Corp Finn ch 16 smart book

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?

$ 1,475,000.00 REASON: (.1*5M)+[2M-(.1*5M)](1-.35)

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

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?

$30.8M 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 percent. If the tax rate is 40 percent, what is the value of the firm?

$50 MILLION

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

*FINANCIAL LEVERAGES INC SLOPE OF THE EPS LINE *RATE OF RET ON ASSETS IS UNAFFECTED BY LEVERAGE *BELOW THE INDIFF OR BREAK EVEN POINT IN EBIT, AN UNLEV CAP STRUCT IS BEST

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

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

*removed; decreases *added; increases

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

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

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

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

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 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: Reason: 11% + .4 × (1 - .4) × (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.

15.20% Reason: $1,900/$12.500 = 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 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

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

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

Debt has a tax ______.

BENEFIT

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

CASH FLOW TO BOTH BONDHOLDERS AND STOCKHOLDERS

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

CHANGE INCREASES VALUE

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

DECREASES

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

False

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

GREATER THAN

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

HIGHER EXPECTED RETURN

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

HIGHEST

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

HOME MADE LEVERAGE

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

HOME MADE 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

Which of the following assumptions is necessary for MM Proposition I to hold?

INDIVIDUALS CAN BORROW ON THEIR OWN AT AN INTEREST RATE EQUAL TO THAT OF THE FIRM

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

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

A company should select the capital structure that:

MAX COMPANY

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

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

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

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 STOCK HOLDERS

A firm's capital structure refers to ___.

THE FIRMS MIX OF DEBT AND EQUITY

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

THE FIRMS VALUE IS MAXIMIZED

A firm with no debt in its capital structure is:

UNLEVERED

With no taxes, MM showed:

capital structure does not matter

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

debt; equity

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

Levered equity has ______ risk than unlevered equity.

greater

An unlevered firm ____.

has an all-equity capital structure

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

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

A key assumption of MM Proposition I is that ___.

individuals can borrow as cheaply as corporations

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

it does not use historical values

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

MM Proposition II shows that ___.

the cost of equity rises with leverage.

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

the return on assets (RO) is unchanged

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

$9000

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.