FIN4131 CAPITAL STRUCTURE

1. Taunton's is an all-equity firm that has 150,000 shares of stock outstanding. Neal, the
financial vice president, is considering borrowing $220,000 at 8.25 percent interest to
repurchase 20,000 shares. Ignoring taxes, what is the value of the firm?

Value per share = $220,000/20,000 = $11

Firm value = 150,000 × $11 = $1,650,000

2. The Christmas Tree Farms, Inc. currently has 45,000 shares of stock outstanding and no
debt. The price per share is $17.50. The firm is considering borrowing funds at 7.5
percent interest and using the proceeds to repurchase 4,000 shares of stock. Ignore taxes.
How much is the firm borrowing?

4,000 × $17.50 = $70,000

3. The Tree House has a pretax cost of debt of 7.9 percent and a return on assets of 11.7
percent. The debt-equity ratio is 0.50. Ignore taxes. What is the cost of equity?

RE = 0.117 + [(0.117 - 0.079) × 0.50] = 13.60 percent

4. The Outlet Mall has a cost of equity of 16.8 percent, a pretax cost of debt of 8.1 percent,
and a return on assets of 14.5 percent. Ignore taxes. What is the debt-equity ratio?

0.17 = 0.145 + [(0.145 - 0.081) × D/E]

D/E = 0.39

5. Brick House Cafe has a 35 percent tax rate and total taxes of $35,280. What is the value
of the interest tax shield if the interest expense is $16,700?

Interest tax shield = 0.35 × $16,700 = $5,845

6. Forbidden Fruit Extracts expects its earnings before interest and taxes to be $325,000 a
year forever. Currently, the firm has no debt. The cost of equity is 16.3 percent and the tax
rate is 35 percent. The company is in the process of issuing $2 million of bonds at par that
carry a 6.5 percent annual coupon. What is the unlevered value of the firm?
VU = [$325,000 × (1 - 0.35)]/0.163 = $1,296,012

7. Kline Construction is an all-equity firm that has projected perpetual earnings before
interest and taxes of $879,000. The current cost of equity is 18.3 percent and the tax rate
is 34 percent. The company is in the process of issuing $6.2 million of 8.5 percent annual
coupon bonds at par. What is the levered value of the firm?
 VU = [$879,000 × (1 - 0.34)]/0.183 = $3,170,163.93
VL = $3,170,163.93 + (0.34 × $6.2m) = $5,278,164

8. Stevenson's Bakery is an all-equity firm that has projected perpetual earnings before
interest and taxes of $138,000 a year. The cost of equity is 13.7 percent and the tax rate is
32 percent. The firm can borrow money at 6.75 percent. Currently, the firm is considering
converting to a debt-equity ratio of 0.45. What is the firm's levered value?

VU = [$138,000 × (1 - 0.32)]/0.137 = $684,963.50

VL = $684,963.50 + [0.32 × (0.45/1.45) × $684,963.50] = $752,987

9. Ready To Go is an all-equity firm specializing in hot ready-to-eat meals. Management has

estimated the firm's earnings before interest and taxes will be $175,000 annually forever.
The present cost of equity is 15.1 percent. Currently, the firm has no debt but is
considering borrowing $750,000 at 9 percent interest. The tax rate is 34 percent. What is
the value of the unlevered firm?

VU = [$175,000 × (1 - 0.34)]/0.151 = $764,901

10. Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of
$826,000 annually forever. Currently, the firm has no debt but is considering borrowing
$650,000 at 6.75 percent interest. The tax rate is 34 percent and the current cost of equity
is 17.2 percent. What is the value of the levered firm?

VU = [$826,000 × (1 - 0.34)]/0.172 = $3,169,534.88

VL = $3,169,534.88 + (0.34 × $650,000) = $3,390,535