Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $3.45 million of EBIT, and is in the 25% federal-plus-state tax bracket. Both firms are small with average sales of $25 million or less during the past 3 years, so both are exempt from the interest deduction limitation. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 25% debt-to- capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure. a. Calculate the return on invested capital (ROIC) for each firm. Round your answers to two decimal places. ROIC for firm LL: ROIC for firm HL: % ROE for firm LL: ROE for firm HL: % b. Calculate the return on equity (ROE) for each firm. Round your answers to two decimal places. % % c. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 25% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL. Round your answer to two decimal places.

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $23 million in invested capital, has $3.45 million of EBIT, and is in the 25% federal-plus-state tax bracket. Both firms are small with average sales of $25 million or less during the past 3 years, so both are exempt from the interest deduction limitation. Firm HL, however, has a debt-to-capital ratio of 60% and pays 11% interest on its debt, whereas LL has a 25% debt-to- capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure. a. Calculate the return on invested capital (ROIC) for each firm. Round your answers to two decimal places. ROIC for firm LL: ROIC for firm HL: % ROE for firm LL: ROE for firm HL: % b. Calculate the return on equity (ROE) for each firm. Round your answers to two decimal places. % % c. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 25% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL. Round your answer to two decimal places.

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Description: SeFirms HL and LL are identical except for their financial leverage ratios and the interest rates they payon debt. Each has $23 million in invested capital, has $3.45 million of EBIT, and is in the 25%federal-plus-state tax bracket. Both firms are s

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. Compute the costs of equity for both ABC and XYZ.
The Morrit Corporation has $450,000 of debt outstanding, and it pays an interest rate of 11% annually. Morrit's annual sales are $3 million, its average tax rate is 25%, and its net profit margin on sales is 5%. If the company does not maintain a TIE ratio of at least 3 to 1, then its bank will refuse to renew the loan, and bankruptcy will result. What is Morrit's TIE ratio? Do not round intermediate calculations. Round your answer to two decimal places.
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $575,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $287,500 and the interest rate on its debt is 8.5 percent. Both firms expect EBIT to be $64,000. Ignore taxes. a. Richard owns $34,500 worth of XYZ's stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part (a). Calculate his total cash flow and rate of return. (Enter your return answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) c. What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g ., 32.16.) d. What is the WACC for ABC…
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $500,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $250,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $51,000. Ignore taxes. a. Richard owns $25,000 worth of XYZ's stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part (a). Calculate his total cash flow and rate of return. (Enter your return answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.) c. What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) d. What is the WACC for ABC and…
a. Richard owns $33,000 worth of XYZ's stock. What rate of return is he expecting? Rate of return b. Calculate the cash flows and rate of return by investing in ABC, and using homemade leverage, how Richard could generate exactly the same? Total cash flow Rate of return ABC XYZ % c. What is the cost of equity for ABC? What is it for XYZ? Cost of equity ABC XYZ $ d. What is the WACC for ABC? For XYZ? WACC %
McConn Manufacturing is currently all-equity financed, has an EBIT of $2 million, and has a corporate tax rate of 21 percent. Natalie, the company’s founder, is the lone shareholder. All earnings are paid out as dividends to Natalie. If the firm were to convert $4 million of equity into debt, the cost would be 10 percent and Natalie would hold all the debt. Assume Natalie pays personal taxes on interest income at a rate of 37 percent but pays taxes on dividends at a rate of 20 percent. Calculate the total cash flow to Natalie after she pays personal taxes if the firm is unlevered and if it is levered
Barclay Corp is operating in a country K where the corporate tax is 40%, personal income tax on bond investment is 25% while the personal tax on stock is 29%. Assume the firm’s earnings before interest and taxes is $5,400,000 and cost of equity with zero debt is 9%. (Please Show Work) If Barclay current has $12 million total market value of debt financing, what would be the market value of the company of Barclay Corp in this country K?(Please Show Work) What is the proportion of debt (wd) and equity (ws) financing for Barclay Corp with financial leverage? (Please Show Work)
Three companies that subcontract with automobile manufacturers have the fol- lowing debt and equity capital amounts and D-E mixes. Assume all equity capital is in the form of stock. Assume the annual revenue is $15 million for each corporation and that, after debt service is considered, the net incomes are $14.4, $13.4, and $10.0 million, respectively. Compute the return on stock for each company, and comment on the return relative to the D-E mixes.
The McGee Corporation finds it is necessary to determine its marginal cost of capital. McGee's current capital structure calls for 50 percent debt, 25 percent preferred stock, and 25 percent common equity. Initially, common equity will be in the form of retained earnings (K) and then new common stock (K). The costs of the various sources of financing are as follows: debt (after-tax), 7.2 percent; preferred stock, 10.0 percent, retained earnings, 12.0 percent; and new common stock, 13.2 percent. a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, K.) Note: Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places. Debt Preferred stock Common equity Weighted average cost of capital Weighted Cost % Capital structure size (X) b. If the firm has $18.5 million in retained earnings, at what size capital structure will the firm run out of retained earnings? Note:…
Dark Creek Corporation's CEO is selecting between two mutually exclusive projects. The company is obligated to make a $3,700 payment to bondholders at the end of the year. To minimize agency cost, the firm's bondholders decide to use a bond covenant to stipulate that the bondholders can demand an additional payment if the company chooses to take on the high-volatility project. How much additional payment to bondholders would make stockholders indifferent between the two projects? Cash flows pertaining to the two projects are shown in the table below. Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff $2,900 $4,000 4,800 Bad 40 Good .60 6,300 O $1366.67 O $1166.67 O $1300.00 O $1233,33
AAA Corporation and BBB Corporation are identical in every way except their capital structures. AAA Corporation, an all-equity firm, has 40million shares of stock outstanding, currently worth $15 per share. BBB Corporation uses leverage in its capital structure. The market value of BBB’s debt is $100million and its cost of debt is 6.7 percent. Each firm is expected to have earnings before interest of $200 million in perpetuity. Assume that every investor can borrow at 6.7 percent per year. Corporate tax rate is 35%. (SHOW YOUR WORK) 1). What is the value of AAA Corporation? 2). What is the value of BBB Corporation? 3). What is the market value of BBB Corporation’s equity? 4). What would be the BBB’s cost of equity (Rs)? 5). What would be BBB’s weighted average cost of capital (WACC)?
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