Homework Help 6
Chapter 6 Homework
Work Problems 1-13. Answer to the Even numbers are below. Please work Odd problems
Chapter 6
2. Operating leverage is the substitution of fixed- for variable-cost methods of production. With operating leverage, sales must increase to cover the higher fixed costs, but once covered, profits rise more rapidly. Financial leverage requires higher cash flows to cover the higher interest payments, but once covered, profits accruing to shareholders grow more quickly with additional sales.
One would not expect to find both high operating leverage and high financial leverage at the same firm, as both types of leverage magnify the risks borne by equity. One mitigating fact is that companies with high operating leverage tend to have high fixed plant and land, which offers attractive loan collateral.
4. Companies can incur significant costs of financial distress without going bankrupt. In fact, these costs are often much larger than the cost of bankruptcy itself. Costs include lost profit opportunities due to cut backs in investment, R&D, and marketing to conserve cash. They also include lost sales as potential buyers worry about the ability of the business to service its products and increased costs as suppliers become less willing to enter into long run contracts and to provide trade credit. In knowledge-based companies, top producers may depart as the company’s stock-based compensation becomes less attractive. Detrimental conflicts of interest among owners, creditors, and managers can also arise when a company gets into financial difficulty, even in the absence of formal bankruptcy.
6. There are two reasons. First, the costs of high debt are comparatively low to such companies because the resale value of their assets is typically high and they have few worries about financial flexibility or adverse signaling effects. Second, managers in such companies have a tendency to rest on their laurels and to make uneconomic investments in search of growth. High debt levels impose a discipline on management encouraging them to generate cash flow to service the debt.
8. a. The customer’s equity investment is $10. The expected investment payoff is $106. Repaying $90 in principal and $3.60 in interest, the residual payoff to the customer is $12.40. A gain of $2.40 on a $10 investment implies a 24 percent return to equity, a substantial increase from the initial 6 percent return.
b. Unless borrowing somehow increases the expected $106 payoff from the investment, it should not make the investment more attractive. It will increase the expected return but also the risk. The ways in which borrowing can increase an investment’s expected payoff are enumerated in the Higgins Five Factor Model. None of those appear relevant here.
c. The Irrelevance Proposition says the same thing more formally: Unless leverage affects an investment’s cash flows, it should not affect its value.
10. a. Market signaling studies suggest that the price of existing FARO shares will fall. One explanation for the decline is that managers know more about their company than outsiders do and that the announcement of an equity sale signals they are worried about the company's prospects. Alternatively, they believe the company’s stock is overvalued at the current price.
b. Expected loss = 30% of issue size = 0.3*($200 million) = $60 million.
c. 60/($42 × 17) = 8.4 percent
d. Price per share = $42 × (1 − 0.084) = $38.47.
12. a. Because there is no debt outstanding, Firm value = Equity value = 100 million x $20 = $2 billion.
b. Firm value is unchanged at $2 billion. Debt outstanding is $1 billion, so equity value is $1 billion. (Equity value = firm value – debt value.)
c. Equity investors neither gain nor lose from the recap. Before the recap, equity value is $2 billion for 100 million shares, or $20 per share. After the recap, equity value is $1 billion for 50 million remaining shares, or $20 per share. (Equity investors that sold shares in the repurchase also received $20 cash for each share.)
d. Market value of firm = $2 billion + $100 million = $2.1 billion. Market value of equity = $2.1 billion – $1 billion = $1.1 billion, an increase of $100 million. All of the value created by the recap accrues to shareholders.
e. Equity investors indeed gain from the recap in this revised scenario. The leveraged recap makes sense to the extent that it increases firm cash flows and hence firm value. Further, all of the increased value accrues to the owners.