Question

You have been hired by a company to provide advice on capital structure decisions. One day...

You have been hired by a company to provide advice on capital structure decisions. One day the CEO puts forward the following arguments to you:

a. I have estimated a cost of debt of 4% and a cost of equity of 15% for my firm. As debt is “cheaper” than equity, I would like to issue a bond and buy back shares to reduce the overall cost of capital of my firm.

b. The leverage from the bond issuance will increase my firm’s expected earnings per share (EPS) which should lead to an increase in the firm’s stock price. That will benefit all shareholders, including myself, since I own 5% of the shares.

Assuming perfect capital markets, do you agree with the CEO’s arguments? Explain your reasoning.

Business   Finance   
0 0
Add a commentTranscribed image text
Next >

Homework Answers

Answer #1

I agree to the CEO's arguments, but with a limiting condition that the leverage should not increase beyond the optimum level.

When equity is replaced by the lower cost debt, the overall cost of capital of the firm should decrease. But, this will be upto a level of debt considered normal for the company. Beyond such a level of normal debt, increase in debt will increase the cost of debt and cost of equity as, the market will feel that the riskiness of the firm is increasing as also the probability of bankruptcy. Beyond such normal level of debt, the OCC will start rising.

0 0
Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Log In

Sign Up

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
1. Capital structure decisions and firm value Why focus on the optimal capital structure? A company’s...
1. Capital structure decisions and firm value Why focus on the optimal capital structure? A company’s capital structure decisions address the ways a firm’s assets are financed (using debt, preferred stock, and common equity capital) and is often presented as a percentage of the type of financing used. As with all financial decisions, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also...
DMH Enterprises recently hired you to estimate their cost of capital. The firm’s capital structure consists...
DMH Enterprises recently hired you to estimate their cost of capital. The firm’s capital structure consists 40% debt, 10% preferred stock and 50% common stock. The firm has outstanding bonds with 15 years left to maturity, par value of $1,000 and an annual coupon of 6%. The bonds currently trade for $695.76. The firm's preferred stock is currently selling for $63.64 and pays a dividend of $7. The firm does not plan on issuing new shares of common equity. It...
You were hired as a consultant to AICC Company, whose target capital structure calls for 30%...
You were hired as a consultant to AICC Company, whose target capital structure calls for 30% debt, 5% preferred, and 65% common equity. The Company’s common stock currently sells at $20 per share and just paid $1 annual dividend per share (D1). The dividend is expected to grow at a constant rate of 5% a year. (10 pts) Using the DCF model, what is the company’s cost of common equity. If the firm’s beta is 1.2, the risk-free rate ,rfr...
2) A small, private firm has approached you for advice on its capital structure decision. It...
2) A small, private firm has approached you for advice on its capital structure decision. It is in the specialty retailing business, and it had earnings before interest and taxes last year of $ 500,000. The book value of equity is $1.5 million, but the estimated market value is $ 6 million. The firm has $ 1 million in debt outstanding, and paid an interest expense of $ 80,000 on the debt last year. (Based upon the interest coverage ratio,...
13.) You were hired as a consultant to XYZ Company, whose target capital structure is 35%...
13.) You were hired as a consultant to XYZ Company, whose target capital structure is 35% debt, 9% preferred, and 56% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 4.75%, the cost of common from retained earnings is 13.10%, and the tax rate is 27.00%. The firm will not be issuing any new common stock. What is XYZ's WACC?
Assume you have just been hired as a business manager of Pamela’s Pizza, a regional pizza...
Assume you have just been hired as a business manager of Pamela’s Pizza, a regional pizza restaurant chain. The firm is currently financed with all equity and it has 15 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s owners would be financially better off if the firms used some        debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that...
Assume you have just been hired as a business manager of Pizza Palace, a regional pizza...
Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10million shares outstanding. When you took your corporate finance course, your instructor stated that most firms’ owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he...
You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt,...
You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 10.50%, and the tax rate is 25%. The firm will not be issuing any new stock. What is Quigley's WACC? Round final answer to two decimal places. Do not round your intermediate calculations.
Assume that my optimal capital structure consists of 45% debt and 55% equity. I have $1,000...
Assume that my optimal capital structure consists of 45% debt and 55% equity. I have $1,000 outstanding bonds. Given the following information, calculate the firm’s WACC. rd= 8%. EBT = $100,000. Payout ratio = 55%. Tax rate = 30%. P0= $25. Growth = 1%. Shares outstanding = 10,000. Flotation cost on additional equity = 15%.
You are the CEO of Company A, an all-equity firm. Company A expects to generate earnings...
You are the CEO of Company A, an all-equity firm. Company A expects to generate earnings before interest and taxes (EBIT) of $100 million over the next year. Currently, Company A has 50 million shares outstanding, and its share price is $7.50. You plan to raise $150 million from the bank at an annual interest rate of 8% to repurchase shares. Assume perfect capital markets. What is the firm’s earnings per share if it issues debt?
ADVERTISEMENT
Need Online Homework Help?

Get Answers For Free
Most questions answered within 1 hours.

Ask a Question
ADVERTISEMENT