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15) Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are expected to remain at this level indefinitely. Stock- holders currently require a 12.1 percent return on their investment. Nico is consider- ing changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level indefi- nitely. However, because of the added risk, the required return demanded by stock holders will increase to 12.6 percent. Based on this information, should Nico make the change? a. Yes b. No c. It’s irrelevant d. Not enough information

****Note**** The answer is not (d. Not enough information)

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Keith Leannon
Keith LeannonLv2
29 Sep 2019

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Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are expected to remain at this level indefinitely. Stock- holders currently require a 12.1 percent return on their investment. Nico is consider- ing changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level indefi- nitely. However, because of the added risk, the required return demanded by stock holders will increase to 12.6 percent. Based on this information, should Nico make the change? a. Yes b. No c. It’s irrelevant d. Not enough information

Star, Inc., a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 50 percent debt. Currently there are 1,000 shares outstanding and the price per share is $65. EBIT is expected to remain at $37,500 per year forever. The interest rate on new debt is 8 percent, and there are no taxes.

1. Ms. Brown, a shareholder of the firm, owns 100 shares of stock. What is her cash flow under the current capital structure, assuming the firm has a dividend payout rate of 100 percent?

2. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume that she keeps all 100 of her shares?

3. Suppose Star does convert, but Ms. Brown prefers the current all-equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure.

4.Using your answer to part (c), explain why Star’s choice of capital structure is irrelevant.

Calculating the cost of equity

Suppose stock in Boone Corporation has a beta of .90. The market rate premium is 7 percent, and the risk-free is 8 percent. Boone's las dividend was $1.80 per share, and the dividend is expected to grow at 7 percent indefinitely. The stock currently sells for $25. What is Boone's cost of equity capital?

Calculating the WACC.

In addition to the information in the previous problem, suppose Boone has a target debt-equity ratio of 50 percent. Its cost of debt is 8 percent, before taxes. If the tax rate is 34 percent, what is the WACC?

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