Ojuola Emmanuel o.

FINMAN MBA 704

Prof. Barbara Manalastas

4th and 5th Requirements

CHAPTER 14: Capital Structure and Leverage

ST-1 KEY TERMS: Define the following terms (page 491)

a. Capital – Capital is a term for financial assets, such as funds held in deposit accounts
and/or funds obtained from special financing sources. Capital can also be associated with
capital assets of a company that requires significant amounts of capital to finance or
expand.
Capital Structure – the particular combination of debt and equity used by a company
to finance its overall operations and growth. Debt comes in the form of bond issues
or loans, while equity may come in the form of common stock, preferred stock,
or retained earnings. Short-term debt such as working capital requirements is also
considered to be part of the capital structure.

Optimal Capital Structure – It is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital.

b. Business Risk – the exposure a company or organization has to factor(s) that will lower
its profits or lead it to fail.
Financial Risk – a term that can apply to businesses, government entities, the financial
market as a whole, and the individual. This risk is the danger or possibility that
shareholders, investors, or other financial stakeholders will lose money.

c. Financial Leverage – the use of borrowed money (debt) to finance the purchase
of assets with the expectation that the income or capital gain from the new asset will
exceed the cost of borrowing.
Operating Leverage – a cost-accounting formula that measures the degree to which a
firm or project can increase operating income by increasing revenue. A business that
generates sales with a high gross margin and low variable costs has high
operating leverage.

Operating Breakeven – It is the point at which sales revenue covers all of the fixed
costs and variable costs but produces no profit for the business. A fixed cost is a cost that
does not change for business based on the number of units produced.

d. Hamada Equation – is a method of analyzing a firm's cost of capital as it uses additional

financial leverage. It draws upon the Modigliani-Miller theorem on capital structure. 

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 Unlevered Beta – Beta is a measure of market risk. Unlevered beta (or asset beta)
measures the market risk of the company without the impact of debt. Unlevering a beta
removes the financial effects of leverage thus isolating the risk due solely to company
assets. 

e. Symmetric Information – Symmetric information is when both parties have equal

knowledge. 

Asymmetric Information – It is also called information failure, happens when one party
to a transaction has greater material knowledge than the other party. Typically, the more
knowledgeable party is the seller. 

f. Modigliani-Miller Theories – this states that the market value of a company is

calculated using its earning power and the risk of its underlying assets and is independent
of the way it finances investments or distributes dividends. There are three methods a
firm can choose to finance: borrowing, spending profits (versus handing them out
to shareholders in the form of dividends), and straight issuance of shares. While
complicated, the theorem in its simplest form is based on the idea that with certain
assumptions in place, there is no difference between a firm financing itself with debt or
equity.

g. Trade-off theory – is the idea that a company chooses how much debt finance and how
much equity finance to use by balancing the costs and benefits.
Signaling theory – based on the assumption that information is not equally available to
all parties at the same time, and that information asymmetry is the rule. 

h. Reserve Borrowing Capacity – The ability to borrow money at a reasonable cost when

good investment opportunities arise. Firms often use less debt than specified by the MM
optimal capital structure to ensure that they can obtain debt capital later if they need to.
Pecking Order – this states that a company should prefer to finance itself first internally
through retained earnings. If this source of financing is unavailable, a company should
then finance itself through debt. Finally, and as a last resort, a company
should finance itself through the issuing of new equity.

i. Windows of opportunity – this are short periods of time within which a key decision
can be made that will produce a desired outcome. Windows of opportunity are often
fleeting, and if the window closes before the decision is made, the chance can be lost
forever.

Net debt – Net debt can be expressed as a metric that indicates the overall debt situation
of a company by netting the value of the liabilities and debts of a company along with its
cash and other similar liquid assets. To put it simple, net debt refers to the total debt of a
company minus cash on hand.

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QUESTIONS: (pages 492 and 493)

14-1. Changes in sales cause changes in profits. Would the profit change associated with sales
changes be larger or smaller if a firm increased its operating leverage? Explain your answer.
Answer: Operating leverage refers to the use of both fixed as well as variable costs to make sales.
If operating leverage is increased (fixed costs are high), then even a small decline in sales can lead
to a large decline in profits and return on equity (ROE). As change in sales leads
to change in profits, it also increases the operating leverage. Sales and profits have positive
relationship, but a small change in sales leads to more change in the profit. Higher fixed expenses
leads to higher operating leverage.

