# Capital Structure and the Cost of Capital

March 13, 2016

Chapter 18: Capital Structure and the Cost of Capital

1) AQ&Q has EBIT of \$2 million, total assets of \$10 million, stock holder’s equity of \$4 million, and pretax interest expense of 10 percent.

a) What is AQ&Q’s indifference level of EBIT?

b) Given its current situation, might it benefit from increasing or decreasing its use of debt? Explain.

c) Suppose we are to AQ&Q’s average tax rate is 40 percent. How does this affect your answers to (A) and (B)?

4) Faulkner’s Fine Fries, Inc. (FFF) is thinking about reducing its debt burden. Given the following capital structure information and an expected EBIT of \$50 million (plus or minus 10 percent) next year, should FFF change their capital structure?

CURRENT PROPOSED

Total assets \$750 million \$750 million

Debt \$450 million \$300 million

Equity \$300 million \$450 million

Common stock price \$30 \$30

Number of shares 10,000,000 15,000,000

Interest rate 12% 12%

• 8) The Nutrex Corporation wants to calculate its weighted average cost of capital. Its target capital structure weights are 40 percent long-term debt and 60 percent common equity. The before-tax cost of debt is estimated to be 10 percent and the company is in the 40 percent tax bracket. The current risk-free interest rate is 8 percent on Treasury bills. The expected return on the market is 13 percent and the firm’s stock beta is 1.8.

a. What is Nutrex ‘s cost of debt?

b. Estimate Nutrex’s expected return on common equity using the security market line.

c. Calculate the after-tax weight average cost of capital.

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