Chapter 16 - Financial Leverage and Capital Policy
: 16.3 Topic: Firm value 62. Stacy owns 38 percent of The Town Centre. She has decided to retire and wants to sell all of her shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock. What is the total market value of The Town Centre? Ignore taxes.
$1,710,526 B. $1,748,219 C. $1,771,089 D. $1,801,406 E. $1,808,649 Firm value = $650,000/0.38 = $1,710,526 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
: 16.2 Topic: Break-even EBIT 56. Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.
$1.46 B. $1.50 C. $1.67 D. $1.88 E. $1.94 Number of shares repurchased = $30,000/$15 = 2,000 EBIT/5,000 = [EBIT - ($30,000 .0.10)]/(5,000 - 2,000); EBIT = $7,500 EPS = [$7,500 - ($30,000 0.10)]/(5,000 - 2,000); EPS = $1.50 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
: 16.2 Topic: Homemade leverage 60. Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?
$2.5 million B. $4.0 million C. $5.0 million D. $5.5 million E. $6.0 million Firm value = 80,000 ($600,000/12,000) = $4 million AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
: 16.4 Topic: M&M Proposition I with taxes 69. Exports Unlimited is an unlevered firm with an aftertax net income of $47,800. The unlevered cost of capital is 14.1 percent and the tax rate is 32 percent. What is the value of this firm?
$270,867 B. $294,380 C. $339,007 D. $378,444 E. $447,489 VU = $47,800/0.141 = $339,007 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition II with taxes 97. Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 10 percent. Bruce currently has no debt, and its cost of equity is 20 percent. The tax rate is 31 percent. What will the value of Bruce & Co. be if the firm borrows $54,000 and uses the loan proceeds to repurchase shares?
$280,130 B. $346,600 C. $361,740 D. $378,900 E. $381,520 VU = $100,000 (1 - 0.31)/0.20; V = $345,000 VL = $345,000 + 0.31($54,000) = $361,740 AACSB: Analytic Bloom's: Application Difficulty: Basic EOC #: 16-14 Learning Objective: 16-2
: 16.2 Topic: EBIT, taxes, and leverage 92. Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Galaxy would have 178,500 shares of stock outstanding. Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. What is the breakeven EBIT?
$287,878.78 B. $298,333.33 C. $351,111.11 D. $333,333.33 E. $341,414.14 EBIT/178,500 = [EBIT - 0.10($1,790,000)]/71,400; EBIT = $298,333.33 AACSB: Analytic Bloom's: Application Difficulty: Basic EOC #: 16-4 Learning Objective: 16-1
: 16.4 Topic: M&M Proposition II with taxes and WACC 99. New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 17 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt?
$29,871.17 B. $31,796.47 C. $32,407.16 D. $34,552.08 E. $37,119.30 VU = $7,000 (1 - 0.34)/0.17 = $27,176.47 VL = $27,176.47 + 0.34 (0.50) ($27,176.47) = $31,796.47 Note: When levered, the value of debt is equal to one-half of the unlevered value of the firm. AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 16-17 Learning Objective: 16-2
: 16.4 Topic: M&M Proposition II with taxes 78. The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield?
$3,948.75 B. $4,112.60 C. $5,311.22 D. $7,897.50 E. $8,225.20 Annual interest tax shield = $270,000 0.075 0.39 = $7,897.50 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.3 Topic: M&M Proposition I with no tax 95. The SLG Corp. uses no debt. The weighted average cost of capital is 12 percent. The current market value of the equity is $31 million and the corporate tax rate is 34 percent. What is EBIT?
$4,180,000 B. $4,821,194 C. $5,636,364 D. $6,230,018 E. $6,568,500 VU = $31,000,000 = EBIT (1 - 0.34)/0.12; EBIT = $5,636,364 AACSB: Analytic Bloom's: Application Difficulty: Basic EOC #: 16-11 Learning Objective: 16-2
: 16.10 Topic: Bankruptcy 54. Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.
