Problem

1. Respond to the following comment: "It's all very well saying that I can sell shares to cover cash needs, but that may mean selling at the bottom of the market. If the company pays a regular cash dividend, investors avoid that risk."

2. "Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.

a. How is the market price of the stock affected by the announcement?

b. How many shares can the company buy back with the $160 million of new debt that it issues? c. What is the market value of the firm (equity plus debt) after the change in capital structure?

d. What is the debt ratio after the change in structure?

e. Who (if anyone) gains or loses?

3. "MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest." Explain carefully whether this is a valid objection.

4. Some companies' debt-equity targets are expressed not as a debt ratio, but as a target debt rating on a firm's outstanding bonds. What are the pros and cons of setting a target rating, rather than a target ratio?

5. The WACC formula seems to imply that debt is "cheaper" than equity--that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.

6. Corporate financial plans are often used as a basis for judging subsequent performance. What do you think can be learned from such comparisons? What problems are likely to arise, and how might you cope with these problems?

7. Suppose that you wish to use financial ratios to estimate the risk of a company's stock. Which of those that we have described in this chapter are likely to be helpful? Can you think of other accounting measures of risk?