Marketing Managment

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CAPITAL STRUCTURE DECISIONS: THE BASICS

Problems 1:
The Star Wood company is currently in the following situation: (1) EBIT = $ 4.7 Million; (2) Tax Rate, T = 40%; (3) Value of Debt, D = $2 Million; (4) rd (Cost of Debt) = 10%; (5) rs (Cost of Equity) = 15%; (6) Shares of stock outstanding = 600,000 & Stock price, Po = $30. The firm’s market value is stable, and it expects no growth, so all earnings are paid out as dividends. The debt consists of perpetual bonds. a. What is the total Market Value of the firm’s Stock?

b. What is the total Firm’s Market Value V?
c. What is the firm’s weighted Average Cost of Capital? d. Suppose the firm can increase its debt so that capital structure has 50 % debt, based on market values (it will issue debt and buy back stock). At this level of debt, its cost of equity rises to 18.5%. Its interest rate on all debt with rise to 12% (it will have to call and refund the old debt). What would be the WACC under this capital structure?

Solution:
Problem 1:
a. Market Value of the firm’s Stock = $30 x 600,000 = $18,000,000

b. Firms Market Value, V = D + S = $2,000,000 + 18,000,000 = $20,000,000

c. D/V = Wd = 2,000,000/ 20,000,000 = 0.10
S/V = We= 18,000,000/20,000,000= 0.90

WACC = Wd (1-T) rd + We (rs)
(0.10)(1-.40)(.10) + 0.90 (.15)
= 14.10%

d. WACC = (0.50)(.12)(.60) + (0.5)(.185) = 12.85%

Problems 2:
LIC is considering a large-scale recapitalization. Currently, LIC financed with 25% debt and 75% equity. LIC is considering increasing its level of debt until it is financed with 60% debt and 40% equity. The beta on its common stock at the current level of debt is 1.5, the risk free rate is 6%, the market risk premium is 4%, and LIC faces a 40% Tax rate. a. What is LIC’s current cost of Equity?

b. What is LIC’s Unlevered Beta?
c. What will be the new beta and new cost of equity if LIC recapitalizes? Equations:
Stock’s beta is the relevant measure of risk for...
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