Chapter 13 Finance

Holiday Decor is an all-equity firm with a total market value of $347,000 and12,000 shares of stock outstanding. Management is considering issuing $48,000 of debt at an interest rate of 7 percent and using the proceeds on a stock repurchase. As an all-equity firm, management believes its earnings before interest and taxes (EBIT) will be $33,000 if the economy is normal, $8,000 if it is in a recession, and $41,000 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. $.75 B. $.67 C. $1.21 D. $1.50 E. $1.33

$.67 EPSRecession= $8,000/12,000 = $.67

Forbidden Fruit Extracts expects its earnings before interest and taxes to be $287,600 a year forever. Currently, the firm has no debt. The cost of equity is 15.4 percent and the tax rate is 34 percent. The company is in the process of issuing $3 million of bonds at par that carry an annual coupon rate of 7.6 percent. What is the unlevered value of the firm? A. $1,371,429 B. $1,331,971 C. $1,107,405 D. $969,325 E. $1,232,571

$1,232,571 VU = [$287,600 ×(1 -.34)]/.154 = $1,232,571

Taunton's is an all-equity firm that has 160,000 shares of stock outstanding. Neal, the financial vice president, is considering borrowing $275,000 at 7.45 percent interest to repurchase 25,000 shares. Ignoring taxes, what is the current value of the firm? A. $1,260,000 B. $1,800,000 C. $1,485,000 D. $1,520,000 E. $1,760,000

$1,760,000 Value per share = $275,000/25,000 = $11 Firm value = 160,000 ×$11 = $1,760,000

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

Legal and accounting fees related to a bankruptcy proceeding

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

Liquidation

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

M & M Proposition II without taxes

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& MProposition I with taxes D. Static theory of capital structure E. No theory suggests this

M&M Proposition I with taxes

Flour Mills is an all-equity firm with a total market value of $891,860. The firm has 38,000 shares of stock outstanding. Management is considering issuing $275,000 of debt at an interest rate of 7.5 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares can the firm repurchase if it issues the debt securities? (Round the number of shares repurchased down to the nearest whole share.) A. 11,717 shares B. 11,618 shares C. 11,647 shares D. 11,656 shares E. 11,699 shares

11,717 shares Shares repurchased = $275,000/($891,860/38,000) = 11,717 shares

Room and Board has determined that $41,650 is the break-even level of earnings before interest and taxes for the two capital structures it is considering. The one structure consists of all equity with 15,500 shares of stock. The second structure consists of 12,500 shares of stock and $65,000 of debt. What is the interest rate on the debt? A. 7.72 percent B. 8.19 percent C. 9.38 percent D. 11.55 percent E. 12.40 percent

12.40 percent EPSU= EPSL $41,650 / 15,500 = [$41,650 - ($65,000× r)] / 12,500 r = 12.40 percent

Bruno's is considering changing from its current all-equity capital structure to 30 percent debt. There are currently 7,500 shares outstanding at a price per share of $39. EBIT is expected to remain constant at $23,000. The interest rate on new debt is 7.5 percent and there are no taxes. Tracie owns $12,675 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? A. $998 B. $1,109 C. $1,115 D. $1,037 E. $1,016

$1,016 All-equity value = 7,500 ×$39 = $292,500 Shares repurchased = 7,500 ×.30= 2,250 shares EPS = [$23,000 - ($292,500)(.30)(.075)]/(7,500 -2,250) = $3.1274 Cash flow = ($3.1274) ($12,675/$39) = $1,016

Great Lakes Shipping is an all-equity firm with anticipated earnings before interest and taxes of $386,000 annually forever. The present cost of equity is 17.1 percent. Currently, the firm has no debt but is considering borrowing $1.48 million at 8.5 percent interest. The tax rate is 35 percent. What is the value of the levered firm? A. $1,985,251 B. $2,006,519 C. $1,888,47 D. $1,666,667 E. $2,018,181

