PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 28, Problem 27PS
Summary Introduction
To discuss: Whether Company G’s debt ratio is calculated in terms of total capitalization or total liabilities. Items to be included in debt and discuss the advantages and disadvantages.
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Students have asked these similar questions
The financial manager of a firm determines the following schedules of cost of debt and cost of equity for various combinations of debt financing:
Debt/Assets
After-Tax Cost of Debt
Cost of Equity
0
%
4
%
7
%
10
4
7
20
4
7
30
4
9
40
5
10
50
5
12
60
8
13
70
8
15
Find the optimal capital structure (that is, optimal combination of debt and equity financing). Round your answers for the capital structure to the nearest whole number and for the cost of capital to one decimal place.
The optimal capital structure: % debt and % equity with a cost of capital of %
Why does the cost of capital initially decline as the firm substitutes debt for equity financing?
The cost of capital initially declines because the firm cost of debt is than the cost of equity.
Why will the cost of funds eventually rise as the firm becomes more financially leveraged?
As the firm becomes more financially leveraged and riskier, the cost of debt…
Select all that are true with respect to the cost of debt.
Group of answer choices
it is the return the firm needs to earn overall to satisfy all investors
It is the rate the debt holders demand given the risk they face as debt holders
Can be estimated using CAPM
Cannot be estimated using CAPM because CAPM is used for estimating the cost of equity
Is always equal to the YTM on a company's existing bonds
Is lower than the YTM on a company's existing debt if there is default risk
Can be proxied by the YTM on a company's existing debt if the debt is risk free
Flag question: Question 7
discuss the meaning of liquidity and solvency as it applies to a company's liquidity and credit-risk. It is often thought that the higher the company's current ratio and/or the lower the debt-to-asset ratio, the better the company's financial condition. Do you agree with these statements? Select from industry examples noted below to support/explain your point of view
Industry
Company
Current Ratio
Debt-Asset Ratio
Oil & Gas
Industry Average 2020
1.08
.52
Exxon
.80
.51
Marathon Oil
1.32
.41
BP America
11.01
.66
Chapter 28 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 28 - Prob. 1PSCh. 28 - Performance measures Keller Cosmetics maintains an...Ch. 28 - Performance measures Table 28.8 gives abbreviated...Ch. 28 - Performance measures Describe some alternative...Ch. 28 - Financial ratios Look again at Table 28.8, which...Ch. 28 - Prob. 6PSCh. 28 - Financial ratios True or false? a. A companys...Ch. 28 - Financial ratios Sara Togas sells all its output...Ch. 28 - Financial ratios As you can see, someone has...Ch. 28 - Prob. 10PS
Ch. 28 - Prob. 11PSCh. 28 - Prob. 12PSCh. 28 - Prob. 13PSCh. 28 - Prob. 14PSCh. 28 - Prob. 15PSCh. 28 - Prob. 16PSCh. 28 - Prob. 17PSCh. 28 - Prob. 18PSCh. 28 - Prob. 19PSCh. 28 - Prob. 20PSCh. 28 - Prob. 21PSCh. 28 - Prob. 22PSCh. 28 - Prob. 23PSCh. 28 - Prob. 25PSCh. 28 - Prob. 26PSCh. 28 - Prob. 27PS
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- An investor concerned whether a company can meet its near-term obligations is most likelyto calculate the:C . fi nancial leverage ratio.arrow_forwardLeverage relates to how much of someone else’s money a business or individual is using to finance its operations. Discuss leverage and the various debt ratios used by an organization. Discuss the benefits and perils of too much leverage. Choose a debt ratio and discuss the importance of monitoring that ratio. For example, the time's interest earned ratio is an important ratio to monitor because it shows if a firm can pay the interest payments on its debt each month. The benefits of leverage allow a firm to use borrowed funds to generate income. Too much leverage can make it difficult for a company to make those payments each month.arrow_forwardUnderstanding the impact of debt in the capital structure Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes. Review the Ilist and identify which items are correct. Check all that apply. Workshop Talking Points An increase in debt financing beyond a certain point is likely to increase the firm's cost of equity. An increase in debt financing decreases the risk of bankruptcy. An increase in the risk of bankruptcy is likely to reduce a firm's free cash flows in the future. Risks of bankruptcy increase management spending on perquisites and increase agency costs. The pretax cost of debt increases as a firm's risk of bankruptcy increases.arrow_forward
