FIN 4610 CH 16 60

Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $42 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes. A. $35,910 B. $38,516 C. $42,000 D. $44,141 E. $45,020

A. $35,910 EBIT/9,000 = [EBIT - ($120,000 0.095)]/[9,000 - ($120,000/$42)]; EBIT = $35,910

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes. A. $1.46 B. $1.50 C. $1.67 D. $1.88 E. $1.94

B. $1.50 Number of shares repurchased = $30,000/$15 = 2,000 EBIT/5,000 = [EBIT - ($30,000 .0.10)]/(5,000 - 2,000); EBIT = $7,500 EPS = [$7,500 - ($30,000 0.10)]/(5,000 - 2,000); EPS = $1.50

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? A. $2.5 million B. $4.0 million C. $5.0 million D. $5.5 million E. $6.0 million

B. $4.0 million Firm value = 80,000 ($600,000/12,000) = $4 million

Which one of the following statements related to Chapter 7 bankruptcy is correct? A. A firm in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern. B. Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated. C. Chapter 7 bankruptcies are always involuntary on the part of the firm. D. Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy. E. Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock are generally issued prior to the firm coming out of bankruptcy.

B. Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated.

The capital structure that maximizes the value of a firm also: A. minimizes financial distress costs. B. minimizes the cost of capital. C. maximizes the present value of the tax shield on debt. D. maximizes the value of the debt. E. maximizes the value of the unlevered firm.

B. minimizes the cost of capital.

The basic lesson of M&M Theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. size of the stockholders' claims.

B. the total cash flow of the firm.

Corporations in the U.S. tend to: A. minimize taxes. B. underutilize debt. C. rely less on equity financing than they should. D. have relatively similar debt-equity ratios across industry lines. E. rely more heavily on debt than on equity as the major source of financing.

B. underutilize debt.

Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $87,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes. A. 300 shares B. 350 shares C. 375 shares D. 425 shares E. 500 shares

C. 375 shares Naylor's interest = $750,000 0.075 = $56,250 Naylor's shares repurchased = $750,000/$50 = 15,000 Naylor's shares outstanding with debt = 60,000 - 15,000 = 45,000 Naylor's EPS, no debt = $87,000/60,000 = $1.45 Naylor's EPS, with debt = ($87,000 - $56,250)/45,000 = $0.683333 Naylor's value of stock = 45,000 $50 = $2,250,000 Naylor's value of debt = $750k Naylor's total value = $2,250,000 + $750,000 = $3,000,000 Naylor's weight stock = $2,250,000/$3,000,000 = 0.75 Naylor's weight debt = $750,000/$3,000,000 = 0.25 Your initial investment = 500 $50 = $25,000 Your new stock position = 0.75 $25,000 = $18,750 Your new number of shares = $18,750/$50 = 375 shares Check: Your new loans = 0.25 $25,000 = $6,250 Your unlevered income = 500 $1.45 = $725 Your levered income = (375 $0.683333) + ($6,250 0.075) = $725

Miller's Dry Goods is an all equity firm with 45,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes. A. 35.6 shares B. 40.0 shares C. 44.4 shares D. 47.5 shares E. 50.1 shares

C. 44.4 shares Miller's interest = $250,000 0.08 = $20,000 Miller's shares repurchased = $250,000/$50 = 5,000 Miller's shares outstanding with debt = 45,000 - 5,000 = 40,000 Miller's EPS, no debt = $128,000/45,000 = $2.844444 Miller's EPS, with debt = ($128,000 - $20,000)/40,000 = $2.70 Miller's value of stock = 40,000 $50 = $2,000,000 Miller's value of debt = $250,000 Miller's total value = $2,000,000 + $250,000 = $2,250,000 Miller's weight stock = $2,000,000/$2,250,000 = 0.888889 Miller's weight debt = $250,000/$2,250,000 = 0.111111 Your initial investment = 400 $50 = $20,000 Your new stock position = 0.888889 $20,000 = $17,777.78 Your new number of shares = $17,777.78/$50 = 355.5556 Number of shares sold = 400 - 355.5556 = 44.4 shares Check: Your new loans = 0.111111 $20,000 = $2,222.22 Your total unlevered income = 400 $2.844444 = $1,137.78 Your total levered income = (355.5556 $2.70) + ($2,222.22 0.08) = $1,137.78

A firm is technically insolvent when: A. it has a negative book value. B. total debt exceeds total equity. C. it is unable to meet its financial obligations. D. it files for bankruptcy protection. E. the market value of its stock is less than its book value.

C. it is unable to meet its financial obligations.

The optimal capital structure: A. will be the same for all firms in the same industry. B. will remain constant over time unless the firm 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.

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest? A. 120 shares B. 150 shares C. 180 shares D. 200 shares E. 250 shares

D. 200 shares JKL interest = $1m 0.08 = $80,000 JKL shares repurchased = $1m/$40 = 25,000 JKL shares outstanding with debt = 75,000 - 25,000 = 50,000 JKL EPS, no debt = $140,000/75,000 = $1.866667 JKL EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20 JKL value of stock = 50,000 $40 = $2m JKL value of debt = $1m JKL total value = $2m + $1m = $3m JKL weight stock = $2m/$3m = 2/3 JKL weight debt = $1m/$3m = 1/3 Your initial investment = 600 $40 = $24,000 Your new stock position = 2/3($24,000) = $16,000 Your new number of shares = $16,000/$40 = 400 Number of shares sold = 600 - 400 = 200 shares Check: Your new loans = 1/3($24,000) = $8,000 Your unlevered income = 600 $1.866667 = $1,120 Your levered income = (400 $1.20) + ($8,000 0.08) = $1,120

A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. only after the firm becomes insolvent. A. I and III only B. I and II only C. I, II, and IV only D. I, II, and III only E. I, II, III, and IV

D. I, II, and III only

Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV

D. I, II, and IV only

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: A. permits creditors to file a prepack immediately after a firm files for bankruptcy protection. B. prevents creditors from submitting any reorganization plans. C. prevents firms from filing for bankruptcy protection more than once. D. permits key employee retention plans only if an employee has another job offer. E. allows firms to pay bonuses to all key employees to entice those employees to remain in the firm's employ.

D. permits key employee retention plans only if an employee has another job offer.

Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes. A. $42,208 B. $44,141 C. $46,333 D. $49,667 E. $52,267

E. $52,267 EBIT/40,000 = [EBIT - ($280,000 0.07)]/25,000; EBIT = $52,267

The static theory of capital structure advocates that the optimal capital structure for a firm: A. is dependent on a constant debt-equity ratio over time. B. remains fixed over time. C. is independent of the firm's tax rate. D. is independent of the firm's weighted average cost of capital. E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

Which form of financing do firms 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

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding? A. consumer claim B. dividend payment to preferred shareholder C. company contribution to the employees' retirement account D. payment to an unsecured creditor E. payment of employee wages

E. payment of employee wages

In general, the capital structures used by U.S. firms: A. tend to overweigh debt in relation to equity. B. generally result in debt-equity ratios between 0.45 and 0.60. C. are fairly standard for all SIC codes. D. tend to be those which maximize the use of the firm's available tax shelters. E. vary significantly across industries.

E. vary significantly across industries.