$42,208 B. $44,141 C. $46,333 D. $49,667 E. $52,267 EBIT/40,000 = [EBIT - ($280,000 0.07)]/25,000; EBIT = $52,267 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
37. Bankruptcy:
(B) transfers value from shareholders to bondholders.
: 16.5 Topic: Bankruptcy costs 39. If a firm has the optimal amount of debt, then the:
(B) value of the firm will exceed the value of the firm if it were unlevered. AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
36. Based on M&M Proposition II with taxes, the weighted average cost of capital: A. is equal to the aftertax cost of debt. B. has a linear relationship with the cost of equity capital. C. is unaffected by the tax rate. D. decreases as the debt-equity ratio increases. E. is equal to RU (1 - TC). Refer to section 16.4
(D) decreases as the debt-equity ratio increases.
: 16.10 Topic: Bankruptcy Multiple Choice Questions 90. East Side, Inc. has no debt outstanding and a total market value of $136,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.
-70.97 percent B. -63.15 percent C. -58.08 percent D. -42.29 percent E. -38.87 percent Share price = $136,000/2,000 = $68 Shares repurchased = $54,000/$68 = 794.117647 Annual interest = $54,000 0.05 = $2,700 EPSNormal = ($12,000 - $2,700)/(2,000 - 794.117647) = $7.712195 EPSRecession = {[$12,000 (1 - 0.55)] - $2,700}/(2,000 - 794.117647) = $2.239024 Percentage change = ($2.239024 - $7.712195)/$7.712195 = -70.97 percent AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 16-1 Learning Objective: 16-1
: 16.4 Topic: M&M Proposition I with taxes 71. Down Bedding has an unlevered cost of capital of 13 percent, a cost of debt of 7.8 percent, and a tax rate of 32 percent. What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent?
.63 B. .68 C. .71 D. .76 E. .84 RE = 0.1551 = 0.13 + (0.13 - 0.078) D/E (1 - 0.32); D/E = 0.71 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition II with taxes 76. Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio?
0.72 B. 0.76 C. 0.79 D. 0.82 E. 0.87 RE = 0.18 = 0.146 + (0.146 - 0.084) D/E (1 - 0.37); D/E = 0.87 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: WACC 83. Young's Home Supply has a debt-equity ratio of 0.80. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.9 percent. What will the firm's cost of equity be if the debt-equity ratio is revised to 0.75?
10.89 percent B. 11.47 percent C. 11.70 percent D. 13.89 percent E. 14.23 percent WACC = [(1.0/1.8) 0.145] + [(0.8/1.8) 0.049] = 0.102333; WACC = 0.102333 = [(1.0/1.75) RE] + [(0.75/1.75) 0.049; RE = 14.23 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: WACC 82. A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital?
11.47 percent B. 11.52 percent C. 11.69 percent D. 12.23 percent E. 12.48 percent WACC = {[($26,400 - $12,000)/$26,400] 0.176} + [($12,000/$26,400) 0.092 (1 - 0.37)] = 12.23 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition II with taxes 75. The Green Paddle has a cost of equity of 13.73 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?
11.85 percent B. 12.78 percent C. 14.29 percent D. 14.46 percent E. 15.08 percent RE = 0.1373 = RU + (RU - 0.076) 0.65 (1 - 0.32); RU = 11.85 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: WACC 84. Percy's Wholesale Supply has earnings before interest and taxes of $106,000. Both the book and the market value of debt is $170,000. The unlevered cost of equity is 15.5 percent while the pre-tax cost of debt is 8.6 percent. The tax rate is 38 percent. What is the firm's weighted average cost of capital?
