Finance ch 13

Which of the following will increase the value of a levered firm according to M&M Proposition I, with taxes? I. Decrease in the amount of the debt II. Increase in the value of the unlevered firm III. Decrease in the tax rate IV. Increase in the interest rate on the debt

II only

Which one of the following terms is inclusive of both direct and indirect bankruptcy costs? A. Financial distress costs B. Capital structure costs C. Financial leverage D. Homemade leverage E. Cost of capital

A

Gulf Shores Inn is comparing two separate capital structures. The first structure consists of 260,000 shares of stock and no debt. The second structure consists of 200,000 shares of stock and $1.5 million of debt. What is the price per share of equity?

260,000x = 200,000x + $1.5m x = $25

Bruno's is considering a change from its current capital structure. Bruno's currently has an all-equity capital structure and is considering a capital structure with 30 percent debt. There are currently 6,500 shares outstanding at a price per share of $46. EBIT is expected to remain constant at $43,000. The interest rate on new debt is 8.5 percent and there are no taxes. Tracie owns $20,700 worth of stock in the company. The firm has a 100 percent payout. What would Tracie's cash flow be under the new capital structure assuming that she keeps all of her shares?

All-equity value = 6,500 × $46 = $299,000 Shares repurchased = ($299,000 × 0.30)/$46 = 1,950 shares EPS = [$43,000 - ($299,000)(0.30)(0.085)]/(6,500 - 1,950) = $7.7748 Cash flow = ($7.7748) ($20,700/$46) = $3,499

Assume both corporate taxes and financial distress costs apply to a firm. Given this, the static theory of capital structure illustrates that: A. a firm's value and its weighted average cost of capital are inversely related. B. a firm's value and its tax rate are inversely related. C. the maximum value of a firm is obtained when a firm is financed solely with debt. D. the value of a firm rises as the interest rate on debt rises. E. the value of a firm rises as both the interest rate on debt and the tax rate rise.

B

In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first? A. Technical insolvency definition B. Absolute priority rule C. Accounting insolvency definition D. Chapter 7 of the Federal Bankruptcy Reform Act of 1978 E. Securities and Exchange Commission

B

Which one of the following is a direct bankruptcy cost? A. Loss of customer goodwill resulting from a bankruptcy filing B. Legal and accounting fees related to a bankruptcy proceeding C. Management time spent on a bankruptcy proceeding D. Any financial distress cost E. Costs a firm spends trying to avoid bankruptcy Refer to Section 13.5.

B

Which one of the following is a key provision of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005? A. Disallowance of bankruptcy prepacks B. Right granted to creditors to file their own reorganization plan once a firm is in bankruptcy for 18 months C. Disallowance of all management bonus payments while a firm is in bankruptcy D. Requirement that only creditors can file reorganization plans for a bankrupt firm E. Requirement for all Chapter 11 bankruptcies to be converted to Chapter 7 bankruptcies after 18 months

B

Which one of the following is minimized when the value of a firm is maximized? A. Return on equity B. WACC C. Debt D. Taxes E. Bankruptcy costs

B

Which one of the following is the equity risk arising from the capital structure selected by a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk

B

Which one of the following statements is correct? A. A prepack is a plan of liquidation used to distribute a firm's assets. B. Bankruptcy courts have "cram-down" powers. C. The absolute priority rule must be strictly followed in all bankruptcy proceedings. D. Creditors cannot force a firm into bankruptcy even though they might like to do so. E. A reorganization plan can be approved only if the firm's creditors all agree with the plan.

B

Which one of the following terms applies to the costs incurred by a firm that is trying to avoid filing for bankruptcy? A. Indirect bankruptcy costs B. Direct bankruptcy costs C. Static theory cost D. Optimal capital structure cost E. Reorganization costs Refer to Section 13.5.

B

Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure? A. Static theory of capital structure B. M&M Proposition I C. M&M Proposition II D. Homemade leverage theory E. WACC

C

Jasper Industrial has no debt outstanding and a total market value of $110,000. 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 15 percent higher. If there is a recession, then EBIT will be 20 percent lower. Jasper Industrial is considering a $35,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 7,500 shares outstanding. Ignore taxes for this problem. What is the percentage change in EPS when a normal economy slips into recession?

EPSNormal = $12,000/7,500 = $1.60 EPSRecession = $12,000(0.80)/7,500 = $1.28 Percentage change ($1.28 - $1.60)/$1.60 = -20 percent only do what the problem is asking for

Christmas Ornaments, Inc. is an all-equity firm with a total market value of $386,000 and 15,000 shares of stock outstanding. Management is considering issuing $75,000 of debt at an interest rate of 8 percent and using the proceeds on a stock repurchase. As an all-equity firm, management believes the earnings before interest and taxes (EBIT) will be $31,000 if the economy is normal, $12,000 if it is in a recession, and $37,000 if the economy booms. Ignore taxes. What will the EPS be if the economy falls into a recession and the firm maintains its all-equity status? A. $0.78 B. $0.80 C. $1.21 D. $1.67 E. $2.07

EPSRecession = $12,000/15,000 = $0.80

Brick House Cafe has a 35 percent tax rate and total taxes of $35,280. What is the value of the interest tax shield if the interest expense is $16,700?

