Finance Chapter 13 Homework

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. Financial risk

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. Interest tax shield

Destruction Builders has 10,000 shares of stock outstanding and no debt. The new CFO is considering issuing $65,000 of debt and using the proceeds to retire 750 shares of stock. The coupon rate on the debt is 7.2 percent. What is the break-even level of earnings before interest and taxes between these two capital structure options? A. $42,035 B. $43,695 C. $65,000 D. $60,200 E. $62,400

E. $62,400 Explanation EPSU = EPSL EBIT/10,000 = [EBIT − ($65,000 × .072)]/(10,000 − 750) EBIT = $62,400

Which one of the following represents the present value of the interest tax shield? A. D × (1 − Tc) B. D/(1 − Tc) C. D/Tc D. D − D(Tc) E. Tc × D

E. Tc × D

Brick House Markets has a tax rate of 21 percent and taxable income of $308,211. What is the value of the interest tax shield if the interest expense is $59,700? A. $12,537 B. $15,010 C. $15,595 D. $13,498 E. $16,023

A. $12,537 Explanation Interest tax shield = .21 × $59,700 = $12,537

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

A. Indirect bankruptcy costs

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. debt-equity ratio.

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. A legal proceeding for liquidating or reorganizing a business

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 without taxes C. M&M Proposition II without taxes D. Homemade leverage theory E. M&M Proposition I with taxes

C. M&M Proposition II without taxes

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.

C. cost of equity increases as a firm increases its debt-equity ratio.

Chick 'N Fish is considering two different capital structures. The first option is an all-equity firm with 22,500 shares of stock. The second option consists of 18,750 shares of stock plus $120,000 of debt at an interest rate of 7.8 percent. Ignore taxes. What is the break-even level of earnings before interest and taxes (EBIT) between these two options? A. $62,813 B.$54,204 C. $60,410 D. $56,150 E. $61,290

D. $56,150 Explanation EPSU = EPSL EBIT/22,500 = [EBIT − ($120,000 × .078)]/18,750 EBIT = $56,150

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. Changes in the capital structure of a firm will generally change the firm's earnings per share.

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. Financial leverage magnifies both profits and losses.

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. Correct E. Levered firms have greater value than unlevered firms.

D. The capital structure of a firm is totally irrelevant.

Which one of the following statements matches M&M Proposition I without taxes? 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. The value of a firm is independent of the firm's capital structure.

Southern Foods has a $13 million bond issue outstanding with a coupon rate of 7.15 percent and a yield to maturity of 7.39 percent. What is the present value of the tax shield if the tax rate is 24 percent? A. $283,140 B. $316,030 C. $4,053,400 D. $3,960,000 E. $3,120,000

E. $3,120,000 Explanation PV of tax shield = .24 × $13,000,000 = $3,120,000

The Woodworker has a pretax cost of debt of 6.25 percent and a return on assets of 15.5 percent. The debt-equity ratio is .41. Ignore taxes. What is the cost of equity? A. 18.46% B. 18.78% C. 19.43% D. 18.94% E. 19.29%

E. 19.29% Explanation RE = .155 + [(.155 − .0625) × .41] = .1929, or 19.29%

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. Business risk

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. Liquidation

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 is affected by both financial and operating leverage.

E. The risk of equity is affected by both financial and operating leverage.