Capital Structure and the Cost of Capital

Chapter 18: Capital Structure and the Cost of Capital

1. AQ&Q has EBIT of $2 million, total assets of $10 million, stockholders’ equity of $4 million, and pretax interest expense of 10 percent.

a. What is AQ&Q’s indifference level of EBIT?

b. Given its current situation, might it benefit from increasing or decreasing its use of debt? Explain.

c. Suppose we are told AQ&Q’s average tax rate is 40 percent. How does this affect your answers to (a) and (b)?

4. Faulkner’s Fine Fries, Inc. (FFF), is thinking about reducing its debt burden. Given the following capital structure information and an expected EBIT of $50 million (plus or minus 10 percent) next year, should FFF change their capital structure?

CURRENT PROPOSED

Total assets $750 million $750 million

Debt 450 million 300 million

Equity 300 million 450 million

Common stock price $30 $30

Number of shares 10,000,000 15,000,000

Interest rate 12% 12%

6. A firm has sales of $10 million, variable costs of $4 million, fixed expenses of $1.5 million, interest costs of $2 million, and a 30 percent average tax rate.

a. Compute its DOL, DFL, and DCL.

b. What will be the expected level of EBIT and net income if next year’s sales rise 10 percent?

c. What will be the expected level of EBIT and net income if next year’s sales fall 20 percent?