Interest tax shield = 0.35 × $16,700 = $5,845 tax rate x interest expense

The Tree House has a pretax cost of debt of 7.9 percent and a return on assets of 11.7 percent. The debt-equity ratio is 0.50. Ignore taxes. What is the cost of equity?

RE = 0.117 + [(0.117 - 0.079) × 0.50] = 13.60 percent

Northern Wood Products is an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $26,000 if the economy is normal, $3,000 if the economy is in a recession, and $33,000 if the economy booms. Ignore taxes. Management is considering issuing $88,000 of debt with a 6 percent coupon rate. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession? A. -$0.27 B. -$0.19 C. $0.03 D. $0.26 E. $0.31

Shares repurchased $88,000/($352,000/16,000) = 4,000 shares Shares outstanding = 16,000 - 4,000 = 12,000 shares EPSRecession = [$3,000 - ($88,000 × 0.06)]/12,000 = -$0.19 88000x .06 is dividends

The Greenbriar is an all-equity firm with a total market value of $520,000 and 20,000 shares of stock outstanding. Management is considering issuing $120,000 of debt at an interest rate of 10 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares will the firm repurchase if it issues the debt securities? A. 2,871 shares B. 3,516 shares C. 4,521 shares D. 4,607 shares E. 4,615 shares

Shares repurchased = $120,000/($520,000/20,000) = 4,615 shares

Forbidden Fruit Extracts expects its earnings before interest and taxes to be $325,000 a year forever. Currently, the firm has no debt. The cost of equity is 16.3 percent and the tax rate is 35 percent. The company is in the process of issuing $2 million of bonds at par that carry a 6.5 percent annual coupon. What is the unlevered value of the firm?

VU = [$325,000 × (1 - 0.35)]/0.163 = $1,296,012

Triangle Enterprises has no debt but can borrow at 9 percent. The firm's WACC is currently 14.7 percent, and there is no corporate tax. If the firm converts to 70 percent debt, what will its cost of equity be?

WACC = 0.147 = 0.30x + 0.70(0.09) x=.28

The level of financial risk to which a firm is exposed is dependent on the firm's: A. tax rate. B. debt-equity ratio. C. return on assets. D. level of earnings before interest and taxes. E. operational level of risk.

b

M&M Proposition II, without taxes, states that the: A. capital structure of a firm is highly relevant. B. weighted average cost of capital decreases as the debt-equity ratio decreases. C. cost of equity increases as a firm increases its debt-equity ratio. D. return on equity is equal to the return on assets multiplied by the debt-equity ratio. E. return on equity remains constant as the debt-equity ratio increases. Refer to Section 13.3.

c

The static theory of capital structure assumes a firm: A. maintains a constant debt-equity ratio. B. has an all-equity structure. C. is fixed in terms of its assets. D. pays no taxes. E. is operating at the point where financial distress costs are eliminated.

c

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as: A. M&M Proposition I. B. capital restructuring. C. homemade leverage. D. M&M Proposition II. E. financial risk management.

c

Which one of the following best defines legal bankruptcy? A. Negotiating new payment terms with a firm's creditors B. A temporary technical insolvency C. A legal proceeding for liquidating or reorganizing a business D. The internal process of revising the capital structure of a firm E. The failure of a firm to meet its financial obligations in a timely manner

c

Which one of the following is correct based on the static theory of capital structure? A. A firm receives the greatest benefit from debt financing when its tax rate is relatively low. B. A debt-equity ratio of 1 is considered to be the optimal capital structure. C. The costs of financial distress decrease the value of a firm. D. The more debt a firm assumes, the greater the incentive to acquire even more debt until such time as the firm is financed with 100 percent debt. E. At the optimal level of debt a firm also optimizes its tax shield on debt.

c

Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases? A. M&M Proposition I, without taxes B. M&M Proposition II, without taxes C. M&M Proposition I, with taxes D. Static theory of capital structure E. No theory suggests this.

c

You are comparing two possible capital structures for a firm. The first option is an all-equity firm. The second option involves the use of $3.8 million of debt. The break-even point between these two financing options occurs when the earnings before interest and taxes (EBIT) are $428,000. Given this, you know that leverage is beneficial to the firm: A. whenever EBIT is less than $428,000. B. only when EBIT is $428,000. C. whenever EBIT exceeds $428,000. D. only if the debt is decreased by $428,000. E. only if the debt is increased by $428,000.

c

Which one of the following statements is the core principle of M&M Proposition I, without taxes? A. A firm's cost of equity is directly related to the firm's debt-equity ratio. B. A firm's WACC is directly related to the firm's debt-equity ratio. C. The interest tax shield increases the value of a firm. D. The capital structure of a firm is totally irrelevant. E. Levered firms have greater value than unlevered firms. Refer to Section 13.3.