$1,985,251 VU = [$386,000 ×(1 -.35)]/.171 = $1,467,251.46 VL = $1,467,251.46 + (.35 ×$1,480,000) = $1,985,251

Northern Wood Products is an all-equity firm with 14,000 shares of stock outstanding and a total market value of $585,480. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $46,800 if the economy is normal, $21,200 if the economy is in a recession, and $56,000 if the economy booms. Ignore taxes. Management is considering issuing $150,000 of debt at a coupon rate of 7 percent. 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? (Round the number of shares repurchased down to the nearest whole share.) A. $.97 B. $1.03 C. $1.36 D. $.88 E. $.68

$1.03 Shares repurchased $150,000/($585,480/14,000) = 3,586 shares Shares outstanding = 14,000 -3,586 = 10,414 shares EPSRecession = [$21,200- ($150,000 × .07)]/10,414 = $1.03

Cross Town Cookies is an all-equity firm with a total market value of $4,187,100. The firm has 127,500 shares of stock outstanding. Management is considering issuing $300,000 of debt at an interest rate of 6 percent and using the proceeds to repurchase shares. The projected earnings before interest and taxes are $215,600. What are the anticipated earnings per share if the debt is issued? Ignore taxes. (Round the number of shares repurchased down to the nearest whole share.) A. $1.59 B. $1.76 C. $1.38 D. $1.67 E. $1.47

$1.67 Shares repurchased = $300,000/($4,187,100/127,500) = 9,135 shares Shares outstanding = 127,500-9,135 = 118,365 shares EPS = [$215,600 - ($300,000 ×.06)]/118,365 = $1.67

Sand Mountain Resort has a tax rate of 32 percent. Its total interest payment for the year just ended was $41,000. What is the interest tax shield for the year? A. $27,590 B. $13,120 C. $13,410 D. 427,880 E. $41,000

$13,120 Interest tax shield = $41,000 ×.32 = 13,120

Brick House Markets has a tax rate of 34 percent and taxable income of $308,211. What is the value of the interest tax shield if the interest expense is $39,700? A. $14,887 B. $15,010 C. $15,595 D. $13,498 E. $16,023

$13,498 Interest tax shield = .34 ×$39,700 = $13,498

Marcos & Sons has no debt. Its current total value is $13 million. What will the company's value be if it sells $5 million in debt and has a tax rate of 35 percent? Assume all debt proceeds are used to repurchase equity. A. $16.25 million B. $18.00 million C. $11.25 million D. $13.00 million E. $14.75 million

$14.75 million VL = $13 million + ($5 million× .35) = $14.75 million

A firm is considering two different capital structures. The first option is an all-equity firm with 40,000 shares of stock. The second option is 28,000 shares of stock plus some debt. Ignoring taxes, the break-even level of earnings before interest and taxes between these two options is $52,000. How much money is the firm considering borrowing if the interest rate is 9 percent? A. $175,000 B. $173,333 C. $208,333 D. $216,667 E. $225,000

$173,333 EPSU= EPSL $52,000 / 40,000 = [$52,000 - (D × .09)] / 28,000 D = $173,333

Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $624,000 annually forever. Currently, the firm has no debt but is considering borrowing $725,000 at 6.75 percent interest. The tax rate is 35 percent and the current cost of equity is 15.2 percent. What is the value of the levered firm? A. $3,187,271 B. $2,769,535 C. $3,307,271 D. $2,922,171 E. $3,506,418

$2,922,171 VU = [$624,000 ×(1 -.35)]/.152 = $2,668,421.05 VL = $2,668,421.05 + (.35 ×$725,000) = $2,922,171

Stevenson's Bakery is an all-equity company that has projected perpetual earnings before interest and taxes of $43,700 a year. The cost of equity is 15.2 percent and the tax rate is 34 percent. The company can borrow money at 7.15 percent. If the company borrows $50,000, what will be its levered value? A. $187,613 B. $189,919 C. $206,750 D. $229,507 E. $203,682

