Financial Management: Theory & Practice
16th Edition
ISBN: 9781337909730
Author: Brigham
Publisher: Cengage
expand_more
expand_more
format_list_bulleted
Concept explainers
Textbook Question
Chapter 21, Problem 3MC
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:
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.
Expert Solution & Answer
Want to see the full answer?
Check out a sample textbook solutionStudents have asked these similar questions
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 average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Suppose the expected free cash flow for Year 1 is $250,000 but it is expected to grow unevenly over 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 $80,000, 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 $95,000, at Year 3 it will be $120,000, and it will grow at 7% thereafter. What is the estimated horizon unlevered…
Mini CaseDavid 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 average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant.
Assume that Firms U and L are in the same risk class and that both have EBIT=$500,000. Firm U uses no debt financing, and its cost of equity is rsU=14%. Firm L has $1 million of debt outstanding at a cost of rd=8%. There are no taxes. Assume that the MM assumptions hold.
Find V, S, rs, and WACC for Firms U and L.
What if a loyal accountant was asked to fudge some figures on behalf of their company, all while straining under a new mortgage?
Imagine that you are the Chief Financial Officer of a medium to large company. It is April and the Chief Executive Officer has just returned from a meeting with the company’s bankers. She calls you to her office to discuss the results of the negotiations. As things stand, the company requires a fairly significant injection of capital which will be used to modernise plant and equipment. The company has been promised new orders if it can produce goods to an international standard. Existing machinery is incapable of manufacturing the required level of quality. Whilst the bank is sympathetic, current lending policies require borrowers to demonstrate an adequate current and projected cash flow, as well as a level of profitability sufficient to indicate a capacity to make repayments from an early date. The problem is that, largely because of some industrial…
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...
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- 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: 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_forwardYou are a management trainee in one of the Manufacturing companies based in Johor, Malaysia. The company was established in 2003 and recently has been listed in Bursa Malaysia. Currently, the debt-equity ratio of the company is 0.30. Your CFO's role demands him to maximize the value of the firm. Your CFO asked you that is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not? He gave you a couple of days to answer this question. You need to support your answers with examples.arrow_forward
- Suppose that you have been given a summer job as an intern at Issac Aircams, a company that manufactures sophisticated spy cameras for remote-controlled military reconnaissance aircraft. The company, which is privately owned, has approached a bank for a loan to help finance its growth. The bank requires financial statements before approving the loan. Required: Classify each cost listed below as either a product cost or a period cost for the purpose of preparing financial statements for the bank. × Answer is complete but not entirely correct. Costs Product Cost / Period Cost Period Cost Product Cost 1. Depreciation on salespersons' cars. 2. Rent on equipment used in the factory. 3. Lubricants used for machine maintenance. 4. Salaries of personnel who work in the finished goods warehouse. 5. Soap and paper towels used by factory workers at the end of a shift. 6. Factory supervisors' salaries. 7. Heat, water, and power consumed in the factory. 8. Materials used for boxing products for…arrow_forwardYou are an investment banker who has two meetings today. Each of these meetings entails clients requesting your services in determining the optimal capital structure for their firms. For each of the cases below, describe whether you would recommend that the firm choose leverage which is less than, about the same as, or greater than the average across all firms. Explain your reasoning fully. a) Your morning meeting is with the CEO of a drug company. This firm makes a unique product that historically generated losses that they still have on their books. But now they have high growth projects coming consistently in the future. Investors are a little concerned on which of the many drug options the firm could choose. The firm has $100 Million in debt and is trading at a MTB multiple of 5X with their market value of equity at $500 Million. b) Your afternoon meeting is with the CEO of a glass producer. They are a mature cash cow with high stable profits. The glass equipment can be used by…arrow_forward2) 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_forward
- In a few sentences, answer the following question as completely as you can. Imagine you are the treasurer of a small manufacturing firm. Your firm is planning to go public (i.e., sell stock to investors for the first time). One unresolved question concerns the market’s required return on the stock. Given what you have learned, how do you think the required return will affect the market value of your firm’s stock? How would you go about estimating this rate?arrow_forwardA company needs financing. The CFO is proposing that her company issues debt rather than equity, because interest rates are low and thus debt is clearly cheaper than equity. 1) What do do you think of the reasoning behind the CFO’s idea (i.e., simply answer the question: is the CFO's reasoning right)? 2) Discuss why you think so.arrow_forwardAttached is a screenshot of a question I'm having some trouble understanding. Would it be possible for you to help me understand which of these options are correct and why the others would be incorrect, given the situation. According to the problem, it is possible for there to be multiple correct answers. Thank you!arrow_forward
- You have been presented with the following draft financial information about Efren Bata Reyes Ltd, a very successful company that develops and licenses specialist computer software and hardware. Its non-current assets mainly consist of property, computer hardware and investments, and there have been additions to these during the year. The company is experiencing increasing competition from rival companies, most of which specialize in hardware or software, but not both. There is pressure to advertise and to cut prices. You are the audit manager. You are planning the audit and are conducting a preliminary analytical review and associated risk analysis for this client for the year ended 31 July 2021. You have been provided with a summarized draft income statement which has been produced very quickly and certain accounting ratios and percentages. You have been informed that the company accounts for research and development costs in accordance with IAS 38 Intangible Assets. INCOME STATEMENT…arrow_forwardYou work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is P400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL − ROEU?arrow_forwardTeresa, 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_forward
arrow_back_ios
SEE MORE QUESTIONS
arrow_forward_ios
Recommended textbooks for you
- Cornerstones of Financial AccountingAccountingISBN:9781337690881Author:Jay Rich, Jeff JonesPublisher:Cengage LearningPrinciples of Accounting Volume 1AccountingISBN:9781947172685Author:OpenStaxPublisher:OpenStax College
- EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT
Cornerstones of Financial Accounting
Accounting
ISBN:9781337690881
Author:Jay Rich, Jeff Jones
Publisher:Cengage Learning
Principles of Accounting Volume 1
Accounting
ISBN:9781947172685
Author:OpenStax
Publisher:OpenStax College
EBK CONTEMPORARY FINANCIAL MANAGEMENT
Finance
ISBN:9781337514835
Author:MOYER
Publisher:CENGAGE LEARNING - CONSIGNMENT
Dividend disocunt model (DDM); Author: Edspira;https://www.youtube.com/watch?v=TlH3_iOHX3s;License: Standard YouTube License, CC-BY