Finance Test 3

Which one of the following is the equity risk that is most related to the daily operations of a firm?

Business risk

Financial risk is

Dependent upon a company's capital structure

Bankruptcy

is a legal proceeding

Taco Corp. is debt-free and has a weighted average cost of capital of 12.7 percent. The current market value of the equity is $2.3 million and there are no taxes. According to M&M Proposition I under Case I (no taxes or bankruptcy costs), what will be the value of the company if it changes to a debt-equity ratio of .85?

$2,300,000

3-Petes Auto Parts, Inc. is debating between a levered and an unlevered capital structure. The all-equity capital structure would consist of 60,000 shares of stock. The debt and equity option would consist of 45,000 shares of stock plus $250,000 of debt with an interest rate of 7.25 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

$72,500 EBITBE = SB*IA/(SB-SA) - SA*IB/(SB-SA) = 0 - (60)(250,000*.0725)/(45-60) = 72,500

Ignoring taxes (M&M Case I), Pewter & Glass has a weighted average cost of capital of 10.82 percent. The company can borrow at 7.4 percent. What is the cost of equity if the debt-equity ratio is .68?

13.15% WACC = wDRD + wERE = 10.82 = (.68/1.68)(7.4) + (1/1.68)(RE) RE = [10.82 - (.68/1.68)(7.4)](1.68) = 13.15

Generic Motors is expected to have an EBIT of $2.2 million next year. Depreciation, the increase in net working capital, and capital spending are expected to be $158,000, $92,000, and $114,000, respectively. All are expected to grow at 15 percent per year for four years. The firm currently has $12 million in debt and 750,000 shares outstanding. After year 5, the adjusted cash flow from assets is expected to grow at 2.5 percent indefinitely. The company's WACC is 8.7 percent and the tax rate is 34 percent. What is the price per share of the company's stock?

ACFA1 = EBIT*(1-t) + Depreciation - Change in NWC - Capital Spending = $2,200,000*(1-0.34) + 158,000 - 92,000 -114,000 = $1,404,000 ACFA2 = $1,404,000*(1.15) = $1,614,600 ACAFA3 = $1,404,000*(1.15)2 = $1,856,790 ACAFA4 = $1,404,000*(1.15)3 = $2,135,309 ACAFA5 = $1,404,000*(1.15)4 = $2,455,605 TV5 = ACFA5(1+g)/(WACC-g) = $2,455,605(1.025)/(.087-.025) = $40,596,691.84 V0 = $1,404,000/(1.087) + $1,614,600/(1.0872 ) + $1,856,790//(1.0873 ) + $2,135,309/(1.0874 ) + ($2,455,605 + $40,596,691.84)/(1.0875 ) = $34,002,577.22 VE = V0 - VD = $34,002,577.22 - 12,000,000 = $22,002,577.22 Price per share = $22,002,577.22/750,000 = $29.34

Which of the following is correct according to pecking-order theory?

Firms stockpile internally generated cash

Which one of the following makes the capital structure of a company irrelevant?

Homemade Leverage

Stan's Supplies has 200,000 shares of common stock outstanding, sales of $2,800,000, total assets of $1,900,000, and a debt-equity ratio of .5. Its net income is $190,000. Based on an industry average P/E ratio of 20.2, what should be the approximate firm's market price per share of common stock?

Industry P/E ratio * Firm's EPS = Approximate share price Net income = $190,000 EPS = $190,000/200,000 shares = $0.95/share Price per share = 20.2 * $0.95 = $19.19

The Frittata Corporation reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings?

Interest tax shield

Which form of financing do companies prefer to use first according to the pecking-order theory?

Internal Funds

Which one of the following states that the value of a company is unrelated to the company's capital structure?

M&M Proposition 1, no tax

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?

M&M Proposition 2

Which one of the following is a direct cost of bankruptcy?

Paying an outside accountant to prepare bankruptcy reports

Which one of the following is a direct cost of bankruptcy?

Paying an outside accountant to prepare bankruptcy reports.

Ashley's Au Pair Service is financed with 90 % equity and 10 % debt. The stock is priced (current price per share is $22.50) such that the expected return is 12 %, and their outstanding debt is yielding 5 %. Assume that Ashley's Au Pair Service issues more debt yielding 5 % to repurchase their outstanding stock such that the firm will be 80 % equity financed, and there are no taxes (this is a Case I world). What is the expected return on the stock after the capital restructuring? (5 points)

RE = RA + (RA-RD)(D/E) 12 % = RE = RA + (RA-5 %)(1/9) = RA + RA(1/9) - 5 %(1/9) = RA(1 + 1/9) - 5 %/9 RA = [12 % + 5 %(1/9)]/(1+1/9) = 11.3 % RE @ D/E=2/8: RE = 11.3 %+ (11.3 % - 5 %)(2/8) = 12.875 %

Ruspin Viniculture has levered value of equity of $689,391. Both the book and the market value of debt is $220,000. The unlevered cost of equity is 13.6 percent while the pretax cost of debt is 7.4 percent. The tax rate is 21 percent. What is the weighted average cost of capital (assuming M&M Case II holds)?

RE = RA + (RA-RD)(D/E)(1-t) = 13.6 + (13.6-7.4)(220,000/689,391)(1-.21) RE = 15.1631% wD = 220,000/(220,000+689,391)=0.2419 wE = 1- wD = 0.7581 WACC = wDRD(1-t) + wERE = (.2419)(7.4%)(1-.21) + (.7581)(15.1631%) 12.91%

Dre's U-Pull Inc. is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity (assuming M&M Case II holds)?

VL = Vu + Dt = 145,000*$22 + 1,500,000(.21) = 3,505,000 VE = VL - VD = 3,505,000 - 1,500,000 = 2,005,000 $2,005,000

Shiva Trophies, Inc. has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company under M&M Case II (taxes, but no bankruptcy costs)?

VL = Vu + Dt = EBIT(1-t)/Ru + Dt = 63,300(1-.23)/.147 + 11,000(.23) = 334,101

The Frittata Corporation has a debt-equity ratio of .64, a WACC of 10.8 percent, a pretax cost of debt of 7.9 percent, and a tax rate of 24 percent (this a Case II world)

What is the levered cost of equity capital? (5 points) WACC = wDRD(1-t) + wERE = 10.8 = (.64/1.64)(7.9)(1-.24) + (1/1.64)(RE) RE = [10.8 - (.64/1.64)(7.9)(1-.24)](1.64) = 13.87 % What is the unlevered cost of equity capital? (5 points) RE = RA + (RA-RD)(D/E)(1-t) = 13.87 % = RA + (RA - 7.9)(.64)(1-.24) = RA + (RA - 7.9 %)(.4864) 13.87 % = RA + RA(.4864) - 7.9 %(.4864) = RA(1 + .4864) - 7.9 %(.4864) RA = [13.87 % + 7.9 %(.4864)]/(1+.4864) = 11.92 %

The absolute priority rule determines:

Which parties receive payment first in a bankruptcy proceeding

The optimal capital structure has been achieved when the:

debt-equity ratio results in the lowest possible weighted average cost of capital.

1) Based on M&M Proposition I with taxes (Case II), the weighted average cost of capital:

decreases as the debt-equity ratio increases.

A firm should select the capital structure that:

maximizes the value of the firm.

Ashley's Au Pair Service was unable to meet its financial obligations and was forced into Chapter 11 legal proceedings to restructure itself so that it could continue as a viable business. The process this company underwent is known as a:

reorganization