$206,750 VU = [$43,700 ×(1 -.34)]/.152 = $189,750 VL = $189,750 + (.34 ×$50,000) = $206,750

Green Tea House has a tax rate of 35 percent and an interest tax shield valued at $8,046 for the year. How much did the firm pay in annual interest? A. $2,816.10 B. $2,304.11 C. $23,468.09 D. $21,107.99 E. $22,988.57

$22,988.57 Interest = $8,046/.35 = $22,988.57

Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $628,000. The current cost of equity is 17.6 percent and the tax rate is 35percent. The company is in the process of issuing $4.3 million of 8.3 percent annual coupon bonds at par. What is the levered value of the firm? A. $3,824,318 B. $3,541,085 C. $3,422,225 D. $2,713,185 E. $3,385,695

$3,824,318 VU = [$628,000 ×(1 -.35)]/.176 = $2,319,318 VL = $2,319,318 + (.35 ×$4,300,000) = $3,824,318

Ready To Go is an all-equity firm specializing in hot ready-to-eat meals. Management has estimated the firm's earnings before interest and taxes will be $68,000 annually forever. The present cost of equity is 14.1 percent. Currently, the firm has no debt but is considering borrowing $450,000 at 8 percent interest. The tax rate is 34 percent. What is the value of the unlevered firm? A. $323,017 B. $346,511 C. $314,141 D. $318,298 E. $305,200

$318,298 VU = [$68,000 ×(1 -.34)]/.141 = $318,298

Tree Farms currently has 48,000 shares of stock outstanding and no debt. The price per share is $22.50. The firm is considering borrowing funds at 8.5 percent interest and using the proceeds to repurchase 1,750 shares of stock. Ignore taxes. How much is the firm borrowing? A. $42,500 B. $39,375 C. $32,750 D. $32,500 E. $40,000

$39,375 1,750 ×$22.50 = $39,375

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 34 percent? A. $283,140 B. $316,030 C. $4,053,400 D. $3,960,000 E. $4,420,000

$4,420,000 PV of tax shield = .34×$13,000,000= $4,420,000

Newborn Nursery has 12,000 bonds outstanding with a face value of $1,000 each. The coupon rate is 6.9 percent and the tax rate is 34 percent. What is the present value of the interest tax shield? A. $4.14 million B. $4.86 million C. $3.87 million D. $3.92 million E. $4.08 million

$4.08 million PV of tax shield = .34 ×12,000 ×$1,000 = $4.08 million

Uptown Construction is comparing two different capital structures. Plan I would result in 16,000 shares of stock and $160,000 in debt. Plan II would result in 18,000 shares of stock and $110,000 in debt. The interest rate on the debt is 9 percent. Ignoring taxes, EPS will be identical for Plans I and II when EBIT equals which one of the following? A. $48,550 B. $50,400 C. $69,600 D. $53,700 E. $60,750

$50,400 [EBIT - ($160,000 ×.09)]/16,000 = [EBIT -($110,000 ×.09)]/18,000 EBIT = $50,400

Ernst Electrical has 7,500 shares of stock outstanding and no debt. The new CFO is considering issuing $50,000 of debt and using the proceeds to retire 600 shares of stock. The coupon rate on the debt is 8.5 percent. What is the break-even level of earnings before interest and taxes between these two capital structure options? A. $48,360 B. $50,020 C. $49,740 D. $52,500 E. $53,125

$53,125 EPSU= EPSL EBIT /7,500 = [EBIT - ($50,000 × .085)] / (7,500 - 600) EBIT = $53,125

Chick 'N Fish is considering two different capital structures. The first option is an all-equity firm with22,500 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

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

The Fruit Mart is an all-equity firm with a current cost of equity of 17.4 percent. The estimated earnings before interest and taxes are $169,500 annually forever. Currently, the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest. The tax rate is 35 percent. What is the value of the unlevered firm? A. $649,207 B. $753,571 C. $656,411 D. $719,307 E. $633,190

$633,190 VU = [$169,500 ×(1 -.35)]/.174 = $633,190

Gulf Shores Inn is comparing two separate capital structures. The first structure consists of 64,000 shares of stock and no debt. The second structure consists of 50,000 shares of stock and $1.01 million of debt. What is the price per share of equity? A. $75.50 B. $69.97 C. $72.14 D. $68.36 E. $74.00

