Case 18 Questions:

1. The firms beta was estimated at 1.1. Treasury bills were yielding 4% and the expected rate of return on the market index was estimated to be 12%. What is the current weighted average cost of capital of the firm? What effect would a change in the debt to equity ratio have on the weighted average cost of capital and the cost of equity capital of the firm?

a. WACC = (E/V) X (RE) + (D/V) X RD X (1-TC) =Weighted Average Cost of Capital

b. RE = RU + (RU RD) X (D/E) X (1-TC) = Cost of Equity

i. (RU) = Risk-free rate + Beta (Market Rate Risk-free rate)

2. Using various combinations of debt and equity, under the assumption that the costs of each component stays constant,show the effect of increasing leverage on the weighted average cost of capital of the firm. Is there a particular capital structure that maximizes the value of the firm? Use the tab labeled question 3, in the Excel file in Blackboard. Explain.

Propositions I and II (with corporate taxes).

VL = VU + TcD

VU = EBIT (1-Tc)

RU

Under Proposition II with taxes: The cost of equity (RE), is:

RE = RU + (RU RD) X (D/E) X (1-TC)

WACC = (E/V) X (RE) + (D/V) X RD X (1-TC)

3. How would the key profitability ratios of the firm be affected if the firm were to raise all of the capital by issuing 5-year notes? Specifically, Net Profit Margin, ROE and ROA.

4. If you were Clive Jones, what would you recommend to the board and why?

5. What are some issues to be concerned about when increasing leverage?

6. Is it fair to assume that if profitability is positively affected in the short run, due to the higher debt ratio, the stock price would increase? Explain.