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
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III. Problems P"o%l!& '
6or the following problem, assume that7 k d # k s 9 k a )*#T
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%ost of debt #nterest %ost of e&uit" :arket value of the firm ;eighted average cost of capital )arnings before interest and taxes