Homework 3-5 Exam 2

CALCULATION 9. Phillips Equipment has 6,500 bonds outstanding that are selling at 96.5 percent of par. Bonds with similar characteristics are yielding 6.7 percent, pretax. The company also has 48,000 shares of 5.5 percent preferred stock and 75,000 shares of common stock outstanding. The preferred stock sells for $64 a share. The common stock has a beta of 1.32 and sells for $41 a share. The preferred stock has a stated value of $100. The U.S. Treasury bill is yielding 2.2 percent and the return on the market is 10.6 percent. The corporate tax rate is 21 percent. What is the weighted average cost of capital? A) 8.09 percent B) 8.64 percent C) 10.18 percent D) 9.30 percent E) 10.56 percent

A) 8.09 percent

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) the total cash flows of that company.

CALCULATION 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) $7,890

CALCULATION 7. Sweet Treats common stock is currently priced at $36.72 a share. The company just paid $2.18 per share as its annual dividend. The dividends have been increasing by 2.2 percent annually and are expected to continue doing the same. What is the cost of equity? A) 9.41 percent B) 9.51 percent C) 8.47 percent D) 8.27 percent E) 8.82 percent

D) 8.27 percent

CALCULATION 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) $2,300,000

CALCULATION 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) $5,120,000

CALCULATION 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) $72,500

CALCULATION 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) .46

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) Internal funds

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) Paying an outside accountant to prepare bankruptcy reports

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) all-equity company; weighted average cost of capital.

4. The capital structure weights used in computing a company's weighted average cost of capital: A) are based on the book values of debt and equity. B) are based on the market values of the outstanding securities. C) depend upon the financing obtained to fund each specific project. D) remain constant over time unless new securities are issued or outstanding securities are redeemed. E) are restricted to debt and common stock.

B) are based on the market values of the outstanding securities.

6. If a company uses its WACC as the discount rate for all of the projects it undertakes then the company will tend to: A) accept all positive net present value projects. B) increase the average risk level of the company over time. C) reject all high-risk projects. D) reject all negative net present value projects. E) favor low-risk projects over high-risk projects.

B) increase the average risk level of the company over time.

CALCULATION 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) $510,229

CALCULATION 8. Southern Bakeries just paid its annual dividend of $.48 a share. The stock has a market price of $17.23 and a beta of .93. The return on the U.S. Treasury bill is 3.1 percent and the market risk premium is 7.6 percent. What is the cost of equity? A) 9.98 percent B) 10.04 percent C) 10.17 percent D) 10.30 percent E) 10.45 percent

C) 10.17 percent

CALCULATION 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) 14.56 percent

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) The optimal capital structure maximizes shareholder value.

2. A company's overall cost of equity is: A) generally less than its WACC given a debt-equity ratio of .5. B) unaffected by changes in the market risk premium. C) directly related to the risk level of the firm. D) generally less than the firm's aftertax cost of debt. E) inversely related to changes in the level of inflation.

C) directly related to the risk level of the firm.

5. A company's weighted average cost of capital: A) is equivalent to the aftertax cost of the outstanding liabilities. B) should be used as the required return when analyzing any new project. C) is the return investors require on the total assets of the firm. D) remains constant when the debt-equity ratio changes. E) is unaffected by changes in corporate tax rates.

C) is the return investors require on the total assets of the firm.

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) will vary over time as taxes and market conditions change.

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) Low probability of financial distress

1. A company's current cost of capital is based on: A) only the return required by the company's current shareholders. B) the current market rate of return on equity shares. C) the weighted costs of all future funding sources. D) both the returns currently required by its debtholders and stockholders. E) the company's original debt-equity ratio.

D) both the returns currently required by its debtholders and stockholders.

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) dependent upon a company's capital structure.

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) weighted average cost of capital is minimized.

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) TCD.

CALCULATION 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) 13.15%

3. Which one of these will increase a company's aftertax cost of debt? A) A decrease in the company's debt-equity ratio B) A decrease in the company's tax rate C) An increase in the credit rating of the company's bonds D) An increase in the company's beta E) A decrease in the market rate of interest

B) A decrease in the company's tax rate

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) the use of personal borrowing to alter an individual's exposure to financial leverage.

CALCULATION 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)50 shares

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) has a positive relationship with the company's cost of equity.

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) sell 36 percent of her shares of QRT stock and loan out the sale proceeds.