Capital Decisions

1) Does an optimal capital structure exist? Explain capital structure theory and how managers use this theory to guide capital decisions within the firm.

2) Solve the following problem and walk through your solution: Gorp Products Inc. is an all-equity firm with 320,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to grow at a constant 4% rate in the future. The company pays 60% of its earnings and its tax rate is 35%. The company is considering issuing $3,250,000 of 12.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 2.5%, the market risk premium is 8.0%, and the firm's beta is currently 0.75. However, the CFO believes the beta would rise to 0.92 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? [Hint: P0 = (EPS*(1-payout ratio))/(rs - g)]

3) Change one of the inputs to the calculation. What will be the overall changes to the results? What external factors outside of the managers control that could affect the outcome?