1. a. Business risk is the riskiness of the firms stock if it uses no debt.

Business risk arises from

uncertainty in projections of the firms cash flows, which in turn means uncertainty about its operating profit and its capital (investment) requirements. In other words, we do not know for sure how large operating profits will be, nor do we know how much we will have to invest to develop new products, build new plants, and so forth. Business risk depends on number of factors: demand variability, sale prices variability, input cost variability, ability to adjust out put price for changes in input costs, the operating leverage. Financial risk is the additional risk placed on the common stockholders as a result of the firms decision to use debt. b. Measuring business risk and financial risk in a total risk sense: A firms stand-alone risk (to its stockholders) is the sum of its business and financial risk: Stand-alone risk = Business risk + Financial risk Within a stand-alone risk framework, business risk can be measured by the standard deviation of the ROE for an unleveraged firm and stand-alone risk can be measured by the standard deviation of the ROE for a leveraged firm. These equations set forth the situation: Stand-alone risk =sROE. Business risk = sROE(U). Financial risk for a leveraged firm = sROE - sROE(U). c. Measuring business risk and financial risk in a market risk framework: Hamada combined the CAPM and the MM with-corporate-taxes model to obtain this expression for beta of a leveraged firm: b = bu + bu(1 - T)(D/E) = Unlevered beta which reflects the riskiness of the firm's assets + increased volatility of the returns to equity due to the use of debt An unleveraged firms beta is determined solely by its business risk, but beta rises as leverage increases.

Thus, in a market risk framework, business risk is measured by the unleveraged beta, bu; financial risk is measured by the change in beta; and stand-alone risk is measured by the leveraged beta, b: Business risk = bU. Financial risk = b bU = bU(1 - T)(D/E) Total market risk = b. d. How business risk affects capital structure decisions: Business risk is the basic risk of a firm's operations without factoring in debt. A firm with greater business risk should use a lower debt ratio in its capital structure. For example, a fine art gallery has more risk than a utility company. A fine art business is subject to changing trends and economic conditions, which make the potential of losing higher. Therefore, it is advisable for businesses in the fine art industry to have a lower debt ratio. The utility company, on the other hand, has a more stable revenue stream and they can use higher debt in its capital structure.

3. S= [EBIT-Kd(D)](1-T)/Ks The numerator is the net income, which is the residual cash flow available to shareholder after deducting the effect of debt and tax. Because firm has no growth, therefore net income does not grows. We use the zero growth discount model to find the value of equity of a firm like what the equation presents. b. If Greta decides to recapitalize, it first must issue more debt and then use the cash from debt issuance to buy back its stock. Below the optimal debt level, when Greta uses more debt and before repurchase, the total market value will increase, shareholder value will decrease and stock price will increase. At the debt level higher than the optimal level, when Greta use more debt and before repurchase, the total market value will decrease, shareholder value will decrease and stock price will decrease as well. In all situations, after repurchase, stock price will remain the same, number of share outstanding decrease, earning per share increase.

2.

All Equity Probabili ty EBIT Interest EBT Taxes Net Income

50% Debt

0.25 $15,000 0 ----------$15,000 6,000 ----------$9,000 ========= == 6.0% n.a.

0.50 $30,000 0 ----------$30,000 12,000 ----------$18,000 ========= == 12.0% n.a. 12.0% 4.2% 0.35

0.25 $45,000 0 ----------$45,000 18,000 ----------$27,000 ========= == 18.0% n.a.

0.25 $15,000 8,250 ----------$6,750 2,700 ----------$4,050 ========= == 5.4% 1.82

0.50 $30,000 8,250 ----------$21,750 8,700 ----------$13,050 ========= == 17.4% 3.64 17.4% 8.5% 0.49

0.25 $45,000 8,250 ----------$36,750 14,700 ----------$22,050 ========= == 29.4% 5.45

ROE TIE E(ROE) Std dev ROE CV

The more debt we use in firms operation, the higher expected ROE and higher risk that the actual ROE will deviate more from expected ROE. It represents the trade off theory between risk and return. 4.
Valuatio n Analysis at Different Capital Structures ($000 for total $): D /V ------0.00% 16.21% 32.15% 48.67% WA CC ------12.00% 11.67% 11.57% 11.68% # Shares ----------7,500 6,284 5,089 3,850 E PS ------2.40 2.67 3.01 3.39

