issue new common stock when funding long-term capital projects?
What theories of capital structure help to explain this
behavior?
2. Define the following categories of risk faced by
corporations:
? Financial
Risk and Business Risk.
? What is
the difference between the two?
? How are
each measured?
3. Briefly describe what the “clientele effect” is
and its implications for a firm’s dividend policy.
4. A corporation is trying to determine its optimal capital
structure, which now consists only of debt and common equity. The firm does not
currently use preferred stock in its capital structure, and it does not plan to
do so in the future. To estimate how much debt would cost at different debt
levels, the company’s treasury staff has consulted with investment bankers and,
on the basis of those discussions, has created the following table:
Debt to Asset Ratio Equity
to Asset Ratio Bond Rating Before Tax Cost of Debt
0.0 1.0 A 6.5%
0.2 0.8 BBB 7.5
0.4 0.6 BB 9.5
0.6 0.4 C 10.5
0.8 0.2 D 14.5
The firm uses CAPM to estimate its cost of common equity,
ks. The company estimates that the risk free rate is 6 percent, the market risk
premium (rm – rf ) is 5 percent, and its tax rate is 40 percent. It is also
estimated that if the company had no debt, its “unlevered Beta”, bU,
would be 1.25. On the basis of this information, what would be the company’s
optimal debt equity mix and what would the weighted average cost of capital
(WACC) be at this optimal capital structure? Show your calculations and a graph
to support your answer.
5. Capital Corp. can issue floating rate debt at the variable
rate, LIBOR + 1.2 percent, and can issue fixed rate debt at 8.95 percent. Shore
Corp. can issue floating rate debt at LIBOR + 1.6 percent and can issue fixed
rate debt at 9.3 percent. Suppose Capital issues floating rate debt and Shore
issues fixed rate debt. They engage in the following interest rate swap:
Capital will make a fixed 8.05 percent payment to Shore, and Shore will make a
floating rate payment equal to LIBOR+.05 to Capital. What are the resulting net
payments of Capital and Shore? If Capital and Shore would like to change the
type of debt they hold and lower their borrowing costs, would this swap make
sense?
