Financial Leverage and Cost of Capital: Illustrative Problems

Cost of Capital

1. Foodie Corporation plans a new issue of bonds with a par value of ₹1,000, a maturity of 28 years,
and an annual coupon rate of 16.0%. Flotation costs associated with a new debt issue would
equal 9.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds
of firms similar to Foodie is 17.0%. The firm's marginal tax rate is 30%. What will the firm's true
cost of debt be for this new bond issue?
2. Foodie Corporation is also considering using a new preferred stock issue. The preferred would
have a par value of ₹400 with an annual dividend equal to 18.0% of par. The company believes
that the market value of the stock would be ₹968.00 per share with flotation costs of ₹68.00 per
share. The firm's marginal tax rate is 40%. What would the firm's cost for this new preferred
stock issue?
3. PIMCO is considering using equity financing. Currently, the firm's stock is selling for ₹47.00 per
share. The firm's dividend for next year is expected to be ₹3.40 with an annual growth rate of
5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 14.0% of
the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of internal
equity?
4. JMP Company is considering using equity financing. Currently, the firm's stock is selling for ₹31.00
per share. The firm's dividend for next year is expected to be ₹5.50 with an annual growth rate of
5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of
the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external
equity?
5. Megha, Inc. (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred
stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%.
Currently, the firm's capital structure has ₹378 million of debt, ₹63 million of preferred stock, and
₹459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making
projections for next period. Its managers have determined that the firm should have ₹92 million
available from retained earnings for investment purposes next period. What is the firm's marginal
cost of capital at a total investment level of ₹155 million?
6. Megha, Inc. (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred
stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%.
Currently, the firm's capital structure has ₹378 million of debt, ₹63 million of preferred stock, and
₹459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making
projections for next period. Its managers have determined that the firm should have ₹92 million
available from retained earnings for investment purposes next period. What is the firm's marginal
cost of capital at a total investment level of ₹247 million?
7. FlikArt Ltd. has determined that its after-tax cost of debt is 9.0%. Its cost of preferred stock is
15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the
firm's capital structure has ₹378 million of debt, ₹63 million of preferred stock, and ₹459 million
of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections
for next period. Its managers have determined that the firm should have ₹92 million available
from retained earnings for investment purposes next period. What is the firm's marginal cost of
capital at a total investment level of ₹157 million?
8. AbC Company Ltd. has determined that its after-tax cost of debt is 9.0%. Its cost of preferred
stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%.
Currently, the firm's capital structure has ₹378 million of debt, ₹63 million of preferred stock, and
₹459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making
 projections for next period. Its managers have determined that the firm should have ₹92 million
available from retained earnings for investment purposes next period. What is the firm's marginal
cost of capital at a total investment level of ₹247 million?
9. A firm has determined that its before-tax cost of debt is 7% for the first ₹112 million in bonds it
issues, and 8% for any bonds issued above ₹112 million. Its cost of preferred stock is 10%. Its cost
of internal equity is 14%, and its cost of external equity is 17%. Currently, the firm's capital
structure has ₹400 million of debt, ₹100 million of preferred stock, and ₹500 million of common
equity. Assume that marginal tax rate is 30%. The firm is currently making projections for next
period. Its managers have determined that the firm should have ₹59 million available from
retained earnings for investment purposes next period. What is the firm's marginal cost of capital
at each of the following total investment levels?
10.Your company has determined that its after-tax cost of debt is 6% for the first ₹100 million in
bonds it issues, and 8% for any bonds issued above ₹100 million. Its cost of preferred stock is 9%.
Its cost of internal equity is 12%, and its cost of external equity is 14%. Currently, the company’s
capital structure has ₹600 million of debt, ₹100 million of preferred stock, and ₹300 million of
common equity. The firm's marginal tax rate is 30%. The company is currently making projections
for next period. Your finance managers have determined that the firm should have ₹75 million
available from retained earnings for investment purposes next period. What is the company’s
marginal cost of capital at each of the following total investment levels?
11.The Blue Dog Company has common stock outstanding that has a current price of ₹20 per share
and a ₹0.5 dividend. Blue Dog’s dividends are expected to grow at a rate of 3% per year, forever.
The expected risk-free rate of interest is 2.5%, whereas the expected market premium is 5%. The
beta on Blue Dog’s stock is 1.2.
a. What is the cost of equity for Blue Dog using the dividend valuation model?
b. What is the cost of equity for Blue Dog using the capital asset pricing model?
Financial Leverage

