Chapter 16 3671

Calculate the cost of capital for an all-equity firm with equity of $12,500 and expected earnings of $1,900.

$1,900/$12,500 = 15.2%

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?

($10m/$14m)(.1218) + ($4m/$14m)(.07)(1 - .35) = .10, or 10%

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?

($16,000/$21,000) × 12% + ($5,000/$21,000) × 8% = 11.05%

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?

0.40 × $20m × 0.08 = $0.64m

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?

11% + .4 × (1 - .4) × (11% - 8) = 11.72%

Calculate the cost of capital for an all-equity firm with equity of $225,000 and expected earnings of $35,000.

15.6%

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. The rate of return on assets is unaffected by leverage. Financial leverage increases the slope of the EPS line.

Which of the following assumptions is necessary for MM Proposition I to hold?

Individuals can borrow on their own at an interest rate equal to that of the firm.

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.

A corporation gains no value from an interest tax shield if which of the following are true?

The corporation is an all-equity firm. Corporate tax rates are zero. The corporation has no debt.

An unlevered firm has a value of $30 million. An identical firm has debt of $2 million with a 7 percent annual coupon. The tax rate is 40 percent. What is the value of the levered firm?

VL= $30m + .4 × $2m = $30.8m

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?

[$10m(1 - .4)]/.12 = $50m

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.

a higher expected return

When calculating the cash flow for a levered firm, you must consider:

cash flows to both bondholders and stockholders

The WACC is the weighted average cost of ______ plus the weighted average cost of ______.

debt; equity

With taxes, the weighted average cost of capital ______ as debt is added to the capital structure.

decreases

Financial leverage affects the performance of a firm because the range of possible values for ___.

earnings per share is wider

Levered equity has ______ risk than unlevered equity.

greater

An unlevered firm ____.

has an all-equity capital structure

Managers should choose the capital structure that will have the ______ firm value.

highest

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 ___.

increase immediately

Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ___.

increases with leverage

A key assumption of MM Proposition I is that ___.

individuals can borrow as cheaply as corporations

The effect of financial leverage ______ for all earning levels.

is variable

MM Proposition I does not work with corporate taxes because:

levered firms pay lower taxes than unlevered firms

A company should select the capital structure that:

maximizes the company's value

According to efficient capital markets theory, stock prices will only react to ___.

new information

The expected return on equity is _____ to leverage.

positively related

Under MM with no taxes, as debt is ________ to capital structure, the cost of equity ______.

removed; decreases added; increases

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because:

shareholders capture the interest tax shield

The manager of a firm should change the capital structure if and only if ___.

the change will increase the value of the firm

MM Proposition II shows that ___.

the cost of equity rises with leverage.

A firm's capital structure refers to ___.

the firm's mix of debt and equity

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __.

the overall cost of capital cannot be reduced as debt is added, the equity becomes more risky

Volatility or ______ increases for equity holders when leverage increases.

risk

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 35 percent?

(.1 × $5m) + [$2m - (.1 × $5m)](1 - .35) = $1,475,000

Alpha Co. has a debt-equity ratio of .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?

12% + .6(12% - 7.5) = 14.7%