11.94 percent B. 12.65 percent C. 13.45 percent D. 14.01 percent E. 14.37 percent VU = [$106,000 (1 - 0.38)]/0.155 = $424,000 VL = $424,000 + (0.38 $170,000) = $488,600 VE = $488,600 - $170,000 = $318,600 RE = 0.155 + (0.155 - 0.086) ($170,000/$318,600) (1 - 0.38) = 0.177827 WACC = [($318,600/$488,600) 0.177827] + [($170,000/$488,600) 0.086 (1 - 0.38)] = 13.45 percent AACSB: Analytic Bloom's: Analysis Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition I with taxes 96. W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its cost of debt is 9 percent. The corporate tax rate is 33 percent. What is the firm's unlevered cost of equity capital?
12.38 percent B. 12.79 percent C. 13.68 percent D. 14.10 percent E. 14.45 percent WACC = 0.10 = (1/2.4) RE + (1.4/2.4) (0.09) (1 - 0.33); RE = 0.15558 RE = 0.15558 = RU + (RU - 0.09)(1.4)(1 - 0.33); RU = 12.38 percent AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 16-12 Learning Objective: 16-2
: 16.4 Topic: PV of tax shield 81. Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 13 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?
12.48 percent B. 12.66 percent C. 13.87 percent D. 14.14 percent E. 14.37 percent VU = [$6,200 (1 - 0.34)]/0.13 = $31,476.92 VL = $31,476.92 + (0.34 $2,500) = $32,326.92 VE = $32,326.92 - $2,500 = $29,826.92 RE = 0.13 + (0.13 - 0.09) ($2,500/$29,826.92) (1 - 0.34) = 0.132213 WACC = [($29,826.92/$32,326.92) 0.132213] + [($2,500/$32,326.92) 0.09 (1 - 0.34)] = 12.66 percent AACSB: Analytic Bloom's: Analysis Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition II with taxes 73. Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $11,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?
12.55 percent B. 13.36 percent C. 13.64 percent D. 14.07 percent E. 14.29 percent VU = [$15,700 (1- 0.38)]/0.12 = $81,116.67 VL = $81,116.67 + (0.38 $11,000) = $85,296.67 VE = $85,296.67 - $11,000 = $74,296.67 RE = 0.12 + [(0.12 - 0.06) ($11,000/$74,296.67) (1 - 0.38)] = 12.55 percent AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 16-2
: 16.2 Topic: Homemade leverage 58. You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest?
120 shares B. 150 shares C. 180 shares D. 200 shares E. 250 shares JKL interest = $1m 0.08 = $80,000 JKL shares repurchased = $1m/$40 = 25,000 JKL shares outstanding with debt = 75,000 - 25,000 = 50,000 JKL EPS, no debt = $140,000/75,000 = $1.866667 JKL EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20 JKL value of stock = 50,000 $40 = $2m JKL value of debt = $1m JKL total value = $2m + $1m = $3m JKL weight stock = $2m/$3m = 2/3 JKL weight debt = $1m/$3m = 1/3 Your initial investment = 600 $40 = $24,000 Your new stock position = 2/3($24,000) = $16,000 Your new number of shares = $16,000/$40 = 400 Number of shares sold = 600 - 400 = 200 shares Check: Your new loans = 1/3($24,000) = $8,000 Your unlevered income = 600 $1.866667 = $1,120 Your levered income = (400 $1.20) + ($8,000 0.08) = $1,120 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 16-1
: 16.4 Topic: M&M Proposition II with taxes 77. Douglass & Frank has a debt-equity ratio of 0.45. The pre-tax cost of debt is 7.6 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent?
13.79 percent B. 14.86 percent C. 15.92 percent D. 18.40 percent E. 18.87 percent RE = 0.133 + (0.133 - 0.076) 0.45 (1 - 0.39) = 14.86 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
: 16.4 Topic: M&M Proposition I with taxes 98. Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization?
