Question

1. Which of the following are ways that a firm can reduce cash flows in order to prevent managers from wastefully spending excess cash flows? Check all that apply.

A) Funneling excess cash flows back to shareholders through higher dividends

B) Minimizing the amount of debt in the firm’s capital structure so that the firm can borrow money at a reasonable rate when good investment opportunities arise

C) Funneling excess cash flows back to shareholders through stock repurchases

D) Increasing the amount of debt in the firm’s target capital structure in the hope that higher debt-service requirements will force managers to be more disciplined

2. General Forge and Foundry Co. currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm’s unlevered beta is 1.16, and its cost of equity is 14.28%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 14.28%. The risk-free rate of interest (rRFrRF) is 5%, and the market risk premium (RP) is 8%. General Forge and Foundry Co.’s marginal tax rate is 35%.

General Forge and Foundry Co. is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. (Question mark data points needed for answer)

D/A Ratio	E/A Ratio	D/E Ratio	Bond Rating	Before-Tax Cost	Levered Beta (b)	Cost of	WACC
				of Debt (rdrd)		Equity (rsrs)
0.0	1.0	0.00	—	—	1.16	14.28	14.28
0.2	0.8	0.25	A	8.10	?	15.80	13.69
0.4	0.6	0.67	BBB	8.50	1.66	18.28	?
0.6	0.4	1.50	BB	10.90	2.29	?	13.58
0.8	0.2	?	C	13.90	4.18	38.44	?

Answer 1

1)	Option A - True
	Option B - True
	Option C - True
	Option D - False
2)
	D/A Ratio	E/A Ratio	D/E Ratio	Bond Rating	Before-Tax Cost	Levered Beta (b)	Cost of	WACC
					of Debt (rdrd)		Equity (rsrs)
	0	1	0	—	—	1.16	14.28	14.28
	0.2	0.8	0.25	A	8.1	1.35	15.8	13.69
	0.4	0.6	0.67	BBB	8.5	1.66	18.28	13.18
	0.6	0.4	1.5	BB	10.9	2.29	23.32	13.58
	0.8	0.2	?	C	13.9	4.18	38.44	14.92
	Calculations:
1)	Levered beta for D/A ratio = 0.2 = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))
	= 1.16*(1+0.65*0.25) =		1.35
2)	WACC for D/A ratio of 0.40 = 8.50*0.65*0.4+18.28*0.6 =					13.18
3)	Cost of equity for D/A = 0.6 = 5+2.29*8 =			23.32
4)	WACC for D/A ratio of 0.80 = 13.90*0.65*0.8+38.44*0.20 =					14.92