d

Which one of the following statements matches M&M Proposition I? A. The cost of equity capital has a positive linear relationship with a firm's capital structure. B. The dividends paid by a firm determine the firm's value. C. The cost of equity capital varies in response to changes in a firm's capital structure. D. The value of a firm is independent of the firm's capital structure. E. The value of a firm is dependent on the firm's capital structure.

d

Newborn Nursery has 8,000 bonds outstanding with a face value of $1,000 each. The coupon rate is 6.5 percent and the tax rate is 40 percent. What is the present value of the interest tax shield

ignore coupon rate only look at taxes PV of tax shield = 0.40 × 8,000 × $1,000 = $3.2 million always value times tax rate

Pre pack

is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan.

WACC

return on assets

Katz is an all-equity development company that has 36,000 shares of stock outstanding at a market price of $25 a share. The firm's earnings before interest and taxes are $29,000. Katz has decided to issue $200,000 of debt at a rate of 6 percent and use the proceeds to repurchase shares. What should Leslie do if she owns 600 shares of Katz stock and wants to use homemade leverage to offset the leverage being assumed by the firm? A. Borrow money and buy an additional 22 shares B. Borrow money and buy an additional 133 shares C. Sell 22 shares and loan out the proceeds D. Sell 56 shares and loan out the proceeds E. Sell 133 shares and loan out the proceeds

Calculate leverage. Shares repurchased = $200,000/$25 = 8,000 Value of equity = (36,000 - 8,000) × $25 = $700,000 Value of debt = $200,000 D/V ratio = $200,000 /($700,000 + $200,000) = 0.2222 Since the firm is using 22.22 percent debt, Faith will need to reduce her investment in the firm by 22.22 percent. Shares to be sold = 600 × 0.2222 = 133 shares calculate the amount of debt and apply it to her investment

Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship? A. Static theory of interest rates B. M&M Proposition I C. Financial risk D. Interest tax shield E. Homemade leverage

D

T.L.C. Enterprises just revised its capital structure from a debt-equity ratio of 0.30 to a debt-equity ratio of 0.45. The firm's shareholders who prefer the old capital structure should: A. sell some shares and hold the sale proceeds in cash. B. sell all of their shares and loan out the entire sale proceeds. C. do nothing. D. sell some shares and loan out the sale proceeds. E. borrow funds and purchase more shares.

D

Which one of the following statements concerning financial leverage is correct? A. Financial leverage increases profits and decreases losses. B. Financial leverage has no effect on a firm's return on equity. C. Financial leverage refers to the use of common stock. D. Financial leverage magnifies both profits and losses. E. Increasing financial leverage will always decrease the earnings per share.

D

Which one of the following statements concerning financial leverage is correct? A. The benefits of leverage are unaffected by the amount of a firm's earnings. B. The use of leverage will always increase a firm's earnings per share. C. The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage. D. Changes in the capital structure of a firm will generally change the firm's earnings per share. E. Financial leverage is beneficial to a firm only when the firm has negative earnings.

D

Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms? A. The levered firm has higher EPS (earnings per share) than the unlevered firm at the break-even point. B. The levered firm will have higher EPS than the unlevered firm at all levels of EBIT. C. The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT. D. The EPS for the unlevered firm will always exceed those of the levered firm. E. The unlevered firm will have higher EPS at relatively low levels of EBIT.

E

Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation? A. Chapter 7 bankruptcy B. Liquidation C. Technical insolvency D. Accounting insolvency E. Reorganization

E

Which one of the following is an implication of M&M Proposition II, without taxes? A. A firm's optimal capital structure is 100 percent debt. B. WACC is unaffected by the capital structure of a firm. C. WACC decreases as the debt-equity ratio increases. D. A firm's capital structure is irrelevant. E. The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations.

E

Which one of the following is the equity risk arising from the daily operations of a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk

E

Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt? A. M&M Proposition I, with taxes B. M&M Proposition II, with taxes C. M&M Proposition I, without taxes D. Homemade leverage proposition E. Static theory of capital structure

E

Which one of the following statements is correct? A. All Chapter 7 bankruptcy filings must include a "workout" agreement. B. Firms must remain in bankruptcy for at least 18 months. C. Key employee retention plans (KERPs) are no longer legal. D. Labor contracts cannot be modified through the bankruptcy process. E. A firm can file for Chapter 11 bankruptcy even if the firm is solvent.

E

Which one of the following terms refers to the termination of a firm as a going concern? A. Insolvency B. Reorganization C. Chapter 11 bankruptcy D. Prepack E. Liquidation

E

Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming the absolute priority rule is followed? A. Claims by unsecured creditors B. Employee wages C. Government tax claims D. Contributions to employee retirement plans E. Bankruptcy administrative expenses

E