FNAN 522 Chapter 16 - Financial Leverage and Capital Structure Policy

The Book Worm is an unlevered firm with an aftertax net income of $237,600. The unlevered cost of capital is 15.6 percent and the tax rate is 34 percent. What is the value of this firm?

$1,523,076.92

Pewter & Glass is an all-equity firm that has 145,000 shares of stock outstanding. The company is in the process of borrowing $750,000 at 6.8 percent interest to repurchase 8,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

$13,593,750

Georga's Restaurants has 5,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semiannually. What is the amount of the annual interest tax shield if the tax rate is 37 percent?

$152,625.00

D. L. Tuckers has $48,000 of debt outstanding that is selling at par and has a coupon rate of 6.75 percent. The tax rate is 35 percent. What is the present value of the tax shield?

$16,800

An unlevered firm has a cost of capital of 16.7 percent and earnings before interest and taxes of $489,602. A levered firm with the same operations and assets has face value of debt of $650,000 with a coupon rate of 7.5 percent that sells at par. The applicable tax rate is 35 percent. What is the value of the levered firm?

$2,133,136.53

Noelle owns 19 percent of The Toy Factory. She has decided to retire and wants to sell all of her shares in this closely held, all-equity firm. The other shareholders have agreed to have the firm borrow the $487,000 needed to repurchase her shares of stock. What is the total market value of the firm? Ignore taxes.

$2,563,158

Paradise Travels is an all-equity firm that has 6,000 shares of stock outstanding at a market price of $34 a share. The firm's management has decided to issue $40,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 7 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

$2.38

The business risk of a firm:

Has a positive relationship with the firm's cost of equity.

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 firm irrelevant?

Homemade leverage.

The value of a firm is maximized when the:

Weighted average cost of capital is minimized.

Corporations in the U.S. tend to:

Underutilize debt.

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 175,000 shares of stock outstanding. Under Plan II, there would be 90,000 shares of stock outstanding and $1.4 million in debt. The interest rate on the debt is 7 percent and there are no taxes. What is the break-even EBIT?

$201,764.71

The Jean Outlet is an all-equity firm that has 152,000 shares of stock outstanding. The company has decided to borrow $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes?

$22,293,333

L.A. Clothing has expected earnings before interest and taxes of $56,700, an unlevered cost of capital of 16.2 percent, and a tax rate of 35 percent. The company also has $9,500 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this firm?

$230,825

Holly's is currently an all-equity firm that has 12,000 shares of stock outstanding at a market price of $36 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 7.2 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.

$31,104

Lester's has expected earnings before interest and taxes of $69,750, an unlevered cost of capital of 12.6 percent, and debt with both a book and face value of $78,000. The debt has a coupon rate of 5.75 percent. The tax rate is 34 percent. What is the value of the firm?

$391,877.14

SLG Corp. is an all-equity firm with a weighted average cost of capital of 9.68 percent. The current market value of the equity is $27.5 million and the tax rate is 35 percent. What is EBIT?

$4,095,385

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?

$4,180,000

Katlin Markets is debating between a levered and an unlevered capital structure. The all-equity capital structure would consist of 75,000 shares of stock. The debt and equity option would consist of 40,000 shares of stock plus $320,000 of debt with an interest rate of 6.25 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

$42,857.14

New Schools expects an EBIT of $87,000 every year forever. The firm currently has no debt, and its cost of equity is 14.6 percent. The firm can borrow at 7.4 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt?

$460,146.57

Hanover Tech is currently an all-equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

$5.288 million

KN&J expects its EBIT to be $138,000 every year forever. The firm can borrow at 10 percent. KN&J currently has no debt and its cost of equity is 17.2 percent. The tax rate is 35 percent. What will the value of KN&J be if the firm borrows $50,000 and uses the loan proceeds to repurchase shares?

$539,012

The June Bug has a $340,000 bond issue outstanding. These bonds have a coupon rate of 6.25 percent, pay interest semiannually, and sell at 101.2 percent of face value. The tax rate is 35 percent. What is the amount of the annual interest tax shield?

$7,437.50

Eastern Markets has no debt outstanding and a total market value of $154,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. The firm is considering a $20,000 debt issue with an interest rate of 6.5 percent. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. What will be the percentage change in EPS if the economy enters a recessionary period?

-62 percent

Which one of these actions generally occurs first in a bankruptcy reorganization?

Filing proofs of claim.

Roy & Daughter has a cost of equity of 13.9 percent and a pretax cost of debt of 6.8 percent. The required return on the assets is 12.9 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

.164

Auto Care has a pretax cost of debt of 6.6 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 34 percent and the cost of equity is 15.8 percent. What is the firm's debt-equity ratio?

.23

Mountain Groves has an unlevered cost of capital of 12.8 percent, a cost of debt of 7.8 percent, and a tax rate of 34 percent. What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent?

.82

The Corner Bakery has a debt-equity ratio of .62. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

11.14 percent

Lamey Co. has an unlevered cost of capital of 10.9 percent, a tax rate of 35 percent, and expected earnings before interest and taxes of $21,800. The company has $25,000 in bonds outstanding that sell at par and have a coupon rate of 6 percent. What is the cost of equity?

11.60 percent

ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all-equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.

12.17; 15.33

A firm has debt of $12,000, a leveraged value of $26,400, a pretax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital?

12.23 percent

W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its pretax cost of debt is 9 percent. The corporate tax rate is 33 percent. What is the firm's unlevered cost of equity capital?

