Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
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Chapter 21, Problem 1MC
David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant:
Who were Modigliani and Miller (MM), and what assumptions are embedded in the MM and Miller models?
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Chapter 21 Solutions
Financial Management: Theory & Practice
Ch. 21 - Prob. 1QCh. 21 - Modigliani and Miller assumed that firms do not...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 -
An unlevered firm has a value of $500 million. An...Ch. 21 - Prob. 3PCh. 21 - Prob. 4PCh. 21 - A company’s most recent free cash flow to equity...Ch. 21 - Air Tampa has just been incorporated, and its...Ch. 21 - Companies U and L are identical in every respect...Ch. 21 - Schwarzentraub Corporation’s expected free cash...
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- David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: Now assume that Firms L and U are both subject to a 25% corporate tax rate. Using the data given in part b, repeat the analysis called for in parts b(1) and b(2) using assumptions from the MM model with taxes.arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.arrow_forward
- Teresa, the owner of Stack Brewery, recently met with a consultant who advised the firm that it was “under-leveraged” and should be “recapitalized”. She had always financed the firm entirely with her own funds and having feigned comprehension at their meeting, wondered exactly this could mean. Briefly explain what condition(s) would be necessary to create firm value by swapping equity for debt (borrowing money against the firm’s assets and paying it to herself as a dividend) Buoyed by this realization, Teresa wondered exactly how much debt to take on. A cursory search of internet resources pointed to the “Static Trade-off Model”, which suggested there was an optimal ratio of debt-to-equity financing which would maximize the value of the company. Briefly explain the two value frictions which impact the firm in this model and describe the “optimal” capital structure in terms of these two concerns. Assuming a risk-free rate of 4% and a market risk premium of 5%, what would…arrow_forwardSimon and Yuri are two accountants for a large financial firm. When trying to devise a long-term accounting strategy, the two have a disagreement. “We should be as transparent as possible when disclosing our financial information,” Simon suggests. “If investors have access to our books, they will see the long-term gains we are making and feel more comfortable investing.”“It’s not that simple,” Yuri retorts. “What if we have a slow quarter and investors panic? Instead, we should keep our financial information as secret as possible while remaining within the law. That will allow us to keep control over the information available to the public.” *** Question | Simon’s argument is based on which of the following assumptions? A) Concealing financial information from the public is unethical. B) The firm can be transparent while still controlling the flow of information to the public. C) The firm is legally required to disclose all financial records to the public. D) Companies that…arrow_forwardNeptune Company offers network communications systems to computer users. The company is planning a major investment expansion but is unsure of the correct measure of equity capital as it has no traded equity. Your job is to determine the basis of the equity cost. List and explain the steps you will need to take. Thearrow_forward
- 2) Financial Statement Analysis. Your firm has hired a consultant. At the conference you're attending, she says this about your company: "Sure, you've got high ROE, but with that comes a lot of risk. You have lots of ROE because you have a high Debt/Equity Ratio." People are looking very confused. Can you explain what the consultant means? How does high Debt/Equity cause lots of risk for your firm? Risk of what, exactly?arrow_forwardAssume that you have finished your MBA program and have applied for a position in the FinancialAccounting Department of a large multinational company. The company is struggling with itsaccounting reporting matters and several accounting reports are under regulatory scrutiny. In theinterview board, the recruitment committee members have asked you the following questions. i. How can you contribute the Financial Accounting Department of this company if youare recruited? (PLEASE DO NOT GIVE OTHER OR EXISTING ANSWER OF BARTLEBY)arrow_forwardAssume that you are a portfolio manager for a large insurance company. The majority of the moneyyou manage is from retired school teachers who depend on the income you earn on their investments. You have invested a significant amount of money in the bonds of a large corporation andhave just received news released by the company’s president explaining that it is unable to meetits current interest obligations because of deteriorating business operations related to increasedinternational competition. The president has a recovery plan that will take at least two years. During that time, the company will not be able to pay interest on the bonds and, she admits, if the plandoes not work, bondholders will probably lose more than half of their money. As a creditor, youcan force the company into immediate bankruptcy and probably get back at least 90 percent of thebondholders’ money. You also know that your decision will cause at least 10,000 people to losetheir jobs if the company ceases…arrow_forward
- You have been the finance director of a clothing company. You have recently been advised by the store manager of slow moving stock (inventory) which would normally have been written down ( reduce value) thus reducing the value of overall Inventory(stock). Managing director wants the financial statements to carry an inflated stock valuation (higher stock valuation ) because he has found a buyer for the company and wants to the sell the company. The managing director has indicated to you that, if the deal ( to sell the company) is successful, all employees will keep their jobs and you will receive a pay increase (higher salary) Which key Fundamental principles of professional ethics is affected and what is the most relevant threats? You cannot simply do what has been asked of you, because the principle of integrity requires a professional accountant not to be associated with information that they believe to be false or misleading. A Self-review threats to your objectivity arises…arrow_forward1) "Information asymmetry lies at the heart of the ethical dilemma that managers, stockholders, and bondholders confront when companies initiate management buyouts or swap debt for equity." Comment on this statement. What steps might a board of directors take to ensure that the company's actions are ethical with regard to all parties? 2) Assume that you are the CFO of a company contemplating a stock repurchase next quarter. You know that there are several methods of reducing the current quarterly earnings, which may cause the stock price to fall prior to the announcement of the proposed stock repurchase. What course of action would you recommend to your CEO? If your CEO came to you first and recommended reducing the current quarter's earnings, what would be your response?arrow_forwardTodd Johnson is the vice president of Finance for Boz Zeppelin Industries, Inc. At a recent finance meeting, Todd made the following statement: “The managers of a company should use the same information as the shareholders of the firm. When managers use the same information to guide their internal operations as shareholders use in evaluating their investments, the managers will be aligned with the stockholders’ profit objectives.” Prepare a one-half page memo to Todd discussing any concerns you might have with his statement.arrow_forward
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