seen by its management are not bright. This suggests that when a firm announces a new stock offering, more often than not, its stock price will . This situation implies that a firm will maintain a reserve borrowing capacity, which will give it the ability to borrow money at a reasonable cost when good investment opportunities arise. Firms often use less debt than specified by the MM optimal capital structure in normal times to ensure that they can obtain debt capital later if necessary.
The pecking order hypothesis states that managers have a preferred sequence of raising capital that impacts their capital structure decisions. The preferred sequence is to raise capital first as spontaneous credit, then retained earnings, then other debt, and finally new common stock. Finally, when a company’s stock is selling for a price different than its intrinsic value, the firm’s managers can adjust the firm’s capital structure to take advantage of the mispricing. Thus, the firm’s managers take advantage of windows of opportunity.

Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME’s debt currently has a 7.5% yield to maturity. The risk-free rate (rRF) is 5.5%, and the market risk premium (rM – rRF) is 6.5%. Using the CAPM, MME estimates that its cost of equity is currently 10.1%. The company has a 40% tax rate.
a. What is MME’s current WACC? Round your answer to 2 decimal places. Do not round intermediate calculations.
%
b. What is the current beta on MME’s common stock? Round your answer to 4 decimal places. Do not round intermediate calculations.

c. What would MME’s beta be if the company had no debt in its capital structure? (That is, what is MME’s unlevered beta, bU?) Round your answer to 4 decimal places. Do not round intermediate calculations.

MME’s financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company’s bonds would rise to 8%. The proposed change will have no effect on the company’s tax rate.
d. What would be the company’s new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
%
e. What would be the company’s new WACC if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations.
%
f. Based on your answer to Part e, would you advise MME to adopt the proposed change in capital structure?

Problem 15-09
Capital Structure Analysis
Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company’s EBIT is $14.87 million, and its tax rate is 30%. Pettit can change its capital structure by either increasing its debt to 60% (based on market values) or decreasing it to 40%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 14% coupon. If it decides to decrease its leverage, it will call its old bonds and replace them with new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.
The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, rs, is 14%. If it increases leverage, rs will be 16%. If it decreases leverage, rs will be 13%.
Present situation (50% debt):
What is the firm’s WACC? Round your answer to three decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million
60% debt:
What is the firm’s WACC? Round your answer to two decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million
40% debt:
What is the firm’s WACC? Round your answer to two decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million

roblem 15-10
Optimal Capital Structure with Hamada
Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 6%, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. The firm’s EBIT is $12.897 million, and it faces a 40% federal-plus-state tax rate. The market risk premium is 5%, and the risk-free rate is 4%. BEA is considering increasing its debt level to a capital structure with 45% debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 8%. BEA has a beta of 0.9.
a. What is BEA’s unlevered beta? Use market value D/S (which is the same as wd/ws) when unlevering. Round your answer to two decimal places.

b. What are BEA’s new beta and cost of equity if it has 45% debt? Do not round intermediate calculations. Round your answers to two decimal places.

Beta

Cost of equity

 %

c.
d. What are BEA’s WACC and total value of the firm with 45% debt? Do not round intermediate calculations. Round your answer to two decimal places.
 %

What is the total value of the firm with 45% debt? Do not round intermediate calculations. Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$ million

 Problem Walk-Through

Problem 15-11
WACC and Optimal Capital Structure
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows:

Market Debt-
to-Value
Ratio (wd)

Market Equity-to-Value
Ratio (ws)

Market Debt-
to-Equity
Ratio (D/S)

Before-Tax Cost of Debt (rd)

0.0

1.0

0.00

7.0%

0.2

0.8

0.25

8.0  

0.4

0.6

0.67

10.0  

0.6

0.4

1.50

12.0  

0.8

0.2

4.00

15.0  

F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analaysis the risk-free rate is 7%, the market risk premium is 5%, and the company’s tax rate is 40%. F. Pierce estimates that its beta now (which is “unlevered” because it currently has no debt) is 0.9. Based on this information, what is the firm’s optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure? Do not round intermediate calculations. Round your answers to two decimal places.

DEBT

 %

EQUITY

 %

WACC

 %

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