FRL 3671 - CH. 16 Learn Smart

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?

$0.64 million 0.40 × $20m × 0.08 = $0.64m

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?

$1,685,000 (.1 × $5m) + [$2m - (.1 × $5m)](1 - .21) = $1,685,000

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?

$30.8 million 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?

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

If an investor buys $20,000 worth of stock by investing $11,000 of their own money, how much was borrowed?

$9,000

Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step. Instructions Choice 1 of 4. Multiply EBIT by 1 minus the corporate tax rate. Choice 2 of 4. Add the present value of the debt tax shield. Choice 3 of 4. Calculate EBIT. Choice 4 of 4. Divide by the cost of equity for an all-equity firm.

1. Calculate EBIT. 2. Multiply EBIT by 1 minus the corporate tax rate. 3. Divide by the cost of equity for an all-equity firm. 4. Add the present value of the debt tax shield.

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?

10% ($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?

11.05% ($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 $12,500 and expected earnings of $1,900.

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

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

15.6%

True or false: Holding equity in an unlevered firm has no risk.

False

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.

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ___. Multiple select question. debt financing is actually better than equity financing. MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes the asset to be financed is the same equity financing is actually better than debt financing

MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes the asset to be financed is the same

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? Multiple select question. The corporation has no debt. The corporation is an all-equity firm. The debt-equity ratio is 1. Corporate tax rates are zero.

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

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)? Multiple select question. 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. Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.

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.

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

a higher expected return

The fact that almost every industry has a debt-equity ratio to which its firms adhere is evidence that the MM Propositions ___.

are missing some real-world factors

Debt has a tax ______.

benefit

With no taxes, MM showed:

capital structure does not matter

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

The capital structure across different industries is ______.

different

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

With taxes, MM Proposition I says the value of the levered firm will be _____ the value of the unlevered firm.

greater than

An unlevered firm ____.

has an all-equity capital structure

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

highest

An accounting balance sheet uses ______ values and a market balance sheet uses ______ values.

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

When an investor borrows money and uses it to purchase stocks is called:

homemade leverage

With ____, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with her own money to buy the company's stock.

homemade leverage

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

Under MM Proposition II with no taxes, the return on assets ______ as debt increases.

is unchanged

The effect of financial leverage ______ for all earning levels.

is variable

Homemade ________ allows an investor to choose any capital structure they want of an unlevered firm.

leverage

MM Proposition I does not work with corporate taxes because:

levered firms pay lower taxes than unlevered firms

When buying on margin, brokers typically charge ______ interest.

low

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ______.

lower

Stockholders want to _____ the value of the entire firm.

maximize

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

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 ___.

on margin

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm ___.

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.

positively

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 ______. Multiple select question. added; decreases removed; decreases added; increases removed; increases

removed; decreases added; increases

Brokers who sell stock on margin will protect themselves by ___. Multiple select question. requiring additional cash contributions from the investor holding the stock as collateral charging high rates of interest selling the stock to satisfy the loan

requiring additional cash contributions from the investor holding the stock as collateral selling the stock to satisfy the loan

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

A beneficial rule to follow is to set the firm's capital structure so that ___.

the firm's value is maximized

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __. Multiple select question. the overall cost of capital cannot be reduced 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

Under MM Proposition II with no taxes, the WACC is invariant to the debt-equity ratio because ___.

the return on assets (RO) is unchanged

A firm with no debt in its capital structure is:

unlevered

Volatility or ______ increases for equity holders when leverage increases.

risk

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?

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

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?

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