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# Optimal Capital Structure for Tangshan Mining Company

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1. Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of \$4.89 per share and dividends are grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to \$5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent.

(a) What is the value per share for Tangshan Mining under the current capital structure?

(b) What is the value per share for Tangshan Mining under the proposed capital structure?

(c) Should Tangshan Mining make the capital structure change? Explain.

2. Zheng Sen's Chinese Take-Out had earnings before interest and taxes of \$40 million last year. The firm has a marginal tax rate of 40 percent and currently has the following capital structure:

(a) Calculate the firm's after-tax return on equity (ROE) and earnings per share EPS)

(b) If the firm retires \$4 million of preferred stock using the proceeds from an equal increase in long-term debt, what would have been the after-tax ROE and EPS?

(c) If the firm retires \$4 million of preferred stock using the proceeds from the sale of 500,000 shares of common stock, what would have been the after-tax ROE and EPS?

3. Global Logistics purchased a new machine on 10/20/2008 for \$1 million on credit. The supplier has offered A&A terms of 2/10, net 45. The current interest rate the bank is offering is 16 percent.

(a) Compute the cost of giving up the cash discount.

(b) Should the firm take or give up the cash discount?

(c) What is the effective rate of interest if the firm decides to take the cash discount by borrowing money?

4. (a) Gerald wants to determine the required return on a stock portfolio with a beta coefficient of 0.5. Assuming the risk-free rate of 6 percent and the market return of 12 percent, compute the required rate of return.

(b) Assuming a risk-free rate of 8 percent and a market return of 12 percent, would Gerald acquire a security with a Beta of 1.5 and a rate of 14 percent given the facts above?

5. A multinational company has two subsidiaries, one in Ireland (local currency = euro) and the other in Denmark (local currency = krone). Pro forma statements of operations indicate the following short-term financial needs for each subsidiary (in equivalent U.S. dollars): Ireland: \$25 million excess cash to be invested (lent to others); Denmark: \$10 million to be raised (borrowed). The following financial data is also available:

(a) Determine the effective rates of interest for the euro and the krone in both the Euromarket and the domestic market.

(b) Where should funds be invested?

(c) Where should funds be raised?

The following 20 multiple choice questions are each worth 2.5 points each. You do not need to show your work here - your response is either correct or incorrect.

6. Bags-N-Things has an issue of \$1,000 par value bonds with a 14 percent annual coupon interest rate. The issue has 10 years remaining to the maturity date. Bonds of similar risk are currently selling to yield a 12 percent rate of return. The current value of each B-N-T bond is _____.

A. \$791.00
B. \$1,000.00
C. \$1,052.24
D. \$1,113.00

7. A bond will sell at a premium when its required return rises above its coupon interest rate.

A. True
B. False

8. The nominal rate of interest is composed of:

A. The real rate plus an inflationary expectation
B. The real rate plus a risk premium
C. The risk-free rate plus an inflationary expectation
D. The risk-free rate plus a risk premium

9. The higher the coefficient of variation, the greater the risk and therefore the higher the expected return.

A. True
B. False

10. The _____ measures the dispersion around the expected value.

A. Coefficient of variation
B. Chi square
C. Mean
D. Standard deviation

11. Combining negatively correlated assets can reduce the overall variability of returns.

A. True
B. False

12. A partnership between a multinational company and a foreign investor in which contractually specified amounts of money and expertise are contributed by the participants for stated proportions of ownership and profit is a

A. Multinational corporation
B. Floating relationship
C. Joint venture
D. Consolidation

13. Noranda Mines, a U.S.-based MNC, has a foreign subsidiary that earns \$1,050,000 before local taxes, with all the after-tax funds to be available to the parent in the form of dividends. The foreign income tax rate is 30 percent, the foreign dividend withholding tax rate is 15 percent, and the firm's U.S. tax rate is 35 percent. What are the funds available to the parent MNC if no tax credits are allowed?

A. \$624,750
B. \$425,250
C. \$257,250
D. \$735,000

14. A financial analyst is responsible for maintaining and controlling the firm's daily cash balances, frequently manages the firm's short-term investments and coordinates short-term borrowing and banking relationships.

A. True
B. False

15. The sole proprietor has unlimited liability; his or her total investment in the business, but not his or her personal assets, can be taken to satisfy customers.

