Problem Set on Capital Structure

1. A company estimates that its fixed operating costs are $500,000, and its variable costs are $3.00 per unit sold. Each unit produced sells for $4.00. What is the companys breakeven point? In other words, how many units must it sell before its operating income becomes positive?

2. Harley Motors has $10 million in assets, which is financed with $2 million of debt and $8 million in equity. If Harleys beta is currently 1.2 and its tax rate is 40 percent, what is its unlevered beta, b_U?

3. Grant Corporation currently has assets of $5 million. The firm is 100 percent equity financed. The company currently has net income of $1 million, and it pays out 40 percent of its net income as dividends. Both net income and dividends are expected to grow at a constant rate of 5 percent per year. There are 200,000 shares of stock outstanding, and it is estimated that the current cost of capital is 13.40 percent.

The company is considering a recapitalization where it will issue $1 million in debt and use the proceeds to repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its before-tax cost of debt will be 11 percent, and the cost of equity will rise to 14.5 percent. The company has a 40 percent federal-plus-state tax rate.

a. What is the current share price of the stock (before the recapitalization)?

b. Assuming that the company maintains the same payout ratio, what will be its stock price following the recapitalization?

c. Would you advise Grant to adopt the change in its capital structure? Why?

4. Cyclone Software Company is trying to estimate its optimal capital structure. Cyclones current capital structure consists of 25 percent debt and 75 percent equity; however, management believes the firm should use more debt. The risk-free rate, r_RF, is 5 percent, the market risk premium, (r_M-r_RF), is 6 percent, and the firms tax rate is 40 percent. Currently, Cyclones cost of equity is 14 percent, which is determined on the basis of the CAPM. What would be cyclones estimated cost of equity if it were to change its capital structure from its present capital structure to 50 percent debt and 50 percent equity.

5. Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent debt and 80 percent equity. Blooms debt currently has an 8 percent yield to maturity. The risk-free rate, r_RF, is 5 percent, and the market risk premium, (r_M-r_RF), is 6 percent. Using the CAPM, Bloom estimates that its cost of equity is currently 12.5 percent. The company has a 40 percent tax rate.

a. What is Blooms current WACC?

b. What is the current beta on Blooms common stock?

c. What would Blooms beta be if the company had no debt in its capital structure? (That is, what is Blooms unlevered beta, b_U?)

Blooms Financial staff is considering changing its capital structure to 40 percent debt and 60 percent equity. If the company went ahead with the proposed change, the yield to maturity on the companys bonds would rise to 9.5 percent. The proposed change will have no effect on the companys tax rate.

d. What would be the companys new cost of equity if it adopted the proposed change in capital structure?

e. What would be the companys new WACC if it adopted the proposed change in capital structure?

f. Would you advise Bloom to adopt the proposed change in capital structure? Explain.