14-2. Would each of the following increase, decrease, or have an indeterminant effect on a firm’s
breakeven point (unit sales)?
a. The sales price increases with no change in unit costs
Answer: The breakeven sales point will decrease since the firm is now making more profit per
sales unit. This results in a lower level of sales required to breakeven.
b. An increase in fixed costs accompanied by a decrease in variable costs.
Answer: The effect on the breakeven point is indeterminant since increase in fixed
cost will increase the breakeven point. However, a lowering of the variable cost lowers the
break-even point.
c. A new firm decides to use MACRS depreciation for both book and tax purposes rather than
the straight-line depreciation method.
Answer: The effect on the breakeven point is indeterminant since the allocation of
depreciation would not have an impact on breakeven.
d. Variable labor costs decline; other things are held constant.
Answer: The breakeven point will decrease.

14-3. Discuss the following statement: All else equal, firms with relatively stable sales are able to
carry relatively high debt ratios. Is the statement true or false? Why?

Answer: The statement is true since the increased fluctuations in the sales quantity impact the
fixed costs and cash flows of the organization. These fluctuations in the sales revenue generate a
risk of not being able to cover the fixed cost, particularly the interest expense. Due to this, their
debt from the market also fluctuates as per the fund requirement. In addition, an organization with
stable sales would have a steady cash flow, which means that it has the capacity to meet its debt
obligation. As a result of their stable cash flow, the lender would allow the firm to borrow at a
higher level resulting in higher debt ratios. On the other hand, organizations that have unstable
sales have a lower debt ratio as compared to the organizations having stable sales.

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14-4. If Congress increased the personal tax rate on interest, dividends, and capital gains but
simultaneously reduced the rate on corporate income, what effect would this have on the average
company’s capital structure

Answer: This will should lead to an increase in the firm's use of debt in its capital structure since
if it increases the corporate tax rate, then the tax deductibility of interest would be greater the
higher the tax rate.

14-5. Which of the following would likely encourage a firm to increase the debt in its capital
structure?

a. The corporate tax rate increases.

Answer: This would increase the value of the interest deductions in the form of corporate tax
shield benefits
b. The personal tax rate increases.
Answer: This would likely cause investors to shift their investment preference from bonds (debt)
to stocks), as interest income would now be taxed higher at the personal level and investors
would benefit relatively more from the deferral of capital gains taxes on the
proportion of equity income not paid out as dividends. In total, this would raise the cost of
debt relative to equity and, thus, firms would be encouraged to use less debt in their capital
structures.
c. Due to market changes, the firm’s assets become less liquid.
Answer: A reduction in the liquidity of a firm’s assets would make them more difficult to sell
quickly if required or result in them only being able to be sold at ‘fire sale’ prices.
Consequently, this would discourage the firm from increasing the amount of debt in its capital
structure, so as to minimize the likelihood of such issues arising.
d. Changes in the bankruptcy code make bankruptcy less costly to the firm.
Answer: This would most likely encourage the firm to use more debt, as the costs associated
with defaulting on debt have decreased.
e. The firm’s sales and earnings become more volatile.
Answer: This is consistent with the firm experiencing an increase in business risk, and they
would belikely to reduce the amount of debt in their capital structure to minimize financial
risk levels and the overall risk of the firm.
14-6. Why do public utilities generally use different capital structures than biotechnology
companies?

Answer: Public utilities generally use different capital structures since biotechnology companies
use relatively little debt as their industries tend to be cyclical, oriented toward research, or
subject to huge product liability suits. Whereas, utility companies, use debt relatively heavily
because their fixed assets make good security for mortgage bonds and also because their
relatively stable sales make it safe to carry more-than-average level of debt.

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14-7. Why is EBIT generally considered independent of financial leverage? Why might EBIT
actually be affected by financial leverage at high debt levels?

Answer: EBIT is independent of financial leverage because it only depends on sales and
operating costs that are not affected by the firm's use of financial leverage. However, at high
levels, firms lose business, employees worry, and operations are not continuous because of
financing difficulties. Financial leverage therefore can influence sales and cost, hence EBIT, if
excessive leverage causes investors, customers, and employees to be concerned about the firm's
future.

14-8. Is the debt level that maximizes a firm's expected EPS the same as the debt level that
maximizes its stock price? Explain.

Answer: When the EPS is maximized, the stock price will be maximized. Theoretically, the
increase in EPS is due to the rise in net income. Assume that other factors stay unchanged, the
net income increases by the reduction in interest expenses on the specific level of debt. Also, the
reduction of the level of debt will increase the value of equity. Consequently, the intrinsic value
of a stock will be higher, which levels up the stock price. That indicates the correlation between
the EPS and the stock price, which are affected by the level of debt. The stock price is
maximized at a level of debt which is lower than the level of debt that maximizes the EPS.

14-9. If a firm went from zero debt to successively higher levels of debt, why would you expect
its stock price to first rise, then hit a peak, and then begin to decline?

