7. Capital structure theory Aa Aa Which of the following are ways that a firm ca

Question

7. Capital structure theory Aa Aa Which of the following are ways that a firm can reduce cash flows in order to prevent managers from wastefully spending excess cash flows? Check all that apply Funneling excess cash flows back to shareholders through stock repurchases Funneling excess cash flows back to shareholders through higher dividends Increasing the amount of debt in the firm's target capital structure in the hope that higher debt-service requirements will force managers to be more disciplined Minimizing the amount of debt in the firm's capital structure so that the firm can borrow money at a reasonable rate when good investment opportunities arise General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.2, and its cost of equity is 13.20%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.20%. The risk-free rate of interest (TRF) is 3%, and the market risk premium (RP) is 8.5% General Forge's marginal tax rate is 30% General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table Before-Tax Cost of Debt (rd) Bond Cost of Equity (rs) 13.20% 14.99% 17.96% Levered D/A E/A Ratio Ratio D/E Ratio Rating Beta (b) WACC 13.20% 13.13% 1.0 0.00 0.25 0.67 1.50 0.0 8.1% 8.5% 10.9% 13.9% 0.2 0.6 1.76 2.46 4.56 0.6 14.14% 0.2 41.76%

Explanation / Answer

1

Funneling excess cash flows back to shareholders through higher dividends.

Funneling excess cash flows back to shareholders through stock repurchases.

2

WACC=D/A*before tax cost of debt*(1-tax rate)+E/A*cost of equity
D/E=(D/A)/(E/A)
Cost of equity=risk free+beta*market risk premium
Hence,
D/A=0.2: cost of equity=14.99%
Hence,levered beta=(14.99%-3%)/8.5%=1.410588

D/A=0.4: WACC=0.4*8.5%*(1-30%)+0.6*17.96%=13.156%

D/A=0.6: Cost of equity=3%+2.46*8.5%=23.91%

D/A=0.8: D/E=0.8/0.2=4
WACC=0.8*13.9%*(1-30%)+0.2*41.76%=16.136%

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