Chap 016

Chapter 16 - Financial Leverage and Capital Structure Policy

Chapter 16 Financial Leverage and Capital Structure Policy Multiple Choice Questions

1. Homemade leverage is: A. the incurrence o de!t !y ! y a corporation in order to pay dividends to shareholders. ". the e#clusive use o de!t to und a corporate e#pansion pro$ect. C. the !orro%ing or lending o money !y individual shareholders as a means o ad$usting their level o inancial leverage. &. !est deined as an increase in a irm's de!t-e(uity ratio. ). the term used to descri!e the capital structure o a levered irm.

*. +hich one o the ollo%ing states that the value o a irm is unrelated to the irm's capital structure, A. Capital Asset Pricing odel ".  Proposition / C.  Proposition // &. La% o 0ne Price ). )icient arets Hypothesis

2. +hich one o the ollo%ing states that a irm's cost o e(uity capital is directly and proportionally related to the irm's capital structure, structure, A. Capital Asset Pricing odel ".  Proposition / C.  Proposition // &. La% o 0ne Price ). )icient arets Hypothesis

3. +hich one o the ollo%ing is the e(uity ris that is most related to the daily operations o a irm, A. maret ris ". systematic ris C. e#trinsic ris &. !usiness ris ). inancial ris

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4. +hich one o the ollo%ing is the e(uity ris related to a irm's capital structure policy, A. maret ". systematic C. e#trinsic &. !usiness ). inancial

6. "utter  5elly reduced its ta#es last year !y 247 !y increasing its interest e#pense !y 18777. +hich o the ollo%ing terms is used to descri!e this ta# savings, A. interest ta# shield ". interest credit C. inancing shield &. current ta# yield ). ta#-loss interest

9. he unlevered cost o capital reers to the cost o capital or a;n<: A. private entity. ". all-e(uity irm. C. governmental entity. &. private individual. ). corporate shareholder.

=. he e#plicit costs8 such as legal and administrative e#penses8 associated %ith corporate deault are classiied as >>>>> costs. A. lotation ". issue C. direct !anruptcy &. indirect !anruptcy ). unlevered

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?. he costs incurred !y a !usiness in an eort to avoid !anruptcy are classiied as >>>>> costs. A. lotation ". direct !anruptcy C. indirect !anruptcy &. inancial solvency ). capital structure

17. "y deinition8 %hich o the ollo%ing costs are included in the term @inancial distress costs@, /. direct !anruptcy costs //. indirect !anruptcy costs ///. direct costs related to !eing inancially distressed8 !ut not !anrupt /. indirect costs related to !eing inancially distressed8 !ut not !anrupt A. / only ". /// only C. / and // only &. /// and / only ). /8 //8 ///8 and /

11. he proposition that a irm !orro%s up to the point %here the marginal !eneit o the interest ta# shield derived rom increased de!t is $ust e(ual to the marginal e#pense o the resulting increase in inancial distress costs is called: A. the static theory o capital structure. ".  Proposition /. C.  Proposition //. &. the capital asset pricing model. ). the open marets theorem.

1*. +hich one o the ollo%ing is the legal proceeding under %hich an insolvent irm can !e reorganiBed, A. restructure process ". !anruptcy C. orced merger &. legal taeover ). rights oer

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12. A !usiness irm ceases to e#ist as a going concern as a result o %hich one o the ollo%ing, A. divestiture ". share repurchase C. li(uidation &. reorganiBation ). capital restructuring

13. )d%ards Farm Products %as una!le to meet its inancial o!ligations and %as orced into using legal proceedings to restructure itsel so that it could continue as a via!le !usiness. he process this irm under%ent is no%n as a: A. merger. ". repurchase program. C. li(uidation. &. reorganiBation. ). divestiture.

14. he a!solute priority rule determines: A. %hen a irm must !e declared oicially !anrupt. ". ho% a distressed irm is reorganiBed. C. %hich $udge is assigned to a particular !anruptcy case. &. ho% long a reorganiBed irm is allo%ed to remain under !anruptcy protection. ). %hich parties receive payment irst in a !anruptcy proceeding.

16. A irm should select the capital structure that: A. produces the highest cost o capital. ". ma#imiBes the value o the irm. C. minimiBes ta#es. &. is ully unlevered. ). e(uates the value o de!t %ith the value o e(uity.

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19. he value o a irm is ma#imiBed %hen the: A. cost o e(uity is ma#imiBed. ". ta# rate is Bero. C. levered cost o capital is ma#imiBed. &. %eighted average cost o capital is minimiBed. ). de!t-e(uity ratio is minimiBed.

1=. he optimal capital structure has !een achieved %hen the: A. de!t-e(uity ratio is e(ual to 1. ". %eight o e(uity is e(ual to the %eight o de!t. C. cost o e(uity is ma#imiBed given a pre-ta# cost o de!t. &. de!t-e(uity ratio is such that the cost o de!t e#ceeds the cost o e(uity. ). de!t-e(uity ratio results in the lo%est possi!le %eighted average cost o capital.

1?. AA ours is comparing t%o capital structures to determine h o% to !est inance its operations. he irst option consists o all e(uity inancing. he second option is !ased on a de!t-e(uity ratio o 7.34. +hat should AA ours do i its e#pected earnings !eore interest and ta#es ;)"/< are less than the !rea-even level, Assume there are no ta#es. A. select the leverage option !ecause the de!t-e(uity ratio is less than 7.47 ". select the leverage option since the e#pected )"/ is less than the !rea-even level C. select the unlevered option since the de!t-e(uity ratio is less than 7.47 &. select the unlevered option since the e#pected )"/ is less than the !rea-even level ). cannot !e determined rom the inormation provided

*7. ou have computed the !rea-even point !et%een a levered and an unlevered capital structure. Assume there are no ta#es. At the !rea-even level8 the: A. irm is $ust earning enough to pay or the cost o the de!t. ". irm's earnings !eore interest and ta#es are e(ual to Bero. C. earnings per share or the levered option are e#actly dou!le those o the unlevered option. &. advantages o leverage e#ceed the disadvantages o leverage. ). irm has a de!t-e(uity ratio o .47.

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*1. +hich one o the ollo%ing statements is correct concerning the relationship !et%een a levered and an unlevered capital structure, Assume there are no ta#es. A. At the !rea-even point8 there is no advantage to de!t. ". he earnings per share %ill e(ual Bero %hen )"/ is Bero or a levered irm. C. he advantages o leverage are inversely related to the level o )"/. &. he use o leverage at any level o )"/ increases the )PS. ). )PS are more sensitive to changes in )"/ %hen a irm is unlevered.

**. 5essica invested in Duantro stoc %hen the irm %as unlevered. Since then8 Duantro has changed its capital structure and no% has a de!t-e(uity ratio o 7.27. o unlever her position8 5essica needs to: A. !orro% some money and purchase additional shares o Duantro stoc. ". maintain her current e(uity position as the de!t o the irm did not aect her personally. C. sell some shares o Duantro stoc and hold the proceeds in cash. &. sell some shares o Duantro stoc and loan out the sale proceeds. ). create a personal de!t-e(uity ratio o 7.27.

*2. +hich one o the ollo%ing maes the capital structure o a irm irrelevant, A. ta#es ". interest ta# shield C. 177 percent dividend payout ratio &. de!t-e(uity ratio that is greater than 7 !ut less than 1 ). homemade leverage

*3.  Proposition / %ith no ta# supports the argument that: A. !usiness ris determines the return on assets. ". the cost o e(uity rises as leverage rises. C. the de!t-e(uity ratio o a irm is completely irrelevant. &. a irm should !orro% money to the point %here the ta# !eneit rom de!t is e(ual to the cost o the increased pro!a!ility o inancial distress. ). homemade leverage is irrelevant.

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*4. he concept o homemade leverage is most associated %ith: A.  Proposition / %ith no ta#. ".  Proposition // %ith no ta#. C.  Proposition / %ith ta#. &.  Proposition // %ith ta#. ). static theory proposition.

*6. +hich o the ollo%ing statements are correct in relation to  Proposition // %ith no ta#es, /. he re(uired return on assets is e(ual to the %eighted average cost o capital. //. Financial ris is determined !y the de!t-e(uity ratio. ///. Financial ris determines the return on assets. /. he cost o e(uity declines %hen the amount o leverage used !y a irm rises. A. / and /// only ". // and / only C. / and // only &. /// and / only ). / and / only

*9.  Proposition // is the proposition that: A. the capital structure o a irm has no eect on the irm's value. ". the cost o e(uity depends on the return on de!t8 the de!t-e(uity ratio8 and the ta# rate. C. a irm's cost o e(uity is a linear unction %ith a slope e(ual to ;E A - E &<. &. the cost o e(uity is e(uivalent to the re(uired rate o return on a irm's assets. ). the siBe o the pie does not depend on ho% the pie is sliced.

*=. he !usiness ris o a irm: A. depends on the irm's level o unsystematic ris. ". is inversely related to the re(uired return on the irm's assets. C. is dependent upon the relative %eights o the de!t and e(uity used to inance the irm. &. has a positive relationship %ith the irm's cost o e(uity. ). has no relationship %ith the re(uired return on a irm's assets according to  Proposition //.

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*?. +hich o the ollo%ing statements related to inancial ris are correct, /. Financial ris is the ris associated %ith the use o d e!t inancing. //. As inancial ris increases so too does the cost o e(uity. ///. Financial ris is %holly dependent upon the inancial policy o a irm. /. Financial ris is the ris that is inherent in a irm's operations. A. / and /// only ". // and / only C. // and /// only &. /8 //8 and /// only ). /8 //8 ///8 and /

27.  Proposition / %ith ta# supports the theory that: A. a irm's %eighted average cost o capital decreases as the irm's de!t-e(uity ratio increases. ". the value o a irm is inversely related to the amount o leverage used !y the irm. C. the value o an unlevered irm is e(ual to the value o a levered irm plus the value o the interest ta# shield. &. a irm's cost o capital is the same regardless o the mi# o de!t and e(uity used !y the irm. ). a irm's cost o e(uity increases as the de!t-e(uity ratio o the irm decreases.

21.  Proposition / %ith ta#es is !ased on the concept that: A. the optimal capital structure is the one that is totally inanced %ith e(uity. ". the capital structure o a irm does not matter !ecause investors can use homemade leverage. C. a irm's +ACC is unaected !y a change in the irm's capital structure. &. the value o a irm increases as the irm's de!t increases !ecause o the interest ta# shield. ). the cost o e(uity increases as the de!t-e(uity ratio o a irm increases.

2*.  Proposition // %ith ta#es: A. has the same general implications as  Proposition // %ithout ta#es. ". states that a irm's capital structure is irrelevant. C. supports the argument that !usiness ris is determined !y the capital structure decision. &. supports the argument that the cost o e(uity decreases as the de!t-e(uity ratio increases. ). concludes that the capital structure decision is irrelevant to the value o a irm.

