Explore BrainMass
Share

Firm Value and Financial Leverage

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

1) Firm value is calculated by adding expected cash flow to the firm's cost of capital under each capital structure. True or False.

2) The degree of financial leverage measures the sensitivity of_______ to changes in ________.

a) net sale, EBIT. b) EBIT, net sales c) EBIT, EPS. d) EPS,EBIT.

3) Explain how diversification affects risk and how correlation between securities affects portfolio risk.

© BrainMass Inc. brainmass.com October 24, 2018, 11:12 pm ad1c9bdddf
https://brainmass.com/economics/finance/firm-value-and-financial-leverage-184841

Solution Preview

1. False. Firm valuation is done by discounting expected cash flows to the firm at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. Thus cash flow is divided by the cost of capital, not added to it.

2. b. The response of earnings before income tax to net sales determines the degree of financial leverage. The greater the operating leverage, the more EBIT will change in response to a change in sales.

3. Each type of investment carries a different type of risk. Exposure to overseas stocks exposes the investor to exchange rate risks, for example. Investing at home carries the risk ...

$2.19
See Also This Related BrainMass Solution

Estimating Free Cash Flow, Return, Financial Leverage etc.

11-1 Meltzer Electronics estimates that its total financing needs for the coming year will be $34.5 million. During the coming fiscal year, the firm's required financing payments on its debt-and-equity financing will toal $12.9 million. The firm's financial manager estimates that operating cash flows for the coming year will total $33.7 million and that the following changes will occur in the accounts noted.

Account Forecast Change
Gross fixed assets $8.9 million
Change in current assets +2.3 million
Change in accounts payable +1.3 million
Change in accrued liabilities +0.8 million

Use the data provided to estimate Meltzer's free cash flow in the coming year.
How much of the free cash flow will the firm have available as a source of new internal financing in the coming year?
How much external financing will Meltzer require during the coming year to meet its total forecast financing need?

11-2 West Coast Manufacturing Company (WCMC) is executing an initial public offering with the following characteristics. The company will sell 10 million shares at an offer price of $25 per share, the underwriter will charge a 7 percent underwriting fee, and the shares are expected to sell for $32 per share by the end of the first-day's trading. Assuming this IPO is executed as expected, answer the following:

Calculate the initial return earned by investors who are allocated shares in the IPO.
How much will WCMC receive from this offering?
What is the total cost (underwriting fee and under pricing) of this issue to WCMC?

What is Financial Leverage and why do firms Use it?

12-1 As Chief Financial Officer of the Magnificent Electronics Corporation (MEC), you are considering a recapitalization plan that would convert MEC from its current all-equity capital structure to one including substantial financial leverage. MEC now has 500,000 shares of common stock outstanding, which are selling for $60 each, and you expect the firm's EBIT to be $2,400,000 per year, for the foreseeable future. The recapitalization proposal is to issue $15,000,000 worth of long-term debt, at an interest rate of 6.0 percent, and use the proceeds to repurchase 250,000 shares of common stock worth $15,000,000. Assuming there are no market frictions such as corporate or personal income taxes, calculate the expected return on equity for MEC shareholders, under both the current all-equity capital structure and under the recapitalization plan.

12-2 The ALL-Star Production Corporation (APC) is considering a recapitalization plain that would convert APC from its current all-equity capital structre to one including some financial leverage. APC now has 10,000,000 shares of common stock outstanding, which are selling for $40.00 each, and you expect the firm's EBIT to be $50,000,000 per year, for the foreseeable future. The recapitalization proposal is to issue $1000,000,000 worth of long-term debt, at an interest rate of 6.50 percent, and use the proceeds to repurchase as many shares as possible, at a price of $40.00 per share. Assume there are no market frictions such as corporate or personal income taxes. Calculate the expected return on equity for APC shareholders, under both the current all-equity capital structure and under the recapitalization plan.

a. Calculate the number of shares outstanding, the per-share price, and the debt-to-equity ratio for APC if the proposed recapitalization is adopted.
b. Calculate the earnings per share (EPS) and the return on equity for APC shareholders, under both the current all-equity capitalization and the proposed mixed debt/equity capital structure.
c. Calculate the breakeven level of EBIT, where earnings per share for APC stockholders are the same, under the current and proposed capital structures.
d. At what level of EBIT will APC shareholders earn zero EPS, under the current and the proposed capital structures?

View Full Posting Details