$72.14 P = $1,010,000 / (64,000 - 50,000) = $72.14

The Piano Movers can borrow at 7.8 percent. The firm currently has no debt, and the cost of equity is 15 percent. The current value of the firm is $680,000. What will the value be if the firm borrows $140,000 and uses the proceeds to repurchase shares? The corporate tax rate is 35 percent. A. $820,000 B. $540,000 C. $750,000 D. $571,000 E. $729,000

$729,000 VL = $680,000 + (.35)($140,000) = $729,000

Granny's Home Remedy has a $27 million bond issue outstanding with a coupon rate of 8.75 percent and a current yield of 8.13 percent. What is the present value of the tax shield if the tax rate is 35 percent? A. $768,285 B. $826,875 C. $839,002 D. $8,160,000 E. $9,450,000

$9,450,000 PV of tax shield = .35×$27,000,000 = $9,450,000

Jasper Industrial has no debt outstanding and a total market value of $216,000. Earnings before interest and taxes, EBIT, are projected to be $15,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 12 percent higher. If there is a recession, then EBIT will be 15 percent lower. There are currently 8,600 shares outstanding. Ignore taxes. What is the percentage change in EPS when a normal economy slips into recession? A. -15.5 percent B. -15.2 percent C. -;15.0 percent D. -16.1 percent E. -14.8 percent

-15.0 percent EPSNormal = $15,000/8,600 = $1.744 EPSRecession = $15,000(1 - .15)/ 8,600 = $1.483 Percentage change ($1.483 -1.744)/$1.744 = -15 percent

Weston Mines has a cost of equity of 14.9 percent, a pretax cost of debt of 7.3 percent, and a return on assets of 12.6 percent. Ignore taxes. What is the debt-equity ratio? A. .52 B. .84 C. .43 D. .77 E. .56

.43 .149 = .126 + [(.126 -.073) ×D/E] D/E = .43

The Outlet Mall has a cost of equity of 16.3 percent, a pretax cost of debt of 7.9 percent, and a return on assets of 13.4 percent. Ignore taxes. What is the debt-equity ratio? A. .46 B. .53 C. .44 D. .59 E. .57

.53 .163 = .134 + [(.134-.079) ×D/E] D/E = .53

The Park Place has a return on assets of 12.9 percent, a cost of equity of 16.2 percent, and a pretax cost of debt of 7.7 percent. What is the debt-equity ratio? Ignore taxes. A. .44 B. .47 C. .67 D. .91 E. .63

.63 .162 = .129 + [(.129 -.077) × D/E] D/E = .63

Glass Growers has a cost of capital of 11.1 percent. The company is considering converting to a debt-equity ratio of .46. The interest rate on debt is7.3 percent. What would be the company’s new cost of equity? Ignore taxes. A. 12.85 percent B. 11.13 percent C. 12.36 percent D. 12.44 percent E. 11.61 percent

12.85 percent WACC = .111 = (1/1.46)(RE) + (.46 /1.46)(.073) RE= .1285, or 12.85 percent

A firm has a cost of debt of 7.8 percent and a cost of equity of 15.6 percent. The debt-equity ratio is .52. There are no taxes. What is the firm's weighted average cost of capital? A. 11.76 percent B. 11.29 percent C. 12.93 percent D. 12.47 percent E. 10.20 percent

12.93 percent WACC = [(1/1.52) ×.156] + [(.52 /1.52) ×.078] = .1293, or 12.93 percent

Delta Mowers has a debt-equity ratio of .6. Its WACC is 11.8 percent, and its cost of debt is 7.7 percent. There is no corporate tax. What is the firm's cost of equity capital? A. 12.60 percent B. 14.26 percent C. 13.83 percent D. 14.29 percent E. 14.80 percent

