Ch 16- FIN 4443
If ABC Co. has earnings before interest and taxes of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders if the interest rate is 10 percent and the tax rate is 21 percent? $1,500,000 $1,685,000 $1,975,000 $975,500
$1,685,000 [EBIT x (1-Tc) + TcRbB] 2,000,000 x(1-.21)+ (.21x.10x5,000,000)= 1,685,000 Tc- Corporate tax rate Rb- interest rate B- amount borrowed
Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12 percent. If the tax rate is 40 percent, what is the value of the firm? $50 million $22 million $83.33 million $6 million
$50m Vu= [EBIT(1 - Tc)]/R0 $50 million[$10m(1 - .4)]/.12 = $50m Tc- corporate tax rate R0- cost of capital
If an investor buys $20,000 worth of stock by investing $11,000 of their own money, how much was borrowed? $9,000 $31,000 $20,000 $11,000
$9,000 $20,000-$11,000= $9,000
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)? Below the indifference or break-even point in EBIT, an unlevered capital structure is best. Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures. Financial leverage increases the slope of the EPS line. The rate of return on assets is unaffected by leverage.
Below the indifference or break-even point in EBIT, an unlevered capital structure is best. Financial leverage increases the slope of the EPS line. The rate of return on assets is unaffected by leverage.
Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step. Divide by the cost of equity for an all-equity firm. Multiply EBIT by 1 minus the corporate tax rate. Add the present value of the debt tax shield. Calculate EBIT.
Calculate EBIT. Multiply EBIT by 1 minus the corporate tax rate. Divide by the cost of equity for an all-equity firm. Add the present value of the debt tax shield.
Holding equity in an unlevered firm has no risk. True False
False
Which of these statements is true regarding corporate capital structures? The capital structure that maximizes the value of the firm provides the most benefit for its stockholders. The best capital structure is always the all-equity option. The optimal capital structure results in a lower stock price and a higher cost of capital.
The capital structure that maximizes the value of the firm provides the most benefit for its stockholders.
An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ______. guaranteed dividends a higher expected return stock options collateral assets
a higher expected return
Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __. as debt is added, the equity becomes more risky capital structures are fixed debt is not cheaper than equity the overall cost of capital cannot be reduced
as debt is added, the equity becomes more risky the overall cost of capital cannot be reduced
When calculating the cash flow for a levered firm, you must consider ______. interest paid to bondholders only dividends paid to stockholders only cash flows to both bondholders and stockholders cash flows to both bondholders and all stakeholders
cash flows to both bondholders and stockholders
The WACC is the weighted average cost of ______ plus the weighted average cost of ______. debt; equity common stock; equity long-term debt; short-term debt capital; funds
debt; equity
With taxes, the weighted average cost of capital ______ as debt is added to the capital structure. decreases remains the same increases
decreases
Financial leverage affects the performance of a firm because the range of possible values for ___. earnings per share is wider operating income is smaller earnings per share is smaller operating income is wider
earnings per share is wider
Levered equity has ______ risk than unlevered equity. Multiple choice question. less greater the same
greater
With taxes, MM Proposition I says the value of the levered firm will be ______ the value of the unlevered firm. greater than less than the same as
greater than
An unlevered firm ______. has more risk than a levered firm is always superior to a levered firm has more volatility than a levered firm has an all-equity capital structure
has an all-equity capital structure
Managers should choose the capital structure that will have the ______ firm value. highest lowest
highest
An accounting balance sheet uses ______ values and a market balance sheet uses ______ values. current; historical current; current historical; current historical; historical
historical; current
An individual can duplicate a levered firm through a strategy called ______ where the investor uses his own funds plus borrowed funds to buy stocks. homemade leverage backyard bonding bootleg debt personal principal
homemade leverage
When an investor borrows money and uses it to purchase stocks is called ______. homemade equity raising debt homemade de-leverage homemade leverage
homemade leverage
When an investor borrows money and uses it to purchase stocks is called ______. homemade leverage homemade de-leverage homemade equity raising debt
homemade leverage
Under MM Proposition II with no taxes, the return on assets ______ as debt increases. is unchanged increases decreases
is unchanged
According to efficient capital markets theory, stock prices will only react to ______. old data government legislation new information macroeconomic shocks
new information
When Pete purchases $10,000 in stock by using $6,000 of his own money and borrowing the remaining $4,000 from his broker, he is buying stock ______. illegally on margin on account
on margin
The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm ______. times the tax rate plus the value of debt minus the tax rate times the value of debt times the tax rate times the value of debt plus the tax rate times the value of debt
plus the tax rate times the value of debt
Under MM Proposition II, a firm's cost of equity capital is ______ related to the firm's debt-equity ratio provided the cost of capital for an all-equity firm exceeds the cost of debt. not negatively indirectly positively
positively
The expected return on equity is ______ to leverage. unrelated negatively related positively related
positively related
Under MM with no taxes, as debt is Blank______ to capital structure, the cost of equity ______. removed; decreases added; decreases removed; increases added; increases
removed; decreases added; increases
Volatility or ______ increases for equity holders when leverage increases. inevitability risk yield-to-maturity certainty
risk
An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because ______. debt has the same cost as equity shareholders prefer levered firms debt reduces the cost of equity shareholders capture the interest tax shield
shareholders capture the interest tax shield
A firm's capital structure refers to ______. how the firm invests its capital the amount of cash in a firm the amount of capital in the firm the firm's mix of debt and equity
the firm's mix of debt and equity
Omega Corp. has $20 million in perpetual debt outstanding with a coupon rate of 8 percent. The tax rate is 40 percent. What is the tax shield from debt? $1.6 million $0 $0.64 million $50 million
0.40 × $20,000,000 × 0.08 = $0.64m tax shield from debt= Tc x Rb x B Tc- Corporate tax rate Rb- interest rate B- amount borrowed
Which of the following assumptions is necessary for MM Proposition I to hold? Personal taxes must be lower than corporate taxes. Managers must be acting to maximize the value of the firm. Individuals can borrow on their own at an interest rate equal to that of the firm. Interest rates must be low.
