Homework 9

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% and the tax rate is 35%. The company is in the process of issuing $4.3m of 8.3% annual coupon bonds at par. What is the levered value of the firm?

A. $3,824,318 V_u = [$628,000 x (1-.35)/.176 = $2,319,318 V_L = $2,319,318 + (.35 x $4,300,000) = $3,824,318

A firm has a weighted average cost of capital of 11.28% and a cost of equity of 14.7%. The debt-equity ratio is 0.72. There are no taxes. What is the firm's cost of debt?

A. 6.53% .1128 = [(1/1.72 x .147] + [(.72/1.72) x Rd] Rd = 6.53%

Holiday Decor is an all-equity firm with a total market value of $347,000 and 12,000 shares of stock outstanding. Management is considering issuing $48,000 of debt at an interest rate of 7$ and using the proceeds on a stock repurchase. As an all-equity firm, management believes its earnings before interest and taxes will be $33,000 if the economy is normal, $8,000 if its 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?

B. $0.67 EPS_recession = $8,000/12,000 = $0.67

Delta Mowers has a debt-equity ratio of 0.6. Its WACC is 11.8% and its cost of debt is 7.7%. There is no corporate tax. What is the firm's cost of equity capital?

B. 14.26% WACC = 0.118 = (1/1.6)Re+(0.6/1.6)(0.077) = .1426 or 14.26%

A firm has a cost of debt of 7.8% and a cost of equity of 15.6%. The debt-equity ratio is 0.52. There are no taxes. What is the firm's weighted average cost of capital?

C. 12.93 % WACC = [(1/1.52) x .156] + [(0.52/1.52) x .078] = .1293 or 12.93%

M&M Proposition II, without taxes, states that the:

C. Cost of equity increases as a firm increases its debt-equity ratio

Which one of the following statements related to the static theory of capital structure is correct?

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

Which one of the following statements concerning financial leverage is correct?

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

Which one of the following statements concerning financial leverage is correct? (2nd)

D. Financial leverage magnifies both profits and losses

TLC Enterprises just revised its capital structure from a debt-equity ratio of .37 to a debt-equity of .48. The firm's shareholders who prefer the old capital structure should:

D. Sell some shares and loan out the sale proceeds

Which one of the following conditions exists at the point where a firm maximizes its value?

D. WACC is minimized

Marcos & Sons has no debt. Its current total value is $13m. What will the company's value be if it sells $5m in debt and has a tax rate of 35%? Assume all debt proceeds are used to repurchase equity.

E. $14.75m V_L = $13m + ($15m x 0.35) = $14.75m

Which one of the following terms refers to the termination of a firm as a going concern?

E. Liquidation

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?

E. Reorganization

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?

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