Chapter 16: exam 3

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Omega Corp. has $20 million in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 40%. What is the tax shield from debt?

$0.64 million

Omega Corp. has $20 million in perpetual debt outstanding with a coupon rate of 8 percent. The tax rate is 40 percent. What is the tax shield from debt?

$0.64 million Reason: 0.40 × $20m × 0.08 = $0.64m

If ABC Co. has earnings before interest and taxes of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders if the interest rate is 10 percent and the tax rate is 35 percent?

$1,475,000 Reason: (.1 × $5m) + [$2m - (.1 × $5m)](1 - .35) = $1,475,000

An unlevered firm has a value of $30 million. An identical firm has debt of $2 million with a 7% annual coupon. The tax rate is 40%. What is the value of the levered firm?

$30.8 million

An unlevered firm has a value of $30 million. An identical firm has debt of $2 million with a 7 percent annual coupon. The tax rate is 40 percent. What is the value of the levered firm?

$30.8 million Reason: VL= $30m + .4 × $2m = $30.8m

Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12%. If the tax rate is 40%, what is the value of the firm?

$50 million

Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12 percent. If the tax rate is 40 percent, what is the value of the firm?

$50 million Reason: [$10m(1 - .4)]/.12 = $50m

If an investor buys $20,000 worth of stock by investing $11,000 of their own money, how much was borrowed?

$9,000

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?

- Financial leverage increases the slope of the EPS line - Below the indifference or break even point in EBIT, an unlevered capital structure is best - The rate of return on assets is unaffected by leverage

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ______________.

- MM demonstrated that debt financing is neither better nor worse than equity financing in the absense of taxes - the asset to be financed is the same

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because ______________.

- as debt is added, the equity becomes more risky - the overall cost of capital cannot be reduced

Brokers who sell stock on margin will protect themselves by ______________.

- selling the stock to satisfy the loan - requiring additional cash contributions from the investor - holding the stock as collateral

???? Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step.

1. Calculate EBIT 2. Multiply EBIT by 1 minus the corporate tax rate 3. Divide the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield

Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step.

1.) Calculate EBIT 2.) Multiply EBIT by 1 minus the corporate tax rate 3.) Divide by the cost of equity for an all-equity firm. 4.) Add the present value of the debt tax shield.

A company with $4 million in debt and $10 million in equity has a cost of debt of 7%, a cost of equity of 12.18%, and a tax rate of 35%. What is the firm's WACC?

10%

A company with $4 million in debt and $10 million in equity has a cost of debt of 7 percent, a cost of equity of 12.18 percent, and a tax rate of 35 percent. What is the firm's WACC?

10% Reason: ($10m/$14m)(.1218) + ($4m/$14m)(.07)(1 - .35) = .10, or 10%

A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8%, and a cost of equity of 12%. What is the firm's WACC if there are no taxes?

11.05%

A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8 percent, and a cost of equity of 12 percent. What is the firm's WACC if there are no taxes?

11.05% Reason: ($16,000/$21,000) × 12% + ($5,000/$21,000) × 8% = 11.05%

King's unlevered cost of equity is 11 percent and its pretax cost of debt is 8 percent. The firm has a debt-equity ratio of .4. If the tax rate is 40 percent, what is King's cost of equity?

11.72% Reason: 11% + .4 × (1 - .4) × (11% - 8) = 11.72%

King's unlevered cost of equity is 11% and its pretax cost of debt is 8%. The firm has a debt-equity ratio of 0.4. If the tax rate is 40%, what is the King's cost of equity?

11.72%; 11% + .4 x (1-.4) x (11% - 8) = 11.72%

Alpha Co. has a debt-equity ratio of .6, a pretax cost of debt of 7.5 percent, and an unlevered cost of equity of 12 percent. What is Alpha's cost of equity if you ignore taxes?

14.7% Reason: 12% + .6(12% - 7.5) = 14.7%

Calculate the cost of capital for an all-equity firm with equity of $12,500 and expected earnings of $1,900.

15.2%

Calculate the cost of capital for an all-equity firm with equity of $225,000 and expected earnings of $35,000.

15.6%

The firm's value of maximized

A beneficial rule to follow is to set the firm's capital structure so that ___________.

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?

Below the indifference or break-even point in EBIT, an unlevered capital structure is best. The rate of return on assets is unaffected by leverage. Financial leverage increases the slope of the EPS line.

A corporation gains no value from an interest tax shield if which of the following are true?

Corporate tax rates are zero. The corporation is an all-equity firm. The corporation has no debt.

True of False: Holding equity in an unlevered firm has no risk.

False

True or false: Holding equity in an unlevered firm has no risk.

False Reason: Since equity still carries risk, an unlevered firm should expect a higher return than what a riskless asset would achieve.

An unlevered firm ______________.

Has an all-equity capital structure

With ________, an invetor replicates a corporation's cap structure by borrowing funds and using those funds along with her own money to buy the company's stock

Homemade leverage

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ___.

MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes the asset to be financed is the same

Which of these statements is true regarding corporate capital structures?

The capital structure that maximizes the value of the firm provides the most benefit for its stockholders.

The manager of a firm should change the capital structure if and only if ___________.