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22. he present value o the interest ta# shield is e#pressed as: A. ;C × &<E A. ". G  ;C × &<. C. I)"/ × ;C × &
23. he interest ta# shield has no value %hen a irm has a: /. ta# rate o Bero. //. de!t-e(uity ratio o 1. ///. Bero de!t. /. Bero leverage. A. / and /// only ". // and / only C. /8 ///8 and / only &. //8 ///8 and / only ). /8 //8 and / only

24. he interest ta# shield is a ey reason %hy: A. the re(uired rate o return on assets rises %hen de!t is added to the capital structure. ". the value o an unlevered irm is e(ual to the value o a levered irm. C. the net cost o de!t to a irm is generally less than the cost o e(uity. &. the cost o de!t is e(ual to the cost o e(uity or a levered irm. ). irms preer e(uity inancing over de!t inancing.

26. "ased on  Proposition // %ith ta#es8 the %eighted average cost o capital: A. is e(ual to the aterta# cost o de!t. ". has a linear relationship %ith the cost o e(uity capital. C. is unaected !y the ta# rate. &. decreases as the de!t-e(uity ratio increases. ). is e(ual to E G × ;1 - C<.

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29. "anruptcy: A. creates value or a irm. ". transers value rom shareholders to !ondholders. C. technically occurs %hen total e(uity e(uals total de!t. &. costs are limited to legal and administrative ees. ). is an ine#pensive means o reorganiBing a irm.

2=. +hich one o the ollo%ing is a direct !anruptcy cost, A. company C)0's time spent in !anruptcy court ". maintaining cash reserves C. maintaining a de!t-e(uity ratio that is lo%er than the optimal ratio &. losing a ey company employee ). paying an outside accountant ees to prepare !anruptcy reports

2?. / a irm has the optimal amount o de!t8 then the: A. direct inancial distress costs must e(ual the present value o the interest ta# shield. ". value o the levered irm %ill e#ceed the value o the irm i it %ere unlevered. C. value o the irm is minimiBed. &. value o the irm is e(ual to L  C × &. ). de!t-e(uity ratio is e(ual to 1.7.

37. +hich one o the ollo%ing has the greatest tendency to increase the percentage o de!t included in the optimal capital structure o a irm, A. e#ceptionally high depreciation e#penses ". very lo% marginal ta# rate C. su!stantial ta# shields rom other sources &. lo% pro!a!ilities o inancial distress ). minimal ta#a!le income

31. he capital structure that ma#imiBes the value o a irm also: A. minimiBes inancial distress costs. ". minimiBes the cost o capital. C. ma#imiBes the present value o the ta# shield on de!t. &. ma#imiBes the value o the de!t. ). ma#imiBes the value o the unlevered irm.

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3*. he optimal capital structure: A. %ill !e the same or all irms in the same industry. ". %ill remain constant over time unless the irm changes its primary operations. C. %ill vary over time as ta#es and maret conditions change. &. places more emphasis on operations than on inancing. ). is unaected !y changes in the inancial marets.

32. he static theory o capital structure advocates that the optimal capital structure or a irm: A. is dependent on a constant de!t-e(uity ratio over time. ". remains i#ed over time. C. is independent o the irm's ta# rate. &. is independent o the irm's %eighted average cost o capital. ). e(uates the ta# savings rom an additional dollar o de!t to the increased !anruptcy costs related to that additional dollar o de!t.

33. he !asic lesson o  heory is that the value o a irm is dependent upon: A. the irm's capital structure. ". the total cash lo% o the irm. C. minimiBing the mareted claims. &. the amount o mareted claims to that irm. ). siBe o the stocholders' claims.

34. +hich orm o inancing do irms preer to use irst according to the pecing-order theory, A. regular de!t ". converti!le de!t C. common stoc &. preerred stoc ). internal unds

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36. +hich o the ollo%ing are correct according to pecing-order theory, /. Firms stocpile internally-generated cash. //. here is an inverse relationship !et%een a irm's proit level and its de!t level. ///. Firms avoid e#ternal de!t at all costs. /. A irm's capital structure is dictated !y its need or e#ternal inancing. A. / and /// only ". // and / only C. /8 ///8 and / only &. /8 //8 and / only ). /8 //8 ///8 and /

39. Corporations in the G.S. tend to: A. minimiBe ta#es. ". underutiliBe de!t. C. rely less on e(uity inancing than they should. &. have relatively similar de!t-e(uity ratios across industry lines. ). rely more heavily on de!t than on e(uity as the ma$or source o inancing.

3=. /n general8 the capital structures used !y G.S. irms: A. tend to over%eigh de!t in relation to e(uity. ". generally result in de!t-e(uity ratios !et%een 7.34 and 7.67. C. are airly standard or all S/C codes. &. tend to !e those %hich ma#imiBe the use o the irm's availa!le ta# shelters. ). vary signiicantly across industries.

3?. A irm is technically insolvent %hen: A. it has a negative !oo value. ". total de!t e#ceeds total e(uity. C. it is una!le to meet its inancial o!ligations. &. it iles or !anruptcy protection. ). the maret value o its stoc is less than its !oo value.

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47. +hich one o the ollo%ing statements related to Chapter 9 !anruptcy is correct, A. A irm in Chapter 9 !anruptcy is reorganiBing its operations such that it can return to !eing a via!le concern. ". Gnder a Chapter 9 !anruptcy8 a trustee %ill assume control o the irm's assets until those assets can !e li(uidated. C. Chapter 9 !anruptcies are al%ays involuntary on the part o the irm. &. Gnder a Chapter 9 !anruptcy8 the claims o creditors are paid prior to the administrative costs o the !anruptcy. ). Chapter 9 !anruptcy allo%s a irm to restructure its e(uity such that ne% shares o stoc are generally issued prior to the irm coming out o !anruptcy.

41. +hich one o the ollo%ing %ill generally have the highest priority %hen assets are distri!uted in a !anruptcy proceeding, A. consumer claim ". dividend payment to preerred shareholder C. company contri!ution to the employees' retirement account &. payment to an unsecured creditor ). payment o employee %ages

4*. A irm may ile or Chapter 11 !anruptcy: /. in an attempt to gain a competitive advantage. //. using a prepac. ///. %hile allo%ing the current management to continue running the irm. /. only ater the irm !ecomes insolvent. A. / and /// only ". / and // only C. /8 //8 and / only &. /8 //8 and /// only ). /8 //8 ///8 and /

42. he "anruptcy A!use Prevention and Consumer Protection Act o *774: A. permits creditors to ile a prepac immediately ater a irm iles or !anruptcy protection. ". prevents creditors rom su!mitting any reorganiBation plans. C. prevents irms rom iling or !anruptcy protection more than once. &. permits ey employee retention plans only i an employee has another $o! oer. ). allo%s irms to pay !onuses to all ey employees to entice those employees to remain in the irm's employ.

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43. Kelso )lectric is de!ating !et%een a leveraged and an unleveraged capital structure. he all e(uity capital structure %ould consist o 378777 shares o stoc. he de!t and e(uity option %ould consist o *48777 shares o stoc plus *=78777 o de!t %ith an interest rate o 9 percent. +hat is the !rea-even level o earnings !eore interest and ta#es !et%een these t%o options, /gnore ta#es. A. 3*8*7= ". 338131 C. 368222 &. 3?8669 ). 4*8*69

44. Holly's is currently an all e(uity irm that has ?8777 shares o stoc outstanding at a maret price o 3* a share. he irm has decided to leverage its operations !y issuing 1*78777 o de!t at an interest rate o ?.4 percent. his ne% de!t %ill !e used to repurchase shares o the outstanding stoc. he restructuring is e#pected to increase the earnings per share. +hat is the minimum level o earnings !eore interest and ta#es that the irm is e#pecting, /gnore ta#es. A. 248?17 ". 2=8416 C. 3*8777 &. 338131 ). 3487*7

46. Se%er's Paradise is an all e(uity irm that has 48777 shares o stoc outstanding at a maret price o 14 a share. he irm's management has decided to issue 278777 %orth o de!t and use the unds to repurchase shares o the outstanding stoc. he interest rate on the de!t %ill !e 17 percent. +hat are the earnings per share at the !rea-even level o earnings !eore interest and ta#es, /gnore ta#es. A. 1.36 ". 1.47 C. 1.69 &. 1.== ). 1.?3

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49. iller's &ry oods is an all e(uity irm %ith 348777 shares o stoc outstanding at a maret price o 47 a share. he company's earnings !eore interest and ta#es are 1*=8777. iller's has decided to add leverage to its inancial operations !y issuing *478777 o de!t at = percent interest. he de!t %ill !e used to repurchase shares o stoc. ou o%n 377 shares o iller's stoc. ou also loan out unds at = percent interest. Ho% many shares o iller's stoc must you sell to oset the leverage that iller's is assuming, Assume you loan out all o the unds you receive rom the sale o stoc. /gnore ta#es. A. 24.6 shares ". 37.7 shares C. 33.3 shares &. 39.4 shares ). 47.1 shares

4=. ou currently o%n 677 shares o 5KL8 /nc. 5KL is an all e(uity irm that has 948777 shares o stoc outstanding at a maret price o 37 a share. he company's earnings !eore interest and ta#es are 1378777. 5KL has decided to issue 1 million o de!t at = percent interest. his de!t %ill !e used to repurchase shares o stoc. Ho% many shares o 5KL stoc must you sell to unlever your position i you can loan out unds at = percent interest, A. 1*7 shares ". 147 shares C. 1=7 shares &. *77 shares ). *47 shares

4?. Maylor's is an all e(uity irm %ith 678777 shares o stoc outstanding at a maret price o 47 a share. he company has earnings !eore interest and ta#es o =98777. Maylor's has decided to issue 9478777 o de!t at 9.4 percent. he de!t %ill !e used to repurchase shares o the outstanding stoc. Currently8 you o%n 477 shares o Maylor's stoc. Ho% many shares o Maylor's stoc %ill you continue to o%n i you unlever this position, Assume you can loan out unds at 9.4 percent interest. /gnore ta#es. A. 277 shares ". 247 shares C. 294 shares &. 3*4 shares ). 477 shares

16-14


67. Pe%ter  lass is an all e(uity irm that has =78777 shares o stoc outstanding. he company is in the process o !orro%ing 6778777 at ? percent interest to repurchase 1*8777 shares o the outstanding stoc. +hat is the value o this irm i you ignore ta#es, A. *.4 million ". 3.7 million C. 4.7 million &. 4.4 million ). 6.7 million

61. he 5ean 0utlet is an all e(uity irm that has 1368777 shares o stoc outstanding. he company has decided to !orro% the 1.1 million to repurchase 98477 shares o its stoc rom the estate o a deceased shareholder. +hat is the total value o the irm i you ignore ta#es, A. 1=82=9897* ". 1=84778777 C. 1?86668669 &. *187778777 ). *183128222

6*. Stacy o%ns 2= percent o he o%n Centre. She has decided to retire and %ants to sell all o her shares in this closely held8 all e(uity irm. he other shareholders have agreed to have the irm !orro% 6478777 to purchase her shares o stoc. +hat is the total maret value o he o%n Centre, /gnore ta#es. A. 1891784*6 ". 1893=8*1? C. 1899187=? &. 18=718376 ). 18=7=863?

