You are the CFO of the US-based company JKL Limited. Your CFO approaches you and tells you

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You are the CFO of the US-based company JKL Limited. Your CFO approaches you and tells you that he intends to debt finance a new 5-year project in Austria. Since he is not very familiar with said financing, he tells you that he has heard about different aspects or variables of said financing. Please name them and explain them briefly.

The company JKL Limited has 10 million shares outstanding. The stock is trading at $60 per share. It also has 400 bonds outstanding, each valued at $500,000. The marginal tax rate is 30%. The expected return for shareholders is approximately 14% and the interest rate on the bonds is 8%. What is JKL's after-tax WACC?

He was recently invited to the directors' meeting to decide on the company's future capital structure. One of his colleagues made the following argument: “As the company becomes more indebted and the debt becomes risky, both shareholders and bondholders demand higher rates of return. Therefore, by reducing the debt ratio we can reduce both the cost of debt and the cost of capital, improving the situation for everyone.”

Using the argument from M&M's Proposition I “The market value of a company is independent of its capital structure”, suggest why this argument is not relevant, and for simplicity ignore the tax implications.

An investor considers whether to invest in debt or stock of STU Corporation. Since he already has to pay a high personal tax rate, he doesn't want to pay more taxes than necessary. Therefore, he weighs the pros and cons of investing in bonds or stocks in local financial markets. The personal tax rate on interest income is 45%, the corporate tax rate is 27.5%, and the tax rate on dividends is 20%. What strategy do you recommend to the investor?

STU Corporation wants to evaluate the value of interest savings due to the tax deductibility of debt interest. The corporate tax rate is provided above. Total debt is $7.5 million and the debt yield is 6.5%. Assuming the current level of debt is permanent, calculate the annual interest payment due and the present value of the perpetual tax shield. Explain in which situations a tax shield could be less relevant and/or even misleading.

Most financial managers measure debt ratios from their companies' balance sheets. Many financial economists emphasize market value balance sheet ratios. What is the correct measurement in principle? Does the trade-off theory propose to explain accounting or market leverage? How about pecking order theory?

VWX Inc. has 100,000 bonds outstanding (at $1,000 each) that are 100% sold. The bonds yield 7.5 percent. The company also has 1 million preferred shares outstanding that currently yield 18.75 percent. It also has 5 million common shares outstanding. The preferred stock sells for $56 per share and the common stock sells for $38 per share. The expected return on the common stock is 13.8%. The corporate tax rate is 34 percent. What is VWX Inc.'s weighted average cost of capital?

The WACC formula implies that debt is “cheaper” than equity, that a company with more debt could use a lower discount rate. This makes sense?

Rockettech Corp. is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 per year in perpetuity.

The company is unsure whether to undertake this expansion and how to finance it. The two options are a common stock issue worth $1 million or a 20-year debt issue worth $1 million. The flotation costs of an equity issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1.5%.

Rockettech's CFO estimates that the required return on the company's capital is 14%, but maintains that IPO costs increase the cost of new capital to 19%. On this basis, the project does not appear viable. On the other hand, he notes that the company can obtain new debt at a 7% yield, which would raise the cost of new debt to 8.5%. Therefore he recommends that Rockettech go ahead with the project and finance it with a long-term debt issue.

Is the CFO right? How would you evaluate the project, considering that the project has the same business risk as the company's other assets?