Assignment – Capital Structure

Q1: Molly Corp. has no debt but can borrow at 9%. The firm’s WACC is currently 15%
and the tax rate is 35%.

a) What is Molly’s cost of equity capital?

b) If the firm converts to 25% debt, what will it’s cost of equity be?
c) If the firm converts to 50% debt, what will it’s cost of equity be?
What is Molly’s WACC is parts b and C?

Q2: The following data reflect the current financial condition of the Levine Corporation:
Value of debt (book =market) 1,000,000
Market value of equity 5,257,143
Sales, last 12 months 12,000,000
Variable operating costs (50% of sales) 6,000,000
Fixed operating costs 5,000,000
Tax rate, T (federal-plus-state) 40%

At the current level of debt, the cost of debt, kd, is 8% and the cost of equity, ks, is
10.5%. Management questions whether or not the capital structure is optimal, so the
financial vice-president has been asked to consider the possibility of issuing $1 million
of additional debt and using the proceeds to repurchase stock. It is estimated that if
the leverage were increased by raising the level of debt to $2 million, the interest rate
on new debt would rise to 9% and ks, would rise to 11.5%. The old 8% debt is senior
to the new debt, and it would remain outstanding, continue to yield 8%, and have a
market value of $1 million. The firm is a zero-growth firm, with all of its earnings paid
out as dividend.
a) Should the firm increase its debt to $2 million?
b) If the firm decided to increase its level of debt to $3 million, its cost of the
additional $2 million of debt would be 12% and Ks, would rise to 15%. The
original 8% of debt would again remain outstanding, and its market value
would remain $1 million. What level of debt should the firm choose: $1
million, $2 million, or $3 million.
c) The market price of the firm’s stock was originally $20 per share.
Calculate the new equilibrium stock prices at debt level of $2 million and
$3 million.
d) Calculate the firm’s earnings per share if it uses debt of $1 million, $2
million, and $3 million. Assume that the firm pays out all of its earnings
as dividends. If you find that EPS increase with more debt, does this mean
that the firm should choose to increase its debt to $3 million, or possible
higher?
e) What would happen to the value of the old bonds if the firm uses more
leverage and the old bonds are not senior to the new bonds?