Answer: The tax benefits from high levels of debts increase linearly, which causes an increase in
the firm's value and stock price. Increase in the proportion of debt from zero debt will have a
positive effect on the stock price due to financial leverage. However, the financial concern for
the payment of debts increases at the firm incurs more debt which in the long run, eventually
offset and begin to exceed the benefits of debt. Hence, the stock price declines.

14- 10. When the Bell System was broken up, the old AT&T was split into a new AT&T in
addition to seven regional telephone companies. The specific reason for forcing the breakup was
to increase the degree of competition in the telephone industry. AT&T had a monopoly on local
service, long distance, and the manufacture of all equipment used by telephone companies; and
the breakup was expected to open most of those markets to competition. In the court order that
set the terms of the breakup, the capital structures of the surviving companies were specified and
much attention was given to the increased competition telephone companies could expect in the
future. Do you think the optimal capital structure after the breakup was the same as the pre-
breakup optimal capital structure? Explain your position.

Answer: No, the optimal capital structure after the break-up is not as the same as the pre-breakup
optimal structure. Break-up increases the business risk of the company. Hence, the new company
will encounter financial risk. Because of this, the management will have different financing
strategy and decisions. Thus, the firm will decrease is debt financing to lessen the financial risk.

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14-11. A firm is about to double its assets to serve its rapidly growing market. It must choose
between a highly automated production process and a less automated one. It also must choose a
capital structure for financing the expansion. Should the asset investment and financing decisions
be jointly determined, or should each decision be made separately? How would these decisions
affect one another? How could the leverage concept be used to help management analyze the
situation?

Answer: The asset investment and financing decisions are determined separately because without
determining the required funds to finance assets, the firm cannot push through with the financing
decisions. The firm should do this separately as asset investment is only one factor to be
supported by the financing decisions of the firm. Both decisions, however, have significant effect
on one another as investing decisions considers the sale and purchase of fixed assets, that can be
used in the operations to generate income, while financing decisions is concerned with the
borrowing and allocation of funds required for the investment decisions. Leverage results from
using borrowed capital as a funding source when investing to expand the firm's asset base and
generate returns on risk capital. It helps the management to analyze the situation as it determines
the optimal capital structure.

CHAPTER 9: Stocks and Their Valuation

ST-1 KEY TERMS: Define the following terms (page 323)

a. Proxy – The written authority to act or speak for another party. Proxies are sent to
stockholders by corporate management in order to solicit authority to vote the
stockholders' shares at the annual meetings.
Proxy fight – Also known as a proxy contest or proxy battle, refers to a situation in
which a group of shareholders in a company joins forces in an attempt to oppose and vote
out the current management or board of directors.

Takeover – This occurs when one company makes a bid to assume control of or acquire
another, often by purchasing a majority stake in the target firm. In the takeover process,
the company making the bid is the acquirer while the company it wishes to take control
of is called the target.

b. Preemptive Right – It is a clause in an option, security or merger agreement that gives

the investor the right to maintain his or her percentage ownership of a company by
buying a proportionate number of shares of any future issue of the security

c. Classified Stocks - shares of a publicly-traded company that have different share

classes, usually denoted by Class A shares and Class B shares.

Founders’ Shares - are the shares issued to the founders of a company. Apart from
founders, it can also refer to the shares given to the early investors in the company.

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d. Marginal Investor – a representative investor whose actions reflect the beliefs of those
people who are currently trading a stock. It is the marginal investor who determines a
stock's price.

Intrinsic value - is a measure of what an asset is worth. This measure is arrived at by

means of an objective calculation or complex financial model, rather than using the
currently trading market price of that asset.

Market Price - is the current price at which an asset or service can be bought or sold.
The economic theory contends that the market price converges at a point where the forces
of supply and demand meet.

e. Required Rate of Return – This is the minimum return an investor will accept for
owning a company's stock, as compensation for a given level of risk associated with
holding the stock. The RRR is also used in corporate finance to analyze the profitability
of potential investment projects.
Expected Rate of Return – It is the expected value of its return. It is a measure of the
center of the distribution of the random variable that is the return.

Actual (Realized) Rate of Return - refers to the actual gain or loss an investor
experiences on an investment or in a portfolio. It is also referred to as the internal rate of
return (IRR).

f. Capital Gains Yield - is the rise in the price of a security, such as common stock. For
common stock holdings, the CGY is the rise in the stock price divided by the original
price of the security.
Dividend Yield - The amount of money a company pays shareholders (over the course of
a year) for owning a share of its stock divided by its current stock price—displayed as a
percentage. The dividend yield is the estimated one-year return of an investment in a
stock-based only on the dividend payment.

Expected Total Return – It is the profit or loss an investor anticipates on an investment

that has known or anticipated rates of return. It is calculated by multiplying potential
outcomes by the chances of them occurring and then totaling these results.

