IFM Exercises Chapter 5: CAPITAL STRUCTURE

Chapter 5: CAPITAL STRUCTURE

CAPITAL STRUCTURE:
1. (IFM Study Manual) A project will produce the following free cash flows at the end
of year with the indicated probabilities:
Free cash flows Probability
15,000,000 0.8
25,000,000 0.1
50,000,000 0.1
An investment of 15,000,000 is required to start the project. The cost of capital is
15%. Calculate the NPV of the project.

2. (IFM Study Manual) A company embarks on a new project. The project will have
free cash flows at the end of one year of 60 million if successful and 20 million if
not successful. The probability that the projects is successful is 0.4.
The cost of capital if the project is unlevered is 20%. The cost of debt capital is 5%.
Calculate the rate of return to investors if 10,000,000 is financed with debt.

Use the following information for exercises 3 and 4:

Free cash flows from a project have the following expected values:
Year Free cash flows
1 20,000,000
2 15,000,000
There are no cash flows after the second year.
The cost of capital is 0.10 and the cost of debt is 0.05.
A one-year loan of 10,000,000 is taken.

3. (IFM Study Manual) Calculate the value of equity at the beginning of the project.
4. (IFM Study Manual) Calculate the rate of return to investors.

5. (IFM Study Manual) Company X and Company Y each have the same cost of capital
and identical asset portfolios with a market value of 1000.
Company X has zero debt. The expected return on equity for Company X is 15%.
The firm value of Company Y is made up of 50% debt and 50% equity. The expected
return on debt for Company Y is 9%.
Assuming no taxes, what is the expected return on equity in Company Y?
(A) 9%

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IFM Exercises Chapter 5: CAPITAL STRUCTURE

(B) 15%
(C) 21%
(D) 27%
(E) 33%

6. (IFM Study Manual) A company is financed by 1000 shares of stock with a current
market value of 100 per share. The company decides to issue 50 5-year bonds with
a par value of 100 and an annual coupon rate of 8% and use the proceeds to pay a
cash dividend to the company’s shareholders. The bonds sell at a market value that
provides an annual effective yield of 10%.
Assuming that Modigliani – Miller Proposition I holds, what is the market value per
share of the company’s stock immediately after the dividend payment?
(A) 95
(B) 95.4
(C) 100
(D) 104.6
(E) 105

7. (IFM Study Manual) The market value of a company’s liabilities consists of 40 of

debt and 80 of equity, for total liabilities of 120.
The beta for the company’s debt and equity are 0.3 and 1.65, respectively. The
expected return on the company’s debt is 9%. The company has a weighted
average cost of capital of 14%.
Which of the following statements are true, ignoring the effect of taxes?
I. If the proceeds from issuing additional equity of 10 are used to retire 10 of
debt, the company’s cost of capital will increase to 14.6%.
II. If a proposed new project has a β of 1.05, the project is riskier than the
company’s existing business.
III. If the risk-free rate is 8%, then the expected risk premium on the market is
5%.
(A) I only
(B) II only
(C) III only

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(D) I and II only

(E) I and III only

8. (IFM Study Manual) A company currently has 5,000,000 shares outstanding with
price 16. It also has 20 million of debt. It decides on a leveraged recapitalization. It
will repurchase 1,000,000 shares.
Currently the expected rate of return on equity is 12% and the risk-free rate is 3%.
Assume a perfect capital market.
Calculate the expected rate of return on equity after the leveraged buyout.

9. (IFM Study Manual) A company currently has market capitalization of 25,000,000

and no debt. Its beta is 0.8.
The annual effective risk-free interest rate is 0.04 and the market risk premium is
0.06.
The company will perform a leveraged recapitalization. The company can borrow
money at the risk-free rate.
How much should the company borrow in order to increase the expected rate of
return on equity to 0.1?

10. (IFM Study Manual) For a company, the unlevered cost of capital is 0.13. The debt
cost of capital is 0.05. Capital is 20% debt and 80% equity.
Calculate the equity cost of capital.

11. (IFM Study Manual) A company’s capital structure consists of debt and equity.
When debt is 25% of the total, the equity cost of capital is 0.15 and the debt cost
of capital is 0.04. When debt is 50% of the total, the equity cost of capital is 0.20.
Calculate the debt cost of capital when debt is 50% of the total capital.

12. (IFM Study Manual) A company has 10,000,000 shares of stock outstanding with
price 15 and no cash or debt. Beta for the company is 1.2. The company then issues
2,000,000 shares. From the proceeds, 20,000,000 is invested in the business and
10,000,000 cash is held.
Calculate the revised beta for equity.