12.38 percent

Miller's Dry Goods is an all-equity firm with 50,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $142,000. Miller's has decided to add leverage to its financial operations by issuing $500,000 of debt at 6 percent interest and using the proceeds to repurchase shares of stock. You own 500 shares of Miller's stock and can loan out funds at 6 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.)

125 shares

Percy's Wholesale Supply has earnings before interest and taxes of $121,000. Both the book and the market value of debt is $190,000. The unlevered cost of equity is 14.7 percent while the pretax cost of debt is 8.6 percent. The tax rate is 35 percent. What is the firm's weighted average cost of capital?

13.07 percent

Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?

13.60 percent

Douglass & Frank has a debt-equity ratio of .35. The pretax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent?

14.39 percent

LP Gas has a cost of equity of 17.4 percent and a pretax cost of debt of 8.1 percent. The debt-equity ratio is .48 and the tax rate is 35 percent. What is the unlevered cost of capital?

15.19 percent

Bruce & Co. expects its EBIT to be $149,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 34 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization?

17.76 percent

Home Decor has a debt-equity ratio of .48. The cost of equity is 16.4 percent and the aftertax cost of debt is 4.2 percent. What will the firm's cost of equity be if the debt-equity ratio is revised to .70?

18.21 percent

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?

180 days

You currently own 900 shares of JKL which is an all-equity firm with 250,000 shares of stock outstanding at a market price of $20 a share. The company's earnings before interest and taxes are $120,000. JKL has decided to issue $1 million of debt at 6.5 percent interest and use the proceeds 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 6.5 percent interest?

180 shares

Winter's Toyland has a debt-equity ratio of .65. The pretax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes?

20.91 percent

Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity?

23.20 percent

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 $102,000. Naylor's has decided to issue $825,000 of debt at 7.5 percent and use the proceeds to repurchase shares. Currently, you own 500 shares of Naylor's stock. How many shares of this stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes.

362.5 shares

North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 70 percent lower. The company is considering a $70,000 debt issue with an interest rate of 7 percent. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding and the tax rate is 34 percent. What will be the percentage change in EPS if the economy has a strong expansion?

43.24 percent

Key Motors has a cost of equity of 11.29 percent and an unlevered cost of capital of 10.4 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $64,000 and the tax rate is 34 percent. What is the pretax cost of debt?

7.82 percent

M&M Proposition II, without taxes, is the proposition that:

A firm's cost of equity is a linear function with a slope equal to (RA - RD).

M&M Proposition I with tax implies that:

A firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.

Which one of the following is the equity risk related to a firm's capital structure policy?

Financial

The unlevered cost of capital refers to the cost of capital for:

An all-equity firm.

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.

At the break-even point, there is no advantage to debt.

Which one of the following is the equity risk that is most related to the daily operations of a firm?

Business risk

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

Firm is earning just enough to pay for the cost of the debt.

The optimal capital structure has been achieved when the:

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

Based on M&M Proposition I with taxes, the weighted average cost of capital:

Decreases as the debt-equity ratio increases.

Financial risk is:

Dependent upon a firm's capital structure.

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs.

Direct bankruptcy

Which one of these statements related to Chapter 11 bankruptcy is correct?

Firms may file for Chapter 11 in an attempt to gain a competitive advantage.

Which one of the following is correct according to pecking-order theory?

Firms stockpile internally generated cash.

The static theory of capital structure advocates that the optimal capital structure for a firm:

Equates the tax savings from an additional dollar of debt to the increased bankruptcy costs.

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Indirect bankruptcy

Westover Mills reduced its taxes last year by $680 by increasing its interest expense by $2,000. Which one of the following terms is used to describe this tax savings?

Interest tax shield

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

Internal funds

Bankruptcy

Is a legal proceeding.

A firm is technically insolvent when:

It is unable to meet its financial obligations.

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Low probability of financial distress.

The concept of homemade leverage is most associated with:

M&M Proposition I with no tax.

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

M&M Proposition I, no tax.

Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?

M&M Proposition II

A firm should select the capital structure that:

Maximizes the value of the firm.

The capital structure that maximizes the value of a firm also:

Minimizes the cost of capital.

Which one of the following is a direct cost of bankruptcy?

Paying an outside accountant to prepare bankruptcy reports.

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

Payment of employee wages.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:

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

Which one of the following is a marketed claim against a firm's cash flows?

Principal payment on long-term debt.

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a:

Reorganization.

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of .30. To unlever her position, Jessica needs to:

Sell some shares of Quantro stock and loan out the sale proceeds.

The present value of the interest tax shield is expressed as:

TC xD.

M&M Proposition I with no tax supports the argument that:

The debt-equity ratio of a firm is completely irrelevant.

AA Tours has earnings before interest and taxes (EBIT) that are less than the break-even earnings per share level. Ignore taxes. Which one of these statements is correct given this situation if the firm wishes to improve its earnings per share?

The firm should reduce its expenses.

The interest tax shield is a key reason why:

The net cost of debt to a firm is generally less than the cost of equity.

Which one of these statements is correct?

The optimal capital structure maximizes shareholder value.

Which one 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.

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called:

The static theory of capital structure.

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

The total cash flow of the firm.

Homemade leverage is:

The use of personal borrowing to alter the individual's degree of financial leverage.

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

The value of a firm increases as the firm's debt increases because of the interest tax shield.

Which one of the following statements related to Chapter 7 bankruptcy is correct?

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

If a firm has the optimal amount of debt, then the:

Value of the levered firm will exceed the value of the firm if it were unlevered.

In general, the capital structures used by U.S. firms:

Vary significantly across industries.

The absolute priority rule determines:

Which parties receive payment first in a bankruptcy proceeding.

The optimal capital structure:

Will vary over time as taxes and market conditions change.