HSA Chapter 13 Problems 1-4

Chapter 13 Problem 1

a. the use of debt financing leverages up ROE from 12.0 percent to 19.2 percent; total dollars returned to investors (including both stockholders and creditors)increased from $600,000 to $680,000; and the “extra” $80,000 came from the “taxman,” as taxes are reduced by that amount

b. ROE 12.0%/15.0%

c. At 20% ROE is 6.0 %

At 0.6% ROE is 12.0%

At .20 % ROE is 18.0 %
The lesson is that although the use of leverage increases expected ROE, it also increases the riskiness to stockholders. This can be seen by the fact that variability of ROE is greater when debt financing is used. However, in this particular illustration, the ROE under every possible
EBIT is higher when debt financing is used than it is under all-equity financing. Thus, it is clear in this example that debt financing dominates all-equity financing (i.e., it is clear that debt financing should be used). However, under different combinations of EBIT, interest rates, and probabilities, the worst case ROE is often lower when debt financing is used than when it is not used, so debt financing is not unambiguously better than all-equity financing. Also, note that the of occurrence and then summing.

d.Stock is 2.0% Stock Debt is 32.0 %

Problem 2

a. = 11% × (1 – 0.00) = 11.0%.

b. 11% × (1 – 0.20) = 8.8%.

c. 11% × (1 – 0.40) = 6.6%.

Problem 3
The corporate cost of capital is the weighted average (blend) of the component costs:
Corporate cost of capital = [wd × R(Rd) × (1 – T)] + [we × R(Re)]
= [0.35 × 7.0% × (1 – 0.00)] + [0.65 × 13.5%]
= 2.45% + 8.775% = 11.2%.

Problem 4

Richmond’s optimal capital structure is 40 percent debt, because its corporate cost of capital is the lowest at that level.