16.30 percent B. 16.87 percent C. 17.15 percent D. 18.29 percent E. 18.86 percent VU = $100,000(1 - 0.31)/0.18 = $383,333.33 VL = $383,333.33 + 0.31($61,000) = $402,243.33 RE = 0.18 + (0.18 - 0.11)($61,000/$402,243.33 - $61,000)(1 - 0.31) = 0.1886 WACC = 0.1886($402,243.33 - $61,000)/$402,243.33 + 0.11($61,000/$402,243.33) (1 - 0.31) = 17.15 percent AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 16-15 Learning Objective: 16-2
: 16.3 Topic: Firm value 63. Winter's Toyland has a debt-equity ratio of 0.72. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes?
19.31 percent B. 19.74 percent C. 20.29 percent D. 20.46 percent E. 21.43 percent RE = 0.161 + (0.161 - 0.087) 0.72 = 21.43 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
: 16.4 Topic: M&M Proposition II with taxes 72. Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity?
22.46 percent B. 22.87 percent C. 23.20 percent D. 23.59 percent E. 25.14 percent VU = [$2,100 (1 - 0.30)]/0.117 = $12,564.10 VL = $12,564.10 + (0.30 $12,000) = $16,164.10 VE = $16,164.10 - $12,000 = $4,164.10 RE = 0.117 + [(0.117 - 0.06) ($12,000/$4,164.10) (1 - 0.30)] = 23.20 percent AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 16-2
: 16.2 Topic: Homemade leverage 59. Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $87,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes.
300 shares B. 350 shares C. 375 shares D. 425 shares E. 500 shares Naylor's interest = $750,000 0.075 = $56,250 Naylor's shares repurchased = $750,000/$50 = 15,000 Naylor's shares outstanding with debt = 60,000 - 15,000 = 45,000 Naylor's EPS, no debt = $87,000/60,000 = $1.45 Naylor's EPS, with debt = ($87,000 - $56,250)/45,000 = $0.683333 Naylor's value of stock = 45,000 $50 = $2,250,000 Naylor's value of debt = $750k Naylor's total value = $2,250,000 + $750,000 = $3,000,000 Naylor's weight stock = $2,250,000/$3,000,000 = 0.75 Naylor's weight debt = $750,000/$3,000,000 = 0.25 Your initial investment = 500 $50 = $25,000 Your new stock position = 0.75 $25,000 = $18,750 Your new number of shares = $18,750/$50 = 375 shares Check: Your new loans = 0.25 $25,000 = $6,250 Your unlevered income = 500 $1.45 = $725 Your levered income = (375 $0.683333) + ($6,250 0.075) = $725 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 16-1
: 16.2 Topic: Break-even EPS 57. Miller's Dry Goods is an all equity firm with 45,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes.
35.6 shares B. 40.0 shares C. 44.4 shares D. 47.5 shares E. 50.1 shares Miller's interest = $250,000 0.08 = $20,000 Miller's shares repurchased = $250,000/$50 = 5,000 Miller's shares outstanding with debt = 45,000 - 5,000 = 40,000 Miller's EPS, no debt = $128,000/45,000 = $2.844444 Miller's EPS, with debt = ($128,000 - $20,000)/40,000 = $2.70 Miller's value of stock = 40,000 $50 = $2,000,000 Miller's value of debt = $250,000 Miller's total value = $2,000,000 + $250,000 = $2,250,000 Miller's weight stock = $2,000,000/$2,250,000 = 0.888889 Miller's weight debt = $250,000/$2,250,000 = 0.111111 Your initial investment = 400 $50 = $20,000 Your new stock position = 0.888889 $20,000 = $17,777.78 Your new number of shares = $17,777.78/$50 = 355.5556 Number of shares sold = 400 - 355.5556 = 44.4 shares Check: Your new loans = 0.111111 $20,000 = $2,222.22 Your total unlevered income = 400 $2.844444 = $1,137.78 Your total levered income = (355.5556 $2.70) + ($2,222.22 0.08) = $1,137.78 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 16-1
: 16.4 Topic: M&M Proposition II with taxes 74. The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $41,000 and the tax rate is 34 percent. What is the pre-tax cost of debt?