14.26 percent WACC = .118 = (1/1.6)RE + (.6/1.6)(.077) = .1426, or 14.26 percent

The Tree House has a pretax cost of debt of 7.3 percent and a return on assets of 12.8 percent. The debt-equity ratio is .46. Ignore taxes. What is the cost of equity? A. 14.50 percent B. 14.82 percent C. 15.47 percent D. 14.98 percent E. 15.33 percent

15.33 percent RE = .128 + [(.128 -.073) × .46] = .1533, or 15.33 percent

Triangle Enterprises has no debt but can borrow at 8 percent. The firm's WACC is currently 13.2 percent, and there is no corporate tax. If the firm converts to 30 percent debt, what will its cost of equity be? A. 16.67 percent B. 12.95 percent C. 14.47 percent D. 16.39 percent E. 15.43 percent

15.43 percent WACC = .132 = .70RE + .30(.08) RE = .1543, or 15.43 percent

. An all-equity firm has a return on assets of 13.3 percent. The firm is considering converting to a debt-equity ratio of .48. The pretax cost of debt is 8.6 percent. Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure? A. 16.01 percent B. 15.28 percent C. 16.60 percent D. 17.03 percent E. 15.56 percent

15.56 percent RE = .133 + [(.133 -.086) × .48] RE=.1556, or 15.56 percent

Northwestern Lumber Products currently has 12,400 shares of stock outstanding and no debt. Patricia, the financial manager, is considering issuing $160,000 of debt at an interest rate of 6.95 percent and using the proceeds to repurchase shares. Given this, how many shares of stock will be outstanding once the debt is issued if the break-even level of EBIT between these two capital structure options is $48,000? Ignore taxes. A. 2,873 shares B. 3,051 shares C. 3,025 shares D. 2,558 shares E. 2,667 shares

2,873 shares EPSU= EPSL $48,000 / 12,400 = [$48,000 - ($160,000 × .0695)] / (12,400 - x) x = 2,873

Bird Houses is an all-equity firm with a total market value of $388,980 and18,000 shares of stock outstanding. Management is considering issuing $68,000 of debt at an interest rate of 6.5 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares will the firm repurchase if it issues the debt securities? (Round the number of shares repurchased down to the nearest whole share.) A. 3,167 shares B. 3,116 shares C. 3,021 shares D. 3,207 shares E. 3,146 shares

3,146 shares Shares repurchased = $68,000/($388,980/18,000) = 3,146 shares

A firm has a weighted average cost of capital of 11.28 percent and a cost of equity of 14.7 percent. The debt-equity ratio is .72. There are no taxes. What is the firm's cost of debt? A. 6.53 percent B. 6.27 percent C. 6.44 percent D. 7.23 percent E. 7.08 percent

6.53 percent 1128 = [(1/1.72 × .147] + [(.72 /1.72) ×RD] RD = 6.53 percent

Debbie's Cookies has a return on assets of 12.6 percent and a cost of equity of 14.8 percent. What is the pretax cost of debt if the debt-equity ratio is .38? Ignore taxes. A. 5.87 percent B. 95.29 percent C. 9.04 percent D. 7.31 percent E. 6.81 percent

6.81 percent .148 = .126 + [(.126 -RD) ×.38] RD = .0681, or 6.81 percent

The Bethlehem Inn is an all-equity firm with 9,000 shares outstanding at a value per share of $26.80. The firm is issuing $39,932 of debt and using the proceeds to reduce the number of outstanding shares. How many shares of stock will be outstanding once the debt is issued? Ignore taxes. A. 7,970 shares B. 7,510 shares C. 7,846 shares D. 8,030 shares E. 7,561 shares

7,510 shares 9,000 - ($39,932/$26.80) = 7,510 shares

Roller Coaster's has a WACC of 11.6 percent, ignoring taxes. It has a target capital structure of 60 percent equity and 40 percent debt and a cost of equity of 14.27 percent. What is the cost of debt? A. 5.5 percent B. 7.6 percent C. 9.3 percent D. 9.4 percent E. 18.7 percent

7.6 percent .1427 = .116 + (.116 - RD)×(.40 / .60) RD = .076

Which one of the following statements related to the static theory of capital structure is correct? A. A firm begins to lose value as soon as the first dollar of debt is incurred. B. The actual value of a firm continually rises in direct proportion to the increased use of debt. C. The linear function of a firm's value has a constant positive slope. D. A firm's value is maximized when a firm operates at its optimal debt level. E. The value of a firm will automatically decrease whenever the debt-equity ratio is decreased

A firm's value is maximized when a firm operates at its optimal debt level

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

A legal proceeding for liquidating or reorganizing a business

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

Absolute priority rule

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

Bankruptcy administrative expenses

Which statement is true? 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.

