WACC and Optimal Capital Structure

The market value of equity is calculated as: A) (Market price) x (# of shares outstanding) B) (Market price) x (# of treasury shares) C) (Market price) x (# of authorized shares) D) (Par value) x (# of shares outstanding)

(A) (Market price) x (# of shares outstanding)

Given the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average coat of capital (WACC): A) 8% B) 7.1% C) 9.05% D)None of the given values

(A) 8% WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt) * (1 - t) = (0.50 * 0.121) + ((0.50 * 0.06) * (1 - 0.35)) = 0.0605 + (0.03 * 0.65) = 0.08

Modigliani and Miller's Proposition I states that: A) The market value of any firm is independent of its capital structure B) The market value of a firm's debt is independent of its capital structure C) The market value of a firm's common stock is independent of its capital structure D) None of the above

(A) The market value of any firm is independent of its capital structure

Total capitalization is defined as: A) Total long-term liabilities plus stockholders' equity B) Total debt plus stockholders' equity C) Total debt minus stockholders' equity D) Current liabilities and stockholders' equity

(A) Total long-term liabilities plus stockholders' equity

What is the yield to maturity on a semi-annual corporate bond that has a coupon rate of 4.5% and 10 years remaining until it matures. It is currently selling for $1086.23.

3.47% In excel, =RATE(20,22.5,-1086.23,1000)*2

What is the yield to call on a semi-annual corporate bond that has a coupon rate of 5% and 10 years remaining until it matures, but it can be called after five years for par value plus one year's payment penalty. It is currently selling for $1096.88

3.77% =RATE(10,25,-1096.88,1000)*2

What is the current yield on a semi-annual bond with a coupon rate of 8% and 9 years remaining until it matures? It is currently selling for $858.39.

9.32% Current Yield = Annual Coupon Payment / Current Market Price of Bond = 80 / 858.39 = 0.0932

What is the yield to call on a semi-annual corporate bond that has a coupon rate of 4% and 8 years remaining until it matures, but it can be called after 3 years for par value plus one year's payment penalty. It is currently selling for $1082.34

2.43% In excel, =RATE(6,20,-1082.34,1040)*2

Risk shifting implies: A) When faced with bankruptcy, managers tend to invest in high risk, high return projects B) When faced with bankruptcy, managers do not expect more equity capital C) When faced with bankruptcy, managers may make accounting changes to conceal the true extent of the problem D) All of the above

(A) When faced with bankruptcy, managers tend to invest in high risk, high return projects

A firm is financed with 30% risk-free debt and 70% equity. The risk-free rate is 8%, the firm's cost of equity capital is 15%, and the firm's marginal tax rate is 35%. What is the firm's weighted average cost of capital? A) 8.00% B) 12.06% C) 15.00% D) 21.43%

(B) 12.02% WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt) * (1 - t) = (0.70 * 0.15) + ((0.30 * 0.08) * (1 - 0.35)) = 0.105 + (0.024 * 0.65) = 0.1206

For a levered firm, A) As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percent B) As EBIT increases, the EPS increases by a larger percent C) As EBIT increases, the EPS decreases D) None of the above

(B) As EBIT increase, the EPS increases by a larger percent

The trade-off theory of capital structure predicts that: A) Unprofitable firms should borrow more than profitable ones B) Safe firms should borrow more than risky ones C) Rapidly growing firms should borrow more than mature firms D) Increasing leverage increases firm value

(B) Safe firms should borrow more than risky ones

A firm is financed with 40% risk-free debt and 60% equity. The risk-free rate is 7%, the firm's cost of equity capital is 18%, and the firm's marginal tax rate is 35%. What is the firm's weighted average cost of capital? A) 18.00% B) 7.00% C) 12.62% D) 13.60%

(C) 12.62% WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt) * (1 - t) = (0.60 * 0.18) + ((0.40 * 0.07) * (1 - 0.35)) = 0.108 + (0.028 * 0.65) = 0.1262

The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.) A) 10% B) 15% C) 8% D) None of the above

(C) 8% WACC=Weight of debt * cost of debt + Weight of equity * cost of equity =($4/($4+$6))*5%+($6/($4+$6))*10% =2%+6% =8%

The pecking order theory of capital structure implies that: (I) Risky firms will end up borrowing more (II) Firms prefer internal finance (III) Firms prefer debt to equity when external financing is required A) I only B) II only C) II and III only D) III only

(C) II and III only

Cost of capital is the same as cost of equity for firms: A) financed entirely by debt B) financed by both debt and equity C) financed entirely by equity D) none of the above

(C) financed entirely by equity

Corporations typically have the right to repurchase a debt issue prior to maturity at a fixed price. Such debt issues are said to be: A) Indentured B) Protected C) Convertible D) Callable

(D) Callable

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because: A) Interest payments on the debt vary with EBIT levels B) Interest payments on the debt stay fixed leaving less income to be distributed over less shares C) Interest payments on the debt stay fixed, leaving less income to be distributed over more shares D) Interest payments on the debt stay fixed, leaving more income to be distributed over less shares

(D) Interest payments on the debt stay fixed, leaving more income to be distributed over less shares

What is the yield to maturity on a semi-annual corporate bond that has a coupon rate of 6% and 7 years remaining until it matures. It is currently selling for $752.87.

11.18% In excel, =RATE(14,30,-752.87,1000)*2

True or False According to Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged.

True

True or False Financial leverage affects the risk of the firm's common stock.

True

True or False Financial leverage increases the expected return and risk of the shareholder.

True