62. +inter's oyland has a de!t-e(uity ratio o 7.9*. he pre-ta# cost o de!t is =.9 percent and the re(uired return on assets is 16.1 percent. +hat is the cost o e(uity i you ignore ta#es, A. 1?.21 percent ". 1?.93 percent C. *7.*? percent &. *7.36 percent ). *1.32 percent

16-16


63. 5eerson  &aughter has a cost o e(uity o 13.6 percent and a pre-ta# cost o de!t o 9.= percent. he re(uired return on the assets is 12.* percent. +hat is the irm's de!t-e(uity ratio !ased on  // %ith no ta#es, A. 7.*6 ". 7.22 C. 7.29 &. 7.32 ). 7.34

64. he Corner "aery has a de!t-e(uity ratio o 7.43. he irm's re(uired return on assets is 13.* percent and its cost o e(uity is 16.1 percent. +hat is the pre-ta# cost o de!t !ased on  Proposition // %ith no ta#es, A. 9.17 percent ". =.9? percent C. 17.6= percent &. 19.46 percent ). 1=.37 percent

66. L.A. Clothing has e#pected earnings !eore interest and ta#es o 3=8?778 an unlevered cost o capital o 13.4 percent8 and a ta# rate o 23 percent. he company also has =8777 o de!t that carries a 9 percent coupon. he de!t is selling at par value. +hat is the value o this irm, A. ***849?.21 ". **28222.22 C. **3817=.16 &. **48*??.21 ). **48396.?1

16-19


69. Hanover ech is currently an all e(uity irm that has 2*78777 shares o stoc outstanding %ith a maret price o 1? a share. he current cost o e(uity is 14.3 percent and the ta# rate is 26 percent. he irm is considering adding 1.* million o de!t %ith a coupon rate o = percent to its capital structure. he de!t %ill !e sold at par value. +hat is the levered value o the e(uity, A. 4.*7? million ". 4.21* million C. 4.326 million &. 6.41* million ). 6.97= million

6=. "right orning Foods has e#pected earnings !eore interest and ta#es o 3=86778 an unlevered cost o capital o 12.* percent8 and de!t %ith !oth a !oo and ace value o *48777. he de!t has an =.4 percent coupon. he ta# rate is 23 percent. +hat is the value o the irm, A. *348477 ". *398677 C. *418477 &. *638=77 ). *918277

6?. )#ports Gnlimited is an unlevered irm %ith an aterta# net income o 398=77. he unlevered cost o capital is 13.1 percent and the ta# rate is 2* percent. +hat is the value o this irm, A. *978=69 ". *?382=7 C. 22?8779 &. 29=8333 ). 33983=?

16-1=


97. An unlevered irm has a cost o capital o 19.4 percent and earnings !eore interest and ta#es o 2*98477. A levered irm %ith the same operations and assets has !oth a !oo value and a ace value o de!t o 6478777 %ith a 9.4 percent annual coupon. he applica!le ta# rate is 2= percent. +hat is the value o the levered irm, A. 182?98*1* ". 182?=8*46 C. 1837*847? &. 183798*=6 ). 183138313

91. &o%n "edding has an unlevered cost o capital o 12 percent8 a cost o de!t o 9.= percent8 and a ta# rate o 2* percent. +hat is the target de!t-e(uity ratio i the targeted cost o e(uity is 14.41 percent, A. .62 ". .6= C. .91 &. .96 ). .=3

9*. 5ohnson ire &istri!utors has de!t %ith !oth a ace and a maret value o 1*8777. his de!t has a coupon rate o 6 percent and pays interest annually. he e#pected earnings !eore interest and ta#es are *81778 the ta# rate is 27 percent8 and the unlevered cost o capital is 11.9 percent. +hat is the irm's cost o e(uity, A. **.36 percent ". **.=9 percent C. *2.*7 percent &. *2.4? percent ). *4.13 percent

16-1?


92. Country arets has an unlevered cost o capital o 1* percent8 a ta# rate o 2= percent8 and e#pected earnings !eore interest and ta#es o 148977. he company has 118777 in !onds outstanding that have a 6 percent coupon and pay interest annually. he !onds are selling at par value. +hat is the cost o e(uity, A. 1*.44 percent ". 12.26 percent C. 12.63 percent &. 13.79 percent ). 13.*? percent

93. he PiBBa Palace has a cost o e(uity o 14.2 percent and an unlevered cost o capital o 11.= percent. he company has **8777 in de!t that is selling at par value. he levered value o the irm is 318777 and the ta# rate is 23 percent. +hat is the pre-ta# cost o de!t, A. 3.92 percent ". 6.1= percent C. 6.4? percent &. 9.** percent ). ?.?* percent

94. he reen Paddle has a cost o e(uity o 12.92 percent and a pre-ta# cost o de!t o 9.6 percent. he de!t-e(uity ratio is 7.64 and the ta# rate is 2* percent. +hat is reen Paddle's unlevered cost o capital, A. 11.=4 percent ". 1*.9= percent C. 13.*? percent &. 13.36 percent ). 14.7= percent

96. "o!'s +arehouse has a pre-ta# cost o de!t o =.3 percent and an unlevered cost o capital o 13.6 percent. he irm's ta# rate is 29 percent and the cost o e(uity is 1= percent. +hat is the irm's de!t-e(uity ratio, A. 7.9* ". 7.96 C. 7.9? &. 7.=* ). 7.=9

16-*7


99. &ouglass  Fran has a de!t-e(uity ratio o 7.34. he pre-ta# cost o de!t is 9.6 percent %hile the unlevered cost o capital is 12.2 percent. +hat is the cost o e(uity i the ta# rate is 2? percent, A. 12.9? percent ". 13.=6 percent C. 14.?* percent &. 1=.37 percent ). 1=.=9 percent

9=. he 5une "ug has a *978777 !ond issue outstanding. hese !onds have a 9.4 percent coupon8 pay interest semiannually8 and have a current maret price e(ual to ?=.6 percent o ace value. he ta# rate is 2? percent. +hat is the amount o the annual interest ta# shield, A. 28?3=.94 ". 3811*.67 C. 48211.** &. 98=?9.47 ). =8**4.*7

9?. eorga's Eestaurants has 38477 !onds outstanding %ith a ace value o 18777 each and a coupon rate o =.*4 percent. he interest is paid semi-annually. +hat is the amount o the annual interest ta# shield i the ta# rate is 29 percent, A. 129826*.47 ". 16*8311.?7 C. 1=98947.77 &. *1783*7.77 ). *228==9.47

=7. &. L. ucers has *18777 o de!t outstanding that is selling at par and has a coupon rate o 9.4 percent. he ta# rate is 2* percent. +hat is the present value o the ta# shield, A. 473 ". 614 C. 633 &. 68*77 ). 689*7

16-*1


=1. 5emisen's has e#pected earnings !eore interest and ta#es o 68*77. /ts unlevered cost o capital is 12 percent and its ta# rate is 23 percent. he irm has de!t %ith !oth a !oo and a ace value o *8477. his de!t has a ? percent coupon and pays interest annually. +hat is the irm's %eighted average cost o capital, A. 1*.3= percent ". 1*.66 percent C. 12.=9 percent &. 13.13 percent ). 13.29 percent

=*. A irm has de!t o 1*87778 a leveraged value o *683778 a pre-ta# cost o de!t o ?.*7 percent8 a cost o e(uity o 19.6 percent8 and a ta# rate o 29 percent. +hat is the irm's %eighted average cost o capital, A. 11.39 percent ". 11.4* percent C. 11.6? percent &. 1*.*2 percent ). 1*.3= percent

=2. oung's Home Supply has a de!t-e(uity ratio o 7.=7. he cost o e(uity is 13.4 percent and the aterta# cost o de!t is 3.? percent. +hat %ill the irm's cost o e(uity !e i the de!te(uity ratio is revised to 7.94, A. 17.=? percent ". 11.39 percent C. 11.97 percent &. 12.=? percent ). 13.*2 percent

=3. Percy's +holesale Supply has earnings !eore interest and ta#es o 1768777. "oth the !oo and the maret value o de!t is 1978777. he unlevered cost o e(uity is 14.4 percent %hile the pre-ta# cost o de!t is =.6 percent. he ta# rate is 2= percent. +hat is the irm's %eighted average cost o capital, A. 11.?3 percent ". 1*.64 percent C. 12.34 percent &. 13.71 percent ). 13.29 percent

16-**


Essay Questions

=4. &ra% the ollo%ing t%o graphs8 one a!ove the other: /n the top graph8 plot irm value on the vertical a#is and total de!t on the horiBontal a#is. Gse this graph to illustrate the value o  a irm under  %ithout ta#es8  %ith ta#es8 and the static theory o capital structure. 0n the lo%er graph8 plot the +ACC on the vertical a#is and the de!t-e(uity ratio on the horiBontal a#is. Gse this second graph to illustrate the value o the irm's +ACC under  %ithout ta#es8  %ith ta#es8 and the static theory. "riely e#plain %hat the t%o graphs reveal a!out irm value and its cost o capital under the three dierent theories.

=6. "ased on the  propositions %ith and %ithout ta#es8 ho% much time should a inancial manager spend analyBing the capital structure o a irm, +hat i the analysis is !ased on the static theory,

=9. Pete is the CF0 o &e#ter /nternational. He %ould lie to increase the de!t-e(uity ratio o the irm !ut is concerned that the irm's shareholders may not !e %illing to accept additional inancial leverage. Pete has come to you or advice. +hat is your recommendation,

16-*2


==. /n each o the theories o capital structure8 the cost o e(uity increases as the amount o de!t increases. So %hy don't inancial managers use as little de!t as possi!le to eep the cost o e(uity do%n, Ater all8 aren't inancial managers supposed to ma#imiBe the value o a irm,

=?. )#plain ho% a irm loses value during the !anruptcy process rom !oth a creditors and a shareholders perspective.

