Question

Which of the following are ways that a firm can reduce cash flows in order to prevent managers from wastefully spending excess cash flows? Check all that apply.

Minimizing the amount of debt in the firm’s capital structure so that the firm can borrow money at a reasonable rate when good investment opportunities arise

Increasing the amount of debt in the firm’s target capital structure in the hope that higher debt-service requirements will force managers to be more disciplined

Funneling excess cash flows back to shareholders through higher dividends

Funneling excess cash flows back to shareholders through stock repurchases

Blue Ram Brewing Company currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm’s unlevered beta is 1.1, and its cost of equity is 11.80%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.80%. The risk-free rate of interest (rRFrRF) is 3%, and the market risk premium (RP) is 8%. Blue Ram’s marginal tax rate is 35%.

Blue Ram is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table.

D/Cap Ratio	E/Cap Ratio	D/E Ratio	Bond Rating	Before-Tax Cost of Debt (rdrd)	Levered Beta (b)	Cost of Equity (rsrs)	WACC
0.0	1.0	0.00	—	—	1.1	11.80%	11.80%
0.2	0.8	0.25	A	8.4%		13.232%	11.678%
0.4	0.6	0.67	BBB	8.9%	1.577	15.616%
0.6	0.4	1.50	BB	11.1%	2.173		12.483%
0.8	0.2		C	14.3%	3.960	34.680%

Answer 1

Answer (a):

Correct options are checked as follows:

Explanation:

When there is lack of acceptable capital projects and excess cash exists, it is prudent to distribute the excess cash to shareholders either as dividends or by repurchasing shares. As such statements C and D are correct. Further, higher leverage will put pressure on management to ensure to optimize operations to provide for higher debt service charges. As such statement B is correct and A is incorrect.

Answer (b):

As required completed table is as follows:

The filled up cells are highlighted.

The above excel with formulas is as follows: