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# Theories of capital structure, risk, CAPM & interest rate swap

1. Why are some corporate financial managers reluctant to issue new common stock when funding long-term capital projects?

What theories of capital structure help to explain this behavior?

2. Define the following categories of risk faced by corporations:

? Financial Risk and Business Risk.
? What is the difference between the two?
? How are each measured?

3. Briefly describe what the "clientele effect" is and its implications for a firm's dividend policy.

4. A corporation is trying to determine its optimal capital structure, which now consists only of debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

Debt to Asset Ratio Equity to Asset Ratio Bond Rating Before Tax Cost of Debt
0.0 1.0 A 6.5%
0.2 0.8 BBB 7.5
0.4 0.6 BB 9.5
0.6 0.4 C 10.5
0.8 0.2 D 14.5

The firm uses CAPM to estimate its cost of common equity, ks. The company estimates that the risk free rate is 6 percent, the market risk premium (rm - rf ) is 5 percent, and its tax rate is 40 percent. It is also estimated that if the company had no debt, its "unlevered Beta", bU, would be 1.25. On the basis of this information, what would be the company's optimal debt equity mix and what would the weighted average cost of capital (WACC) be at this optimal capital structure? Show your calculations and a graph to support your answer.

5. Capital Corp. can issue floating rate debt at the variable rate, LIBOR + 1.2 percent, and can issue fixed rate debt at 8.95 percent. Shore Corp. can issue floating rate debt at LIBOR + 1.6 percent and can issue fixed rate debt at 9.3 percent. Suppose Capital issues floating rate debt and Shore issues fixed rate debt. They engage in the following interest rate swap: Capital will make a fixed 8.05 percent payment to Shore, and Shore will make a floating rate payment equal to LIBOR+.05 to Capital. What are the resulting net payments of Capital and Shore? If Capital and Shore would like to change the type of debt they hold and lower their borrowing costs, would this swap make sense?

#### Solution Summary

The solution presents a comprehensive response including a graph for better understanding of the issues.

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