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FM II Assignment 12 W22

This document provides examples and problems related to capital structure and leverage. It includes sample data on debt ratios, bond ratings, and costs of debt for different levels of leverage. It then presents two practice problems involving calculating unlevered beta and estimating cost of equity given changes in capital structure. The final problem provides projections for earnings per share and stock price at different debt ratios to determine an optimal capital structure for a company.

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49 views2 pages

FM II Assignment 12 W22

This document provides examples and problems related to capital structure and leverage. It includes sample data on debt ratios, bond ratings, and costs of debt for different levels of leverage. It then presents two practice problems involving calculating unlevered beta and estimating cost of equity given changes in capital structure. The final problem provides projections for earnings per share and stock price at different debt ratios to determine an optimal capital structure for a company.

Uploaded by

Farah Imami
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lahore School of Economics

Financial Management II
Capital Structure and Leverage – 2
Chapter 14 Assignment 12

Examples
1. Harley Motors has $10 million in assets, which were financed with $2 million of debt and $8 million in equity. Harley’s beta is currently 1.2, and its tax rate is 40%.
Use the Hamada equation to find Harley’s unlevered beta, bU.

2. Slides recapitalization example data:

Amount D/Asset D/E Bond rd


Borrowed Ratio Ratio Rating
$0 0 0 -- --
250,000 0.125 0.143 AA 8.0%
500,000 0.250 0.333 A 9.0%
750,000 0.375 0.600 BBB 11.5%
1,000,000 0.500 1.000 BB 14.0%
1,250,000 0.625 1.667 B 16.5%

EBIT = $400,000 Tax rate = 40%


# of shares outstanding when there is no debt = 80,000 Total assets = $2,000,000
Unlevered beta = 1.00 Risk-free rate = 6%
Market risk premium = 6% Market price of shares = $25
New debt is used to repurchase shares so total assets remain same.

Problems for Assignment


1. Barnes Co. currently has a capital structure that consists of 40% debt and 60% common equity. The company has a 40% tax rate. Currently the levered beta (bL) on
the company’s stock is 1.4.
a) What is the company’s unlevered beta (bU)?
b) What would be the company’s levered beta (bL) if Barnes changed its capital structure to 20% debt and 80% common equity?

2. Cyclone Software Co. is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes
that the firm should use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 6%; and the firm’s tax rate is 40%. Currently, Cyclone’s cost of
equity is 14%, which is determined by the CAPM. What would be Cyclone’s estimated cost of equity if it changed its capital structure to 50% debt and 50% equity?
3. Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt ratio is somewhere between 20% and 50%,
and her staff has compiled the following projections for EPS and the stock price at various debt levels:

Debt Ratio Projected EPS Projected Stock Price


20% $3.20 $35.00
30 3.45 36.50
40 3.75 36.25
50 3.50 35.50

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