Growth Rate – This refers to the percentage change of a specific variable within a
specific time period.

g. Zero Growth Stock – It refers when a stock has a return of a definite amount until the
stock reaches maturity.

h. Constant Growth (Gordon) Model – is used to determine the intrinsic value of a stock
based on a future series of dividends that grow at a constant rate. It is a popular and
straightforward variant of a dividend discount mode (DDM).

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 Supernormal (Nonconstant) Growth – It is a security that experiences especially robust
growth for a time, then eventually reverts back to normal levels of growth. During their
supernormal growth stage, these stocks outperform the market significantly and provide
investors with returns that are well above average. In order to be considered a
supernormal growth stock, a stock’s price must continue to grow at an unusually fast
pace for at least one year.

i. Corporate Valuation Model – is a process and a set of procedures used to estimate the
economic value of an owner’s interest in a business. Valuation is used by financial
market participants to determine the price they are willing to pay or receive to perfect the
sale of a business.

j. Horizon (Terminal) Date – This is the date when the growth rate becomes constant.

Horizon (Continuing) Value – This is the value at the horizon date of all dividends
expected thereafter.

k. Preferred Stock - This is a class of corporate shares that are separate from common
stock and have specific rights that aren’t available to common shareholders.

Easy Problems: 9-1 to 9-6 (pages 324 and 324)

9-1. Warr Corporation just paid a dividend of $1.50 a share (that is, D0 = $1.50). The dividend is
expected to grow 7% a year for the next 3 years and then at 5% a year thereafter. What is the
expected dividend per share for each of the next 5 years?

D0 = $1.50
Solution: Answer:

Year 1 : $1.50 (1+0.07)^1 = $1.61

Year 2 : $1.50 (1+0.07)^2 = $1.72
Year 3 : $1.50 (1+0.07)^3 = $1.84
Year 4 : $1.50 (1+0.05)^4 = $1.93
Year 5 : $1.50 (1+0.05)^5 = $2.03

9-2. Thomas Brothers is expected to pay a $0.50 per share dividend at the end of the year (that is,
D1 = $0.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate
of return on the stock is 15%. What is the stock's current value per share?
Solution:
D1 = $0.50; g = 7%; rs = 15%
Stock's current value per share (P^0) = D1 / (Rs - g)
= (.50/ .15 - .07)
Answer: Stock's current value per share (P^0) = $6.25

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9-3. Harrison Clothiers' stock currently sells for $20.00 a share. It just paid a dividend of $1.00 a
share (that is, D0 = $1.00). The dividend is expected to grow at a constant rate of 6% a year.
What stock price is expected 1 year from now? What is the required rate of return?

Solution:
D0= 1.00; g= 6%
P^1= Po (1+g) = $20(1+.06) = $21.20
Rate of return r^p= (D1 / Po) + g
= 1.00(1.06) / 20 + .06

Answer:
Required rate of return = 11.30%

9-4. Hart Enterprises recently paid a dividend, D0, of $1.25. It expects to have nonconstant
growth of 20% for 2 years followed by a constant rate of 5% thereafter. The firm's required
return is 10%.

0 1 2 3
|------------------------|---------------------------|-----------------------------|
Gs=20% Gs=20% g=5%

a. How far away is the horizon date?

Answer: The terminal, or horizon, date is the date when the growth rate becomes
constant. This occurs at the end of Year 2.

b. What is the firm's horizon, or continuing, value?

D0=1.25; Gs = 20% ; N=2 yrs; g=5%; gs=10%.

Solution:
D1 = 1.25*1.20
= $1.50
D2 = 1.50*1.20
= $1.80
D3 = 1.80*1.05
= $1.89
P2 = D3/(Ks-g)
= 1.89/(0.10-0.05)
Answer: P2 = $37.80

c. What is the firm's intrinsic value today, P^ 0 ?

Solution:
P^0 = 0 + 1.50/(1.10)^1 + 1.80+37.80/(1.20)^2
= 1.36 + 32.73
Answer: P^0 = $34.09

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9-5. Smith technologies is expected to generate $150 million in free cash flow next year, and
FCF is expected to grow at a constant rate of 5% per year indefinitely. Smith has no debt or
preferred stock and its WACC is at 10%. If smith has 50 million shares of stock outstanding,
what is the stock's value per share?

Solution:
Firm value = FCF1/(WACC - g)
= $150,000,000/(0.10 - 0.05)
= $3,000,000,000
Equity value per share = Equity value/Shares outstanding
= $3,000,000,000/50,000,000
Answer: Stock’s Value per share = $60

9-6. Fee founders has perpetual preferred stock outstanding that sells for $60 a share and pays a
dividend of $5 at the end of each year. What is the required rate of return?

Solution:
Dp = $5; Vp= $60
rp= Dp / Vp
= 5 / 60
Answer: Required rate of return = 8.33%

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