4.73 percent B. 6.18 percent C. 6.59 percent D. 7.22 percent E. 9.92 percent RE = 0.153 = 0.118 + (0.118 - RD) [$22,000/($41,000 - $22,000)] (1 - 0.34); RD = 7.22 percent AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
11. The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M&M Proposition I. C. M&M Proposition II. D. the capital asset pricing model. E. the open markets theorem. Refer to section 16.6
A
: 16.10 Topic: Technical insolvency 50. Which one of the following statements related to Chapter 7 bankruptcy is correct?
A firm in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern. B. Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated. C. Chapter 7 bankruptcies are always involuntary on the part of the firm. D. Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy. E. Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock are generally issued prior to the firm coming out of bankruptcy. Refer to section 16.10 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-3
64. Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M&M II with no taxes? A. 0.26 B. 0.33 C. 0.37 D. 0.43 E. 0.45
A. 0.26 RE = 0.146 = 0.132 + (0.132 - 0.078) D/E; D/E = 0.26
79. Georga's Restaurants has 4,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent? A.$137,362.50 B. $162,411.90 C. $187,750.00 D. $210,420.00 E. $233,887.50 Annual interest tax shield = 4,500 $1,000 0.0825 0.37 = $137,362.50
A. Annual interest tax shield = 4,500 $1,000 0.0825 0.37 = $137,362.50
20. You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the:
A. Firm is just earning enough to pay for the cost of debt.
21. Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. A. At the break-even point, there is no advantage to debt. B. The earnings per share will equal zero when EBIT is zero for a levered firm. C. The advantages of leverage are inversely related to the level of EBIT. D. The use of leverage at any level of EBIT increases the EPS. E. EPS are more sensitive to changes in EBIT when a firm is unlevered. Refer to section 16.2
A. at the break-even point, there is no advantage to debt.
41. The capital structure that maximizes the value of a firm also: A. minimizes financial distress costs. B. minimizes the cost of capital. C. maximizes the present value of the tax shield on debt. D. maximizes the value of the debt. E. maximizes the value of the unlevered firm.
A. minimizes financial distress costs.
55. Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $42 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes.
A.) $35,910 EBIT/9,000 = [EBIT - ($120,000 0.095)]/[9,000 - ($120,000/$42)]; EBIT = $35,910 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-1
67. Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 36 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity? A. $5.209 million B. $5.312 million C. $5.436 million D. $6.512 million E. $6.708 million
B. $5.312m VL = (320,000 $19) + (0.36 $1.2m) = $6.512m VE = $6.512m - $1.2m = $5.312m
12. Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? A. restructure process B. bankruptcy C. forced merger D. legal takeover E. rights offer Refer to section 16.10
B. Bankruptcy
91. North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes. A. 38.80 percent B. 45.26 percent C. 50.45 percent D. 53.92 percent E. 61.07 percent
C. $50.45 Share price = $175,000/2,500 = $70 Shares repurchased = $70,000/$70 = 1,000 Annual interest = $70,000 0.07 = $4,900 EPS Normal = [($16,000 - $4,900)(1 - 0.34)]/(2,500 - 1,000) = $4.884 EPS Expansion = (expression error)/(2,500 - 1,000) = $7.348 Percentage change = ($7.348 - $4.884)/$4.884 = 50.45 percent
65. The Corner Bakery has a debt-equity ratio of 0.54. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M&M Proposition II with no taxes? A. 7.10 percent B. 8.79 percent C. 10.68 percent D. 17.56 percent E. 18.40 percent
C. 10.68% RE = 0.161 = 0.142 + (0.142 - Rd) 0.54; Rd = 10.68 percent
93. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 11 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent. A. 12.17; 12.68 B. 12.17; 12.94 C. 12.17; 13.33 D. 12.29; 12.68 E. 12.29; 13.33
C. 12.17; 13.33 ABC: RE = RA = $58,400/$480,000 = 12.17 percent XYZ: RE = 0.1217 + (0.1217 - 0.11)(1)(1) = 13.33 percent Note: ABC: Equity = $480,000 XYZ: Equity = $240,000; Debt = $480,000 - $240,000 = $240,000
: 16.3 Topic: M&M Proposition I with no tax 26. Which of the following statements are correct in relation to M&M Proposition II with no taxes? I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt-equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises.