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13. (IFM Study Manual) The Longhorn Company is considering a project. At the end of
one year, this project may pay 40,000 if successful, or 10,000 if it is not. The
probability of success is 0.5. The cost of equity capital to fund this project is 12.5%
if no debt is taken.
The company borrows 15,000 to fund the project. If the project fails, the debtors
will get 10,000 only. Since this debt is risky, debtors expect a return of 8% on the
debt.
Calculate the rate of return for equity shareholders.

14. (IFM Study Manual) A company’s capital structure is 20,000,000 equity, 40,000,000
debt, and 4,000,000 cash. Beta is 1.2 for equity and 0.1 for debt.
The risk-free rate is 0.04. The market risk premium is 0.06. The tax rate is 0.
Calculate the WACC for the company.

15. (IFM Study Manual) Jane Inc. currently has 50 million shares outstanding with price
20, and 500 million in debt, paying 5% interest. Earnings after interest are
100,000,000. It is considering a project that requires a 100 million investment and
will increase earnings by 11 million.
Before starting the project, the equity beta is 1.1 and the debt beta is 0.1.
Assume the debt beta does not change.
Calculate the revised equity beta:
a) if the project is financed with equity
b) if the project is financed with debt
.
16. (IFM sample questions) Determine which one of the following statements is TRUE
with respect to a perfect capital market:
(A) Taxes and transaction costs can exist.
(B) A firm’s choice of capital structure will have an effect on its cost of capital.
(C) A firm’s choice of capital structure will always have an effect on the firm’s
value.
(D) Leverage has no effect on the risk of equity, even where there is no default
risk.
(E) The total value of a levered firm is equal to the total value of the firm
without leverage.

THE EFFECT OF TAXES ON CAPITAL STRUCTURE:

17. (IFM Study Manual) A project requires 100,000,000 in capital. It is financed with
50% equity and 50% debt. An interest rate of 6% is paid on debt. The corporate tax
rate is 21%. Calculate the tax shield for one year.

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18. (IFM Study Manual) Xerxes Manufacturing has 20 million shares outstanding with
price 32. It has no debt. After-tax return on equity is 15%.
In order to increase return on equity, it borrows x and uses to repurchase shares.
It pays 6% interest on the loan. Xerxes’s corporate tax rate is 25%.
Calculate the amount to borrow so that after-tax return on equity is 20%.

19. (IFM Study Manual) A company’s capital structure is 80% debt, 20% equity. Its tax
rate is 0.21. Its cost of capital is 0.12 for equity, 0.04 for debt.
Determine the different between its pretax and after tax WACC.

20. (IFM Study Manual) Amazing Fast-Food issues 50,000,000 of bonds. The bonds pay
8% interest rate at the end of each year and mature in 5 years. The risk-free rate is
4%. The corporate tax rate is 20%. The tax shield is risk-free.
Calculate the present value of the tax shield.

21. (IFM Study Manual) Optimal Tools Company has 20 million in debt, on which it pays
6% interest. The corporate tax rate for Optimal is 25%. It plans to maintain this
level of debt permanently.
Calculate the present value at 6% interest of the tax shield.

22. (IFM Study Manual) A company’s target debt-to-equity ratio is 0.25. It expects
assets to increase 2% per year. Currently assets are 2500 million. The corporate tax
rate is 21%.
It pays 5% interest on its debt. The risk-free rate is 4%. The tax shield is risk-free.
Calculate the present value of the tax shield.

23. (IFM Study Manual) Fabulous Fashion Company target a debt-to-equity ratio of 4.
Its free cash flows are 2 million in the coming year, expected to increase 3% per
year. Its cost of debt is the risk-free rate, which is 5%. Its cost of equity capital is
12%.
The corporate tax rate is 25%.
Estimate the present value of the tax shield.

24. (IFM Study Manual) For XYZ Company, you are given:
i. The cost of debt capital for the company is 0.1D/(D+E), where D is the
amount of debt and E is the amount of equity.
ii. The unlevered cost of capital is 0.15.
iii. The corporate tax rate is 20%.

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The risk-free rate is 0.05 and the market risk premium is 0.10.
Calculate the debt proportion of capital needed to make WACC equal to 0.14.

25. (IFM Study Manual) Beta Supplies has 100 million in debt. It pays 6% interest each
year at the end of year. In addition, it retires 10% of the remaining balance of the
loan at the end of each year.
The corporate tax rate is 0.21.
Calculate the present value at 4% of the tax shield.

OTHER FACTORS AFFECTING OPTIMAL DEBT-EDQUITY RATIO:

(Lesson 11 – IFM Study Manual Page 127 to 137)

EQUITY FINANCING:
(Lesson 12 – IFM Study Manual Page 139 to 146)

DEBT FINANCING:
(Lesson 13 – IFM Study Manual Page 147 to 150)