The change will increase the value of the firm

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.

a higher expected return

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___________.

a higher expected return

Under MM with no taxes, as debt is ________ to capital structure, the cost of equity ______.

added; increases removed; decreases

The fact that almost every industry has a debt-equity ratio to which its firms adhere is evidence that the MM Propositions ______________.

are missing some real world factors

The fact that almost every industry has a debt-equity ratio to which its firms adhere is evidence that the MM Propositions ___.

are missing some real-world factors

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __.

as debt is added, the equity becomes more risky the overall cost of capital cannot be reduced

Debt has a tax ______.

benefit

With no taxes, MM showed:

capital structure does not matter

When calculating the cash flow for a levered firm, you must consider:

cash flows to both bondholders and stockholders

The WACC is the weighted average cost of ______ plus the weighted average cost of ______.

debt; equity

With taxes, the weighted average cost of capital ______ as debt is added to the capital structure.

decreases

The capital structure across different industries is ______.

different

Financial leverage affects the performance of a firm because the range of possible values for ___.

earnings per share is wider

Financial leverage affects the performance of a firm because the range of possible values for ______________.

earnings per share is wider

Levered equity has ______ risk than unlevered equity.

greater

With taxes, MM Proposition I says the value of the levered firm will be _____ the value of the unlevered firm.

greater than

An unlevered firm ____.

has an all-equity capital structure

Managers should choose the capital structure that will have the ______ firm value.

highest

An accounting balance sheet uses ______ values and a market balance sheet uses ______ values.

historical; current

Brokers who sell stock on margin will protect themselves by ___.

holding the stock as collateral selling the stock to satisfy the loan requiring additional cash contributions from the investor

An individual can duplicate a levered firm through a strategy called ____ where the investor uses his own funds plus borrowed funds to buy stocks.

homemade leverage

An individual can duplicate a levered firm through a strategy called ________ where the investor uses his own funds plus borrowed funds to buy stocks.

homemade leverage

When an investor borrows money and uses it to purchase stocks is called:

homemade leverage

With ____, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with her own money to buy the company's stock.

homemade leverage

According to the efficient markets theory, the announcement of a future plant expansion (with a positive NPV) should cause the stock price and therefore the value of the firm to ___.

increase immediately

According to the efficient markets theory, the announcement of a future plant expansion (with a positive NPV) should cause the stock price and therefore the value of the firm to ______________.

increase immediately

Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ___.

increases with leverage

Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ______________.

increases with leverage

A key assumption of MM Proposition I is that ___.

individuals can borrow as cheaply as corporations

A key assumption of MM Proposition I is that ________.

individuals can borrow as cheaply as corporations

Under MM Proposition II with no taxes, the return on assets ______ as debt increases.

is unchanged

The effect of financial leverage ______ for all earning levels.

is variable

A market value balance sheet differs from an accounting balance sheet because ___.

it does not use historical values

A market value balance sheet differs from an accounting balance sheet because ______________.

it does not use historical values

Homemade _____________ allows an investor to choose any capital structure they want of an unlevered firm.

leverage

After the issuance of debt, an unlevered firm becomes ___.

levered

After the issuance of debt, an unlevered firm becomes __________.

levered

MM Proposition I does not work with corporate taxes because:

levered firms pay lower taxes than unlevered firms

When buying on margin, brokers typically charge ______ interest.

low

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ______.

lower

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be ______________.

lower

Stockholders want to _____ the value of the entire firm.

maximize

A company should select the capital structure that:

maximizes the company's value

According to efficient capital markets theory, stock prices will only react to ___.

new information

According to efficient capital markets theory, stock prices will only react to ______________.

new information

When Pete purchases $10,000 in stock by using $6,000 of his own money and borrowing the remaining $4,000 from his broker, he is buying stock ___.

on margin

When Pete purchases $10,000 in stock by using $6,000 of his own money and borrowing the remaining $4,000 from his brother, he is buying _________.

on margin

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm ___.

plus the tax rate times the value of debt

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm______________.

plus the tax rate times the value of the debt

Under MM Proposition II, a firm's cost of equity capital is ______ related to the firm's debt-equity ratio provided the cost of capital for an all-equity firm exceeds the cost of debt.

positively

The expected return on equity is _____ to leverage.

positively related

The expected return on equity is ______ to leverage

positively related

Volatility or ______ increases for equity holders when leverage increases.

risk

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because:

shareholders capture the interest tax shield

The manager of a firm should change the capital structure if and only if ___.

the change will increase the value of the firm

MM Proposition shows that ______________.

the cost of equity rises with leverage

MM Proposition II shows that ___.

the cost of equity rises with leverage.

A firm's capital structure refers to ___.

the firm's mix of debt and equity

A beneficial rule to follow is to set the firm's capital structure so that ___.

the firm's value is maximized

Under MM Proposition II with no taxes, the WACC is invariant to the debt-equity ratio because ___.

the return on assets (RO) is unchanged

Under MM Proposition II with no taxes, the WACC is invariant to the debt-equity ratio because ______________.

the return on assets (Ro) is unchanged

A firm with no debt in its capital structure is:

unlevered


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