Multiple Choice Questions

?7. )ast Side8 /nc. has no de!t outstanding and a total maret value o 1268777. )arnings !eore interest and ta#es8 )"/8 are pro$ected to !e 1*8777 i economic conditions are normal. / there is strong e#pansion in the economy8 then )"/ %ill !e *9 percent higher. / there is a recession8 then )"/ %ill !e 44 percent lo%er. )ast Side is considering a 438777 de!t issue %ith a 4 percent interest rate. he proceeds %ill !e used to repurchase shares o stoc. here are currently *8777 shares outstanding. /gnore ta#es. / the economy enters a recession8 )PS %ill change !y >>>> percent as compared to a normal economy8 assuming that the irm recapitaliBes. A. -97.?9 percent ". -62.14 percent C. -4=.7= percent &. -3*.*? percent ). -2=.=9 percent

16-*3


?1. Morth Side8 /nc. has no de!t outstanding and a total maret value o 1948777. )arnings !eore interest and ta#es8 )"/8 are pro$ected to !e 168777 i economic conditions are normal. / there is strong e#pansion in the economy8 then )"/ %ill !e 24 percent higher. / there is a recession8 then )"/ %ill !e 97 percent lo%er. Morth Side is considering a 978777 de!t issue %ith a 9 percent interest rate. he proceeds %ill !e used to repurchase shares o stoc. here are currently *8477 shares outstanding. Morth Side has a ta# rate o 23 percent. / the economy e#pands strongly8 )PS %ill change !y >>>> percent as compared to a normal economy8 assuming that the irm recapitaliBes. A. 2=.=7 percent ". 34.*6 percent C. 47.34 percent &. 42.?* percent ). 61.79 percent

?*. ala#y Products is comparing t%o dierent capital structures8 an all-e(uity plan ;Plan /< and a levered plan ;Plan //<. Gnder Plan /8 ala#y %ould have 19=8477 shares o stoc outstanding. Gnder Plan //8 there %ould !e 918377 shares o stoc outstanding and 1.9? million in de!t outstanding. he interest rate on the de!t is 17 percent and there are no ta#es. +hat is the !reaeven )"/, A. *=98=9=.9= ". *?=8222.22 C. 2418111.11 &. 2228222.22 ). 2318313.13

?2. A"C Co. and NO Co. are identical irms in all respects e#cept or their capital structure. A"C is all e(uity inanced %ith 3=78777 in stoc. NO uses !oth stoc and perpetual de!t its stoc is %orth *378777 and the interest rate on its de!t is 11 percent. "oth irms e#pect )"/ to !e 4=8377. /gnore ta#es. he cost o e(uity or A"C is >>>>> percent8 and or NO it is >>>>>> percent. A. 1*.19 1*.6= ". 1*.19 1*.?3 C. 1*.19 12.22 &. 1*.*? 1*.6= ). 1*.*? 12.22

16-*4


?3. Lamont Corp. uses no de!t. he %eighted average cost o capital is 11 percent. he current maret value o the e(uity is 2= million and there are no ta#es. +hat is )"/, A. 283*28777 ". 2847=8677 C. 289=18177 &. 28=?=8977 ). 381=78777

?4. he SL Corp. uses no de!t. he %eighted average cost o capital is 1* percent. he current maret value o the e(uity is 21 million and the corporate ta# rate is 23 percent. +hat is )"/, A. 381=78777 ". 38=*181?3 C. 486268263 &. 68*27871= ). 6846=8477

?6. +.. rees8 /nc. has a de!t-e(uity ratio o 1.3. /ts +ACC is 17 percent8 and its cost o de!t is ? percent. he corporate ta# rate is 22 percent. +hat is the irm's unlevered cost o e(uity capital, A. 1*.2= percent ". 1*.9? percent C. 12.6= percent &. 13.17 percent ). 13.34 percent

?9. "ruce  Co. e#pects its )"/ to !e 1778777 every year orever. he irm can !orro% at 17 percent. "ruce currently has no de!t8 and its cost o e(uity is *7 percent. he ta# rate is 21 percent. +hat %ill the value o "ruce  Co. !e i the irm !orro%s 438777 and uses the loan proceeds to repurchase shares, A. *=78127 ". 2368677 C. 2618937 &. 29=8?77 ). 2=184*7

16-*6


?=. "ruce  Co. e#pects its )"/ to !e 1778777 every year orever. he irm can !orro% at 11 percent. "ruce currently has no de!t8 and its cost o e(uity is 1= percent. he ta# rate is 21 percent. "ruce %ill !orro% 618777 and use the proceeds to repurchase shares. +hat %ill the +ACC !e ater recapitaliBation, A. 16.27 percent ". 16.=9 percent C. 19.14 percent &. 1=.*? percent ). 1=.=6 percent

??. Me% Schools8 /nc. e#pects an )"/ o 98777 every year orever. he irm currently has no de!t8 and its cost o e(uity is 19 percent. he irm can !orro% at = percent and the corporate ta# rate is 23 percent. +hat %ill the value o the irm !e i it converts to 47 percent de!t, A. *?8=91.19 ". 2189?6.39 C. 2*8379.16 &. 23844*.7= ). 29811?.27

16-*9


Chapter 16 Financial Leverage and Capital Structure Policy Ans%er Key


1. Homemade leverage is: A. the incurrence o de!t !y a corporation in order to pay dividends to shareholders. ". the e#clusive use o de!t to und a corporate e#pansion pro$ect. C. the !orro%ing or lending o money !y individual shareholders as a means o ad$usting their level o inancial leverage. &. !est deined as an increase in a irm's de!t-e(uity ratio. ). the term used to descri!e the capital structure o a levered irm. Eeer to section 16.*

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: )omemade le!erage

*. +hich one o the ollo%ing states that the value o a irm is unrelated to the irm's capital structure, A. Capital Asset Pricing odel B.  Proposition / C.  Proposition // &. La% o 0ne Price ). )icient arets Hypothesis Eeer to section 16.2

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition .

16-*=


2. +hich one o the ollo%ing states that a irm's cost o e(uity capital is directly and proportionally related to the irm's capital structure, A. Capital Asset Pricing odel ".  Proposition / C.  Proposition // &. La% o 0ne Price ). )icient arets Hypothesis Eeer to section 16.2

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition ..

3. +hich one o the ollo%ing is the e(uity ris that is most related to the daily operations o a irm, A. maret ris ". systematic ris C. e#trinsic ris D. !usiness ris ). inancial ris Eeer to section 16.2

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: Business ris

16-*?


4. +hich one o the ollo%ing is the e(uity ris related to a irm's capital structure policy, A. maret ". systematic C. e#trinsic &. !usiness E. inancial Eeer to section 16.2

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: 0inancial ris

6. "utter  5elly reduced its ta#es last year !y 247 !y increasing its interest e#pense !y 18777. +hich o the ollo%ing terms is used to descri!e this ta# savings, . interest ta# shield ". interest credit C. inancing shield &. current ta# yield ). ta#-loss interest Eeer to section 16.3

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: .nterest ta2 s3ield

16-27


9. he unlevered cost o capital reers to the cost o capital or a;n<: A. private entity. B. all-e(uity irm. C. governmental entity. &. private individual. ). corporate shareholder. Eeer to section 16.3

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: 4nle!ered cost of ca(ital

=. he e#plicit costs8 such as legal and administrative e#penses8 associated %ith corporate deault are classiied as >>>>> costs. A. lotation ". issue C. direct !anruptcy &. indirect !anruptcy ). unlevered Eeer to section 16.4

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%5 o(ic: Banru(tcy costs

16-21


?. he costs incurred !y a !usiness in an eort to avoid !anruptcy are classiied as >>>>> costs. A. lotation ". direct !anruptcy C. indirect !anruptcy &. inancial solvency ). capital structure Eeer to section 16.4

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%5 o(ic: Banru(tcy costs

17. "y deinition8 %hich o the ollo%ing costs are included in the term @inancial distress costs@, /. direct !anruptcy costs //. indirect !anruptcy costs ///. direct costs related to !eing inancially distressed8 !ut not !anrupt /. indirect costs related to !eing inancially distressed8 !ut not !anrupt A. / only ". /// only C. / and // only &. /// and / only E. /8 //8 ///8 and / Eeer to section 16.4

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%5 o(ic: 0inancial distress costs

16-2*


11. he proposition that a irm !orro%s up to the point %here the marginal !eneit o the interest ta# shield derived rom increased de!t is $ust e(ual to the marginal e#pense o the resulting increase in inancial distress costs is called: . the static theory o capital structure. ".  Proposition /. C.  Proposition //. &. the capital asset pricing model. ). the open marets theorem. Eeer to section 16.6

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%# o(ic: Static t3eory of ca(ital structure

1*. +hich one o the ollo%ing is the legal proceeding under %hich an insolvent irm can !e reorganiBed, A. restructure process B. !anruptcy C. orced merger &. legal taeover ). rights oer Eeer to section 16.17

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: Banru(tcy

16-22


12. A !usiness irm ceases to e#ist as a going concern as a result o %hich one o the ollo%ing, A. divestiture ". share repurchase C. li(uidation &. reorganiBation ). capital restructuring Eeer to section 16.17

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: Li7uidation

13. )d%ards Farm Products %as una!le to meet its inancial o!ligations and %as orced into using legal proceedings to restructure itsel so that it could continue as a via!le !usiness. he process this irm under%ent is no%n as a: A. merger. ". repurchase program. C. li(uidation. D. reorganiBation. ). divestiture. Eeer to section 16.17

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: 8eorgani9ation

16-23


14. he a!solute priority rule determines: A. %hen a irm must !e declared oicially !anrupt. ". ho% a distressed irm is reorganiBed. C. %hich $udge is assigned to a particular !anruptcy case. &. ho% long a reorganiBed irm is allo%ed to remain under !anruptcy protection. E. %hich parties receive payment irst in a !anruptcy proceeding. Eeer to section 16.17

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: Absolute (riority rule

16. A irm should select the capital structure that: A. produces the highest cost o capital. B. ma#imiBes the value o the irm. C. minimiBes ta#es. &. is ully unlevered. ). e(uates the value o de!t %ith the value o e(uity. Eeer to section 16.1

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%" o(ic: Ca(ital structure

16-24


19. he value o a irm is ma#imiBed %hen the: A. cost o e(uity is ma#imiBed. ". ta# rate is Bero. C. levered cost o capital is ma#imiBed. D. %eighted average cost o capital is minimiBed. ). de!t-e(uity ratio is minimiBed. Eeer to section 16.1

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%" o(ic: 0irm !alue

1=. he optimal capital structure has !een achieved %hen the: A. de!t-e(uity ratio is e(ual to 1. ". %eight o e(uity is e(ual to the %eight o de!t. C. cost o e(uity is ma#imiBed given a pre-ta# cost o de!t. &. de!t-e(uity ratio is such that the cost o de!t e#ceeds the cost o e(uity. E. de!t-e(uity ratio results in the lo%est possi!le %eighted average co st o capital. Eeer to section 16.1

