1 Questions and Exercises

CHAPTER 2
CAPITAL STRUCTURE
BASIC

1. Corporate Voting The shareholders of the Stackhouse Company need to elect seven new
directors. There are 960,000 shares outstanding currently trading at $48 per share. You would like to
serve on the board of directors; unfortunately no one else will be voting for you. How much will it cost
you to be certain that you can be elected if the company uses straight voting? How much will it cost
you if the company uses cumulative voting?

2. Cumulative Voting The shareholders of Bryant Power Corp. need to elect three new directors to
the board. There are 16,500,000 shares of common stock outstanding, and the current share price is
$13.75. If the company uses cumulative voting procedures, how much will it cost to guarantee
yourself one seat on the board of directors?

3. Financial Leverage Frusciante, Inc., has 290,000 bonds outstanding. The bonds have a par value
of $1,000, a coupon rate of 7 percent paid semiannually, and 8 years to maturity. The current YTM on
the bonds is 7.5 percent. The company also has 10 million shares of stock outstanding, with a market
price of $23 per share. What is the company’s market value debt–equity ratio?

4. Financial Leverage Harrison, Inc., has the following book value balance sheet:

a. What is the debt–equity ratio based on book values?

b. Suppose the market value of the company’s debt is $225 million and the market value of equity is
$670 million. What is the debt–equity ratio based on market values?
c. Which is more relevant, the debt–equity ratio based on book values or market values? Why?

5. EBIT and Leverage Music City, Inc., has no debt outstanding and a total market value of
$295,000. Earnings before interest and taxes, EBIT, are projected to be $23,000 if economic
conditions are normal. If there is strong expansion in the economy, then EBIT will be 25 percent
higher. If there is a recession, then EBIT will be 40 percent lower. The company is considering an
$88,500 debt issue with an interest rate of 8 percent. The proceeds will be used to repurchase shares
of stock. There are currently 5,000 shares outstanding. Ignore taxes for this problem.
 Corporate Finance 11th edition by Ross, Westerfield, Jaffe, and Jordan 2

a. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is
issued. Also calculate the percentage changes in EPS when the economy expands or enters a
recession.
b. Repeat part (a) assuming that the company goes through with recapitalization. What do you
observe?
c. Suppose the company in Problem 1 has a market-to-book ratio of 1.0. Calculate return on equity,
ROE, under each of the three economic scenarios before any debt is issued. Also calculate the
percentage changes in ROE for economic expansion and recession, assuming no taxes.

6. Break-Even EBIT Franklin Corporation is comparing two different capital structures, an all-equity
plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 315,000 shares of
stock outstanding. Under Plan II, there would be 225,000 shares of stock outstanding and $4.14
million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes.
a. If EBIT is $750,000, which plan will result in the higher EPS?
b. If EBIT is $1,750,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
d. Use MM Proposition I to find the price per share of equity under each of the two proposed plans.
What is the value of the firm?

7. Homemade Leverage Star, Inc., a prominent consumer products firm, is debating whether or not
to convert its all-equity capital structure to one that is 35 percent debt. Currently there are 6,000
shares outstanding and the price per share is $58. EBIT is expected to remain at $39,600 per year
forever. The interest rate on new debt is 7 percent, and there are no taxes.
a. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the
current capital structure, assuming the firm has a dividend payout rate of 100 percent?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that
she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all-equity capital structure.
Show how she could unlever her shares of stock to recreate the original capital structure.
d. Using your answer to part (c), explain why the company’s choice of capital structure is irrelevant.

8. Calculating WACC Weston Industries has a debt–equity ratio of 1.5. Its WACC is 10.5 percent,
and its cost of debt is 6 percent. The corporate tax rate is 35 percent.
a. What is the company’s cost of equity capital?
b. What is the company’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt–equity ratio were 2? What if it were 1.0? What if it were
zero?

9. Firm Value Janetta Corp. has EBIT of $850,000 per year that is expected to continue in perpetuity.
The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent.
The company also has a perpetual bond issue outstanding with a market value of $1.9 million.
a. What is the value of the company?
b. The CFO of the company informs the company president that the value of the company is $4.3
million. Is the CFO correct?
 3 Questions and Exercises

10. Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms
except that Dietrich is more levered. Both companies will remain in business for one more year. The
companies’ economists agree that the probability of the continuation of the current expansion is 80
percent for the next year, and the probability of a recession is 20 percent. If the expansion continues,
each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession
occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg’s
debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation
requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a
discount rate of 13 percent.
a. What is the value today of Steinberg’s debt and equity? What about that for Dietrich’s?
b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because
the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this
statement?

