Capital structure practice questions/problems

1. Consider the Albatross Company that has $1 million of assets, which are currently financed
using 40 percent debt and 60 percent equity. Suppose Albatross were to acquire $0.5 million
of additional assets, but can select between two financing alternatives: all debt, borrowing
at 5%, or all equity, issuing 1 million new shares. What is the debt-equity ratio for each
alternative financing arrangement?

2. Consider two firms, A and B:

Firm A Firm B
Discount rate for earnings stream 10% 12%
Discount rate for risk-free debt earnings 5% 8%
Earnings before additional interest $100 $200

Alternative 1
Debt $0 $0

Alternative 2
Debt $500 $1,000

Assume that the tax rate is 0%. Calculate the capitalization rate for earnings for each firm
and for each alternative financing arrangement. In addition, calculate the value of equity
and debt in each case.

3. Explain why interest deductibility would encourage companies to use debt financing.

4. Explain how each of the following affects the capital structure decision:
a. Interest deductibility
b. Likelihood of bankruptcy
c. Limited liability
d. Net operating loss carryovers

5. The ABC Company has a current capital structure consisting of $100,000 of 10% coupon
debt and $300,000 of equity. ABC wants to raise $100,000 of capital by either selling
additional shares of stock or issuing debt. There is currently 30,000 shares of stock
outstanding and ABC expects to pay 10% interest per year. ABC expects operating earnings
of $30,000 in the following year.
a. What is ABC’s debt ratio under each of the two financing alternatives?
b. If interest on debt is not deductible by ABC, what is the distribution of next year’s
$30,000 among claimants?
c. If interest on debt is deductible by ABC, and ABC has a tax rate of 30%, what is the
distribution of next year’s $30,000 among claimants (including the government)?
d. Suppose ABC’s probability distribution of next year’s earnings is as follows:

Operating
Scenario Probability earnings
Good 25% $50,000
Normal 50% $30,000
Bad 25% $0

What is ABC’s expected earnings to owners and standard deviation of earnings to

owners under the two alternatives? Assume that there are no taxes.

Capital structure practice questions/problems 1