Concept Checks

8.1: any decline in operating inome is offset by the lower cost of capital
It will also lead to an increase in firm value if the operating income stays constant. Firm value is operating income discounted back at the cost of capital.

8.2: will increase the optimal debt ratio for the firm
The cost of equity will be lower at each level of debt. The cost of debt already reflects the risk.

8.3: Cost of Capital using book value = (16/28.342) 13.85% + (12.342/28.342)4.80% = 9.91%

8.4: See below

D/(D+E)
0.00%
10.00%
20.00%
Second Iteration
D/E
0.00%
11.11%
25.00%
$ Debt
$0
$6,207
$12,414
EBITDA.
$6,693
$6,693
$6,693
Depreciation
$1,134
$1,134
$1,134
EBIT
$5,559
$5,559
$5,559
$5,559
Interest
$0
$447
$894
$968
Tax. Inc.
$5,559
$5,112
$4,665
$4,591
Int. cov °
12.44
6.22
5.74
Likely Rating AAA AAA A+ A+
Interest Rate
7.20%
7.20%
7.80%
7.80%
Eff. Tax Rate
36.00%
36.00%
36.00%
Cost of debt
4.61%
4.61%
4.99%

 

8.5:
If the firm can buy the stock back at the current price of $ 75.38, the remaining stockholders will get a much greater increase in the stock price. The increase can be computed as follows:
Number of shares bought back = New Debt Issued / $ 75.38 = ($24,828-11180) /$75.38 = 181.05 million shares [$24,828 is the dollar debt at 40%, which is the optimal]
Number of shares remaining = 675.13 - 181.05 = 494.08 million shares
Increase in value per share = $8,474 / 494.08 = $17.15

8.6: False.
The cost of debt reflects default risk, and the cost of equity reflects a higher beta (which also reflects the higher risk of default)

8.7: False
The cost of equity will also go down at every level of debt.

8.8: any of the above, depending upon...
whether firms, on average, are above, below or close to their optimal leverage (as measured by the cost of capital approach)