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Answer on Economics of Enterprise Question for LaMarcus Streeter

Question #6760
5. DeAngelo Corp.'s projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.
Increase in Capital Budget
Increase Debt Lower Payout Do Both to 75% to 20%___________________
a. $114.0 $73.3 $333.9
b. $120.0 $77.2 $351.5
c. $126.4 $81.2 $370.0
d. $133.0 $85.5 $389.5
e. $140.0 $90.0 $410.0
Expert's answer
The answer:
e. $140.0 $90.0 $410.0

Explanation:
To take start capital structure (25% debt and 75% equity) we have next capital budget (from $150 mln):
To equity capital: (100% - 65%)*$150 mln = $52.5 mln, capital budget = $52.5 mln / 0.75 = $70 mln

(1) if debt ratio is raised to 75%, the equity ratio is 25%, capital budget = $52.5 mln / 0.25 = $210 mln,
the increase is $210 - $70 = $140 mln;
(2) retained income = (100% - 20%)*$150 mln = $120 mln, if 25% debt and 75% equity =>
=> capital budget = $120 mln/0.75 = $160 mln => the increase is $160 - $70 = $90 mln;
(3) we have retained income $120 mln, 75% debt and 25% equity => capital budget = $120 mln / 0.25 = $480 mln, the
increase is $480 - $70 = $410 mln;

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