Question

Capital Structure Theory Modern capital structure theory began in 1958 when Professors Modigliani and Miller (MM) published a paper that proved under a restrictive set of assumptions that a firm's value is unaffected by its capital structure. By indicating the conditions under which capital structure is irrelevant, they provided dues about what is required to make capital structure relevant and impact a firm's value. In 1963 they wrote a paper that included the impact of corporate taxes on capital structure. With the tax deductibility of -Select- payments, but not -Select- payments, and if all their other assumptions held, they concluded that an optimal capital structure consisted of -Select- % debt. This paper was then modified when Merton Miller brought in the effects of personal taxes. Bond interest income is taxed at -Select- rates than income from stocks (received as dividends and capital gains). Consequently, investors are willing to accept relatively low before-tax returns on stock as compared to the before-tax return on bonds. Most observers believe that interest deductibility has a -Select- effect than the favorable tax treatment of income from stocks, so the U.S. tax system favors the corporate use of -Select- MM assumed there are no bankruptcy costs but firms do go bankrupt and bankruptcy costs are high. Bankruptcy-related problems are likely to increase the more debt a firm has in its capital structure. Therefore, bankruptcy costs discourage firms from using debt in excessive levels. This led to the development of the Trade-Off Theory, which states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy. MM assumed that investors and managers have the same information about a firm's prospects, which is known as -Select- information. However, managers have better information than investors, which is known as -Select- information. -Select- theory recognizes that investors and managers do not have the same information regarding a firm's prospects. We would expect a firm with very favorable prospects to avoid selling stock, and to instead raise any required new capital by using new debt, even if this moved its debt ratio beyond its target level. The announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its management are not bright. This suggests that when a firm announces a new stock offering, more often than not, its stock price will -Select-- ). This situation implies that a firm will maintain a reserve borrowing capacity, which will give it 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 in normal times to ensure that they can obtain debt capital later if necessary The pecking order hypothesis states that managers have a preferred sequence of raising capital that impacts their capital structure decisions. The preferred sequence is to raise capital first as spontaneous credit, then retained earnings, then other debt, and finally new common stock. Finally, when a company's stock is selling for a price different than its intrinsic value, the firm's managers can adjust the firm's capital structure to take advantage of the mispricing. Thus, the firm's managers take advantage of windows of opportunity. Quantitative Problem: Currently, Meyers Manufacturing Enterprises (MME) has a capital structure consisting of 35% debt and 65% equity. MME's debt currently has a 6.5% yield to maturity. The risk-free rate (RF) is 4.5%, and the market risk premium (nM - TRF) is 5.5%. Using the CAPM, MME estimates that its cost of equity is currently 12.2%. The company has a 40% tax rate. a. What is MME's current WACC? Round your answer to 2 decimal places. Do not round intermediate calculations, b. What is the current beta on MME's common stock? Round your answer to 4 decimal places. Do not round Intermediate calculations. c. What would MME's beta be if the company had no debt in its capital structure? (That is, what is MME's unlevered beta, bu?) Round your answer to 4 decimal places. Do not round intermediate calculations. MME's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 7%. The proposed change will have no effect on the company's tax rate. d. What would be the company's new cost of equity if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations. e. What would be the company's new WACC if it adopted the proposed change in capital structure? Round your answer to 2 decimal places. Do not round intermediate calculations. f. Based on your answer to Part e, would you advise MME to adopt the proposed change in capital structure? -Select-

Answer 1

1.
Interest

2.
Dividend

3.
100%

4.
lower

5.
higher

6.
debt

7.
perfect

8.
asymmetric

9.
Signalling

10.
Decrease

1.
=proportion of debt*yield to maturity*(1-tax rate)+proportion of equity*cost of equity
=35%*6.5%*(1-40%)+65%*12.2%
=9.30%

2.
=(cost of equity-risk free rate)/market risk premium
=(12.2%-4.5%)/5.5%
=1.40000

3.
=Current beta/(1+(1-tax rate)*Debt/Equity)
=1.40/(1+(1-40%)*35%/65%)
=1.05814

4.
=risk free rate+New beta*market risk premium
=4.5%+1.05814*(1+(1-40%)*45%/55%)*5.5%
=13.17674800%

5.
=proportion of debt*yield to maturity*(1-tax rate)+proportion of equity*cost of equity
=45%*7%*(1-40%)+55%*13.17674800%
=9.13721140%

6.
YES