15. Earnings and Leverage. Reliable Gearing currently isa ll-equiti-financed.

It has 10,000 shares of eq

Selling at $100 a share. The firm is considering a capital restructuring. The low-debt plan calls for a de
The high-debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 1

a. What will be the debt-to-equity ratio after each contemplated restructuring?

b. If earnings before interest and tax (EBIT) will be either $90,000 or $130,000, what will be earnings p
If both scenarios are equally likely, what is expected EPS under each financing mix? Is the high-debt m

c. Suppose that EBIT is $100,000. What is EPS under each financing mex? Why are they the same in th
nced. It has 10,000 shares of equitiy outstanding.
The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock.
ebt will pay an interest rate of 10% The firm pays no taxes.

130,000, what will be earnings per share for each financing mex for both possible values of EBIT?
nancing mix? Is the high-debt mix preferable?

ex? Why are they the same in this particular case?

buy back stock.

e values of EBIT?
19. Debt Irrelevance. Whats wrong with the following arguments?

a. As the firm borrow more and debt bocems risky, both sotkc-and bondholder demand higher rates o
Thus by reducing the debt ratio we can reduce both the costo of debt and the cost of equity, making e

b. Moderate borrowing doesnt significantly affect the probability of financial distress or bankruptcy.
Consequently, moderate borrowing wont increase the expected rate of return demanded by stockhold

C. A capital investment opportunity offering a 10% internal rate of return is an attractive project if it c

C. A capital investment opportunity offering a 10% internal rate of return is an attractive project if it c
 dholder demand higher rates of return.
and the cost of equity, making everybody better off.

ancial distress or bankruptcy.

f return demanded by stockholders

rn is an attractive project if it can be 100% debt-financed at an 8% interest rate.

rn is an attractive project if it can be 100% debt-financed at an 8% interest rate.

22. Tax Shields. Look back to Table 3-3 where we provided a summary 2006 income statement for Pep
If the tax rate is 35% What is PepsiCos annual interest tax shield?
What is the present value of the annual tax shield if the company plans to maintain its current debt le
2006 income statement for PepsiCo, Inc.

s to maintain its current debt level indefinitely? Assume a discount rate of 8%

23. WACC. Here is Establishment Idustriess market-value balance sheet

Net Woring capital $550 Debt $800

Long-Term assets 2150 Equity1900 1900
Value of firm 2700 2700

The debt is yielding 7%, and the costo of equity is 14% The tax rate is 35%. Investors expect this leve

a. What is Establishments WACC?

b. Write out a market- value balance sheet assuming Establisment has no debt. Use your answer to Q
35%. Investors expect this level of debt to be permanent.

s no debt. Use your answer to Quiz Question 4

24. Tax Shields and WACC. Here are book-and market-value balance sheets of the United Frypan Comp

MARKET-VALUE BALANCE SHEET

Net Working capital $20 Debt $40
Long-term assets 80 Equity 60
$100 $100

MARKET-VALUE BALANCE SHEET

Net Working capital $20 Debt $40
Long-term assets 140 Equity 120
$160 $160

Assume that MMs theory holds except for taxes. There is no growth, and the $40 of debt is expected

a. How much of the firms value is accounted for by the debt-generated tax chield?
b. What is United Frypans after-tax WACC if rdebt = 8% r equity = 15%
c. Now suppose that Congress passes a law that eliminates the deductibility of interest for tax purpose
What will be the new value of the firm, other things equal? Assume an 8% borrowing rate.
United Frypan Company

of debt is expected to be permanent. Assume a 35 % corporate tax rate.

erest for tax purposes after a grace period of 5 years.