Solutions Manual
CHA HAPTER 24 ASSESSI NG LONGTERM DEBT, EQU QUI TY AND CAPI TALSTRUCTURE SUGGESTED ANSWERS TO THE R EVIEW EVIEW QUESTIONS AND PROBLEMS I.
Questions
1. Capital structure is the composition of a firm’s financing, financing, which consists of its permanent sources of capital. 2. The financia financiall manager’s manager’s object objective ive in making making capital capital structu structure re decisions decisions is to find the financing mix that maximizes the market value of the firm. This structure is called the optimal capital structure. structure . . !nder nder ide ideali alized zed con conditi ditio ons with ith no incom ncomee taxe taxess, the traditional approach approach to capital structure suggests that there is an optimal capital structure which simultaneousl" maximizes the firm’s market value and minimizes its weighted average cost of capital. !nder !nder idealized idealized conditions conditions with no income taxes, the Modigliani and Miller model implies that the total market value and cost of capital are independent of a firm’s capital structure. !nder idealized conditions with corporate income taxes, the Modigliani and Miller Miller model concludes that leverage affects value, and that firms should be financed with virtuall" all debt. !nder !nder relaxed relaxed assumptions assumptions,, the contempor contemporary ary approac approach h suggests that there is an optimal range for the capital structure of the firm. #f the firm finances outside this range, the value of the firm will decline. $. %hoosing %hoosing an optimal optimal or targe targett capital capital structure structure involv involves es tradeoff tradeoff among among opposi opposing ng benefi benefits ts and costs costs and re&uir re&uires es the use use of both both anal" anal"tic tical al techni&ues and informed judgment. '. ( firm firm can anal"z anal"zee its capit capital al struct structure ure b" perform performing ing an )*#T + )anal" anal"sis sis assess assessing ing risk risk associ associate ated d with with variou variouss capita capitall struct structure ures s computing debt management ratios and comparing them with industr" standards and seeking the opinion of lenders, investment anal"sts, and investment bankers. )*#T + )- anal"sis is useful for evaluating the sensitivit" of )- to changes in )*#T under various financing plans. 24-1
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Assessing Long-term Debt, Equity and Capital Structure
/. The indifference point is the )*#T level at which )- is e&ual under alternate financing plans. This point ma" be found either graphicall" or mathematicall". 0. )*#T + )- anal"sis ma" be criticized because it does not directl" consider the longrun financial conse&uences of financing alternatives and concentrates on earnings maximization rather than wealth maximization. . %apital structure decisions are tempered b" such considerations as cash flow, market conditions, profitabilit" and stabilit", control, management preferences, financial flexibilit", and business risk. II. Multiple Choice Questions
1. 2. .
3 3 (
$. '. /.
* * 3
0. . 5.
3 % (
14.
3
III. Problems P"o%l!& '
6or the following problem, assume that7 k d # k s 9 k a )*#T
8 8 8 8 8 8
%ost of debt #nterest %ost of e&uit" :arket value of the firm ;eighted average cost of capital )arnings before interest and taxes
3
4,444 3
8
4,444 4.4
8
1,444,444
24-2
Assessing Long-term Debt, Equity and Capital Structure
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-ubstituting )*#T 8 44,444, # 8 4,444, and k s 8 4.12, the market value of e&uit" is7 - 8
44,444 > 4,444 4.12
8
024,444 4.12
8
/,444,444
-ubstituting 3 8 1,444,444 and - 8 /,444,444, the total market value of the firm is7 9
8 1,444,444 ? /,444,444 8 0,444,444
44,444 0,444,444
8 4.11$ or 11.$@
P"o%l!& #
3
244,444 3
8
244,444 4.4
8
2,'44,444
24-3
Chat!" #$
Assessing Long-term Debt, Equity and Capital Structure
-ubstituting )*#T 8 44,444, # 8 244,444, and k s 8 4.12', the market value of e&uit" is7 - 8
44,444 > 244,444 4.12'
8
/44,444 4.12'
8
$,44,444
-ubstituting 3 8 2,'44,444 and - 8 $,44,444, the total market value of the firm is7 9
8 2,'44,444 ? $,44,444 8 0,44,444
44,444 0,44,444
8 4.145/ or 14.5/@
2,'44,444 8 $,'44,444 24-4
Assessing Long-term Debt, Equity and Capital Structure
Chat!" #$
-ubstituting )*#T 8 44,444, # 8 244,444, and - 8 $,'44,444, the cost of e&uit" is7 k s 8
44,444 > 244,444 $,'44,444
8 4.1 or 1.@
P"o%l!& $
1,'44,444 14,444,444
8 4.1'44 or 1'.44@
P"o%l!& )
3ebt )&uit" Total
A
!
