Determine various measures of business risk.

Determine theoretical optimal capital structure

Chapter 16 Problems: 1, 2, 3, 4, 5, 6, 7, 8.
i) Response to the Problems should be in APA format, including inserted Excel
spreadsheets and tables properly formatted and a cover page.
b) Chapter 17 Mini Case: "a" thru "e"
i) All assignments must be submitted to the instructor in Word 2003 format. If you are
utilizing another version please convert the file prior to sending it to the instructor.
ii) Response to the Problems and the Mini Case should be in APA format, including
inserted Excel spreadsheets and tables properly formatted and a cover page. Submit both
assignments to the instructor in one paper by the end of Module 6.

Chapter 16
1) Shapland Inc. has fixed operating costs of $500,000 and variable costs of $50 per
unit. If it sells the product for $75 per unit, what is the break-even quantity?
2) Counts Accounting has a beta of 1.15. The tax rate is 40% and Counts is financed
with 45% debt. What is Countss unlevered beta?
3) Ethier Enterprise has an unlevered beta of 1.0. Ethier is financed with 50% debt
and has a levered beta of 1.6. If the risk-free rate is 5.5% and the market risk
premium
is 6%, how much is the additional premium that Ethiers shareholders
require to be compensated for financial risk?
4) Nichols Corporations value of operations is equal to $500 million after a
recapitalization
(the firm had no debt before the recap). It raised $200 million in new
debt and used this to buy back stock. Nichols had no short-term investments
before or after the recap. After the recap, wd _ 0.4. What is S (the value of equity
after the recap)?
5)Lee Manufacturings value of operations is equal to $900 million after a
recapitalization
(the firm had no debt before the recap). Lee raised $300 million in new debt
and used this to buy back stock. Lee had no short-term investments before or after
the recap. After the recap, wd _ 1/3. The firm had 30 million shares before the
recap. What is P (the stock price after the recap)?
6)Dye Trucking raised $150 million in new debt and used this to buy back stock.
After the recap, Dyes stock price is $7.5. If Dye had 60 million shares of stock
before the recap, how many shares does it have after the recap?
7)
Schweser Satellites Inc. produces satellite earth stations that sell for $100,000
each. The firms fixed costs, F, are $2 million; 50 earth stations are produced
and sold each year; profits total $500,000; and the firms assets (all equity
financed) are $5 million. The firm estimates that it can change its production
process, adding $4 million to investment and $500,000 to fixed operating costs.
This change will (1) reduce variable costs per unit by $10,000 and (2) increase
output by 20 units, but (3) the sales price on all units will have to be lowered
to $95,000 to permit sales of the additional output. The firm has tax loss
carryforwards
that cause its tax rate to be zero, its cost of equity is 16%, and it uses
no debt.
a. What is the incremental profit? To get a rough idea of the projects profitability,
what is the projects expected rate of return for the next year (defined as
the incremental profit divided by the investment)? Should the firm make the
investment?
b. Would the firms break-even point increase or decrease if it made the change?
c. Would the new situation expose the firm to more or less business risk than the

old one?

(16-7)
978-1-111-03259-3, Financial Management: Theory and Practice, 12e, Eugene F. Brigham, Michael C. Ehrhardt -
Cengage Learning

Problems 601

Here are the estimated ROE distributions for Firms A, B, and C:

Probability
0.1 0.2 0.4 0.2 0.1
Firm A: ROEA 0.0% 5.0% 10.0% 15.0% 20.0%
Firm B: ROEB (2.0) 5.0 12.0 19.0 26.0
Firm C: ROEC (5.0) 5.0 15.0 25.0 35.0

a. Calculate the expected value and standard deviation for Firm Cs ROE. ROE A _
10.0%, _A _ 5.5%; ROEB _ 12.0%, _B _ 7.7%.
b. Discuss the relative riskiness of the three firms returns. (Assume that these
distributions are expected to remain constant over time.)
c. Now suppose all three firms have the same standard deviation of basic earning
power (EBIT/Total assets), _A _ _B _ _C _ 5.5%. What can we tell about
the financial risk of each firm?
16-8)
Here are the estimated ROE distributions for Firms A, B, and C:
Probability
0.1 0.2 0.4 0.2 0.1
Firm A: ROEA 0.0% 5.0% 10.0% 15.0% 20.0%
Firm B: ROEB (2.0) 5.0 12.0 19.0 26.0
Firm C: ROEC (5.0) 5.0 15.0 25.0 35.0

a. Calculate the expected value and standard deviation for Firm Cs ROE. ROE A _
10.0%, _A _ 5.5%; ROEB _ 12.0%, _B _ 7.7%.
b. Discuss the relative riskiness of the three firms returns. (Assume that these
distributions are expected to remain constant over time.)
c. Now suppose all three firms have the same standard deviation of basic earning
power (EBIT/Total assets), _A

8-1-111-03259-3, Financial Management: Theory and Practice, 12e, Eugene F. Brigham, Michael C. Ehrhardt -
Cengage Learning

638 Chapter 17 Capital Structure Decisions: Extensions

Mini Case
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level
of debt financing. The company uses short-term debt to finance its temporary
working
capital needs, but it does not use any permanent (long-term) debt. Other solar
technology companies average about 30% debt, and Mr. Lyons wonders why they
use so much more debt and how it affects stock prices. To gain some insights into
the matter, he poses the following questions to you, his recently hired assistant:
a. BusinessWeek recently ran an article on companies debt policies, and the
names Modigliani and Miller (MM) were mentioned several times as leading
researchers on the theory of capital structure. Briefly, who are MM, and what
assumptions are embedded in the MM and Miller models?
b. Assume that Firms U and L are in the same risk class, and that both have
EBIT _ $500,000. Firm U uses no debt financing, and its cost of equity is r sU _
14%. Firm L has $1 million of debt outstanding at a cost of rd _ 8%. There are
no taxes. Assume that the MM assumptions hold, and then:
(1) Find V, S, rs, and WACC for Firms U and L.
(2) Graph (a) the relationships between capital costs and leverage as measured
by D/V, and (b) the relationship between value and D.
c. Using the data given in part b, but now assuming that Firms L and U are both
subject to a 40% corporate tax rate, repeat the analysis called for in b-(1) and
b-(2) under the MM with-tax model.
d. Now suppose investors are subject to the following tax rates: Td _ 30% and
Ts _ 12%.
(1) What is the gain from leverage according to the Miller model?
(2) How does this gain compare with the gain in the MM model with
corporate taxes?
(3) What does the Miller model imply about the effect of corporate debt on
the value of the firm; that is, how do personal taxes affect the situation?
e. What capital structure policy recommendations do the three theories (MM
without taxes, MM with corporate taxes, and Miller) suggest to financial managers?
Empirically, do firms appear to follow any one of these guidelines?