1. Identify in the space provided on the left below if the following statements are true (T)...
Question:
1. Identify in the space provided on the left below if the following statements are true (T) or false (F).
(a) Because of differing market imperfections, financing decisions (related to right side of balance sheet) are less easily reversed than investment decisions (related to left side of balance sheet).
(b) Given the current tax code, financing decisions don't affect the total size of cash flow available to all suppliers of capital; they just affect who receives the flows.
(c) When making a dividend decision, managers should primarily be concerned about what signal it conveys to the market.
(d) The semi-strong form of the efficient-market hypothesis states that prices reflect all publicly available information.
(e) In efficient markets the expected return on each stock is the same.
2. You are the financial vice-president of the e-mba.com Corporation. Management is questioning whether or not the existing capital structure is optimal so you have been asked to consider the possibility of issuing $1 million of additional debt and using the proceeds to repurchase stock. The following data reflect the current financial conditions of the e.mba.com Corporation:
Value of debt (book = market)...................................................................................$1,000,000
Market value of equity……………………………………………….......................……$5,257,143
Sales, last 12 months……………………………………………....................….…….$12,000,000
Variable operating costs (50% of sales)..………………………………...................…$6,000,000
Fixed operating costs…………………………………………………......................…..$5,000,000
Tax rate, T (federal-plus-state).………………………………………………….....................40%
At the current level of debt, the cost of debt, kd, is 8 percent and the cost of equity, ke, is 10.5 percent. It is estimated that if the leverage were increased by raising the level of debt to $2 million, the interest rate on new debt would rise to 9 percent and the cost of equity would rise to 11.5 percent. The old 8 percent debt is senior to the new debt, and it would remain outstanding, continue to yield 8 percent, and have a market value of $1 million. The firm is a zero-growth firm, with all of its earnings paid out as dividends.
a. Should the firm increase its debt to $2 million?
b. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2 million of debt would be 12 percent and ke would rise to 15 percent. The original 8 percent of debt would again remain outstanding, and its market value would remain $1 million. What level of debt should the firm choose: $1 million, $2 million, or $3 million?
c. The market price of the firm's stock was originally $20 per share. Calculate the new equilibrium stock prices at debt levels of $2 million and $3 million.
d. What would happen to the value of the old bonds if EMBA.com Corporation uses more leverage and the old bonds are not senior to the new bonds? What would happen to the value of equity? Explain.
3. Do you agree or disagree with the following statements? Briefly explain why.
(a) "In a world of no corporate or personal taxes, no agency costs or information asymmetries, a lower dividend payout will reduce a firm's cost of capital."
(b) "Unlike new capital, which needs a stream of new dividends to service it, retained earnings have zero cost."
(c) "If a company repurchases stock instead of paying a dividend, the number of shares falls and earnings per share rise. Thus stock repurchase must always be preferred to paying dividends."
College Mathematics for Business Economics Life Sciences and Social Sciences
ISBN: 978-0321614001
12th edition
Authors: Raymond A. Barnett, Michael R. Ziegler, Karl E. Byleen