Explore BrainMass
Share

# WACC: Capital Structure and Equity

This content was STOLEN from BrainMass.com - View the original, and get the already-completed solution here!

On January 1, the total market value of the Tysseland Company was \$60 million. During the year, the company plans to raise and invest \$30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt \$30,000,000
Common Equity 30,000,000
Total capital \$60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently selling at \$30 a share. Stockholder's required rate of return is estimated to be 12 percent, consisting of a dividend yield of 4 percent and an expected constant growth rate of 8 percent. (The next expected dividend is \$1.20, so \$1.20/\$30 = 4%.) The marginal corporate tax rate is 40 percent.

a. To maintain the present capital structure, how much of the new investment must be financed by common equity?

b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity. What is the WACC?

c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?

#### Solution Preview

On January 1, the total market value of the Tysseland Company was \$60 million. During the year, the company plans to raise and invest \$30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt \$30,000,000
Common Equity 30,000,000
Total capital \$60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently selling at \$30 a share. Stockholder's ...

#### Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment in text file.

\$2.19

## Equity, capital structure, WACC, after-tax cost of debt, stock, and leverage

True/False-
1. The firm's cost of external equity capital is the same as the required rate of return on the firms outstanding common stock_________
2. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost__________
3. A firm's capital structure has no impact on the firm's weighted average cost of capital_________.
4. The after-tax cost of debt contributes to the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm_________
5. Flotation costs associated with issuing new equity cause the cost of external equity to be lower than the cost of retained earnings_________.
6. The optimal capital structure is that capital structure which strikes a balance between risk and return such that the firm's stock price is maximized__________.
7. The ability of a firm to raise the sufficient capital under adverse conditions in order to sustain steady operations is referred to as financial flexibility_________.
8. The management of a firm can control the degree of total leverage to some extent_______.
9. The fact that interest is tax deductible tends to make corporate debt less expensive than common or preferred stock__________.
10. The probability of incurring bankruptcy increases as the firm debt/equity ratio decreases_________.
11. The degree of operating leverage is defined as the percentage change in operating earnings associated with a given percentage change in sales________.

Multiple Choice-
1. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?
a) Long-term debt
b) Common Stock
c) Short-term debt.
d) Preferred stock.
e) All of the above are considered capital components

2. If a firm can shift its capital structure so as to change its WACC, which would be preferred?
a) Decrease the WACC which will increase the value of the firm
b) Increase the WACC because this will increase the value of the firm
c) Decrease the WACC because this will decrease the value of the firm
d) Increase the WACC because this will decrease the value of the firm
e) None of the above

3. The firm's WACC is:
a) Set by the Board of Directors because it is the benchmark they use to evaluate upper management.
b) Regulated by the IRS because tax-deductible debt is included in the computation
c) Determined by the financial markets because investors provide the funds used by firms and these funds have costs, which are the return demanded by investors.
d) The same as the firm's IRR
e) The total NPV of all the capital budgeting projects in which the firm invests in any year.

4. The target capital structure of the firm is the capital structure that
a) Minimizes the operating risk of the firm's assets
b) Maximizes the earnings per share potential
c) Minimizes the default risk of long-term debt
d) Maximizes the price of the firm's stock.
e) None of the above

5. The combination of debt and equity that maximizes a firm's value is known as the
a) Degree of financial leverage (DFL)
b) Maximum WACC
d) Optimal capital structure

6. A firm should raise capital according to its optimal capital structure so as to minimize its
a) EPS
b) Market value
c) Net income
d) Weighted Average Cost of Capital (WACC)

7. Which of the following is not one of the four primary factors that influence capital structure decisions?
b) Tax position
c) Financial flexibility
d) The firm's inventory valuation method
e) The firm's managerial attitude

8. As a general rule, the capital structure that
a) Maximizes expected EPS also maximizes the price per share of common
b) Minimizes the interest rate on debt also maximizes the expected EPS
c) Minimizes the required rate on equity also maximizes the stock price
d) Maximizes the price per share of common also minimizes the WACC
e) None of the above.

Problems-
1. The Foster Company's financing plans for next year include the sale of long-term bonds with a 10% coupon. They believe they can sell the bonds at a price that will provide a YTM of 12%. If the marginal tax rate is 34%, what is Foster's after-tax cost of debt?

2. Markely Industries plans to issue some \$100 par preferred stock with an 11% dividend. The stock is selling on the market for \$97 and Markely must pay flotation costs of 5% on the market price. What is the cost of the preferred stock to Markely?

3. The Carson Company's next expected dividend is \$3.18; it's growth rate is 6%; and its stock currently sells for \$36 a share. New stock can be sold to net the firm \$32.40 per share.
a) What is Carson's percentage flotation cost?
b) What is Carson's cost of new common stock?

4. The Robert's Company has operating leverage of 1.5 and financial leverage of 2.0. What is the Company's degree of total leverage?

5. What would be the degree of financial leverage of Steel Works Corp. if EBIT = \$20,000, interest expense = \$10,000, the marginal tax rate = 40% and net income = \$6,000?

View Full Posting Details