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%" o(ic: Ca(ital structure

16-26


1?. AA ours is comparing t%o capital structures to determine h o% to !est inance its operations. he irst option consists o all e(uity inancing. he second option is !ased on a de!t-e(uity ratio o 7.34. +hat should AA ours do i its e#pected earnings !eore interest and ta#es ;)"/< are less than the !rea-even level, Assume there are no ta#es. A. select the leverage option !ecause the de!t-e(uity ratio is less than 7.47 ". select the leverage option since the e#pected )"/ is less than the !rea-even level C. select the unlevered option since the de!t-e(uity ratio is less than 7.47 D. select the unlevered option since the e#pected )"/ is less than the !rea-even level ). cannot !e determined rom the inormation provided Eeer to section 16.*

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: 0inancial le!erage

*7. ou have computed the !rea-even point !et%een a levered and an unlevered capital structure. Assume there are no ta#es. At the !rea-even level8 the: . irm is $ust earning enough to pay or the cost o the de!t. ". irm's earnings !eore interest and ta#es are e(ual to Bero. C. earnings per share or the levered option are e#actly dou!le those o the unlevered option. &. advantages o leverage e#ceed the disadvantages o leverage. ). irm has a de!t-e(uity ratio o .47. Eeer to section 16.*

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: 0inancial le!erage

16-29


*1. +hich one o the ollo%ing statements is correct concerning the relationship !et%een a levered and an unlevered capital structure, Assume there are no ta#es. . At the !rea-even point8 there is no advantage to de!t. ". he earnings per share %ill e(ual Bero %hen )"/ is Bero or a levered irm. C. he advantages o leverage are inversely related to the level o )"/. &. he use o leverage at any level o )"/ increases the )PS. ). )PS are more sensitive to changes in )"/ %hen a irm is unlevered. Eeer to section 16.*

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: Brea$e!en (oint

**. 5essica invested in Duantro stoc %hen the irm %as unlevered. Since then8 Duantro has changed its capital structure and no% has a de!t-e(uity ratio o 7.27. o unlever her position8 5essica needs to: A. !orro% some money and purchase additional shares o Duantro stoc. ". maintain her current e(uity position as the de!t o the irm did not aect her personally. C. sell some shares o Duantro stoc and hold the proceeds in cash. D. sell some shares o Duantro stoc and loan out the sale proceeds. ). create a personal de!t-e(uity ratio o 7.27. Eeer to section 16.*

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: )omemade le!erage

16-2=


*2. +hich one o the ollo%ing maes the capital structure o a irm irrelevant, A. ta#es ". interest ta# shield C. 177 percent dividend payout ratio &. de!t-e(uity ratio that is greater than 7 !ut less than 1 E. homemade leverage Eeer to section 16.*

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: )omemade le!erage

*3.  Proposition / %ith no ta# supports the argument that: A. !usiness ris determines the return on assets. ". the cost o e(uity rises as leverage rises. C. the de!t-e(uity ratio o a irm is completely irrelevant. &. a irm should !orro% money to the point %here the ta# !eneit rom de!t is e(ual to the cost o the increased pro!a!ility o inancial distress. ). homemade leverage is irrelevant. Eeer to section 16.2

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition . wit3 no ta2

16-2?


*4. he concept o homemade leverage is most associated %ith: .  Proposition / %ith no ta#. ".  Proposition // %ith no ta#. C.  Proposition / %ith ta#. &.  Proposition // %ith ta#. ). static theory proposition. Eeer to section 16.2

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition . wit3 no ta2

*6. +hich o the ollo%ing statements are correct in relation to  Proposition // %ith no ta#es, /. he re(uired return on assets is e(ual to the %eighted average cost o capital. //. Financial ris is determined !y the de!t-e(uity ratio. ///. Financial ris determines the return on assets. /. he cost o e(uity declines %hen the amount o leverage used !y a irm rises. A. / and /// only ". // and / only C. / and // only &. /// and / only ). / and / only Eeer to section 16.2

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition .. wit3 no ta2es

16-37


*9.  Proposition // is the proposition that: A. the A. the capital structure o a irm has no eect on the irm's value. ". the ". the cost o e(uity depends on the return on de!t8 the de!t-e(uity ratio8 and the ta# rate. C. a irm's cost o e(uity is a linear unction %ith a slope e(ual to ;E A - E &<. &. the &. the cost o e(uity is e(uivalent to the re(uired rate o return on a irm's assets. ). the ). the siBe o the pie does not depend on ho% the pie is sliced. Eeer to section 16.2

AACSB: N/A N/A Bloom's: Knowledge Knowledge Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$" "#$" Section: "#%* o(ic: +,+ -ro(osition ..

*=. he !usiness ris o a irm: A. depends A. depends on the irm's level o unsystematic ris. ". is ". is inversely related to the re(uired return on the irm's assets. C. is C. is dependent upon the relative %eights o the de!t and e(uity used to inance the irm. D. has a positive relationship %ith the irm's cost o e(uity. ). has ). has no relationship %ith the re(uired return on a irm's assets according to  Proposition //. Eeer to section 16.2

AACSB: N/A N/A Bloom's: Com(re3ension Com(re3ension Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$" "#$" Section: "#%* o(ic: Business ris

16-31


*?. +hich o the ollo%ing statements related to inancial ris are correct, /. Financial ris is the ris associated %ith the use o d e!t inancing. //. As inancial ris increases so too does the cost o e(uity. ///. Financial ris is %holly dependent upon the inancial policy o a irm. /. Financial ris is the ris that is inherent in a irm's operations. A. / A. / and /// only ". // ". // and / only C. // C. // and /// only D. /8 //8 and /// only ). /8 ). /8 //8 ///8 and / Eeer to section 16.2

AACSB: N/A N/A Bloom's: Com(re3ension Com(re3ension Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$" "#$" Section: "#%* o(ic: 0inancial ris

27.  Proposition / %ith ta# supports the theory that: cap ital decreases as the irm's de!t-e(uity ratio increases. . a irm's %eighted average cost o capital ". the ". the value o a irm is inversely related to the amount o leverage used !y the irm. C. the C. the value o an unlevered irm is e(ual to the value o a levered irm plus the value o the interest ta# shield. &. a &. a irm's cost o capital is the same regardless o the mi# o de!t and e(uity used !y the irm. ). a ). a irm's cost o e(uity increases as the de!t-e(uity ratio o the irm decreases. Eeer to section 16.3

AACSB: N/A N/A Bloom's: Com(re3ension Com(re3ension Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$& "#$& Section: "#%1 o(ic: +,+ -ro(osition . wit3 ta2es

16-3*


21.  Proposition / %ith ta#es is !ased on the concept that: A. the A. the optimal capital structure is the one that is totally inanced %ith e(uity. ". the ". the capital structure o a irm does not matter !ecause investors can use homemade leverage. C. a C. a irm's +ACC is unaected !y a change ch ange in the irm's capital structure. D. the value o a irm increases as the irm's de!t increases !ecause o the interest ta# shield. ). the ). the cost o e(uity increases as the de!t-e(uity ratio o a irm increases. Eeer to section 16.3

AACSB: N/A N/A Bloom's: Com(re3ension Com(re3ension Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$& "#$& Section: "#%1 o(ic: +,+ -ro(osition . wit3 ta2es

2*.  Proposition // %ith ta#es: . has the same general implications as  Proposition // %ithout ta#es. ". states ". states that a irm's capital structure is irrelevant. C. supports C. supports the argument that !usiness ris is determined !y the capital structure decision. &. supports &. supports the argument that the cost o e(uity decreases as the de!t-e(uity ratio increases. ). concludes ). concludes that the capital structure decision is irrelevant to the value o a irm. Eeer to section 16.3

AACSB: N/A N/A Bloom's: Com(re3ension Com(re3ension Difficulty: Difficulty: Basic Learning Obecti!e: Obecti!e: "#$& "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

16-32


22. he present value o the interest ta# shield is e#pressed as: A. ;C × &<E A. ". G  ;C × &<. C. I)"/ × ;C × &
AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: - of interest ta2 s3ield

23. he interest ta# shield has no value %hen a irm has a: /. ta# rate o Bero. //. de!t-e(uity ratio o 1. ///. Bero de!t. /. Bero leverage. A. / and /// only ". // and / only C. /8 ///8 and / only &. //8 ///8 and / only ). /8 //8 and / only Eeer to section 16.3

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: .nterest ta2 s3ield

16-33


24. he interest ta# shield is a ey reason %hy: A. the re(uired rate o return on assets rises %hen de!t is added to the capital structure. ". the value o an unlevered irm is e(ual to the value o a levered irm. C. the net cost o de!t to a irm is generally less than the cost o e(uity. &. the cost o de!t is e(ual to the cost o e(uity or a levered irm. ). irms preer e(uity inancing over de!t inancing. Eeer to section 16.3

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: .nterest ta2 s3ield

26. "ased on  Proposition // %ith ta#es8 the %eighted average cost o capital: A. is e(ual to the aterta# cost o de!t. ". has a linear relationship %ith the cost o e(uity capital. C. is unaected !y the ta# rate. D. decreases as the de!t-e(uity ratio increases. ). is e(ual to E G × ;1 - C<. Eeer to section 16.3

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

16-34


29. "anruptcy: A. creates value or a irm. B. transers value rom shareholders to !ondholders. C. technically occurs %hen total e(uity e(uals total de!t. &. costs are limited to legal and administrative ees. ). is an ine#pensive means o reorganiBing a irm. Eeer to section 16.4

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%5 o(ic: Banru(tcy

2=. +hich one o the ollo%ing is a direct !anruptcy cost, A. company C)0's time spent in !anruptcy court ". maintaining cash reserves C. maintaining a de!t-e(uity ratio that is lo%er than the optimal ratio &. losing a ey company employee E. paying an outside accountant ees to prepare !anruptcy reports Eeer to section 16.4

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$* Section: "#%5 o(ic: Banru(tcy costs

16-36


2?. / a irm has the optimal amount o de!t8 then the: A. direct inancial distress costs must e(ual the present value o the interest ta# shield. B. value o the levered irm %ill e#ceed the value o the irm i it %ere unlevered. C. value o the irm is minimiBed. &. value o the irm is e(ual to L  C × &. ). de!t-e(uity ratio is e(ual to 1.7. Eeer to section 16.6

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$& Section: "#%# o(ic: O(timal ca(ital structure

37. +hich one o the ollo%ing has the greatest tendency to increase the percentage o de!t included in the optimal capital structure o a irm, A. e#ceptionally high depreciation e#penses ". very lo% marginal ta# rate C. su!stantial ta# shields rom other sources D. lo% pro!a!ilities o inancial distress ). minimal ta#a!le income Eeer to section 16.6


16-39


31. he capital structure that ma#imiBes the value o a irm also: A. minimiBes inancial distress costs. B. minimiBes the cost o capital. C. ma#imiBes the present value o the ta# shield on de!t. &. ma#imiBes the value o the de!t. ). ma#imiBes the value o the unlevered irm. Eeer to section 16.6

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%# o(ic: O(timal ca(ital structure

3*. he optimal capital structure: A. %ill !e the same or all irms in the same industry. ". %ill remain constant over time unless the irm changes its primary operations. C. %ill vary over time as ta#es and maret conditions change. &. places more emphasis on operations than on inancing. ). is unaected !y changes in the inancial marets. Eeer to section 16.6


16-3=


32. he static theory o capital structure advocates that the optimal capital structure or a irm: A. is dependent on a constant de!t-e(uity ratio over time. ". remains i#ed over time. C. is independent o the irm's ta# rate. &. is independent o the irm's %eighted average cost o capital. E. e(uates the ta# savings rom an additional dollar o de!t to the increased !anruptcy costs related to that additional dollar o de!t. Eeer to section 16.6

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%# o(ic: Static t3eory of ca(ital structure

33. he !asic lesson o  heory is that the value o a irm is dependent upon: A. the irm's capital structure. B. the total cash lo% o the irm. C. minimiBing the mareted claims. &. the amount o mareted claims to that irm. ). siBe o the stocholders' claims. Eeer to section 16.9

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%; o(ic: +,+ 3eory

16-3?


