fin351

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?

($16,000/$21,000) × 12% + ($5,000/$21,000) × 8% = 11.05%

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

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

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

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?

12% + .6(12% - 7.5) = 14.7%

Calculate the cost of capital for an all-equity firm with equity of $225,000 and expected earnings of $35,000.

35,000/225000=15.6%

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?

= EBIT(1-tax rate)/unleveraged cost of capital =$10m(1 - .4)]/.12 = $50m

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?

= cost of equity+ debt-equity(1-tax rate) * (cost of equity- cost of debt) =11% + .4 × (1 - .4) × (11% - 8) = 11.72%

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?

=tax rate * debt outstanding * coupon rate =.4 * 20 * .08 = .64

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

False, Since equity still carries risk, an unlevered firm should expect a higher return than what a riskless asset would achieve.

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 stockholders.

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

a higher expected return

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

added; increases removed; decreases

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

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

false, Since equity still carries risk, an unlevered firm should expect a higher return than what a riskless asset would achieve.

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

greater than

An unlevered firm ____.

has an all-equity capital structure

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

historical; current

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

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

Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity ___. increases with leverage

increases with leverage

A key assumption of MM Proposition I is that ___.

individuals can borrow as cheaply as corporations

Under MM Proposition II with no taxes, the return on assets ______ as debt increases. is unchanged

is unchanged

The effect of financial leverage ______ for all earning levels.

is variable

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

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

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

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

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

the return on assets (RO) is unchanged

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?

VL= $30m + .4 × $2m = $30.8m