Problems and Questions

1. MVP Inc., a manufacturing firm with no debt outstanding and a market value of $100 million is considering borrowing $ 40 million and buying back stock. Assuming that the interest rate on the debt is 9% and that the firm faces a tax rate of 35%, answer the following questions:

2. A business in the 45% tax bracket is considering borrowing money at 10%.

3. WestingHome Inc. is a manufacturing company, which has acccumulated an net operating loss of $ 2 billion over time. It is considering borrowing $ 5 billion to acquire another company.

4. Answer true or false to the following questions relating to the free cash flow hypothesis.

5. Assess the likelihood that the following firms will be taken over, based upon your understanding of the free cash flow hypothesis.

You can assume that earnings and free cash flows are highly correlated.

6. Nadir, Inc., an unlevered firm, has expected earnings before interest and taxes of $2 million per year. Nadir's tax rate is 40%, and the market value is V=E=$12 million. The stock has a beta of 1, and the risk free rate is 9%. [Assume that E(Rm)-Rf=6%] Management is considering the use of debt; debt would be issued and used to buy back stock, and the size of the firm would remain constant. The default free interest rate on debt is 12%. Since interest expense is tax deductible, the value of the firm would tend to increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated, approximately, that the present value of any bankruptcy cost is $8 million and the probability of bankruptcy will increase with leverage according to the following schedule:

Value of debt Probability of failure

$ 2,500,000 0.00%

$ 5,000,000 8.00%

$ 7,500,000 20.5%

$ 8,000,000 30.0%

$ 9,000,000 45.0%

$10,000,000 52.5%

$12,500,000 70.0%

7. Agency costs arise from the conflict between stockholders and bondholders, but they do not impose any real costs on firms. Comment.

8. Two firms are considering borrowing. One firm has excellent prospects in terms of future projects and is in an area in which cash flows are volatile and future needs are difficult to assess. The other firm has more stable cash flows and fewer project opportunities and predicts its future needs with more precision. Other things remaining equal, which of these two firms should borrow more?

9. How would you respond to a claim by a firm that maintaining flexibility is always good for stockholders, though they might not recognize it in the short term?

10. A firm that has no debt has a market value of $100 million and a cost of equity of 11%. In the Miller-Modigliani world,

11. XYZ Pharma Inc. is a pharmaceutical company that traditionally has not used debt to finance its projects. Over the last 10 years, it has also reported high returns on its projects and growth, and made substantial research and development expenses over the time period. The health care business overall is growing much slower now, and the projects that the firm is considering have lower expected returns.

12. Stockholders can expropriate wealth from bondholders through their invesment, financing and dividend decisions. Explain.

13. Bondholders can always protect themselves against stockholder expropriation by writing bond covenants. There is, therefore, no agency cost associated with the conflict between stockholders and bondholders. Do you agree?

14. Unitrode Inc., which makes analog/linear integrated circuits for power management, is a firm that has not used debt in the financing of its projects. The managers of the firm contend that they do not borrow money because they want to maintain financial flexibility.

a. How does not borrowing money increase financial flexibility?

b. What is the trade-off you would be making, if you have excess debt capacity, and you choose not to use it, because you want financial flexibility?

15. Consolidated Power is a regulated electric utility which has equity with a market value of $ 1.5 billion and debt outstanding of $ 3 billion. A consultant notes that this is a high debt ratio relative to the average across all firms, which is 27%, and suggests that the firm is overlevered.

16. Assume that legislators are considering a tax reform plan which will lower the corporate tax rate from 36% to 17%, while preserving the tax deductibility of interest expenses. What effect would this tax reform plan have on the optimal debt ratio of companies? Why? What if the tax deductibility of debt were removed?

17. Governments often step in to protect large companies that get into finanical trouble and bail them out. If this is an accepted practice, what effect would you expect it to have on the debt ratios of firms? Why?

18. The Miller-Modigliani theorem proposes that debt is irrelevant. Under what conditions is this true? If debt is irrelevant, what is the effect of changing the debt ratio on the cost of capital?

19. Based upon the financing heirarchy described in this chapter, what types of securities would you expect financially strong firms to issue? What about financially weak firms? Why?

20. In general, private firms tend to take on much less debt than publicly traded firms. Based upon the discussion in this chapter, how would you explain this phenomenon?

21. There is a significant cost to bankruptcy since the stock price essentially goes to zero. Comment.

22. Studies indicate that the direct cost of bankruptcy is small. What are the direct costs? What are the indirect costs of bankruptcy? What types of firms are most exposed to these indirect costs?

23. When stockholders have little power over incumbent managers, firms are likely to be underlevered. Comment.

24. The following graph summarizes the debt ratio of Xerox from 1970 to 1995.

25. Debt is always cheaper than equity. Therefore, the optimal debt ratio is all debt. How would you respond?