C. I and II only AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-1
: 16.4 Topic: PV of interest tax shield 34. The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.
C. I, III, IV
13. A business firm ceases to exist as a going concern as a result of which one of the following? A. divestiture B. share repurchase C. liquidation D. reorganization E. capital restructuring
C. Liquidation
27. M&M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity is a linear function with a slope equal to (RA - RD). D. the cost of equity is equivalent to the required rate of return on a firm's assets. E. the size of the pie does not depend on how the pie is sliced. Refer to section 16.3
C. a firm's cost of equity is a linear function with a slope equal to (RA - RD)
49. A firm is technically insolvent when: A. it has a negative book value. B. total debt exceeds total equity. C. it is unable to meet its financial obligations. D. it files for bankruptcy protection. E. the market value of its stock is less than its book value. Refer to section 16.10
C. it is unable to meet its financial obligations.
24. M&M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. E. homemade leverage is irrelevant.
C. the debt-equity ratio of a firm is completely irrelevant.
35. The interest tax shield is a key reason why: A. the required rate of return on assets rises when debt is added to the capital structure. B. the value of an unlevered firm is equal to the value of a levered firm. C. the net cost of debt to a firm is generally less than the cost of equity. D. the cost of debt is equal to the cost of equity for a levered firm. E. firms prefer equity financing over debt financing. Refer to section 16.4
C. the net cost of debt to a firm is generally less than the cost of equity.
: 16.2 Topic: Homemade leverage 2. Which one of the following states that the value of a firm is unrelated to the firm's capital structure?
Capital Asset Pricing Model B. M&M Proposition I C. M&M Proposition II D. Law of One Price E. Efficient Markets Hypothesis Refer to section 16.3 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
: 16.3 Topic: M&M Proposition I 3. Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?
Capital Asset Pricing Model B. M&M Proposition I C. M&M Proposition II D. Law of One Price E. Efficient Markets Hypothesis Refer to section 16.3 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
70. An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500. A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon. The applicable tax rate is 38 percent. What is the value of the levered firm?
D. $1,407,286 VU = [$327,500 (1 - 0.38)]/0.175 = $1,160,285.71 VL = $1,160,285.71 + 0.38($650k) = $1,407,286
66. L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm?
D. $225,299.31 VU = [$48,900 (1 - 0.34)]/0.145 = $222,579.31 VL = $222,579.31 + 0.34 ($8,000) = $225,299.31 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 16-2
52. A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. only after the firm becomes insolvent. A. I and III only B. I and II only C. I, II, and IV only D. I, II, and III only E. I, II, III, and IV
D. I, II, and III only
46. Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing.
D. I, II, and IV only
61. The Jean Outlet is an all equity firm that has 146,000 shares of stock outstanding. The company has decided to borrow the $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes? A. $18,387,702 B. $18,500,000 C. $19,666,667 D. $21,000,000 E. $21,413,333
E. $21,413,333 Firm value = 146,000 ($1.1m/7,500) = $21,413,333
94. Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?
E. $4,180,000 V = $38,000,000 = EBIT/0.11 EBIT = $4,180,000
80. D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield? A. $504 B. $615 C. $644 D. $6,200 E. $6,720
E. $6,720 Present value of the tax shield = 0.32 $21,000 = $6,720
5. Which one of the following is the equity risk related to a firm's capital structure policy? A. market B. systematic C. extrinsic D. business E. financial
E. Financial
: 16.5 Topic: Bankruptcy costs 10. By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt
E. I, II, III, and IV Refer to section 16.5 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-3
33. The present value of the interest tax shield is expressed as:
E. Tc D.
18. The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital. Refer to section 16.1
E. debt-equity ratio results in the lowest possible weighted average cost of capital.
43. The STATIC THEORY OF CAPITAL STRUCTURE advocates that the optimal capital structure for a firm:
E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt. Refer to section 16.6 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
51. Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?
