Finance 4010 Exam 2

2) Which of the following is NOT an advantage of private debt over public debt? A) It is liquid. B) It need not be registered with the U.S. Securities and Exchange Commission. C) It has to have interest and principal payments made upon it. D) It does not dilute the ownership of a firm.

A

7) A bond has a face value of $100 and a conversion ratio of 25. What is the conversion price? A) $0.25 B) $2.50 C) $4.00 D) $25.00

Answer: Explanation: C) $100 / 25 = $4.00

10) The basic lesson of M&M theory is that the value of a company is dependent upon: A) the company's capital structure. B) the total cash flows of that company. C) minimizing the marketed claims. D) the amount of the company's marketed claims. E) size of the stockholders' claims.

B

5) What is a call provision? A) the periodic repurchasing of issued bonds through a sinking fund by the issuer B) an option to the issuer to repurchase the bonds at a predetermined price C) the option for the bondholder to convert each bond owned into a fixed number of shares of common stock D) a clause in a bond contract that restricts the actions of the issuer that might harm the interests of the bondholders

B

7) The symbol "RU" refers to the cost of capital for a(n) ________ while "RA" represents the___________. A) privately owned entity; unlevered cost of capital. B) all-equity company; weighted average cost of capital. C) levered company; cost of capital for an all-equity company. D) levered company; weighted average cost of capital. E) unlevered company; average cost of equity.

B

11) Ignoring taxes, 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? A) 12.87% B) 13.15% C) 11.09% D) 15.85% E) 12.49%

B RE = .1082 + (.1082 − .074)(.68) RE = .1315, or 13.15%

1) Which of the following is usually a form of public debt? A) a preferred stock B) a bank loan C) a bond issue D) a revolving line of credit

C

1) Which one of these statements is correct? A) Capital structure has no effect on shareholder value. B) The optimal capital structure occurs when the cost of equity is minimized. C) The optimal capital structure maximizes shareholder value. D) Shareholder value is maximized when WACC is also maximized. E) Unlevered firms have more value than levered firms when firms are profitable.

C

3) Which of the following terms best describes a loan where a larger line of credit or lower interest rate has been obtained by providing collateral to back that loan? A) a term loan B) a revolving line of credit C) an asset-backed line of credit D) a private placement

C

4) Homemade leverage is: A) 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 use of personal borrowing to alter an individual's exposure to financial leverage. D) best defined as an increase in a company's debt level. E) the term used to describe the capital structure of a levered firm.

C

4) The optimal capital structure: A) will be the same for all companies within the same industry. B) will remain constant over time unless the company 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.

C

9) Miller's Dry Goods is an all-equity firm with 40,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $160,000. Miller's has decided to add leverage to its financial operations by issuing $200,000 of debt at 7 percent interest and using the proceeds to repurchase shares of stock. Jen owns 500 shares of Miller's stock and can loan out funds at 7 percent interest. How many shares of Miller's stock must Jen sell to offset the leverage that Miller's is assuming? (Assume Jen loans out all of the funds she receives from the sale of stock. Ignore taxes.) A) 125 shares B) 100 shares C) 50 shares D) 25 shares E) 75 shares

C

6) Lester's has expected earnings before interest and taxes of $74,800, an unlevered cost of capital of 11.6 percent, and debt with both a book and face value of $84,000. The debt has a coupon rate of 6.35 percent and the tax rate is 24 percent. What is the value of this company? A) $403,136 B) $347,600 C) $510,229 D) $387,094 E) $428,507

C Answer: Explanation: VU = [$74,800(1 − .24)]/.116 VU = $490,069 VL = $490,069 + .24($84,000) VL = $510,229

7) Johnson Tire Distributors has debt with both a face and a market value of $35,000. This debt has a coupon rate of 6.6 percent and pays interest annually. The expected earnings before interest and taxes are $8,300, the tax rate is 21 percent, and the unlevered cost of capital is 10.9 percent. What is the cost of equity? A) 12.46 percent B) 12.87 percent C) 14.56 percent D) 13.59 percent E) 15.14 percent

C Answer: Explanation: VU = [$8,300(1 − .21)]/.109 VU = $60,156 VL = $60,156 + .21($35,000) VL = $67,506 VE = $67,506 − 35,000 VE = $32,506 RE = .109 + [(.109 − .066)($35,000/$32,506)(1 − .21)] RE = .1456, or 14.56%

2) The value of a firm is maximized when the: A) cost of equity is maximized. B) tax rate equals the cost of capital. C) levered cost of capital is maximized. D) weighted average cost of capital is minimized. E) debt-equity ratio is minimized.