D ----------$0 25,000 50,000 75,000

S ----------$150,000 129,231 105,517 79,091

V ----------150,000 154,231 155,517 154,091

P ------$20.00 20.56 20.74 20.55

100,000 125,000

53,333 23,864

153,333 148,864

65.22% 83.97%

20.44 19.85

11.74% 12.09%

2,609 1,202

3.68 4.37

Optimal Debt Level ($000):

$50,000

5. a. Total Debt=50mil, therefore total market value V=155517(thousands) We use25mil to repurchase stock Share price after repurchase: P= (V-Do)/No=(155517-25000)/6248=20.77 Number of share after repurchase N1=No-(D-Do)/P=6248-(50000-25000)/20.77=5080(thousands) b. Total debt=50mil, therefore total market value V=155517 Share price after repurchase: P= (V-Do)/No=(155517-25000)/6248=20.77 c. Stock price P=20.77 is higher than P=20.74 in the Question 4 at the same debt level 50 million because: we divide (V-Do) by a smaller number of share outstanding (number of share at 25 million debt versus number of share at 0 debt) despite the fact that the numerator VDo is smaller than those of the question 4 because the old debt level in question 4 is 0, but the old debt level in this situation is 25 million. 6.
Valuation Analysis at Different Capital Structures ($000 for total $): WA CC ------12.00% 11.67% 11.57% 11.68% 11.74% # Shares ----------7,500 6,284 5,089 3,850 2,609

D ----------$0 25,000 50,000 75,000 100,000

S ----------$150,000 129,231 105,517 79,091 53,333

V ----------150,000 154,231 155,517 154,091 153,333

D/V ------0.00% 16.21% 32.15% 48.67% 65.22%

P ------$20.00 20.56 20.74 20.55 20.44

EPS ------2.40 2.67 3.01 3.39 3.68

125,000

23,864

148,864

83.97%

19.85

12.09%

1,202

4.37

Optimal Debt Level ($000):

$50,000

EPS is not maximized at the same debt level that maximizes stock price. As we use more debt, the value of WACC began to decrease as we substitute low cost debt to high cost equity. However, when debt increases more, cost of debt and cost of equity also increase, which depress the effect of using more low cost debt instead of high cost equity. At some level, WACC will begin to rise. In this case, the optimal debt level is 50 million dollar. When we use more debt, stock price began to increase, then at a particular debt level,it will decline As we use more debt, EPS increase.

7.a
D ----------$0 25,000 50,000 75,000 100,000 125,000 S ----------$138,462 $118,929 $91,875 $65,000 $31,304 ($13,636) V ----------138,462 143,929 141,875 140,000 131,304 111,364 D /V ------0.00% 17.37% 35.24% 53.57% 76.16% 112.24% P ------$18.46 19.19 18.92 18.67 17.51 14.85 WA CC ------13.00% 12.51% 12.69% 12.86% 13.71% 16.16% #shar es ----------7,500 6,197 4,857 3,482 1,788 (918) E PS ------2.40 2.69 3.03 3.36 4.03 3.27

Optimal Debt Level ($000):

$25,000

b.
D ----------$0 25,000 50,000 75,000 100,000 125,000 S ----------$163,636 $149,348 $126,000 $101,250 $75,000 $48,649 V ----------163,636 174,348 176,000 176,250 175,000 173,649 D /V ------0.00% 14.34% 28.41% 42.55% 57.14% 71.98% P ------$21.82 23.25 23.47 23.50 23.33 23.15 WA CC ------11.00% 10.32% 10.23% 10.21% 10.29% 10.37% #Sha res ----------7,500 6,425 5,369 4,309 3,214 2,101 E PS ------2.40 2.67 2.93 3.29 3.73 4.28

Optimal Debt Level ($000):

