QUESTION 25 Questions 25 to 30 New Heritage Doll Co. is considering opening five

Question

QUESTION 25

Questions 25 to 30

New Heritage Doll Co. is considering opening five new retail stores in East Coast that would require external financing. Amy Chen, the CFO of New Heritage announced in a board meeting that the management is planning to increase the proportion of debt in the company’s capital structure.

Celestila Moonn is one of the senior managers at the corporate finance department of New Heritage gathered the following market data for her analysis to identify the capital structure that maximizes the firm’s stock price and minimizes the weighted average cost of capital.

In response to a question regarding capital structure theory, Moonn made the following statement:

The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.

Table 1

Market value of debt

$100 milion

Yield to maturity on debt

8.0%

Market price per share of common stock

$30

Number of shares of common stock

10milion

Cost of capital if all equity-financed

10.3%

Marginal tax rate

35%

Table 2

Debt-to-Total Capital

Ratio %

Cost of Equity %

Cost of debt %

20

7.7

12.5

30

8.4

13.0

40

9.3

14.0

50

10.4

16.0

Based on Tables 1 & 2, the current after-tax cost of debt for New Heritage’s is closest to:

7.65%

2.8%

5.2%

1 points   

QUESTION 26

Based on Tables 1 & 2, New Heritage’s current cost of equity capital is closest to:

10.8%

10.3%

12.75%

1 points   

QUESTION 27

Based on Tables 1 & 2, what debt-to-total capital ratio would minimize New Heritage’s weighted average cost of capital?

20%

30%

40%

1 points   

QUESTION 28

Holding operating earnings constant, an increase in the marginal tax rate to 40 percent would:

Result in a higher cost of debt capital.

Result in a lower cost of debt capital.

Not affect the company’s cost of capital.

1 points   

QUESTION 29

According to the pecking order theory, New Heritage’s announced capital structure change:

May be optimal if new debt is issued after new equity is made complete use of as a source of capital.

Is optimal because debt is cheaper than equity on an after-tax basis.

May be optimal if new debt is issued after internally generated funds are made complete use of as a source of capital.

1 points   

QUESTION 30

New Heritage currently has a Debt to Asset ratio of 33.33 percent but Caleb feels its optimal Debt to Asset ratio should be 16.67 percent. Sales are currently $750,000, and the total assets turnover (Sales/Assets) is 7.5. If New Heritage needs to raise $100,000 to expand, how should the expansion be financed so as to produce the desired debt ratio? Expansion should be finance with:

100% Equity

75% debt, 25% equity

100% debt

25% debt, 75% equity.

Table 1

Market value of debt

$100 milion

Yield to maturity on debt

8.0%

Market price per share of common stock

$30

Number of shares of common stock

10milion

Cost of capital if all equity-financed

10.3%

Marginal tax rate

35%

Explanation / Answer

1. Ke= I( 1-t)=8(1-0.35)=5.20%

2. As per MM model

Ke= kc1+(kc1-kd)D/E(1-t)= 10.3+(10.3-8)100/300*(1-0.35)=10.79 or 10.8%

3. Calculation of WACC

0.2*12.5+0.8*7.7= 8.66%

0.3*13+0.7*8.4= 9.78%

0.4*14+0.6*9.3=11.18%

Debt to capital ratio 0.2 gives minimum WACC

4. Due to rise in marginal tax rate , cost of debt capital will fall.

5.As per Pecking order theory Retained earning should be used first then debt and then external equity.

Hence the correct option is C.

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