<4.4 x 4.4= <4.04 x 4.1$=
8 2$@ 8 5.@ 12.2@
24-5
<4./4 x 4.14= <4.$4 x 4.1=
8 8
/@ 0.2@ 1.2@
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Assessing Long-term Debt, Equity and Capital Structure
P"o%l!& *
4.$= 4.1'
9alue of the firm with 8 no leverage
$5',444 4.1'
8
8 ,44,444
2. The total market value with 2,444,444 in debt is7 9alue of the firm with 8 ,44,444 ? <4.$= <2,444,444= leverage 8 ,54,444
3ue to the tax shelter, the firm is able to increase its value in a linear manner with more debt. P"o%l!& +
Vu
( * % 3 ) 6
$4,444,444 $4,444,444 $4,444,444 $4,444,444 $4,444,444 $4,444,444
NTD
? ? ? ? ? ?
/44,444 1,244,444 2,$44,444 ,/44,444 $,244,444 ',$44,444
24-6
-D
> > > > > >
4 144,444 2'4,444 44,444 2,444,444 ',444,444
V'
8 8 8 8 8 8
$4,/44,444 $1,144,444 $2,1'4,444 $2,44,444 $2,244,444 $4,$44,444
Assessing Long-term Debt, Equity and Capital Structure
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%apital -tructure 3 is preferred because it provides the greatest market value of the firm.
6 b 8 024,444
!nder lan *, the firm does not have an" fixed financial costs
6 b 8 4
8
)-
<)*#TB + 024= <1 > 4.$= + 4 '44
8
<)*#TB + 4= <1 > 4.$= + 4 0'4
4.// )*#TB + $0'.24 '44
8
4.// )*#TB 0'4
%ross multipl"ing7 <0'4= <4.// )*#TB + $0'.24= $5' )*#TB + '/,$44 1/' )*#TB )*#TB
24-7
8 8 8 8
<'44= <4.// )*#TB= 4 )*#TB '/,$44 2,1/4
Chat!" #$
Assessing Long-term Debt, Equity and Capital Structure
)*#T Cess7 #nterest on new debt )arnings before taxes Cess7 #ncome taxes <$@= Det income
Plan A" Debt
Plan !" #rdinary Equity Share
2,0'4,444 024,444 2,44,444 /54,244 1,5,44
2,0'4,444 4 2,0'4,444 5',444 1,1',444
'44,444 2./
0'4,444 2.$2
Erdinar" e&uit" shares )arnings per share
8
<)*#TB + ,244= <1 > 4.$= + '2' 8 2,444 4.// )*#TB + 2,112 + '2' 2,444
8
)- 4.$= + '2' 2,'44 4.// )*#TB + 1,$'2 + '2' 2,'44
%ross multipl"ing7 <2,'44= <4.// )*#TB + 2,/0= 1,/'4 )*#TB + /,'52,'44 4 )*#TB )*#TB
8 8 8 8
24-8
<2,444= <4.// )*#TB + 1,500= 1,24 )*#TB + ,5'$,444 2,/,'44 0,55'.$''
Assessing Long-term Debt, Equity and Capital Structure
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ȓ
8 5,'44,444, and G 8 1,'44,444, the z
0,55',$'' + 5,'44,444 1,'44,444
8
+ 1,'4$,'$' 1,'44,444
8
+ 1.44
The area under the normal curve with a z 8 + 1.44 is 4.$1. The probabilit" that )*#T will be below the indifference point of 0,55',$'' is 4.1'0 <4.'444 + 4.$1=, or 1'.0 percent.
)*#T Cess7 #nterest on existing debt #nterest on new debt )arnings before taxes Cess7 #ncome taxes <$@= Det income Cess7 referred share dividends )arnings available to ordinar" e&uit" shareholders Erdinar" e&uit" shares )arnings per share
Plan $" Debt
Plan %" #rdinary Equity Share
5,'44,444 2,244,444 1,444,444 /,44,444 2,1$2,444 $,1',444 '2',444
5,'44,444 2,244,444 4 0,44,444 2,$2,444 $,1,444 '2',444
,/,444
$,25,444
2,444,444 1.2
2,'44,444 1.02