Individuals can borrow on their own at an interest rate equal to that of the firm.
Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ______. increases with leverage is unaffected by leverage decreases with leverage
increases with leverage
King's unlevered cost of equity is 11 percent and its pretax cost of debt is 8 percent. The firm has a debt-equity ratio of .4. If the tax rate is 40 percent, what is King's cost of equity? Multiple choice question. 12.59% 10.59% 11.72% 11%
11% + .4 × (1 - .4) × (11% - 8) = 11.72%
A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8 percent, and a cost of equity of 12 percent. What is the firm's WACC if there are no taxes? 8.95% 11.05% 9.85% 11.75%
11.05% WAAC= (S/ B+S) x Rs + (B/ B+S) x Rb ($16,000/$21,000) × 12% + ($5,000/$21,000) × 8% = 11.05%
Calculate the cost of capital for an all-equity firm with equity of $225,000 and expected earnings of $35,000. 12.4% 9.6% 16.5% 15.6%
15.6% Rs for unlevered firm Rs= (expected equity/ earnings) $35,000/$225,000 = 15.6%
Which of the following assumptions is necessary for MM Proposition I to hold? Interest rates must be low. Individuals can borrow on their own at an interest rate equal to that of the firm. Personal taxes must be lower than corporate taxes. Managers must be acting to maximize the value of the firm.
Individuals can borrow on their own at an interest rate equal to that of the firm.
Stockholders want to ______ the value of the entire firm. Maximize Minimize
Maximize
The effect of financial leverage ______ for all earning levels. is variable is advantageous is disadvantageous
is variable
Under MM Proposition II with no taxes, the WACC is invariant to the debt-equity ratio because ______. the return on assets (RO) is unchanged the return on debt (RD) remains constant the return on assets (RO) is lower the return on debt (RD) declines
the return on assets (RO) is unchanged
A company with $4 million in debt and $10 million in equity has a cost of debt of 7 percent, a cost of equity of 12.18 percent, and a tax rate of 35 percent. What is the firm's WACC? 12.41% 11.27% 4.55% 10%
10% ($10m/$14m)(.1218) + ($4m/$14m)(.07)(1 - .35) = .10, WACC= (S/VL)Rs+ (B/VL)Eb(1-Tc)
Alpha Co. has a debt-equity ratio of 0.6, a pretax cost of debt of 7.5 percent, and an unlevered cost of equity of 12 percent. What is Alpha's cost of equity if you ignore taxes? 16.5% 14.7% 9.3% 12%
14.7% Rs=12%+.06(12%-7.5%)= 14.7% Rs= R0 + (B/S) (R0-RB) R0- cost of capital for an all equity firm B/S- debt to equity ratio RB- cost of debt
A corporation gains no value from an interest tax shield if which of the following are true? The debt-equity ratio is 1. The corporation has no debt. Corporate tax rates are zero. The corporation is an all-equity firm.
The corporation has no debt. Corporate tax rates are zero. The corporation is an all-equity firm.
According to the efficient markets theory, the announcement of a future plant expansion (with a positive NPV) should cause the stock price and therefore the value of the firm to ______. decrease when the plant actually expands increase immediately decrease immediately increase when the plant actually expands
increase immediately
A market value balance sheet differs from an accounting balance sheet because ______. it does not use historical values assets and liabilities do not have to be equal it places liabilities on the left side it places assets on the right side
it does not use historical values
MM Proposition I does not work with corporate taxes because ______. levered firms pay more taxes than unlevered firms levered firms pay lower taxes than unlevered firms dividends are tax deductible
levered firms pay lower taxes than unlevered firms
A company should select the capital structure that ______ results in the lowest debt maximizes the company's value has the lowest leverage results in the lowest taxes
maximizes the company's value
The manager of a firm should change the capital structure if and only if ________ it benefits management the value of the debt exceeds the value of the equity the change will decrease the value of the firm the change will increase the value of the firm
the change will increase the value of the firm
MM Proposition II shows that ______. there is no risk involved with leverage when there are no corporate taxes equity is less expensive than debt the market value of the firm is unaffected by its capital structure the cost of equity rises with leverage
the cost of equity rises with leverage
A beneficial rule to follow is to set the firm's capital structure so that ______. the firm's value is maximized the firm's bondholders are satisfied the firm's value is minimized dividends are maximized
the firm's value is maximized