34. +hich orm o inancing do irms preer to use irst according to the pecing-order theory, A. regular de!t ". converti!le de!t C. common stoc &. preerred stoc E. internal unds Eeer to section 16.=

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%< o(ic: -ecing$order t3eory

36. +hich o the ollo%ing are correct according to pecing-order theory, /. Firms stocpile internally-generated cash. //. here is an inverse relationship !et%een a irm's proit level and its de!t level. ///. Firms avoid e#ternal de!t at all costs. /. A irm's capital structure is dictated !y its need or e#ternal inancing. A. / and /// only ". // and / only C. /8 ///8 and / only D. /8 //8 and / only ). /8 //8 ///8 and / Eeer to section 16.=

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%< o(ic: -ecing$order t3eory

16-47


39. Corporations in the G.S. tend to: A. minimiBe ta#es. B. underutiliBe de!t. C. rely less on e(uity inancing than they should. &. have relatively similar de!t-e(uity ratios across industry lines. ). rely more heavily on de!t than on e(uity as the ma$or source o inancing. Eeer to section 16.?

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%= o(ic: Ca(ital structure

3=. /n general8 the capital structures used !y G.S. irms: A. tend to over%eigh de!t in relation to e(uity. ". generally result in de!t-e(uity ratios !et%een 7.34 and 7.67. C. are airly standard or all S/C codes. &. tend to !e those %hich ma#imiBe the use o the irm's availa!le ta# shelters. E. vary signiicantly across industries. Eeer to section 16.?

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$& Section: "#%= o(ic: Ca(ital structure

16-41


3?. A irm is technically insolvent %hen: A. it has a negative !oo value. ". total de!t e#ceeds total e(uity. C. it is una!le to meet its inancial o!ligations. &. it iles or !anruptcy protection. ). the maret value o its stoc is less than its !oo value. Eeer to section 16.17

AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: ec3nical insol!ency

47. +hich one o the ollo%ing statements related to Chapter 9 !anruptcy is correct, A. A irm in Chapter 9 !anruptcy is reorganiBing its operations such that it can return to !eing a via!le concern. B. Gnder a Chapter 9 !anruptcy8 a trustee %ill assume control o the irm's assets until those assets can !e li(uidated. C. Chapter 9 !anruptcies are al%ays involuntary on the part o the irm. &. Gnder a Chapter 9 !anruptcy8 the claims o creditors are paid prior to the administrative costs o the !anruptcy. ). Chapter 9 !anruptcy allo%s a irm to restructure its e(uity such that ne% shares o stoc are generally issued prior to the irm coming out o !anruptcy. Eeer to section 16.17

AACSB: N/A Bloom's: Com(re3ension Difficulty: Basic Learning Obecti!e: "#$* Section: "#%"6 o(ic: Banru(tcy

16-4*


41. +hich one o the ollo%ing %ill generally have the highest priority %hen assets are distri!uted in a !anruptcy proceeding, A. consumer claim ". dividend payment to preerred shareholder C. company contri!ution to the employees' retirement account &. payment to an unsecured creditor E. payment o employee %ages Eeer to section 16.17


4*. A irm may ile or Chapter 11 !anruptcy: /. in an attempt to gain a competitive advantage. //. using a prepac. ///. %hile allo%ing the current management to continue running the irm. /. only ater the irm !ecomes insolvent. A. / and /// only ". / and // only C. /8 //8 and / only D. /8 //8 and /// only ). /8 //8 ///8 and / Eeer to section 16.17


16-42


42. he "anruptcy A!use Prevention and Consumer Protection Act o *774: A. permits creditors to ile a prepac immediately ater a irm iles or !anruptcy protection. ". prevents creditors rom su!mitting any reorganiBation plans. C. prevents irms rom iling or !anruptcy protection more than once. D. permits ey employee retention plans only i an employee has another $o! oer. ). allo%s irms to pay !onuses to all ey employees to entice those employees to remain in the irm's employ. Eeer to section 16.17


43. Kelso )lectric is de!ating !et%een a leveraged and an unleveraged capital structure. he all e(uity capital structure %ould consist o 378777 shares o stoc. he de!t and e(uity option %ould consist o *48777 shares o stoc plus *=78777 o de!t %ith an interest rate o 9 percent. +hat is the !rea-even level o earnings !eore interest and ta#es !et%een these t%o options, /gnore ta#es. A. 3*8*7= ". 338131 C. 368222 &. 3?8669 E. 4*8*69 )"/378777 Q I)"/ - ;*=78777 × 7.79
AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: Brea$e!en >B.

16-43


44. Holly's is currently an all e(uity irm that has ?8777 shares o stoc outstanding at a maret price o 3* a share. he irm has decided to leverage its operations !y issuing 1*78777 o de!t at an interest rate o ?.4 percent. his ne% de!t %ill !e used to repurchase shares o the outstanding stoc. he restructuring is e#pected to increase the earnings per share. +hat is the minimum level o earnings !eore interest and ta#es that the irm is e#pecting, /gnore ta#es. . 248?17 ". 2=8416 C. 3*8777 &. 338131 ). 3487*7 )"/?8777 Q I)"/ - ;1*78777 × 7.7?4
AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: Brea$e!en >B.

46. Se%er's Paradise is an all e(uity irm that has 48777 shares o stoc outstanding at a maret price o 14 a share. he irm's management has decided to issue 278777 %orth o de!t and use the unds to repurchase shares o the outstanding stoc. he interest rate on the de!t %ill !e 17 percent. +hat are the earnings per share at the !rea-even level o earnings !eore interest and ta#es, /gnore ta#es. A. 1.36 B. 1.47 C. 1.69 &. 1.== ). 1.?3 Mum!er o shares repurchased Q 27877714 Q *8777 )"/48777 Q I)"/ - ;278777 × .7.17
AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$" Section: "#%& o(ic: Brea$e!en >-S

16-44


49. iller's &ry oods is an all e(uity irm %ith 348777 shares o stoc outstanding at a maret price o 47 a share. he company's earnings !eore interest and ta#es are 1*=8777. iller's has decided to add leverage to its inancial operations !y issuing *478777 o de!t at = percent interest. he de!t %ill !e used to repurchase shares o stoc. ou o%n 377 shares o iller's stoc. ou also loan out unds at = percent interest. Ho% many shares o iller's stoc must you sell to oset the leverage that iller's is assuming, Assume you loan out all o the unds you receive rom the sale o stoc. /gnore ta#es. A. 24.6 shares ". 37.7 shares C. 33.3 shares &. 39.4 shares ). 47.1 shares iller's interest Q *478777 × 7.7= Q *78777 iller's shares repurchased Q *47877747 Q 48777 iller's shares outstanding %ith de!t Q 348777 - 48777 Q 378777 iller's )PS8 no de!t Q 1*=8777348777 Q *.=33333 iller's )PS8 %ith de!t Q ;1*=8777 - *78777<378777 Q *.97 iller's value o stoc Q 378777 × 47 Q *87778777 iller's value o de!t Q *478777 iller's total value Q *87778777  *478777 Q *8*478777 iller's %eight stoc Q *87778777*8*478777 Q 7.=====? iller's %eight de!t Q *478777*8*478777 Q 7.111111 our initial investment Q 377 × 47 Q *78777 our ne% stoc position Q 7.=====? × *78777 Q 198999.9= our ne% num!er o shares Q 198999.9=47 Q 244.4446 Mum!er o shares sold Q 377 - 244.4446 Q 33.3 shares C3ec: ?our new loans @ 6%"""""" × &6666 @ &&&&%&& ?our total unle!ered income @ 166 × &%<11111 @ ""*;%;< ?our total le!ered income @ *55%555# × &%;6 E &&&&%&& × 6%6< @ ""*;%;<

AACSB: Analytic Bloom's: Analysis Difficulty: .ntermediate Learning Obecti!e: "#$" Section: "#%& o(ic: )omemade le!erage

16-46


4=. ou currently o%n 677 shares o 5KL8 /nc. 5KL is an all e(uity irm that has 948777 shares o stoc outstanding at a maret price o 37 a share. he company's earnings !eore interest and ta#es are 1378777. 5KL has decided to issue 1 million o de!t at = percent interest. his de!t %ill !e used to repurchase shares o stoc. Ho% many shares o 5KL stoc must you sell to unlever your position i you can loan out unds at = percent interest, A. 1*7 shares ". 147 shares C. 1=7 shares D. *77 shares ). *47 shares 5KL interest Q 1m × 7.7= Q =78777 5KL shares repurchased Q 1m37 Q *48777 5KL shares outstanding %ith de!t Q 948777 - *48777 Q 478777 5KL )PS8 no de!t Q 1378777948777 Q 1.=66669 5KL )PS8 %ith de!t Q ;1378777 - =78777<478777 Q 1.*7 5KL value o stoc Q 478777 × 37 Q *m 5KL value o de!t Q 1m 5KL total value Q *m  1m Q 2m 5KL %eight stoc Q *m2m Q *2 5KL %eight de!t Q 1m2m Q 12 our initial investment Q 677 × 37 Q *38777 our ne% stoc position Q *2;*38777< Q 168777 our ne% num!er o shares Q 16877737 Q 377 Mum!er o shares sold Q 677 - 377 Q *77 shares C3ec: ?our new loans @ "/*&1666 @ <666 ?our unle!ered income @ #66 × "%<####; @ ""&6 ?our le!ered income @ 166 × "%&6 E <666 × 6%6< @ ""&6


