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##### Explain what is meant by business and financial risk.

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**Question**

a. Explain what is meant by business and financial risk.;b. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A;also has a higher cost of equity capital? Explain.;Problem 2 (4 Marks);Is there an easily identifiable debt-equity ratio that will maximize the value of a;firm? Why or why not?;Problem 3 (6 Marks);What two basic options does a firm have if it cannot (or chooses not to) make a;contractually required payment such as interest? Describe them.;Problem 4 (7 Marks);According to M&M World II proposition II, a firm will continue to increase in value as it;adds debt its capital structure. When financial distress is introduced to the value;equation in World III, what happens to the value of the company and the WACC of the;firm? Use diagrams to explain your answer.;Problem 5 (6 Marks);ABC Inc. is an unlevered firm. The current market value of its equity is $18 million and;required rate of return is 8%.;a. If there is no taxes, what is the value of its EBIT?;b. If the tax rate is 35%, what is the value of its EBIT?;(Assume there is no concern about financial distress and general M&M assumptions;apply);Problem 6 (7 Marks);With a weighted average cost of capital of 9%, Nova Fun Inc. is considered to be a good;publicly traded firm. Currently it has a debt to equity ratio of 1.5, cost of debt of 5.5%;and corporate tax rate of 35%.;a. What will be the cost of equity for a firm that is in the same business as Nova;Fun Inc. but 100% equity financed?;b. What can you conclude on the role of debt on cost of equity capital from your;findings? Why the cost may change? Explain.;(Assume there is no concern about financial distress and general M&M assumptions;apply);1;Fall 2014, Assignment #3;Problem 7 (9 Marks);ABC Inc. is an unlevered firm with a weighted average cost of capital of 15%. The firm;has been doing well and has reached a stable EBIT at a level of $19,750. The firm;hopes to be able to generate this level of EBIT forever without any need for growth.;Given its stability in cash flows, now lenders are willing to lend to it at a rate of 10%.;The firms income tax rate is 35%. If the firm wants to change its capital structure to;have 50% of its financing coming from debt (i.e. the debt to be issued is worth 50%;of the pre-restructuring value of the firm), what will be the value of its equity;under the new capital structure?;(Assume there is no concern about financial distress and general M&M assumptions;apply);Problem 8 (13 Marks);a. Assume all the assumptions and results related to M&M theorem apply and there is;no financial distress concern. A firm has debt (D) and equity (E). For this firm the cost;of debt is RD, cost of unlevered equity is RU, and cost of equity is RE. If the corporate tax;rate is tC and weighted average cost of capital is WACC, show that;WACC = RU[1 tC(D/V)].;You may use any equations from the text related to CAPM & M&M propositions.;b. What does the equation above tell us about the relationship between weighted;average cost of capital and debt? What role does the interest tax shield play in;the value of WACC?;Problem 9 (11 Marks);Real world in not free of tax or financial distress. For this problem assume that;firms pay taxes and financial distress is possible. Consider an all equity financed;firm that has no growth and pays out all of its earnings. Currently the risk-free;rate is 3%. It has 3,000,000 shares outstanding. However, it is planning to raise;$3,000,000 in debt at an interest rate of 6% and repurchase its outstanding;shares with the debt proceeds. Notice that in the presence of financial distress;cost of debt increases. After the new debt offering, the equity beta for the firm is;expected to be 2. The current market rate of return is 9%, and the firms EBIT is;$6,000,000. If the firms tax rate is 35%, what will be the new share price and;WACC for the firm after the restructuring?;Problem 10 (5 Marks);How does business risk and financial risk interact and affect the cost of equity;capital? Explain.

Paper#27059 | Written in 18-Jul-2015

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