E. payment of employee wages
48. In general, the capital structures used by U.S. firms:
E. vary significantly across industries.
15. The absolute priority rule determines: A. when a firm must be declared officially bankrupt. B. how a distressed firm is reorganized. C. which judge is assigned to a particular bankruptcy case. D. how long a reorganized firm is allowed to remain under bankruptcy protection. E. which parties receive payment first in a bankruptcy proceeding.
E. which parties receive payment first in a bankruptcy proceeding.
23. Which one of the following makes the capital structure of a firm irrelevant?
Homemade Leverage
: 16.3 Topic: Business risk 29. Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations.
I and III only B. II and IV only C. II and III only D. I, II, and III only E. I, II, III, and IV Refer to section 16.3 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-1
: 16.3 Topic: M&M Proposition I with no tax 25. The concept of homemade leverage is most associated with:
M&M Proposition I with no tax. B. M&M Proposition II with no tax. C. M&M Proposition I with tax. D. M&M Proposition II with tax. E. static theory proposition. Refer to section 16.3 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
68. Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm? A. $245,500 B. $247,600 C. $251,500 D. $264,800 E. $271,300
VU = [$48,600 (1 - 0.34)] /0.132 = $243,000 VL = $243,000 + (0.34 $25,000) = $251,500
: 16.3 Topic: Financial risk 30. M&M Proposition I with tax supports the theory that:
a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases. B. the value of a firm is inversely related to the amount of leverage used by the firm. C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. E. a firm's cost of equity increases as the debt-equity ratio of the firm decreases. Refer to section 16.4 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
: 16.2 Topic: Break-even point 22. Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to:
borrow some money and purchase additional shares of Quantro stock. B. maintain her current equity position as the debt of the firm did not affect her personally. C. sell some shares of Quantro stock and hold the proceeds in cash. D. sell some shares of Quantro stock and loan out the sale proceeds. E. create a personal debt-equity ratio of 0.30. Refer to section 16.2 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-1
: 16.5 Topic: Bankruptcy 38. Which one of the following is a direct bankruptcy cost?
company CEO's time spent in bankruptcy court B. maintaining cash reserves C. maintaining a debt-equity ratio that is lower than the optimal ratio D. losing a key company employee E. paying an outside accountant fees to prepare bankruptcy reports Refer to section 16.5 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-3
: 16.1 Topic: Capital structure 17. The value of a firm is maximized when the:
cost of equity is maximized. B. tax rate is zero. C. levered cost of capital is maximized. D. weighted average cost of capital is minimized. E. debt-equity ratio is minimized. Refer to section 16.1 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
: 16.3 Topic: M&M Proposition II 28. The business risk of a firm:
depends on the firm's level of unsystematic risk. B. is inversely related to the required return on the firm's assets. C. is dependent upon the relative weights of the debt and equity used to finance the firm. D. has a positive relationship with the firm's cost of equity. E. has no relationship with the required return on a firm's assets according to M&M Proposition II. Refer to section 16.3 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-1
: 16.6 Topic: Optimal capital structure 40. Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?
exceptionally high depreciation expenses B. very low marginal tax rate C. substantial tax shields from other sources D. low probabilities of financial distress E. minimal taxable income Refer to section 16.6 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
: 16.5 Topic: Bankruptcy costs 9. The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.
flotation B. direct bankruptcy C. indirect bankruptcy D. financial solvency E. capital structure Refer to section 16.5 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-3
: 16.4 Topic: Unlevered cost of capital 8. The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs.
