Question 1 Jimmy Shoes Inc. has 10,000 shares outstanding with a stock price of $40 per share. The current weighted average cost of capital is 7%. It also carries long-term debt of $200,000 at an interest rate of 7% p.a. One of the agenda items in its AGM is to switch to a D/E of 1. Based on this information, answer the following questions: a) What will be the number of outstanding shares for Jimmy Shoes Inc. if it switches to a D/E ratio of 1? (Hint: Current Debt = $200,000, current equity = 10,000 shares x $40 = $400,000, current D/E = 2/4 = 0.5/1. If the firm seeks to increase its D/E to 1, it can think of borrowing more) b) What is the level of EBIT at which shareholders will be indifferent between the two capital structures, the one with a D/E = 0.5/1 and the other with a D/E of 1?
Question 1 Jimmy Shoes Inc. has 10,000 shares outstanding with a stock price of $40 per share. The current weighted average cost of capital is 7%. It also carries long-term debt of $200,000 at an interest rate of 7% p.a. One of the agenda items in its AGM is to switch to a D/E of 1. Based on this information, answer the following questions: a) What will be the number of outstanding shares for Jimmy Shoes Inc. if it switches to a D/E ratio of 1? (Hint: Current Debt = $200,000, current equity = 10,000 shares x $40 = $400,000, current D/E = 2/4 = 0.5/1. If the firm seeks to increase its D/E to 1, it can think of borrowing more) b) What is the level of EBIT at which shareholders will be indifferent between the two capital structures, the one with a D/E = 0.5/1 and the other with a D/E of 1?
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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Concept explainers
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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Transcribed Image Text:Question 1
Jimmy Shoes Inc. has 10,000 shares outstanding with a stock price of $40 per
share. The current weighted average cost of capital is 7%. It also carries
long-term debt of $200,000 at an interest rate of 7% p.a. One of the agenda.
items in its AGM is to switch to a D/E of 1. Based on this information,
answer the following questions:
a) What will be the number of outstanding shares for Jimmy Shoes Inc. if
it switches to a D/E ratio of 1? (Hint: Current Debt = $200,000,
current equity = 10,000 shares x $40 = $400,000, current D/E = 2/4 =
0.5/1. If the firm seeks to increase its D/E to 1, it can think of
borrowing more)
b) What is the level of EBIT at which shareholders will be indifferent
between the two capital structures, the one with a D/E = 0.5/1 and the
other with a D/E of 1?
Question 2
a) You currently own 600 shares of JKL, Inc. JKL is an all-equity firm
that has 75,000 shares of stock outstanding at a market price of $40
a share. The company's earnings before interest and taxes are $140,000.
JKL has decided to issue $1 million of debt at 8 percent interest.
This debt will be used to repurchase shares of stock. How many shares.
of JKL stock must you sell to unlever your position if you can loan
out funds at 8 percent interest?
b) If the cost of equity is 25%, the WACC is 16% and cost of debt is 10%,
what will be the implied D/E ratio?
c) Why is financial leverage considered as a fair-weather friend? (Max
50 words)
Question 3
a) In each of the theories of capital structure the cost of equity rises
as the amount of debt increases. So why don't financial managers use
as little debt as possible to keep the cost of equity down? After all,
isn't the goal of the firm to maximize share value and minimize
shareholder costs?
b) Country Markets has an unlevered cost of capital of 12 percent, a tax
rate of 38 percent, and expected earnings before interest and taxes
of $15,700. The company has $12,000 in bonds outstanding that have a
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