Bankruptcy courts have "cram-down" powers.

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

Business risk

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

Financial leverage magnifies both profits and losses

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

Financial risk

Which one of the following is an example of a direct bankruptcy cost? A. Operating at a debt-equity ratio that is less than the optimal ratio B. Reducing the dividend payout ratio as a means of increasing a firm's equity C. Forgoing a positive net present value project to conserve current cash D. Incurring legal fees for the preparation of bankruptcy filings E. Losing a key customer due to concerns over a firm's financial viability

Incurring legal fees for the preparation of bankruptcy filings

Gabe's Market is comparing two different capital structures. Plan I would result in 15,000 shares of stock and $210,000 in debt. Plan II would result in 13,000 shares of stock and $252,000 in debt. The interest rate on the debt is 8 percent. Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $52,000. The all-equity plan would result in 25,000 shares of stock outstanding. Of the three plans, the firm will have the highest EPS with _____ and the lowest EPS with ____. A. Plan I; Plan II B. Plan II; the all-equity plan C. Plan II; Plan I D. Plan I; the all-equity plan E. the all-equity plan; Plan I

Plan II; the all-equity plan EPSAll-equity = $52,000/25,000 = $2.08 EPSPlan I = [$52,000 - ($210,000 × .08)]/15,000 = $2.35 EPSPlan II = [$52,000 - ($252,000 × .08)]/13,000 = $2.45

Peter's Tools recently defaulted on a bank loan. To avoid a bankruptcy proceeding, the bank agreed to a composition. This composition would do which one of the following? A. Forgive the loan payment in its entirety B. Extend the due date on the missed loan payment C. Reduce the amount of the loan payments so Peter's can pay on time D. Transfer some of Peter's assets to the bank in lieu of the loan payment E. Transfer all the equity shares in Peter’s to the lending bank

Reduce the amount of the loan payments so Peter's can pay on time

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

Reorganization

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

Right granted to creditors to file their own reorganization plan once a firm is in bankruptcy for 18 months

Which one of the following statements is correct regarding bankruptcies post-2005? 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 are no longer permitted under any circumstances. D. Labor contracts cannot be modified through the bankruptcy process. E. Section 363 speeds up the bankruptcy process via a bidding process.

Section 363 speeds up the bankruptcy process via a bidding process

Shoe Box Stores is currently an all-equity firm with 25,000 shares of stock outstanding. Management is considering changing the capital structure to 35 percent debt. The interest rate on the debt would be 8 percent. Ignore taxes. Jamie owns 600 shares of Shoe Box Stores stock that is priced at $22 a share. What should Jamie do if she prefers the all-equity structure but Shoe Box Stores adopts the new capital structure? A. Borrow money and buy an additional 180 shares B. Borrow money and buy an additional 210 shares C. Keep her shares but loan out all of the dividend income at 8 percent D. Sell 210 shares and loan out the proceeds at 8 percent E. Sell 180 shares and loan out the proceeds at 8 percent

Sell 210 shares and loan out the proceeds at 8 percent Since the firm is using 35 percent leverage, Jamie can offset the firm's leverage by selling shares and loaning out 35 percent of her investment at 8 percent interest. Number of shares to be sold = 600 shares × .35 = 210 shares

Katz is an all-equity development company that has 52,000 shares of stock outstanding at a market price of $32 a share. The firm's earnings before interest and taxes are $46,000. Katz has decided to issue $176,000 of debt at a rate of 8 percent and use the proceeds to repurchase shares. What should Leslie do if she owns 500 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 53 shares B. Borrow money and buy an additional 56 shares C. Sell 48 shares and loan out the proceeds D. Sell 56 shares and loan out the proceeds E. Sell 53 shares and loan out the proceeds