flotation B. issue C. direct bankruptcy D. indirect bankruptcy E. unlevered Refer to section 16.5 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-3
: 16.4 Topic: M&M Proposition I with taxes 32. M&M Proposition II with taxes:
has the same general implications as M&M Proposition II without taxes. B. states that a firm's capital structure is irrelevant. C. supports the argument that business risk is determined by the capital structure decision. D. supports the argument that the cost of equity decreases as the debt-equity ratio increases. E. concludes that the capital structure decision is irrelevant to the value of a firm. Refer to section 16.4 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
: 16.3 Topic: Financial risk 6. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings?
interest tax shield B. interest credit C. financing shield D. current tax yield E. tax-loss interest Refer to section 16.4 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
: 16.3 Topic: M&M Proposition II 4. Which one of the following is the equity risk that is most related to the daily operations of a firm?
market risk B. systematic risk C. extrinsic risk D. business risk E. financial risk Refer to section 16.3 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
: 16.10 Topic: Liquidation 14. Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a:
merger. B. repurchase program. C. liquidation. D. reorganization. E. divestiture. Refer to section 16.10 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-3
: 16.8 Topic: Pecking-order theory 47. Corporations in the U.S. tend to:
minimize taxes. B. underutilize debt. C. rely less on equity financing than they should. D. have relatively similar debt-equity ratios across industry lines. E. rely more heavily on debt than on equity as the major source of financing. Refer to section 16.9 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
: 16.10 Topic: Bankruptcy 53. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:
permits creditors to file a prepack immediately after a firm files for bankruptcy protection. B. prevents creditors from submitting any reorganization plans. C. prevents firms from filing for bankruptcy protection more than once. D. permits key employee retention plans only if an employee has another job offer. E. allows firms to pay bonuses to all key employees to entice those employees to remain in the firm's employ. Refer to section 16.10 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-3
: 16.4 Topic: Interest tax shield 7. The unlevered cost of capital refers to the cost of capital for a(n):
private entity. B. all-equity firm. C. governmental entity. D. private individual. E. corporate shareholder. Refer to section 16.4 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
: 16.10 Topic: Absolute priority rule 16. A firm should select the capital structure that:
produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity. Refer to section 16.1 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
: 16.7 Topic: M&M Theory 45. Which form of financing do firms prefer to use first according to the pecking-order theory?
regular debt B. convertible debt C. common stock D. preferred stock E. internal funds Refer to section 16.8 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
: 16.1 Topic: Capital structure 19. AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.
select the leverage option because the debt-equity ratio is less than 0.50 B. select the leverage option since the expected EBIT is less than the break-even level C. select the unlevered option since the debt-equity ratio is less than 0.50 D. select the unlevered option since the expected EBIT is less than the break-even level E. cannot be determined from the information provided Refer to section 16.2 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-1
: 16.6 Topic: Static theory of capital structure 44. The basic lesson of M&M Theory is that the value of a firm is dependent upon:
the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. size of the stockholders' claims. Refer to section 16.7 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-2
1. Homemade leverage is:
the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm. Refer to section 16.2 AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 16-1
: 16.4 Topic: M&M Proposition I with taxes 31. M&M Proposition I with taxes is based on the concept that:
the optimal capital structure is the one that is totally financed with equity. B. the capital structure of a firm does not matter because investors can use homemade leverage. C. a firm's WACC is unaffected by a change in the firm's capital structure. D. the value of a firm increases as the firm's debt increases because of the interest tax shield. E. the cost of equity increases as the debt-equity ratio of a firm increases. Refer to section 16.4 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
: 16.6 Topic: Optimal capital structure 42. The optimal capital structure:
will be the same for all firms in the same industry. B. will remain constant over time unless the firm changes its primary operations. C. will vary over time as taxes and market conditions change. D. places more emphasis on operations than on financing. E. is unaffected by changes in the financial markets. Refer to section 16.6 AACSB: N/A Bloom's: Comprehension Difficulty: Basic Learning Objective: 16-2
