Chapter 16 Smartbook

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 0.40 × $20m × 0.08 = $0.64m

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 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 percent. If the tax rate is 40 percent, what is the value of the firm?

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

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

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% 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% $1,900/$12.500 = 15.2%

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

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

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

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

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

earnings per share is wider

An unlevered firm ____.

has an all-equity capital structure

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

homemade 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

The effect of financial leverage ______ for all earning levels.

is variable

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 expected return on equity is _____ to leverage.

positively related

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

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

removed; decreases added; increases

Volatility or ______ increases for equity holders when leverage increases.

risk

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

MM Proposition II shows that ___.

the cost of equity rises with leverage.

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

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

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

the return on assets (RO) is unchanged