Sell 53 shares and loan out the proceeds Shares repurchased = $176,000/$32 = 5,500 Value of equity = (52,000 -5,500) ×$32 = $1,488,000 Value of debt = $176,000 Debt ratio = $176,000/($176,000 + 1,488,000) = .1057 Since the firm is using 10.57 percent debt, Leslie will need to reduce her investment in the firm by 10.57 percent. Shares to be sold = 500 ×.1057 =53 shares

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

Tc ×D

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

The capital structure of a firm is totally irrelevant

. 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.

The costs of financial distress decrease the value of a firm.

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

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

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

The unlevered firm will have higher EPS at relatively low levels of EBIT

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

The value of a firm is independent of the firm's capital structure

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

WACC

Which one of the following conditions exists at the point where a firm maximizes its value? A. The tax benefit from an additional dollar of debt is zero. B. Financial distress costs are equal to zero. C. The debt-equity ratio is 1.0. D. WACC is minimized. E. The cost of equity is minimized

WACC is minimized

When is a firm insolvent from an accounting perspective? A. When the firm is unable to meet its financial obligations in a timely manner B. When the firm's debt exceeds the value of the firm's equity C. When the firm has a negative net worth D. When the firm's revenues cease E. When the market value of the firm's equity equals zero

When the firm has a negative net worth

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.

a firm's value and its weighted average cost of capital are inversely related.

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.

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

. 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

debt-equity ratio

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

financial distress costs

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

homemade leverage

. 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

indirect bankruptcy costs

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

interest tax shield

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 and operations. D. pays no taxes. E. is operating at the point where financial distress costs are eliminated

is fixed in terms of its assets and operations

A prepack: A. guarantees full payment to all creditors but lengthens the time span of the debt. B. is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan. C. protects the interests of both the current creditors and the existing shareholders. D. applies only if a firm files under Chapter 7 of the bankruptcy code. E. extends the time that a firm is protected by the bankruptcy process.

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

. T.L.C. Enterprises just revised its capital structure from a debt-equity ratio of .37 to a debt-equity ratio of .48. 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

sell some shares and loan out the sale proceeds

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

static theory of capital structure

M&M Proposition I with taxes states that: A. the optimal capital structure is the all-equity option. B. the levered value of a firm exceeds the firm's unlevered value. C. a firm's capital structure is irrelevant. D. the value of a firm is independent of taxes. E. WACC remains constant given any debt-equity ratio

the levered value of a firm exceeds the firm's unlevered value

According to M& M Proposition I with taxes, the value of a levered firm will increase when the: A. value of the unlevered firm increases. B. tax rate is decreased. C. debt-equity ratio is lowered. D. interest rate on the debt is lowered. E. interest rate on the debt is increased.

value of the unlevered firm increases

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

whenever EBIT exceeds $428,000

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

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

Gabella's is an all-equity firm that has 36,000 shares of stock outstanding at a market price of $27 a share. The firm has earnings before interest and taxes of $57,600 and has a 100 percent dividend payout ratio. Ignore taxes. Gabella's has decided to issue $125,000 of debt at a rate of 9 percent and use the proceeds to repurchase shares. Terry owns 800 shares of Gabella's stock and has decided to continue holding those shares. How will Gabella's debt issue affect Terry's annual dividend income? A. Decrease from $640 to $567 B. Increase from $2,160 to $1,890 C. Decrease from $640 to $591 D. Increase from $1,890 to $2,160 E. No change

Decrease from $640 to $591 All-equity EPS = $57,600/36,000 = $1.60 Debt and equity EPS = [$57,600 - ($125,000 ×.09)]/[36,000 - ($125,000/$27)] = $1.4775 Terry's all-equity dividend income = 400 ×$1.60 = $640 Terry's debt and equity dividend income = 400 ×$1.4775 = $591