. 10
( 10 .)

b. it eliminates dividends.

4. DGF Corporation has come to you for some advice on how best to increase their
leverage over time. In the most recent year, DGF had EBITDA of $ 300 million, owed $
1 billion in both book value and market value terms, and had a net worth of $ 2 billion
(the market value was twice the book value). It had a beta of 1.30, and the interest rate on
its debt is 8% (the treasury bond rate is 7%). If it moves to its optimal debt ratio of 40%,
the cost of capital is expected to drop by 1%.

a. How should the firm move to its optimal? In particular, should it borrow money and
take on projects or should it pay dividends/repurchase stock?

b. Are there any other considerations that may affect your decision?

5. STL Inc. has asked you for advice on putting together the details of the new debt issues
it is planning to make. What information would you need to obtain to provide this

6. Assume now that you have uncovered the following facts about the types of projects
STL takes:

a. The projects are primarily infrastructure projects, requiring large initial investments
and long gestation periods.

b. Most of the new projects will be in emerging markets, and the cash flows are expected
to be in the local currencies, when they do occur.

c. The magnitude of the cash flows will, in large part, depend upon how quickly the
economies of the emerging markets grow in the long term.

How would you use this information in the design of the projects?

7. You are attempting to structure a debt issue for Eaton Corporation, a manufacturer of
automotive components. You have collected the following information on the market
values of debt and equity for the last ten years:

Year Market Value of Equity Debt
1985 1824.9 436


1986 2260.6 632
1987 2389.6 795
1988 1960.8 655
1989 2226 836
1990 1875.9 755
1991 2009.7 795
1992 2589.3 833
1993 3210 649
1994 3962.7 1053
In addition, you have the following information on the changes in long term interest rates,
inflation rates, GNP, and exchange rates over the same period.

Year Long Bond Rate GNP Growth Weighted Dollar Inflation Rate
1985 11.40% 6.44% 125.95 3.50%
1986 9.00% 5.40% 112.89 1.90%
1987 9.40% 6.90% 95.88 3.70%
1988 9.70% 7.89% 95.32 4.10%
1989 9.30% 7.23% 102.26 4.80%
1990 9.30% 5.35% 96.25 5.40%
1991 8.80% 2.88% 98.82 4.20%
1992 8.10% 6.22% 104.58 3.00%
1993 7.20% 5.34% 105.22 3.00%
1994 8.00% 5.97% 98.6 2.60%


Using this information,

a. Estimate the duration of this firm™s projects. How would you use this information in
designing the debt issue?

b. How cyclical is this company? How would that affect your debt issue?

c. Estimate the sensitivity of firm value to exchange rates. How would you use this
information in designing the debt issue?

d. How sensitive is firm value to inflation rates? How would you use this information in
designing the debt issue?

e. What factors might lead you to override the results of this analysis?

8. Repeat the analysis in problem 7 for a private firm that has provided you with the
following estimates of operating income for the ten years for which you have the macro
economic data:

Year Operating Income
1985 463.05
1986 411.696
1987 483.252
1988 544.633
1989 550.65
1990 454.875
1991 341.481
1992 413.983
1993 567.729
1994 810.968


9. Assuming that you do the analysis in problem 8 with both firm value and operating
income, what are the reasons for the differences you might find in the results, using each?
When would you use one over the other?

10. Pfizer, a major pharmaceutical company, has a debt ratio of 10.30% and is
considering increasing its debt ratio to 30%. Its cost of capital is expected to drop from
14.51% to 13.45%. Pfizer had earnings before interest and taxes of $ 2 billion in 1995,
and a book value of capital (debt + equity) of approximately $ 8 billion. It also faced a
tax rate of 40% on its income. The stock in the firm is widely held, but the corporate
charter includes significant anti-takeover restrictions.

a. Should Pfizer move to its desired debt ratio quickly or gradually? Explain.

b. Given the choice in part a, explain how you would move to the optimal?

c. Pfizer is consider using the excess debt capacity for an acquisition. What are some of
the concerns it should have?

11. Upjohn, which is also a major pharmaceutical company, is considering increasing its
debt ratio from 11% to 40%, which is its optimal debt ratio. Its beta is 1.17, and the
current treasury bond rate is 6.50%. The return on equity was 14.5% in the most recent
year, but it is dropping, as health care matures as a business. The company has also been
mentioned as a possible takeover target, and is widely held.

a. Would you suggest that Upjohn move to the optimal ratio immediately? Explain.

b. How would you recommend that Upjohn increase its debt ratio?

12. U.S. steel companies have generally been considered mature in terms of growth, and
often take on high leverage to finance their plant and equipment. Steel companies in
some emerging markets often have high growth rates and good growth prospects. Would
you expect these companies to also have high leverage? Why or why not?


13. You are trying to decide whether the debt structure that Bethlehem Steel has currently
is appropriate, given its assets. You regress changes in firm value against changes in
interest rates, and arrive at the following equation “

Change in Firm Value = 0.20% - 6.33 (Change in Interest Rates)

a. If Bethlehem Steel has primarily short term debt outstanding, with a maturity of 1 year,
would you deem it appropriate?

b. Why might Bethlehem Steel be inclined to use short term debt to finance longer term

14. Railroad companies in the United States tend to have long term, fixed rate, dollar
denominated debt. Explain why.

15. The following table summarizes the results of regressing changes in firm value
against changes in interest rates for six major footwear companies “

Change in Firm Value = a + b (Change in Long Term Interest Rates)

Company Intercept (a) Slope Coefficient (b)

LA Gear -0.07 -4.74

Nike 0.05 - 11.03

Stride Rite 0.01 -8.08

Timberland 0.06 -22.50

Reebok 0.04 - 4.79

Wolverine 0.06 -2.42

a. How would you use these results to design debt for each of these companies?

b. How would you explain the wide variation across companies? Would you use the
average across the companies in any way?


16. You have run a series of regressions of firm value changes at Motorola, the
semiconductor company, against changes in a number of macro-economic variables. The
results are summarized below “

Change in Firm Value = 0.05 - 3.87 (Change in Long Term Interest Rate)

Change in Firm Value = 0.02 + 5.76 (Change in Real GNP)

Change in Firm Value = 0.04 - 2.59 (Inflation Rate)

Change in Firm Value = 0.05 - 3.40 ($/DM)

a. Based upon these regressions, how would you design Motorola™s financing?

b. Motorola, like all semiconductor companies, is sensitive to the health of high
technology companies. Is there any special feature you can add to the debt to reflect this



. 10
( 10 .)