Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 21, Problem 1MC
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:
Who were Modigliani and Miller (MM), and what assumptions are embedded in the MM and Miller models?
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David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Suppose the expected free cash flow for Year 1 is $250,000 but it is expected to grow unevenly over the next 3 years: FCF2=$290,000 and FCF3=$320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is $80,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be $95,000, at Year 3 it will be $120,000, and it will grow at 7% thereafter. What is the estimated horizon unlevered…
Mini CaseDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Assume that Firms U and L are in the same risk class and that both have EBIT=$500,000. Firm U uses no debt financing, and its cost of equity is rsU=14%. Firm L has $1 million of debt outstanding at a cost of rd=8%. There are no taxes. Assume that the MM assumptions hold.
Find V, S, rs, and WACC for Firms U and L.
Provide an explanation of the impact of external factors on the financial position of your selected company. Use the Interest Rates Spreadsheet to demonstrate the implications of interest rate changes on at least one.
Specifically, the following critical elements must be addressed:
Macroeconomic Items: The CEO of your selected company is convinced that financial analysis should hinge only on what is happening internally within the company. Convince the CEO otherwise based on the following:
Analyze the implications of interest rate changes on any of your calculations. Support your claims.
Determine how an issue in the overall stock market—negative or positive—might impact the company’s stock valuation numbers, other financial variables, or its overall portfolio management. Support your response with evidence through research, references, and citations.
Analyze the impact of any external factor of PepsiCo. discussed throughout the course on the company’s financial position.…
Chapter 21 Solutions
Financial Management: Theory & Practice
Ch. 21 - Prob. 1QCh. 21 - Modigliani and Miller assumed that firms do not...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 - Prob. 3PCh. 21 - Prob. 4PCh. 21 - A company’s most recent free cash flow to equity...Ch. 21 - Air Tampa has just been incorporated, and its...Ch. 21 - Companies U and L are identical in every respect...Ch. 21 - Schwarzentraub Corporation’s expected free cash...
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- David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: Now assume that Firms L and U are both subject to a 25% corporate tax rate. Using the data given in part b, repeat the analysis called for in parts b(1) and b(2) using assumptions from the MM model with taxes.arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.arrow_forward
- You are a management trainee in one of the Manufacturing companies based in Johor, Malaysia. The company was established in 2003 and recently has been listed in Bursa Malaysia. Currently, the debt-equity ratio of the company is 0.30. Your CFO's role demands him to maximize the value of the firm. Your CFO asked you that is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not? He gave you a couple of days to answer this question. You need to support your answers with examples.arrow_forwardIn a few sentences, answer the following question as completely as you can. Imagine you are the treasurer of a small manufacturing firm. Your firm is planning to go public (i.e., sell stock to investors for the first time). One unresolved question concerns the market’s required return on the stock. Given what you have learned, how do you think the required return will affect the market value of your firm’s stock? How would you go about estimating this rate?arrow_forwardTexo Enterprises is a relatively small and new business firm and you have been appointed as their new Finance Manager. What are your expected functions of this new position?arrow_forward
- Teresa, the owner of Stack Brewery, recently met with a consultant who advised the firm that it was “under-leveraged” and should be “recapitalized”. She had always financed the firm entirely with her own funds and having feigned comprehension at their meeting, wondered exactly this could mean. Briefly explain what condition(s) would be necessary to create firm value by swapping equity for debt (borrowing money against the firm’s assets and paying it to herself as a dividend) Buoyed by this realization, Teresa wondered exactly how much debt to take on. A cursory search of internet resources pointed to the “Static Trade-off Model”, which suggested there was an optimal ratio of debt-to-equity financing which would maximize the value of the company. Briefly explain the two value frictions which impact the firm in this model and describe the “optimal” capital structure in terms of these two concerns. Assuming a risk-free rate of 4% and a market risk premium of 5%, what would…arrow_forwardA company needs financing. The CFO is proposing that her company issues debt rather than equity, because interest rates are low and thus debt is clearly cheaper than equity. 1) What do do you think of the reasoning behind the CFO’s idea (i.e., simply answer the question: is the CFO's reasoning right)? 2) Discuss why you think so.arrow_forwardAfter discussions with Josh, Carrington and Genevieve agree that they would like to try to increase the value of the company stock. Like many small business owners, they want to retain control of the company and do not want to sell stock to outside investors. They also feel that the company's debt is at a manageable level and do not want to borrow more money, What steps can they take to increase the price of the stock? Are there any condi- tions under which this strategy would not increase the stock price?arrow_forward
- Simon and Yuri are two accountants for a large financial firm. When trying to devise a long-term accounting strategy, the two have a disagreement. “We should be as transparent as possible when disclosing our financial information,” Simon suggests. “If investors have access to our books, they will see the long-term gains we are making and feel more comfortable investing.”“It’s not that simple,” Yuri retorts. “What if we have a slow quarter and investors panic? Instead, we should keep our financial information as secret as possible while remaining within the law. That will allow us to keep control over the information available to the public.” *** Question | Simon’s argument is based on which of the following assumptions? A) Concealing financial information from the public is unethical. B) The firm can be transparent while still controlling the flow of information to the public. C) The firm is legally required to disclose all financial records to the public. D) Companies that…arrow_forward2) Financial Statement Analysis. Your firm has hired a consultant. At the conference you're attending, she says this about your company: "Sure, you've got high ROE, but with that comes a lot of risk. You have lots of ROE because you have a high Debt/Equity Ratio." People are looking very confused. Can you explain what the consultant means? How does high Debt/Equity cause lots of risk for your firm? Risk of what, exactly?arrow_forwardThe CFO of Mousetrap, Ms. Harried is analyzing the effects of a switch from the current unlevered position (no debt) to a levered firm (with debt), using the Miller-Modigliani (MM) framework. Last night, a bandicoot (a large, tropical marsupial omnivore in the order Peramelemorphia) scurried into the finance department at Mouse-trap, Inc., and chewed up a good part of her analysis. Help Ms. Harried fill in the missing numbers in the following table. Assume that Mousetrap Inc. fulfils all the assumptionsunderlying the MM propositions.arrow_forward
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