INTERMEDIATE

11. Valuing Callable Bonds KIC, Inc., plans to issue $5 million of bonds with a coupon rate of 8
percent and 30 years to maturity. The current market interest rates on these bonds are 7 percent. In
one year, the interest rate on the bonds will be either 10 percent or 6 percent with equal probability.
Assume investors are risk-neutral.
a. If the bonds are noncallable, what is the price of the bonds today?
b. If the bonds are callable one year from today at $1,080, will their price be greater or less than the
price you computed in (a)? Why?

12. Valuing Callable Bonds Bowdeen Manufacturing intends to issue callable, perpetual bonds with
annual coupon payments. The bonds are callable at $1,175. One-year interest rates are 9 percent.
There is a 60 percent probability that long-term interest rates one year from today will be 10 percent,
and a 40 percent probability that they will be 8 percent. Assume that if interest rates fall the bonds will
be called. What coupon rate should the bonds have in order to sell at par value?
13. Firm Value Cavo Corporation expects an EBIT of $26,850 every year forever. The company
currently has no debt, and its cost of equity is 14 percent. The tax rate is 35 percent.
a. What is the current value of the company?
b. Suppose the company can borrow at 8 percent. What will the value of the company be if it takes on
debt equal to 50 percent of its unlevered value? What if it takes on debt equal to 100 percent of its
unlevered value?
c. What will the value of the company be if it takes on debt equal to 50 percent of its levered value?
What if the company takes on debt equal to 100 percent of its levered value?

14. MM Proposition I without Taxes Alpha Corporation and Beta Corporation are identical in every
way except their capital structures. Alpha Corporation, an all-equity firm, has 18,000 shares of stock
outstanding, currently worth $35 per share. Beta Corporation uses leverage in its capital structure.
The market value of Beta’s debt is $85,000, and its cost of debt is 9 percent. Each firm is expected to
have earnings before interest of $93,000 in perpetuity. Neither firm pays taxes. Assume that every
investor can borrow at 9 percent per year.
a. What is the value of Alpha Corporation?
b. What is the value of Beta Corporation?
c. What is the market value of Beta Corporation’s equity?
 Corporate Finance 11th edition by Ross, Westerfield, Jaffe, and Jordan 4

d. How much will it cost to purchase 20 percent of each firm’s equity?

e. Assuming each firm meets its earnings estimates, what will be the dollar return to each position in
part (d) over the next year?
f. Construct an investment strategy in which an investor purchases 20 percent of Alpha’s equity and
replicates both the cost and dollar return of purchasing 20 percent of Beta’s equity.
g. Is Alpha’s equity more or less risky than Beta’s equity? Explain.

15. Stock Value and Leverage Green Manufacturing, Inc., plans to announce that it will issue $1.8
million of perpetual debt and use the proceeds to repurchase common stock. The bonds will sell at
par with a coupon rate of 6 percent. Green is currently an all-equity company worth $5.9 million with
350,000 shares of common stock outstanding. After the sale of the bonds, the company will maintain
the new capital structure indefinitely. The company currently generates annual pretax earnings of
$1.35 million. This level of earnings is expected to remain constant in perpetuity. The tax rate is 40
percent.
a. What is the expected return on the company’s equity before the announcement of the debt issue?
b. Construct the company’s market value balance sheet before the announcement of the debt issue.
What is the price per share of the firm’s equity?
c. Construct the company’s market value balance sheet immediately after the announcement of the
debt issue.
d. What is the company’s stock price per share immediately after the repurchase announcement?
e. How many shares will the company repurchase as a result of the debt issue? How many shares of
common stock will remain after the repurchase?
f. Construct the market value balance sheet after the restructuring.
g. What is the required return on the company’s equity after the restructuring?

CHALLENGE

16. Treasury Bonds The following Treasury bond quote appeared in The Wall Street
Journal on May 11, 2004:

Why would anyone buy this Treasury bond with a negative yield to maturity? How is this possible?

17. Business and Financial Risk Assume a firm’s debt is risk-free, so that the cost of debt equals
the risk-free rate, Rf. Define βA as the firm’s asset beta—that is, the systematic risk of the firm’s
assets. Define βs to be the beta of the firm’s equity. Use the capital asset pricing model, CAPM, along
with MM Proposition II to show that βS = βA x (1 + B/S), where B/S is the debt–equity ratio. Assume
the tax rate is zero.

18. Stockholder Risk Suppose a firm’s business operations mirror movements in the economy as a
whole very closely—that is, the firm’s asset beta is 1.0. Use the result of the previous problem to find
the equity beta for this firm for debt–equity ratios of 0, 1, 5, and 20. What does this tell you about the
relationship between capital structure and shareholder risk? How is the shareholders’ required return
on equity affected? Explain.