$75,000

8. a. Greta Cosmetic value: V= Vu + T.D= 150 + 0.4*50= 170 b. VL=Vu + [1-(1-Tc)(1-Ts)/(1-Td)]D= 167.86 c. The differences between 3 techniques No growth model: V= S +D= (EBIT-rd*D)(1-T)/rS.=155.715 In the Miller model, he brought the effects of personal taxes. The differences between the taxes for interest of stock and bond are the reason why the investors can accept the low before-tax returns on stock relative to bonds. He point out (1) the deductibility of interest favor in using debt, ( 2) the more favorable tax treatment of income from stock. In MM model, they care the corporate taxes and focus on the tax shield as a part of firms value. In no-growth model, it is only depended on the net income and the return of equity. 9. Control would clearly be an issue. There is a danger of loss of control if the company does not use enough debt , and there is also a danger of loss of control (through bankruptcy) if it uses too much debt. If company using too much debt it will be threaten by bankruptcy or lost investment opportunities. If the company decides to raise the long term funds by issuing further equity shares, it dilutes the controlling interest of the present shareholders, as there are more equity shareholders having absolute voting rights. In this case, Greta have 2 options (1) raising debts to invest and develop new products; (2) keeping using and raising equity to invest more. If she uses more equity, she can lose her controlling power in the future. Consequently, she will use more debt to satisfy the managers for catching the opportunities and also remain her power in broad of management.

10.

a. Victoria, the financial advisor, is using the comprehensive and quantitative analysis to develop her analysis by using complex mathematical and statistical modeling, measurement and research. Therefore, the major weaknesses are missing the subjective judgment based on the non-quantifiable information such as management expertise, industry cycles, strength of research and development, and labor relations. As a result, sometimes, she can overestimate and underestimate the firms value, ability in management, human resources that let her make wrong decisions. b.

In the chart, there is a fairly wide range of debt level in capital structure over which value of firm change very little, so it does not make great deal whether capital structure of Greta is 16% or 65% debt ( its optimal capital structure is 32.15%). Therefore the target capital structure best thought of as a range. Furthermore the target capital structure should be in a range due to the uncertainty of raising capital from debt or stock issuance. c. Factors that managers consider when setting their firms target capital structure:

(a) Internal factors (b) External factors (c) General factors (a) Internal factors:

Cost of Capital: The process of raising the funds involves some cost. While planning the capital structure, it should be ensured that the use of the capital should be capable of earning the revenue enough to meet the cost of capital. It should be noted here that the borrowed funds are cheaper than the equity funds so far as the cost of capital is concerned. This is because of two reasons: (a) The interest rates (i.e. the form of return on the borrowed capital) are usually less than the dividend rates (i.e. the form of return on the equity capital). (b) The interest paid on borrowed capital is an allowable expenditure for income tax purposes while the dividends are the appropriate out of the profits. Risk Factor: While planning the capital structure, the risk factor consideration inevitably comes into picture. If the company raises the capital by way of borrowed capital, it accepts the risk in two ways. Firstly, the company has to maintain the commitment of payment of the interest as well as the installments of the borrowed capital, at a predecided rate and at a predecided time, irrespective of the fact whether there are profits or losses. Secondly, the borrowed capital is usually the secured capital. If the company fails to meet its contractual obligations, the lenders of the borrowed capital may enforce the sale of assets offered to them as security. On the other hand, if the company raises the capital by way of equity capital, the risk on the part of the company is minimum. Firstly, as dividend is the appropriation of the profits, if there are no profits, the company may not be paying the dividend for years together, Secondly, the company is not expected to repay the equity capital, unlike borrowed capital, during the lifetime of the company. Thirdly, the company is not required to offer any security or mortgage its assets for raising the funds in the form of equity capital. Control Factor: While planning the capital structure and more particularly while raising additional funds, the control factor plays an important role, especially in case of closely held private limited companies. If the company decides to raise the long term funds by issuing further equity shares or preference shares, it dilutes the controlling interest of the present shareholders / owners, as the equity shareholders enjoy absolute voting rights and preference share holders enjoy limited voting rights. The control factor usually does not come into the picture in case of borrowed capital unless the lender of the long term funds, i.e. Banks or financial institutions, stipulate the appointment of nominee directors on the Board of Directors of the company. (b) External Factors General Economic Conditions: While planning the capital structure, the general economic conditions should be considered. If the economy is in the state of depression, preference will be given to equity form of capital as it will be involving less amount of risk. But it may not be possible always as the investors may not be willing to take the risk. Under such circumstances, the company may be required to go in for borrowed capital. If the capital market is in boom and the interest rates are likely to decline in further, equity form of capital may be considered immediately,