D

3) Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to: A) borrow some money and purchase additional shares of QRT stock. B) maintain her current equity position as the debt of the firm does not affect her personally. C) sell 36 percent of her shares of QRT stock and hold the proceeds in cash. D) sell 36 percent of her shares of QRT stock and loan out the sale proceeds. E) create a personal debt-equity ratio of .36.

D

3) Which one of the following provides the greatest tendency to increase the percentage of debt included in a company's optimal capital structure? A) Exceptionally high depreciation expenses B) Very low marginal tax rate C) Substantial tax shields from other sources D) Low probability of financial distress E) Minimal taxable income

D

5) The business risk of a company: A) depends on the company's level of unsystematic risk. B) is inversely related to the required return on the company's assets. C) is dependent upon the relative weights of the debt and equity used to finance the company. D) has a positive relationship with the company's cost of equity. E) has no relationship with the required return on a company's assets according to M&M theory.

D

6) Financial risk is: A) the risk inherent in a company's operations. B) a type of unsystematic risk. C) inversely related to the cost of equity. D) dependent upon a company's capital structure. E) irrelevant to the value of a company.

D

9) The June Bug has a $565,000 bond issue outstanding. These bonds have a coupon rate of 6.65 percent, pay interest semiannually, and sell at 98.7 percent of face value. The tax rate is 21 percent. What is the amount of the annual interest tax shield? A) $7,573 B) $6,907 C) $8,333 D) $7,890 E) $8,250

D Annual interest tax shield = $565,000(.0665)(.21) Annual interest tax shield = $7,890

1) The present value of the interest tax shield is expressed as: A) TCD/RA. B) VU + TCD. C) TCDRA. D) [EBIT(TCD)]/RA. E) TCD.

E

2) Which one of the following is a direct cost of bankruptcy? A) Bypassing a positive NPV project to avoid additional debt B) Investing in 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 to prepare bankruptcy reports

E

5) Which form of financing do companies prefer to use first according to the pecking-order theory? A) Regular debt B) Convertible debt C) Common stock D) Preferred stock E) Internal funds

E

8) Katlin Markets 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. A) $50,500 B) $68,200 C) $81,400 D) $66,667 E) $72,500

E Answer: Explanation: EBIT/60,000 = [EBIT − $250,000(.0725)]/45,000 EBIT = $72,500

8) Auto Care has a pretax cost of debt of 8.3 percent and an unlevered cost of capital of 13.7 percent. The total tax rate is 23 percent and the cost of equity is 15.6 percent. What is the debt-equity ratio? A) .47 B) .61 C) .53 D) .42 E) .46

E Answer: Explanation: RE = .156 = .137 + (.137 − .083)(D/E)(1 − .23) D/E = .46

10) Lamont 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, what will be the value of the company if it changes to a debt-equity ratio of .85? A) $18,110,236 B) $1,955,000 C) $15,393,701 D) $2,705,882 E) $2,300,000

E Answer: E Explanation: VL = VE = $2,300,000

12) The Jean Outlet is an all-equity firm that has 64,000 shares of stock outstanding. The company has decided to borrow $120,000 to repurchase 1,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes? A) $5,340,000 B) $4,638,000 C) $5,068,700 D) $4,950,000 E) $5,120,000

E Explanation: Firm value = 64,000($120,000/1,500) Firm value = $5,120,000

What is the break-even EBIT equation?

EBIT/Current # of shares = EBIT- New Interest/New # of shares

How does a firm increase leverage?

Issuance of debt, using funds to repurchase shares of stock

How does a firm decrease leverage?

Issuance of new shares, retire outstanding debt

What are the indirect costs of financial distress?

Loss of customers Loss of suppliers Cost to employees (layoffs) Fire sales of assets

4) If a bank loan covenant is not met, then the loan goes into technical default and the banks can demand immediate repayment or renegotiate the terms of the loan. T/F

TRUE

6) A company issues a callable (at par) ten-year, 6% coupon bond with annual coupon payments. The bond can be called at par in one year after release or any time after that on a coupon payment date. On release, it has a price of $104 per $100 of face value. What is the yield to call of this bond when it is released? A) 0.60% B) 1.50% C) 1.92% D) 5.47%

Using a financial calculator, PV = -104, FV = 100, PMT = 6, N =1; computing interest = 1.92%; yield to call = 1.92%

What is MM proposition I?

Value (levered)= Value of debt + Value of Equity = Value (unlevered) - Capital structure does not change the value of the firm - Capital restructuring changes risk for equity holders