Reference no: EM132428797

Capital Structure in a Perfect Market

Question 1: Suppose Microsoft has no debt and an equity cost of capital of 9.5%. The average debt-to-value ratio for the software industry is 12.8%. If Microsoft took on the average amount of debt for its industry, the cost of its equity would be __________%. (Round to two decimal places.)

Question 2: Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is 0.54. Due to the increased risk, shareholders now expect a return of 15%. Assuming there are no taxes and Hubbard's debt is risk-free, the interest rate on the debt is __________%. (Round to two decimal places.)

Question 3: Arnell Industries has just issued $20 million in debt (at par). The firm will pay interest only on this debt. Arnell/s marginal tax rate is expected to be 30% for the foreseeable future.

a. Suppose Arnell pays interest of 10% per year on its debt. The annual interest tax shield is $__________ million. (Round to three decimal places.)

b. The present value of the interest tax shield is $__________ million. (Round to one decimal place.)

c. Suppose instead that the interest rate on the debt is 6%. In this case, the present value of the interest tax shield is $__________ million. (Round to one decimal place.)

Question 4: Rogot Instruments makes fine violins and cellos. It has $1.9 million in debt outstanding, equity valued at $2.3 million, and pays corporate income tax at a rate of 31%. Its cost of equity is 12% and its cost of debt is 6%.

a. Rogot's pre-tax weighted average cost of capital is __________%. (Round to two decimal places.)

b. Rogot's effective after-tax weighted average cost of capital is __________%. (Round to two decimal places.)