leaving the borrowed form of capital to be tapped in future. It may also be possible to raise more equity capital in boom as the investors may be ready to take risk and to invest. Level of Interest Rates: If funds are available in the capital market, only at the higher rates of the interest, the raising of capital in the form of borrowed capital may be delayed till the interest rates become favorable. Policy of Lending Institutions: If the policy of term lending institutions is rigid and harsh, it will be advisable not to go in for borrowed capital, but the equity capital form should be tapped. Taxation Policy: Taxation policy of the Government has to be viewed from the angles of both corporate taxation and as well as individual taxation. The return on borrowed capital i.e. interest is an allowable deduction for income tax purposes while computing taxable income of the company, while return on equity capital i.e. dividend is not considered like that as it is the appropriation out of the taxable profits. As far as individual taxation is concerned, both interest as well as dividend will be taxable in the hands of lender of the capital subject to specified deductions available for the purposes. Statutory Restrictions: The statutory restrictions prescribed by the Government and various statutes are required to be taken into consideration before the capital structure is planned. The company has to decide the capital structure within the overall framework prescribed by the Government and various statutes. (c) General Factors: Constitution of Company: While deciding about the capital structure, the constitution of the company plays an important role. In case of private limited company, the control factor may be more important while in case of public limited company, cost factor may be more important. Characteristics of Company: Characteristics of the company, in terms of size, age and credit standing play very important role in deciding capital structure. Very small companies and the companies in their early stages of life have to depend more on the equity capital, as they have limited bargaining capacity, they cant tap various sources of raising the funds and they do not enjoy the confidence of the investors. Similarly, the companies having good credit standing in the market, may be in the position to get the funds from the sources of their choice. But this choice may not be available to the companies having poor credit standing. Stability of Earnings: lf the sales and earnings of the company are not likely to be stable enough over a period of time and are likely to be subject to wide fluctuation, the risk factor plays more important role and the company may not be able to have more borrowed capital in its capital structure as it carries more risk. However, if the earnings and sales of the company are fairly constant and stable over the period of time, it may afford to take the risk, where the cost factor or control factor may play important role.

Attitude of the Management: lf the attitude of the management is too conservative, the control factor may play an important role in capital structure decision. If the policy of the management is liberal, the cost factor may get more importance.
11. The company should seek to grow because of some following reasons. First of all, Greta Company has a lot of opportunities to grow fast. According to the James perfume field, the sales had increased sharply in 1994 and were projected to continue increasing in the future. Secondly, until now, the Greta Cosmetic Corporation hasnt ever used debt. If they use more debt to grow, they will receive the deductibility of cost of debt and reach the optimal capital structure. As a result, the investors can see more profits and raise their investments in Greta Company. Additionally, the demand for small-ticket products was stable from 1995, so a new product line is needed to satisfy the various demands of the customers. If Greta does not seek to grow, they can lose their market share due to competing firms in the same industries that they develop some special alternative products. If they decide to grow, this decision can affect the optimal capital structure by: Value of unlevered firm = VU = FCF/(rTS g) Value of (growing) tax shield = VTS = rdTD/(rTS g) So value of levered firm =VL = VU + rdTD/(rTS g) If the firm uses debt and growth rate is positive, then, as firm grows, VL increases, which means value of tax shield increase over time because VU is stable. Therefore, the amount of debt and cost of debt will increase over time and the optimal capital structure would have higher debt ratio. Further a firm with very positive prospects tries to avoid selling stock, rather to raise any required new capital by other means, including using debt beyond the normal target capital structure. So, it supports the idea that Greta uses more debt in its capital structure.