Capital Structure (class Exercise)
CITY UNIVERSITY OF HONG KONGDEPARTMENT OF ACCOUNTANCYCapital Structure – Class ExerciseQuestion 1You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. Calculate the expected ROE for the firms. 0% Debt, U 60% Debt, LOper. income (EBIT) $400,000 $400,000Required investment $2,500,000 $2,500,000% Debt 0.0% 60.0%$ of Debt $0.00 $1,500,000$ of Common equity $2,500,000 $1,000,000Interest rate NA 10.00%Tax rate 35% 35%Question 2You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Calculate the ROE of the two financing plans.
Operating Data Other Data Capital $4,000 Higher wd 60%ROIC = EBIT(1 – T)/Capital 13.00% Higher interest rate 13%Tax rate 35% Lower wd 10% Lower interest rate 9%Question 3Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%), but its new CFO is considering changing the capital structure so wd = 60.0% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 – wd. Given the data shown below, by how much would this recapitalization change the firms cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)