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80% C 80.00%

90% D 100.00%

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The direct and indirect bankruptcy cost is estimated to be 25% of the firm value. Estimate

the optimal debt ratio of the firm, based upon levered firm value.

19. In 1995, an analysis of the capital structure of Reebok provided the following results

on the weighted average cost of capital and firm value.

Actual Optimal Change

Debt Ratio 4.42% 60.00% 55.58%

Beta for the Stock 1.95 3.69 1.74

Cost of Equity 18.61% 28.16% 9.56%

Bond Rating A- B+

After-tax Cost of Debt 5.92% 6.87% 0.95%

WACC 18.04% 15.38% -2.66%

Firm Value (with no growth) $ 3,343 mil $ 3,921 mil $ 578 mil

Stock Price $ 39.50 $ 46.64 $ 7.14

This analysis was based upon the 1995 earnings before interest and taxes of $ 420

million, and a tax rate of 36.90%.

a. Why is the optimal debt ratio for Reebok so high?

b. What might be some of your concerns in moving to this optimal?

20. Timberland Inc., a manufacturer and retailer of footwear and sportswear, is

considering is highly levered status. In 1995, the firm had $ 237 million in market value

of debt outstanding, and 11 million shares outstanding at $ 19.88 per share. The firm had

earnings before interest and taxes of $ 44 million, a book value of capital of $ 250 million

and a tax rate of 37%. The treasury bond rate is 7.88%, and the stock has a beta of 1.26.

The following table summarizes the estimated bond ratings and interest rates at different

levels of debt for Timberland â€“

Debt Ratio Bond Rating Interest Rate on Debt

0% AAA 8.18%

10% AAA 8.18%

20% A+ 8.88%

30% A 9.13%

40% A- 9.38%

50% BB 10.38%

60% BB 10.38%

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70% B 11.88%

80% B- 12.88%

90% CCC 13.88%

a. Estimate the optimal debt ratio, using the cost of capital approach.

b. Estimate the optimal debt ratio, using the return differential approach.

c. Will the two approaches always give you identical results? Why or why not?

21. You are trying the evaluate whether United Airlines has any excess debt capacity. In

1995, UAL had 12.2 million shares outstanding at $ 210 per share, and debt outstanding

of approximately $ 3 billion (book as well as market value). The debt had a rating of B,

and carried a market interest rate of 10.12%. In addition, the firm had leases outstanding,

with annual lease payments anticipated to by $ 150 million. The beta of the stock is 1.26,

and the firm faces a tax rate of 35%. The treasury bond rate is 6.12%.

a. Estimate the current debt ratio for UAL.

b. Estimate the current cost of capital.

c. Based upon 1995 operating income, the optimal debt ratio is computed to be 30%, at

which point the rating will be BBB, and the market interest rate is 8.12%.

d. Would the fact that 1995 operating income for airlines was depressed alter your

analysis in any way? Explain why.

22. Intel has earnings before interest and taxes of $ 3.4 billion, and faces a marginal tax

rate of 36.50%. It currently has $ 1.5 billion in debt outstanding, and a market value of

equity of $ 51 billion. The beta for the stock is 1.35, and the pre-tax cost of debt is 6.80%.

The treasury bond rate is 6%. Assume that the firm is considering a massive increase in

leverage to a 70% debt ratio, at which level the bond rating will be C (with a pre-tax

interest rate of 16%).

a. Estimate the current cost of capital.

b. Assuming that all debt gets refinanced at the new market interest rate, what would your

interest expenses be at 70% debt? Would you be able to get the entire tax benefit? Why

or why not?

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c. Estimate the beta of the stock at 70% debt, using the conventional levered beta

calculation. Reestimate the beta, on the assumption that C rated debt has a beta of 0.60.

Which one would you use in your cost of capital calculation?

d. Estimate the cost of capital at 70% debt.

e. What will happen to firm value if Intel moves to a 70% debt ratio?

f. What general lessons on capital structure would you draw for other growth firms?

23. NYNEX, the phone utility for the New York Area, has approached you for advice on

its capital structure. In 1995, NYNEX had debt outstanding of $ 12.14 billion and equity

outstanding of $ 20.55 billion. The firm had earnings before interest and taxes of $ 1.7

billion, and faced a corporate tax rate of 36%. The beta for the stock is 0.84, and the

bonds are rated A- (with a market interest rate of 7.5%). The probability of default for A-

rated bonds is 1.41%, and the bankruptcy cost is estimated to be 30% of firm value.

a. Estimate the unlevered value of the firm.

b. Value the firm, if it increases its leverage to 50%. At that debt ratio, its bond rating

would be BBB, and the probability of default would be 2.30%.

c. Assume now that NYNEX is considering a move into entertainment, which is likely to

be both more profitable and riskier than the phone business. What changes would you

expect in the optimal leverage?

24. A small, private firm has approached you for advice on its capital structure decision.

It is in the specialty retailing business, and it had earnings before interest and taxes last

year of $ 500,000.

The book value of equity is $ 1.5 million, but the estimated market value is $ 6

â€¢

million.

The firm has $ 1 million in debt outstanding, and paid an interest expense of $ 80,000

â€¢

on the debt last year. (Based upon the interest coverage ratio, the firm would be rated

AA, and would be facing an interest rate of 8.25%.)

The equity is not traded, but the average beta for comparable traded firms is 1.05, and

â€¢

their average debt/equity ratio is 25%.

a. Estimate the current cost of capital for this firm.

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b. Assume now that this firm doubles it debt from $ 1 million to $ 2 million, and that the

interest rate at which it can borrow increases to 9%. Estimate the new cost of capital, and

the effect on firm value.

c. You also have a regression that you have run of debt ratios of publicly traded firms

against firm characteristics â€“

DBTFR = 0.15 + 1.05 (EBIT/FIRM VALUE) - 0.10 (BETA)

Estimate the debt ratio for the private firm, based upon this regression.

d. What are some of the concerns you might have in extending the approaches used by

large publicly traded firms to estimate optimal leverage to smaller firms?

25. XCV Inc., which manufactures automobile parts for assembly, is considering the

costs and the benefits of leverage. The CFO notes that the return on equity of the firm,

which is only 12.75% now, based upon the current policy of no leverage, could be

increased substantially by borrowing money. Is this true? Does it follow that the value of

the firm will increase with leverage? Why or why not?

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