16-49


4?. Maylor's is an all e(uity irm %ith 678777 shares o stoc outstanding at a maret price o 47 a share. he company has earnings !eore interest and ta#es o =98777. Maylor's has decided to issue 9478777 o de!t at 9.4 percent. he de!t %ill !e used to repurchase shares o the outstanding stoc. Currently8 you o%n 477 shares o Maylor's stoc. Ho% many shares o Maylor's stoc %ill you continue to o%n i you unlever this position, Assume you can loan out unds at 9.4 percent interest. /gnore ta#es. A. 277 shares ". 247 shares C. 294 shares &. 3*4 shares ). 477 shares Maylor's interest Q 9478777 × 7.794 Q 468*47 Maylor's shares repurchased Q 947877747 Q 148777 Maylor's shares outstanding %ith de!t Q 678777 - 148777 Q 348777 Maylor's )PS8 no de!t Q =98777678777 Q 1.34 Maylor's )PS8 %ith de!t Q ;=98777 - 468*47<348777 Q 7.6=2222 Maylor's value o stoc Q 348777 × 47 Q *8*478777 Maylor's value o de!t Q 947 Maylor's total value Q *8*478777  9478777 Q 287778777 Maylor's %eight stoc Q *8*478777287778777 Q 7.94 Maylor's %eight de!t Q 9478777287778777 Q 7.*4 our initial investment Q 477 × 47 Q *48777 our ne% stoc position Q 7.94 × *48777 Q 1=8947 our ne% num!er o shares Q 1=894747 Q 294 shares C3ec: ?our new loans @ 6%&5 × &5666 @ #&56 ?our unle!ered income @ 566 × "%15 @ ;&5 ?our le!ered income @ *;5 × 6%#<**** E #&56 × 6%6;5 @ ;&5


16-4=


67. Pe%ter  lass is an all e(uity irm that has =78777 shares o stoc outstanding. he company is in the process o !orro%ing 6778777 at ? percent interest to repurchase 1*8777 shares o the outstanding stoc. +hat is the value o this irm i you ignore ta#es, A. *.4 million B. 3.7 million C. 4.7 million &. 4.4 million ). 6.7 million Firm value Q =78777 × ;67787771*8777< Q 3 million

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: 0irm !alue

61. he 5ean 0utlet is an all e(uity irm that has 1368777 shares o stoc outstanding. he company has decided to !orro% the 1.1 million to repurchase 98477 shares o its stoc rom the estate o a deceased shareholder. +hat is the total value o the irm i you ignore ta#es, A. 1=82=9897* ". 1=84778777 C. 1?86668669 &. *187778777 E. *183128222 Firm value Q 1368777 × ;1.1m98477< Q *183128222


16-4?


6*. Stacy o%ns 2= percent o he o%n Centre. She has decided to retire and %ants to sell all o her shares in this closely held8 all e(uity irm. he other shareholders have agreed to have the irm !orro% 6478777 to purchase her shares o stoc. +hat is the total maret value o he o%n Centre, /gnore ta#es. . 1891784*6 ". 1893=8*1? C. 1899187=? &. 18=718376 ). 18=7=863? Firm value Q 64787777.2= Q 1891784*6


62. +inter's oyland has a de!t-e(uity ratio o 7.9*. he pre-ta# cost o de!t is =.9 percent and the re(uired return on assets is 16.1 percent. +hat is the cost o e(uity i you ignore ta#es, A. 1?.21 percent ". 1?.93 percent C. *7.*? percent &. *7.36 percent E. *1.32 percent E ) Q 7.161  ;7.161 - 7.7=9< × 7.9* Q *1.32 percent

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition ..

16-67


63. 5eerson  &aughter has a cost o e(uity o 13.6 percent and a pre-ta# cost o de!t o 9.= percent. he re(uired return on the assets is 12.* percent. +hat is the irm's de!t-e(uity ratio !ased on  // %ith no ta#es, . 7.*6 ". 7.22 C. 7.29 &. 7.32 ). 7.34 E ) Q 7.136 Q 7.12*  ;7.12* - 7.79=< × &) &) Q 7.*6


64. he Corner "aery has a de!t-e(uity ratio o 7.43. he irm's re(uired return on assets is 13.* percent and its cost o e(uity is 16.1 percent. +hat is the pre-ta# cost o de!t !ased on  Proposition // %ith no ta#es, A. 9.17 percent ". =.9? percent C. 17.6= percent &. 19.46 percent ). 1=.37 percent E ) Q 7.161 Q 7.13*  ;7.13* - E d< × 7.43 E d Q 17.6= percent


16-61


66. L.A. Clothing has e#pected earnings !eore interest and ta#es o 3=8?778 an unlevered cost o capital o 13.4 percent8 and a ta# rate o 23 percent. he company also has =8777 o de!t that carries a 9 percent coupon. he de!t is selling at par value. +hat is the value o this irm, A. ***849?.21 ". **28222.22 C. **3817=.16 D. **48*??.21 ). **48396.?1 G Q I3=8?77 × ;1 - 7.23
AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition . wit3 ta2es

69. Hanover ech is currently an all e(uity irm that has 2*78777 shares o stoc outstanding %ith a maret price o 1? a share. he current cost o e(uity is 14.3 percent and the ta# rate is 26 percent. he irm is considering adding 1.* million o de!t %ith a coupon rate o = percent to its capital structure. he de!t %ill !e sold at par value. +hat is the levered value o the e(uity, A. 4.*7? million B. 4.21* million C. 4.326 million &. 6.41* million ). 6.97= million L Q ;2*78777 × 1?<  ;7.26 × 1.*m< Q 6.41*m ) Q 6.41*m - 1.*m Q 4.21*m


16-6*


6=. "right orning Foods has e#pected earnings !eore interest and ta#es o 3=86778 an unlevered cost o capital o 12.* percent8 and de!t %ith !oth a !oo and ace value o *48777. he de!t has an =.4 percent coupon. he ta# rate is 23 percent. +hat is the value o the irm, A. *348477 ". *398677 C. *418477 &. *638=77 ). *918277 G Q I3=8677 × ;1 - 7.23

6?. )#ports Gnlimited is an unlevered irm %ith an aterta# net income o 398=77. he unlevered cost o capital is 13.1 percent and the ta# rate is 2* percent. +hat is the value o this irm, A. *978=69 ". *?382=7 C. 22?8779 &. 29=8333 ). 33983=? G Q 398=777.131 Q 22?8779


16-62


97. An unlevered irm has a cost o capital o 19.4 percent and earnings !eore interest and ta#es o 2*98477. A levered irm %ith the same operations and assets has !oth a !oo value and a ace value o de!t o 6478777 %ith a 9.4 percent annual coupon. he applica!le ta# rate is 2= percent. +hat is the value o the levered irm, A. 182?98*1* ". 182?=8*46 C. 1837*847? D. 183798*=6 ). 183138313 G Q I2*98477 × ;1 - 7.2=

91. &o%n "edding has an unlevered cost o capital o 12 percent8 a cost o de!t o 9.= percent8 and a ta# rate o 2* percent. +hat is the target de!t-e(uity ratio i the targeted cost o e(uity is 14.41 percent, A. .62 ". .6= C. .91 &. .96 ). .=3 E ) Q 7.1441 Q 7.12  ;7.12 - 7.79=< × &) × ;1 - 7.2*< &) Q 7.91

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

16-63


9*. 5ohnson ire &istri!utors has de!t %ith !oth a ace and a maret value o 1*8777. his de!t has a coupon rate o 6 percent and pays interest annually. he e#pected earnings !eore interest and ta#es are *81778 the ta# rate is 27 percent8 and the unlevered cost o capital is 11.9 percent. +hat is the irm's cost o e(uity, A. **.36 percent ". **.=9 percent C. *2.*7 percent &. *2.4? percent ). *4.13 percent G Q I*8177 × ;1 - 7.27
AACSB: Analytic Bloom's: Analysis Difficulty: .ntermediate Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

92. Country arets has an unlevered cost o capital o 1* percent8 a ta# rate o 2= percent8 and e#pected earnings !eore interest and ta#es o 148977. he company has 118777 in !onds outstanding that have a 6 percent coupon and pay interest annually. he !onds are selling at par value. +hat is the cost o e(uity, . 1*.44 percent ". 12.26 percent C. 12.63 percent &. 13.79 percent ). 13.*? percent G Q I148977 × ;1- 7.2=
AACSB: Analytic Bloom's: Analysis Difficulty: .ntermediate Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

16-64


93. he PiBBa Palace has a cost o e(uity o 14.2 percent and an unlevered cost o capital o 11.= percent. he company has **8777 in de!t that is selling at par value. he levered value o the irm is 318777 and the ta# rate is 23 percent. +hat is the pre-ta# cost o de!t, A. 3.92 percent ". 6.1= percent C. 6.4? percent D. 9.** percent ). ?.?* percent E ) Q 7.142 Q 7.11=  ;7.11= - E &< × I**8777;318777 - **8777

94. he reen Paddle has a cost o e(uity o 12.92 percent and a pre-ta# cost o de!t o 9.6 percent. he de!t-e(uity ratio is 7.64 and the ta# rate is 2* percent. +hat is reen Paddle's unlevered cost o capital, . 11.=4 percent ". 1*.9= percent C. 13.*? percent &. 13.36 percent ). 14.7= percent E ) Q 7.1292 Q E G  ;E G - 7.796< × 7.64 × ;1 - 7.2*< E G Q 11.=4 percent


16-66


96. "o!'s +arehouse has a pre-ta# cost o de!t o =.3 percent and an unlevered cost o capital o 13.6 percent. he irm's ta# rate is 29 percent and the cost o e(uity is 1= percent. +hat is the irm's de!t-e(uity ratio, A. 7.9* ". 7.96 C. 7.9? &. 7.=* E. 7.=9 E ) Q 7.1= Q 7.136  ;7.136 - 7.7=3< × &) × ;1 - 7.29< &) Q 7.=9


99. &ouglass  Fran has a de!t-e(uity ratio o 7.34. he pre-ta# cost o de!t is 9.6 percent %hile the unlevered cost o capital is 12.2 percent. +hat is the cost o e(uity i the ta# rate is 2? percent, A. 12.9? percent B. 13.=6 percent C. 14.?* percent &. 1=.37 percent ). 1=.=9 percent E ) Q 7.122  ;7.122 - 7.796< × 7.34 × ;1 - 7.2?< Q 13.=6 percent


