Finance Exam 3 Chapter 16 Practice Problems

An unlevered company has a cost of capital of 14.6 percent and earnings before interest and taxes of $240,090. A levered company with the same operations and assets has a face value of debt of $85,000 with a coupon rate of 7.5 percent that sells at par. The applicable tax rate is 22 percent. What is the value of the levered company?

$1,301,373

SLG Corp. is an all-equity firm with a weighted average cost of capital of 10.02 percent. The current market value of the equity is $13.4 million and the total tax rate is 22 percent. What is EBIT?

$1,721,385

Ornaments, Inc., is an all-equity firm with a total market value of $542,000 and 20,700 shares of stock outstanding. Management believes the earnings before interest and taxes (EBIT) will be $76,400 if the economy is normal. If there is a recession, EBIT will be 20 percent lower, and if there is a boom, EBIT will be 30 percent higher. The tax rate is 35 percent. What is the EPS in a recession?

$1.92

D. L. Tuckers has $57,000 of debt outstanding that is selling at par and has a coupon rate of 7.15 percent. The tax rate is 21 percent. What is the present value of the tax shield?

$11,970

Georga's Restaurants has 7,000 bonds outstanding with a face value of $1,000 each, a market price of $982, and a coupon rate of 6.95 percent. The interest is paid semiannually. What is the amount of the annual interest tax shield if the tax rate is 23 percent?

$111,895

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 $2.8 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?

$2,800,000

L.A. Clothing has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company?

$334,101

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?

$7,890

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 7.35 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

$73,500

The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.08 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

10.52%

KN Stitches has debt of $26,000, a leveraged value of $78,400, a pretax cost of debt of 7.05 percent, a cost of equity of 15.3 percent, and a tax rate of 21 percent. What is the weighted average cost of capital?

12.07%

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 .58?

12.80%

Home Decor has a pretax cost of debt is 6.8 percent and a tax rate of 22 percent. What is the cost of equity if the debt-equity ratio is .65? WACC is 12.05%

16.44%

Southwest Sands currently has 22,000 shares of stock outstanding. It is considering issuing $128,000 of debt at an interest rate of 7.5 percent. The break-even level of EBIT between these two capital structure options is $74,000. How many shares of stock will be repurchased if the company undergoes the recapitalization? Ignore taxes.

2,854.05

The Greenbriar is an all-equity firm with a total market value of $599,000 and 23,800 shares of stock outstanding. Management is considering issuing $217,000 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?

8,622 shares

Which form of financing do companies prefer to use according to the pecking-order theory?

Common Stock

You have computed the break-even point between a levered and an unleveled capital structure. Ignore taxes. At the break-even level, the

Company is earning just enough to pay for the cost of debt

The optimal capital structure has been achieved when the

Debt-equity ratio results in the lowest possible weighted average cost of capital

M&M Proposition II with taxes

Has the same general implications as M&M Proposition II without taxes

Which one of the following makes the capital structure of a company irrelevant?

Homemade Leverage

The costs incurred by a business in an effort to avid bankruptcy are classified as ___ costs.

Indirect bankruptcy

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings?

Interest Tax Shield

The concept of homemade leverage is most associated with

M&M Proposition I with no tax

Which of the following states that the value of a company is unrelated to the company's capital structure?

M&M Proposition I, no tax

A firm should select the capital structure that

Maximizes the value of the firm

Hanover Tech is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

TBD

The present value of interest tax shield is expressed as

TcD

Which of the following statements is correct in relation to M&M Proposition II, without taxes?

The required return on assets is equal to the weighted average cost of capital (WACC)

The basic lesson of M&M theory is that the value of a company is dependent upon

The total cash flows of that company

M&M Proposition I with taxes is based on the concept that

The value of a taxable company increases as the level of debt increases.

If a company has the optimal amount of debt, then the

The value of the levered company will exceed the value of the unlevered company