1.You own your own firm, and you want to raise $30 million to fund an expansion. Currently, you own 100% of the firm’s equity, and the firm has no debt. To raise the $30 million solely through equity, you will need to sell two-thirds of the firm. However, you would prefer to maintain at least a 50% equity stake in the firm to retain control.

a. If you borrow $20 million, what fraction of the equity will you need to sell to raise the remaining $10 million? (Assume perfect capital markets.)

b. What is the smallest amount you can borrow to raise the $30 million without giving up control? (Assume perfect capital markets.)

2.Empire Industries forecasts net income this coming year as shown below (in thousands of dollars):

Approximately $200,000 of Empire’s earnings will be needed to make new, positive-NPV investments. Unfortunately, Empire’s managers are expected to waste 10% of its net income on needless perks, pet projects, and other expenditures that do not contribute to the firm. All remaining income will be returned to shareholders through dividends and share repurchases.

a. What are the two benefits of debt financing for Empire?

b. By how much would each $1 of interest expense reduce Empire’s dividend and share repurchases?

c. What is the increase in the total funds Empire will pay to investors for each $1 of interest expense?

3.Ralston Enterprises has assets that will have a market value in one year as follows:

That is, there is a 1% chance the assets will be worth $70 million, a 6% chance the assets will be worth $80 million, and so on. Suppose the CEO is contemplating a decision that will benefit her personally but will reduce the value of the firm’s assets by $10 million. The CEO is likely to proceed with this decision unless it substantially increases the firm’s risk of bankruptcy.

a. If Ralston has debt due of $75 million in one year, the CEO’s decision will increase the probability of bankruptcy by what percentage?

b. What level of debt provides the CEO with the biggest incentive not to proceed with the decision?

4.Although the major benefit of debt financing is easy to observe—the tax shield—many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.

5.If it is managed efficiently, Remel Inc. will have assets with a market value of $50 million, $100 million, or $150 million next year, with each outcome being equally likely. However, managers may engage in wasteful empire building, which will reduce the firm’s market value by $5 million in all cases. Managers may also increase the risk of the firm, changing the probability of each outcome to 50%, 10%, and 40%, respectively.

a. What is the expected value of Remel’s assets if it is run efficiently? Suppose managers will engage in empire building unless that behavior increases the likelihood of bankruptcy. They will choose the risk of the firm to maximize the expected payoff to equity holders.

b. Suppose Remel has debt due in one year as shown below. For each case, indicate whether managers will engage in empire building, and whether they will increase risk. What is the expected value of Remel’s assets in each case?

i. $44 million

ii. $49 million

iii. $90 million

iv. $99 million

c. Suppose the tax savings from the debt, after including investor taxes, is equal to 10% of the expected payoff of the debt. The proceeds from the debt, as well as the value of any tax savings, will be paid out to shareholders immediately as a dividend when the debt is issued. Which debt level in part (b) is optimal for Remel?

6.Which of the following industries have low optimal debt levels according to the trade-off theory?

Which have high optimal levels of debt?

a. Tobacco firms

b. Accounting firms

c. Mature restaurant chains

d. Lumber companies

e. Cell phone manufacturers

7.According to the managerial entrenchment theory, managers choose capital structure so as to preserve their control of the firm. On the one hand, debt is costly for managers because they risk losing control in the event of default. On the other hand, if they do not take advantage of the tax shield provided by debt, they risk losing control through a hostile takeover.

Suppose a firm expects to generate free cash flows of $90 million per year, and the discount rate for these cash flows is 10%. The firm pays a tax rate of 40%. A raider is poised to take over the firm and finance it with $750 million in permanent debt. The raider will generate the same free cash flows, and the takeover attempt will be successful if the raider can offer a premium of 20% over the current value of the firm. What level of permanent debt will the firm choose, according to the managerial entrenchment hypothesis?

8.Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 100 million shares outstanding. The correct price for these shares is either $14.50 or $12.50 per share. Investors view both possibilities as equally likely, so the shares currently trade for $13.50.

IST must raise $500 million to build a new production facility. Because the firm would suffer a large loss of both customers and engineering talent in the event of financial distress, managers believe that if IST borrows the $500 million, the present value of financial distress costs will exceed any tax benefits by $20 million. At the same time, because investors believe that managers know the correct share price, IST faces a lemons problem if it attempts to raise the $500 million by issuing equity.

a. Suppose that if IST issues equity, the share price will remain $13.50. To maximize the long term share price of the firm once its true value is known, would managers choose to issue equity or borrow the $500 million if

i. they know the correct value of the shares is $12.50?

ii. they know the correct value of the shares is $14.50?

b. Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price?

c. Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price in that case?

d. How would your answers change if there were no distress costs, but only tax benefits of leverage?

9.During the Internet boom of the late 1990s, the stock prices of many Internet firms soared to extreme heights. As CEO of such a firm, if you believed your stock was significantly overvalued,would using your stock to acquire non-Internet stocks be a wise idea, even if you had to pay a small premium over their fair market value to make the acquisition?

10.“We R Toys” (WRT) is considering expanding into new geographic markets. The expansion will have the same business risk as WRT’s existing assets. The expansion will require an initial investment of $50 million and is expected to generate perpetual EBIT of $20 million per year. After the initial investment, future capital expenditures are expected to equal depreciation, and no further additions to net working capital are anticipated.

WRT’s existing capital structure is composed of $500 million in equity and $300 million in debt (market values), with 10 million equity shares outstanding. The unlevered cost of capital is 10%,and WRT’s debt is risk free with an interest rate of 4%. The corporate tax rate is 35%, and there are no personal taxes.

a. WRT initially proposes to fund the expansion by issuing equity. If investors were not expecting this expansion, and if they share WRT’s view of the expansion’s profitability, what will the share price be once the firm announces the expansion plan?

b. Suppose investors think that the EBIT from WRT’s expansion will be only $4 million. What will the share price be in this case? How many shares will the firm need to issue?

c. Suppose WRT issues equity as in part (b). Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now? Why does it differ from that found in part (a)?

d. Suppose WRT instead finances the expansion with a $50 million issue of permanent riskfree debt. If WRT undertakes the expansion using debt, what is its new share price once the new information comes out? Comparing your answer with that in part (c), what are the two advantages of debt financing in this case?