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: The book value cost of capital is as follows:
10% (16.5/(16.5+13.1) + 3.29% (13.1/(16.5+13.1)) = 7.03%

8.3: The share price will be between $26.91 and the estimated value of $27.59
If the firm buys the stock back at $28, the remaining stockholders will get a smaller increase in the stock price. The increase can be computed as follows:
Number of shares bought back = Additional dollar debt/ $ 28 = 6263/28 = 223.68 million shares Dollar Premium paid to stockholders = 223.68 * (28-26.91) = $243 million
Premium for remaining stockholders = 1400 - 243 = 1167 million
Increase in stock price for remaining stockholders = 1167/(2047.6 - 223.68) = $0.64
Stock price after buyback = $26.91 + 0.64 = $27.55

8.4: These costs are only partially captured in the cost of capital through the costs of debt and equity.
To fully assess them, you will have to adjust the operating income as the rating drops.

8.5: It may increase or decrease the optimal debt ratio, depending upon which effect dominates

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). It may not fully reflect indirect bankruptcy costs but this can be captured in the operating income.

8.7: 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)