Académique Documents
Professionnel Documents
Culture Documents
Answer:
Claims
Debt
800 Equity
800
300
500
800
2b. ABC's cost of debt (rd) for the capital structure found in part 2a is 5.0%. Find ABC's
cost of equity (re) for the capital structure found in part 2a.
Answer:
Original: WACC = wd(rd) + we(re) = .25(4%) + .75(12%) = 10%
Because of the "perfect markets" assumption, we know that firm value, share price,
and WACC all are constant, regardless of capital structure.
Restructured: WACC = wd(rd) + we(re) = 10% = .375(5%) +.625(re), re= 13%
2c. (5 points) Carefully explain why ABC's cost of equity (re) changes when ABC changes its capital structure.
Answer:
An increase in financial leverage results in an increase in the risk and required return of equity.
Increased financial leverage increases the risk of equity because debt is the priority claim; as the amount
of debt increases, any risk in the cash flows produced by the firm's assets is concentrated on a smaller
and smaller equity claim, making the risk larger and larger.
3. Carefully explain how the existence of "bankruptcy costs" can affect a firm's optimal capital
structure.
Answer: Even the threat of bankruptcy can have large effects on the value of a company,
such as lost sales, or the loss of valuable employees. Because the threat of bankruptcy
increases with financial leverage, companies with large bankruptcy costs tend to have less
debt in their optimal capital structure.
4. The assets of firm A are expected to provide cash flows that are more risky than the cash flows
expected from the assets of firm B. Does this mean that the required rate of return on equity is
higher for firm A than for firm B? Carefully explain why or why not.
Answer: Not necessarilyIf firm B uses more financial leverage, then the additional financial risk may
sufficiently increase the risk and required rate of return on firm Bs equity so that it is higher than that of firm As
equity.
Working Capital Questions