- a. Explain how do analysts use ratios to analyse a firm’s leverage? Which ratios convey more important information to a credit analyst those revolving around the levels of indebtedness or those measuring the ability to service debt? What is the relationship between a firm’s level of indebtedness and risk? What must happen in order for an increase in leverage to be successful? Discuss and illustrate all your answer.arrow_forwardCalculate the projected debt ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest-earned ratio, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?arrow_forward13. A short-term creditor would be interested in A. profitability ratio. B. efficiency ratio. C. liquidity ratio. D. leverage ratio. The quick ratio of a firm would be unaffected by which of the following? 14. A. Land held for investment is sold for cash. B. Equipment is purchased, financed by a long-term debt issue. C. Inventories are sold for cash D. Inventories are sold on a credit basis.arrow_forward
- Comment on each of the following statements:a) Equity cost of a company with debt is higher than that of a company without debt due to risk of bankruptcy.b) Only risks associated with corporate bonds are interest rate and reinvestment risk.c) In Modigliani-Miller model (from 1963) cost of capital depends positively on cost of debt.d) Weighted average cost of capital (WACC) can always be used to value projects or companies.e) All projects with positive NPV should be accepted and those with negative NPV should be rejected.f) Greater the growth opportunities, higher the level of indebtedness of companies.g) More tangible assets the firm has, the higher the level of indebtedness.arrow_forwardPlease explain the following identity for the Weighted Average Cost of Capital or WACC. Why is the WACC important for those companies making capital investments? WACC where Re Rf + Beta (Rm - Rf) Debt Tx) ( (Debt equity) = Rd (1-Tx) - +arrow_forwardNext, we need to calculate MMMs cost of debt. We can use different approaches to estimate it One approach is to take the companys interest expense and divide it by total debt (which is the sum of short-term debt and long-term debt). This approach only works if the historical cost of debt equals the yield to maturity in todays market (i.e., if MMMs outstanding bonds are trading at dose to par). This approach may produce misleading estimates in years in which MMM issues a significant amount of new debt. For example, if a company issues a great deal of debt at the end of the year, the full amount of debt will appear on the year-end balance sheet, yet we still may not see a sharp increase in annual interest expense because the debt was outstanding for only a small portion of the entire year. When this situation occurs, the estimated cost of debt will likely understate the true cost of debt. Another approach is to try to find this number in the notes to the companys annual report by accessing the company's home page and its Investor Relations section. Alternatively, you can go to other external sources, such as bondsonline.com, for corporate bond spreads, which can be used to find estimates of the cost of debt. Finally, you can also go to Morningstar.com, which will provide yield to maturity information on the firms various bond issues. A longer-term issues YTM could provide an estimate of the firms current cost of debt to be used in the WACC calculation. Remember that you need the after-tax cost of debt to calculate a firm's WACC, so you will need MMMs tax rate (which has averaged around 30% in recent years). What is your estimate of MMMs after-tax cost of debt?arrow_forward
- The cost of equity is _______. A. the interest associated with debt B. the rate of return required by investors to incentivize them to invest in a company C. the weighted average cost of capital D. equal to the amount of asset turnoverarrow_forwardThe cost of is highest for firms that are likely to have profitable future growth opportunities requiring large investments. debt covenants asset substitution debt maturity debt overhangarrow_forwardWeighted Average Cost of Capital (WACC) theory suggests there is an optimal capital structure. Discuss this statement to include an explanation of: What is meant by ‘capital structure’. How changes in capital structure effect WACC The relationship of WACC to the market value of a company The traditional view of the optimum gearing ratio. You may find graphical illustration(s) can support your discussion.arrow_forward
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Financial leverage explained; Author: The Finance story teller;https://www.youtube.com/watch?v=GESzfA9odgE;License: Standard YouTube License, CC-BY