Capital Structure (class Exercise)

CITY UNIVERSITY OF HONG KONG

DEPARTMENT OF ACCOUNTANCY

Capital Structure – Class Exercise

Question 1

You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. Calculate the expected ROE for the firms.

        0% Debt, U        60% Debt, L

Oper. income (EBIT)        $400,000        $400,000

Required investment        $2,500,000        $2,500,000

% Debt        0.0%        60.0%

$ of Debt        $0.00        $1,500,000

$ of Common equity        $2,500,000        $1,000,000

Interest rate        NA        10.00%

Tax rate        35%        35%

Question 2

You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Calculate the ROE of the two financing plans.

        Operating Data                        Other Data        

Capital        $4,000        Higher wd        60%

ROIC = EBIT(1 – T)/Capital        13.00%        Higher interest rate        13%

Tax rate        35%        Lower wd        10%

                Lower interest rate        9%

Question 3

Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%), but its new CFO is considering changing the capital structure so wd = 60.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)