Chapter 17 - Capital Structure: Limits to the Use of Debt
62. The Do-All-Right Marketing Research firm has promised payments to its bondholders that total $100. The company believes that there is a 85% chance that the cash flow will be sufficient to meet these claims. However, there is a 15% chance that cash flows will fall short, in which case total earnings are expected to be $65. If the bonds sell in the market for $84, what is an estimate of the bankruptcy costs for Do-All-Right? Assume a cost of debt of 10%.
The expected amount bondholders receive if cash flows fall short under bankruptcy is: $84 = [($100 * .85) + (X * .15)]/1.1; X = $49.34
Without bankruptcy costs, the bonds would sell for: [(100 * .85) + ($65 * .15)]/1.1 = $86.14 Therefore, estimated bankruptcy costs must be $65.00 - $49.34 = $15.66.Impact on price is (.15(15.66))/1.1 = $2.14
Topic: BANKRUPTCY COSTS Type: ESSAYS
63. Establishing a capital structure for a firm is not simple. Although financial theory guides the process, there is no simple formula. List and explain four main items that one should consider in determining the capital structure.
Some points to consider are:
o Taxes--tax shield to debt if TC > TB
o Type of Assets--tangible assets based firms have lower costs of financial distress
o Uncertainty of operating income--firms in higher risk classes have greater probability of experiencing financial distress
Pecking order and Financial slack--External financing is more expensive. Financial slack allows for shortfall coverage
Topic: CAPITAL STRUCTURE CONSIDERATIONS Type: ESSAYS
Wigdor Manufacturing is currently all equity financed, has an EBIT of $2 million, and is in the 34% tax bracket. Louis, the company's founder, is the lone shareholder.
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Chapter 17 - Capital Structure: Limits to the Use of Debt
64. If the firm were to convert $4 million of equity into debt at a cost of 10%, what would be the total cash flow to Louis if he holds all the debt? Compare this to Louis' total cash flow if the firm remains unlevered.
Topic: TOTAL CASH FLOW FOR THE UNLEVERED FIRM Type: ESSAYS
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Chapter 17 - Capital Structure: Limits to the Use of Debt
65. Assume that all earnings are paid out as dividends. Now consider the fact that Louis must pay personal tax on the firm's cash flow. Louis pays taxes on interest at a rate of 33%, but pays taxes on dividends at a rate of 28%. Calculate the total cash flow to Louis after he pays personal taxes.
Topic: TOTAL CASH FLOW AFTER PERSONAL TAXES Type: ESSAYS
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Chapter 17 - Capital Structure: Limits to the Use of Debt
66. Consider an economy in which there are three groups of investors and no others.
There are no personal taxes on income from stocks. An investment is available that pays a tax-free 4%. The corporate tax rate is 50%. Total corporate income before earnings and taxes (EBIT) is $224 million forever. What is the maximum debt-to-equity ratio for the economy as a whole?
The interest rate on debt = .04/(1 - .5) = .08
Total corporate value = [224 - (800 * .08)] [1 - .5]/04 = $2,000
Note - Doctors are indifferent about holding debt, so they will hold debt. Maximum debt to equity ratio = $800/$2,000 = .40 = 40%
Topic: CAPITAL STRUCTURE Type: ESSAYS
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