A. True
B. False

16. The _____ has/have the ultimate responsibility in guiding corporate affairs and carrying out policies.

A. Board of Directors
B. Chief Executive Officer
C. Stockholders
D. Creditors

17. The greater the interest rate and the longer the period of time, the higher the present value.

A. True
B. False

18. The future value of \$100 received today and deposited at 6 percent for four years is

A. \$126
B. \$79
C. \$124
D. \$116

19. The future value of a dollar _____ as the interest rate increases and _____ the farther in the future an initial deposit is to be received.

A. Decreases; decreases
B. Decreases; increases
C. Increases; increases
D. Increases; decreases

20. The FVIFA is the future value of \$1 ordinary annuity for n periods compounded at i percent.

A. True
B. False

21. Sensitivity analysis is a behavioral approach that uses several possible values for a given variable, such as cash inflows, to assess that a variable's impact on the firm's return.

A. True
B. False

22. If bankruptcy were to occur, stockholders would have prior claim on assets over

A. Preferred stockholders
B. Secured creditors
C. Unsecured creditors
D. No one

23. Preferred stock is a special form of stock having a fixed periodic dividend that must be paid prior to payment of any interest to outstanding bonds.

A. True
B. False

24. Like bonds, the par value on a common stock is used as a basis for determining its fixed dividend.

A. True
B. False

25. A firm has the balance sheet accounts "Common Stock" and "Paid-in Capital in Excess of Par" with values of \$10,000 and \$250,000 respectively. The firm has 10,000 common shares outstanding. If the firm had a par value of \$1, the stock originally sold for

A. \$24/share
B. \$25/share
C. \$26/share
D. \$30/share

#### Solution Preview

1. Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of \$4.89 per share and dividends grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to \$5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent.

(a) What is the value per share for Tangshan Mining under the current capital structure?
40% Debt
Ke 10.89%
Growth Rate 5%
Dividend (Div) 4.89

Value of shares (Div/(Ke - G)) 83.02

(b) What is the value per share for Tangshan Mining under the proposed capital structure?
50% Debt
Ke 11.34%
Growth Rate 6%
Dividend (Div) 5.24

Value of shares (Div/(Ke - G)) 98.13

(c) Should Tangshan Mining make the capital structure change? Explain.
It is more advisable that the company restructure its capital. This is because the share value will increase from \$83.02 to \$98.13

2. Zheng Sen's Chinese Take-Out had earnings before interest and taxes of \$40 million last year. The firm has a marginal tax rate of 40 percent and currently has the following capital structure:

(a) Calculate the firm's after-tax return on equity (ROE) and earnings per share EPS)
Zheng Sen Take out
Earnings 40,000,000

PAYMENTS VALUA
Debt 8,800,000 12% 1,056,000
Preferred stock 8,000,000 14% 1,120,000
Total payments 2,176,000
Taxes (40% x (40000000 - total payments) 15,129,600
residual Income 22,694,400
Shares 2,000,000
EPS (residual income/no. of shares) 11.35
ROE (residual income/total equity) 1.42

(b) If the firm retires \$4 million of preferred stock using the proceeds from an equal increase in long-term debt, what would have been the after-tax ROE and EPS?
Zheng Sen Take out
Earnings 40,000,000

PAYMENTS VALUA
Debt 12,000,000 12% 1,440,000
Preferred stock -
Total payments 1,440,000
Taxes 15,424,000
residual Income 23,136,000
Shares 2,000,000
EPS 11.57
ROE 1.45
Practically no effect or change in both ratios.
(c) If the firm retires \$4 million of preferred stock using the proceeds from the sale of 500,000 shares of common stock, what would have been the after-tax ROE and EPS?
Zheng Sen Take out
Earnings 40,000,000

PAYMENTS VALUA
Debt 12,000,000 12% 1,440,000
Preferred stock -
Total payments 1,440,000
Taxes 15,424,000
residual Income 23,136,000
Shares 2,500,000
EPS 9.25
ROE 1.16
Both ratios will decrease.

3. Global Logistics purchased a new machine on 10/20/2008 for \$1 ...

#### Solution Summary

The solution examines Tangshan Mining Company as it chooses an optimal capital structure.

\$2.49