16-69


9=. he 5une "ug has a *978777 !ond issue outstanding. hese !onds have a 9.4 percent coupon8 pay interest semiannually8 and have a current maret price e(ual to ?=.6 percent o ace value. he ta# rate is 2? percent. +hat is the amount o the annual interest ta# shield, A. 28?3=.94 ". 3811*.67 C. 48211.** D. 98=?9.47 ). =8**4.*7 Annual interest ta# shield Q *978777 × 7.794 × 7.2? Q 98=?9.47

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: .nterest ta2 s3ield

9?. eorga's Eestaurants has 38477 !onds outstanding %ith a ace value o 18777 each and a coupon rate o =.*4 percent. he interest is paid semi-annually. +hat is the amount o the annual interest ta# shield i the ta# rate is 29 percent, . 129826*.47 ". 16*8311.?7 C. 1=98947.77 &. *1783*7.77 ). *228==9.47 Annual interest ta# shield Q 38477 × 18777 × 7.7=*4 × 7.29 Q 129826*.47

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: .nterest ta2 s3ield

16-6=


=7. &. L. ucers has *18777 o de!t outstanding that is selling at par and has a coupon rate o 9.4 percent. he ta# rate is 2* percent. +hat is the present value o the ta# shield, A. 473 ". 614 C. 633 &. 68*77 E. 689*7 Present value o the ta# shield Q 7.2* × *18777 Q 689*7

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: - of ta2 s3ield

=1. 5emisen's has e#pected earnings !eore interest and ta#es o 68*77. /ts unlevered cost o capital is 12 percent and its ta# rate is 23 percent. he irm has de!t %ith !oth a !oo and a ace value o *8477. his de!t has a ? percent coupon and pays interest annually. +hat is the irm's %eighted average cost o capital, A. 1*.3= percent B. 1*.66 percent C. 12.=9 percent &. 13.13 percent ). 13.29 percent G Q I68*77 × ;1 - 7.23
AACSB: Analytic Bloom's: Analysis Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: FACC

16-6?


=*. A irm has de!t o 1*87778 a leveraged value o *683778 a pre-ta# cost o de!t o ?.*7 percent8 a cost o e(uity o 19.6 percent8 and a ta# rate o 29 percent. +hat is the irm's %eighted average cost o capital, A. 11.39 percent ". 11.4* percent C. 11.6? percent D. 1*.*2 percent ). 1*.3= percent +ACC Q RI;*68377 - 1*8777<*68377J × 7.196  I;1*8777*68377< × 7.7?* × ;1 - 7.29
AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: FACC

=2. oung's Home Supply has a de!t-e(uity ratio o 7.=7. he cost o e(uity is 13.4 percent and the aterta# cost o de!t is 3.? percent. +hat %ill the irm's cost o e(uity !e i the de!te(uity ratio is revised to 7.94, A. 17.=? percent ". 11.39 percent C. 11.97 percent &. 12.=? percent E. 13.*2 percent +ACC Q I;1.71.=< × 7.134J  I;7.=1.=< × 7.73?J Q 7.17*222 +ACC Q 7.17*222 Q I;1.71.94< × E )J  I;7.941.94< × 7.73? E ) Q 13.*2 percent

AACSB: Analytic Bloom's: A((lication Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: FACC

16-97


=3. Percy's +holesale Supply has earnings !eore interest and ta#es o 1768777. "oth the !oo and the maret value o de!t is 1978777. he unlevered cost o e(uity is 14.4 percent %hile the pre-ta# cost o de!t is =.6 percent. he ta# rate is 2= percent. +hat is the irm's %eighted average cost o capital, A. 11.?3 percent ". 1*.64 percent C. 12.34 percent &. 13.71 percent ). 13.29 percent G Q I1768777 × ;1 - 7.2=
AACSB: Analytic Bloom's: Analysis Difficulty: Basic Learning Obecti!e: "#$& Section: "#%1 o(ic: FACC

16-91



?7. )ast Side8 /nc. has no de!t outstanding and a total maret value o 1268777. )arnings !eore interest and ta#es8 )"/8 are pro$ected to !e 1*8777 i economic conditions are normal. / there is strong e#pansion in the economy8 then )"/ %ill !e *9 percent higher. / there is a recession8 then )"/ %ill !e 44 percent lo%er. )ast Side is considering a 438777 de!t issue %ith a 4 percent interest rate. he proceeds %ill !e used to repurchase shares o stoc. here are currently *8777 shares outstanding. /gnore ta#es. / the economy enters a recession8 )PS %ill change !y >>>> percent as compared to a normal economy8 assuming that the irm recapitaliBes. . -97.?9 percent ". -62.14 percent C. -4=.7= percent &. -3*.*? percent ). -2=.=9 percent Share price Q 1268777*8777 Q 6= Shares repurchased Q 4387776= Q 9?3.119639 Annual interest Q 438777 × 7.74 Q *8977 )PS Mormal Q ;1*8777 - *8977<;*8777 - 9?3.119639< Q 9.91*1?4 )PSEecession Q RI1*8777 × ;1 - 7.44
AACSB: Analytic Bloom's: Analysis Difficulty: Basic >OC G: "#$" Learning Obecti!e: "#$" Section: "#%& o(ic: >B. and le!erage

16-9*


?1. Morth Side8 /nc. has no de!t outstanding and a total maret value o 1948777. )arnings !eore interest and ta#es8 )"/8 are pro$ected to !e 168777 i economic conditions are normal. / there is strong e#pansion in the economy8 then )"/ %ill !e 24 percent higher. / there is a recession8 then )"/ %ill !e 97 percent lo%er. Morth Side is considering a 978777 de!t issue %ith a 9 percent interest rate. he proceeds %ill !e used to repurchase shares o stoc. here are currently *8477 shares outstanding. Morth Side has a ta# rate o 23 percent. / the economy e#pands strongly8 )PS %ill change !y >>>> percent as compared to a normal economy8 assuming that the irm recapitaliBes. A. 2=.=7 percent ". 34.*6 percent C. 47.34 percent &. 42.?* percent ). 61.79 percent Share price Q 1948777*8477 Q 97 Shares repurchased Q 97877797 Q 18777 Annual interest Q 978777 × 7.79 Q 38?77 )PS Mormal Q I;168777 - 38?77<;1 - 7.23
AACSB: Analytic Bloom's: Analysis Difficulty: Basic >OC G: "#$& Learning Obecti!e: "#$& Section: "#%& o(ic: >B. ta2es and le!erage

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?*. ala#y Products is comparing t%o dierent capital structures8 an all-e(uity plan ;Plan /< and a levered plan ;Plan //<. Gnder Plan /8 ala#y %ould have 19=8477 shares o stoc outstanding. Gnder Plan //8 there %ould !e 918377 shares o stoc outstanding and 1.9? million in de!t outstanding. he interest rate on the de!t is 17 percent and there are no ta#es. +hat is the !reaeven )"/, A. *=98=9=.9= B. *?=8222.22 C. 2418111.11 &. 2228222.22 ). 2318313.13 )"/19=8477 Q I)"/ - 7.17;189?78777
AACSB: Analytic Bloom's: A((lication Difficulty: Basic >OC G: "#$1 Learning Obecti!e: "#$" Section: "#%& o(ic: Brea$e!en >B.

?2. A"C Co. and NO Co. are identical irms in all respects e#cept or their capital structure. A"C is all e(uity inanced %ith 3=78777 in stoc. NO uses !oth stoc and perpetual de!t its stoc is %orth *378777 and the interest rate on its de!t is 11 percent. "oth irms e#pect )"/ to !e 4=8377. /gnore ta#es. he cost o e(uity or A"C is >>>>> percent8 and or NO it is >>>>>> percent. A. 1*.19 1*.6= ". 1*.19 1*.?3 C. 1*.19 12.22 &. 1*.*? 1*.6= ). 1*.*? 12.22 A"C: E ) Q E A Q 4=83773=78777 Q 1*.19 percent NO: E ) Q 7.1*19  ;7.1*19 - 7.11<;1<;1< Q 12.22 percent Mote: A"C: )(uity Q 3=78777 NO: )(uity Q *378777 &e!t Q 3=78777 - *378777 Q *378777

AACSB: Analytic Bloom's: A((lication Difficulty: Basic >OC G: "#$= Learning Obecti!e: "#$" Section: "#%* o(ic: Cost of e7uity

16-93


?3. Lamont Corp. uses no de!t. he %eighted average cost o capital is 11 percent. he current maret value o the e(uity is 2= million and there are no ta#es. +hat is )"/, A. 283*28777 ". 2847=8677 C. 289=18177 &. 28=?=8977 E. 381=78777  Q 2=87778777 Q )"/7.11 )"/ Q 381=78777

AACSB: Analytic Bloom's: A((lication Difficulty: Basic >OC G: "#$"6 Learning Obecti!e: "#$" Section: "#%* o(ic: +,+ -ro(osition . wit3 no ta2

?4. he SL Corp. uses no de!t. he %eighted average cost o capital is 1* percent. he current maret value o the e(uity is 21 million and the corporate ta# rate is 23 percent. +hat is )"/, A. 381=78777 ". 38=*181?3 C. 486268263 &. 68*27871= ). 6846=8477 G Q 2187778777 Q )"/ ;1 - 7.23<7.1* )"/ Q 486268263

AACSB: Analytic Bloom's: A((lication Difficulty: Basic >OC G: "#$"" Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition . wit3 ta2es

16-94


?6. +.. rees8 /nc. has a de!t-e(uity ratio o 1.3. /ts +ACC is 17 percent8 and its cost o de!t is ? percent. he corporate ta# rate is 22 percent. +hat is the irm's unlevered cost o e(uity capital, . 1*.2= percent ". 1*.9? percent C. 12.6= percent &. 13.17 percent ). 13.34 percent +ACC Q 7.17 Q ;1*.3< E )  ;1.3*.3< ;7.7?< ;1 - 7.22< E ) Q 7.1444= E ) Q 7.1444= Q E G  ;E G - 7.7?<;1.3<;1 - 7.22< E G Q 1*.2= percent

AACSB: Analytic Bloom's: Analysis Difficulty: Basic >OC G: "#$"& Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition .. wit3 ta2es

?9. "ruce  Co. e#pects its )"/ to !e 1778777 every year orever. he irm can !orro% at 17 percent. "ruce currently has no de!t8 and its cost o e(uity is *7 percent. he ta# rate is 21 percent. +hat %ill the value o "ruce  Co. !e i the irm !orro%s 438777 and uses the loan proceeds to repurchase shares, A. *=78127 ". 2368677 C. 2618937 &. 29=8?77 ). 2=184*7 G Q 1778777 ;1 - 7.21<7.*7  Q 2348777 L Q 2348777  7.21;438777< Q 2618937

AACSB: Analytic Bloom's: A((lication Difficulty: Basic >OC G: "#$"1 Learning Obecti!e: "#$& Section: "#%1 o(ic: +,+ -ro(osition . wit3 ta2es

16-96

Chap 016

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