Finance

Section I – Short answer.  For each question in this section, indicated whether you agree or disagree with the statement and provide a short rationale to support your decision.  2 points each.

1. In a world with taxes but no bankruptcy costs, the optimal capital structure for a firm would be 100% debt financing.  Agree or disagree, and why.
2. If a firm engages in a reverse stock split, the price per share usually falls.  Agree or disagree, and why.
3. When a firm adds new debt on top of existing debt, the component cost of debt for the firm often increases.  Agree or disagree, and why.

Section II – Discussion. For each question or statement, provide an in-depth answer.  4 points each.

1. Why do companies split their stocks?  Who benefits?  Who loses?  Is there any economic value created by a stock split?  Explain. 
2. Explain how adding additional debt to the capital structure of firm can actually increase firm value. 

Section III – Problems.  Show all your work, and clearly designate final answers.  Problems 1-2 are worth 10 points each.

1. Safety Systems owns and operates a fire extinguisher manufacturing firm.  The firm currently has $50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. The firm is planning a leveraged buyout, where it will increase its debt-to-equity ratio to .80. The tax rate is 25%.  A) What is the unlevered beta of the firm?  Explain your answer in words.  B) What will be the new beta after the leverage buyout?  Explain your answer in words.  C) Explain the likely effect on both the component cost of equity capital and the firm’s overall weighted average cost of capital. Why would a firm pursue such a strategy?