New Heritage Doll Co

1. New Heritage Doll Co. is considering opening five new retail stores in East Coast that would require external financing. Amy Chen, the CFO of New Heritage announced in a board meeting that the management is planning to increase the proportion of debt in the company’s capital structure.

   Celestila Moonn is one of the senior managers at the corporate finance department of New Heritage gathered the following market data for her analysis to identify the capital structure that maximizes the firm’s stock price and minimizes the weighted average cost of capital.

   In response to a question regarding capital structure theory, Moonn made the following statement:

   The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.

   Table 1
   Market value of debt	$500,000,000
   Yield to maturity on debt	7.0%
   Market price per share of common stock	$23
   Number of shares of common stock	45,000,000
   Cost of capital if all equity-financed	9.50%
   Marginal tax rate	30%

     

   Table 2
   Debt-to-Total Capital Ratio %	Cost of Debt %	Cost of Equity %
   20	8.7	13.5
   30	9.4	14.0
   40	10.3	15.0
   50	11.4	17.0

   Based on the data provided on the Tables 1 & 2, New Heritage’s current after tax cost of debt is closest to:

   A.

   5.0%

   B.

   7.0%

   C.

   8.7%

1 points   

QUESTION 2

1. Based on the data provided on the Tables 1 & 2, New Heritage’s current cost of equity capital is closest to:

   A.

   13.5%

   B.

   10.35%

   C.

   9.5%

1 points   

QUESTION 3

1. Based on the data provided on the Tables 1 & 2, what debt-to-total capital ratio would maximize New Heritage’s stock price and minimize weighted average cost of capital?

   A.

   11.15%

   B.

   0.1177%

   C.

   11.77%

1 points   

QUESTION 4

1. Based on market value, New Heritage’s current capital structure is closest to:

   	A.	60% equity financed and 40% debt financed
   	B.	65% equity financed and 35% debt financed
   	C.	67% equity financed and 33% debt financed.

1 points   

QUESTION 5

1. Is Moonn correct with respect to her statement regarding capital structure theory?

   	A.	No, because adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all equity.
   	B.	No, because adding the tax shield provided by equity to the Modigliani and Miller framework suggests that the optimal capital structure is all debt.
   	C.	Yes.