1. A company has an equity beta of 1.5, a debt-to-equity ratio of 0.4, and a marginal tax rate of 30
percent. Comment on how its financing structure affects its riskiness.
2. The beta of a publicly traded company’s stock is 1.3 and that the market value of equity and debt
are, respectively, $540 million and $720 million. If the marginal tax rate of this company is 40
percent, what is the asset beta of this company?
3. Mr. Ray is the business development manager of Aerotechnique S.A., a private Belgian
subcontractor of aerospace parts. Although Aerotechnique is not listed on the Belgian Stock
Exchange, Ray needs to evaluate the levered beta for the company. He has access to the
following information:
The average levered and average unlevered betas for the group of comparable companies
operating in different European countries are 1.6 and 1.0, respectively.
i. Aerotechnique’s debt-to-equity ratio, based on market values, is 1.4.
ii. Aerotechnique’s corporate tax rate is 34 percent.
What shall be Aerotechnique’s levered beta?
4. The Singapore-based Chuang Ho Company provides copper wired components for cellular
telephone manufacturers globally. Chuang Ho is going to establish a subsidiary that would
require assets of SGD 3 billion, and wants to select a capital structure that would minimize its
cost of capital for the subsidiary. Alex Ahn, the company’s CFO, wants to evaluate a target
leverage structure and uses a scenario approach to evaluate the cost of capital for the present 0
percent debt and a possible 50 percent debt or 80 percent debt. Chuang Ho’s marginal tax rate is
35 percent. Ahn has gathered the following information regarding costs of capital:
 a. The marginal cost of equity rises with increased level of debt from 13.5 percent (no
debt) to 18 percent (50% debt), to 28 percent (80% debt).
b. The marginal cost of borrowing is 12 percent on 50 percent debt, and 18 percent on
80 percent debt.
Which capital structure is expected to have the lowest cost of capital?
5. Sinfosys, Inc. has ₹387.5 million in debt and their current market value of equity is ₹700 million.
Assume Sinfosys, Inc. has the capacity to utilize their tax debt shield and the other valuation
consequences of capital structure are insignificant. Most of Sinfosys, Inc.’s debt is floating rate,
their return on debt is 8%, their return on assets is 12% and their corporate tax rate is 35%.
a. If Sinfosys, Inc. plans on keeping its borrowing permanently at this level, what is the
value of their capital structure/financing?
b. Assuming the situation in part (a), what is Sinfosys, Inc.’s return on equity?
c. Sinfosys, Inc.’s investment bankers have suggested that they entirely alter their
capital structure policy and instead of keeping the debt level constant, they should
have a constant proportion of debt. They will still start at their current capital
structure, 35.6% debt (387.5/(700+387.5)). What effect will this have on Sinfosys,
Inc.’s return on equity?
d. Your boss has asked you to explain why this change in capital structure policy has
changed the estimated return on equity.

6. M/s Kannan Bros. has no debt outstanding and a total market value of ₹10 million. Earnings
before interest and taxes (EBIT.) are projected to be ₹1.125 million if economic conditions are
normal. All net income is paid out to equity holders as dividends. If there is a strong expansion in
the economy, then EBIT will be ₹1.5 million. If there is a recession, then EBIT will be ₹750,000.
Cannon is considering a ₹4 million debt issue with a 10% interest rate. The debt proceeds will be
used to buy up stock. Ignore taxes. The current and proposed capital structures are given below.

Current Capital Proposed Capital

Structure Structure

Assets ₹10,000,000 ₹10,000,000

Debt 0.00 ₹4,000,000

Equity ₹10,000,000 ₹6,000,000

Share Price ₹25.00 ₹25.00

Shares 400,000 240,000

Outstanding

Bond Coupon na 10%

Rate

Bond YTM na 10%

a. Calculate earnings per share (EPS) and return on equity (ROE) under each of the three
economic scenarios under the firm's current capital structure.
b. Calculate earnings per share (EPS) and return on equity (ROE) under each of the three
 economic scenarios assuming the firm goes through with the recapitalization.
c. On one graph, graph EPS as a function of EBIT under the current capital structure and
under the proposed capital structure. Using your answers from parts (a), (b) and the
graph, what are the effects of leverage on EPS? on ROE?

7. Two firms, No Leverage Inc. and High Leverage, Inc., have equal amounts of operating risk and
differ only in their capital structures. No Leverage is unlevered and High Leverage has ₹400,000
of perpetual floating rate debt in its capital structure. Assume that the perpetual amount of
income of both firms available for stockholders is paid out as dividends. The growth rate for both
firms is zero. The income tax rate for both firms is 34 percent. Assume there are no bankruptcy
or agency costs associated with debt financing.

No Leverage, Inc. High Leverage, Inc.

Equity in capital structure ₹1,000,000 ?

Cost of Equity 10% ?

Debt in capital structure 0.00 ₹400,000

Pre-tax cost of debt na 6%

ESINFOSYS, INC. ₹100,000 ₹100,000

a. Determine the market value of No Leverage, Inc.

b. Determine the market value of High Leverage, Inc.
c. Determine the market value of equity for High Leverage, Inc. What is the relationship
between the value of the unlevered firm and the value of a levered firm once we consider
the effect of corporate income taxes?
d. What is the cost of equity capital for High Leverage, Inc.? WACC for High Leverage, Inc.?
Using the WACC and a FCF DCF, what is the market value of High Leverage?