A. Under the conditions of the M&M capital structure theory, the firms financing decisions do not have an impact on firm value. When this theory holds (i.e., is true), how do the firms financing decisions affect the firms weighted average cost of capital? Describe how the cost of equity and cost of debt behave as the firm increases its use of debt financing.

B. Presently, H. Swank, Inc., does not use any financial leverage and has total financing equal to $1 million. It is considering refinancing and issuing $500,000 of debt that pays 5 percent interest and using that money to buy back half the firms common stock. Assume that the debt has a 30-year maturity, and that Swank will have no principal payments for 30 years. Swank

currently pays all its net income to common shareholders in the form of cash dividends and intends to continue to do this in the future. The corporate tax rate on the firms earnings is 35 percent. Swanks current income statement (before the debt issue) is as follows:

Net operating income (EBIT) ....................$100,000

Interest expense....................................................... 0

Earnings before taxes .................................$100,000

Income taxes ...............................................(35,000)

Net income ..................................................$ 65,000

1- If Swank issues the debt and uses it to buy back common stock, how much money can the firm distribute to its stockholders and bondholders next year if the firms EBIT remains equal to $100,000?

2- What are Swanks interest tax savings from the issuance of the debt?

3- Are Swanks stockholders better off after the debt issue? Why or why not?