Ch-124

Chapter 12—Capital Structure MULTIPLE CHOICE 1. The uncertainty caused by the variability of a firm’s cash flows is called . . . a. financial risk b. business risk c. financial leverage d. none of the above ANS: B DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions 2. Which of the following is considered an indirect cost of bankruptcy? a. document printing expenses b. professional fees paid to lawyers c. loss of key employees d. none of the above ANS: C DIF: E REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 3. Which of the following is considered a direct cost of bankruptcy? a. diversion of management’s time b. constrained capital investment spending c. lost sales d. none of the above ANS: D DIF: E REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 4. A situation where shareholders refuse financing a “good” investment, because they think that only the bondholders will benefit will lead to . . . a. asset substitution b. underinvestment c. overinvestment d. none of the above ANS: B DIF: E REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 5. The proposition that the market value of the firm is independent of its capital structure is called . . . a. M&M proposition I b. M&M proposition II c. the capital asset pricing model d. none of the above ANS: A DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NARRBEGIN: Bavarian Brew Bavarian Brew

Bavarian Brew, an unlevered firm, has an expected EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock. NARREND 6. What is the value of Bavarian Brew before restructuring? Assume no corporate taxes. a. $500,000 b. $5,000,000 c. $1,000,000 d. $3,300,000 ANS: B $500,000/.10 = $5,000,000 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew 7. What is the value of Bavarian Brew before restructuring? Assume a corporate tax rate of 34%. a. $5,000,000 b. $500,000 c. $3,300,000 d. $1,000,000 ANS: C 5000,000(1-.34)/.10 = $3,300,000 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew 8. What is the value of Bavarian Brew after restructuring. Assume no corporate taxes. a. $3,300,000 b. $5,000,000 c. $500,000 d. $1,000,000 ANS: B 500,000/.10 + 0 = $5,000,000 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew 9. What is the value of Bavarian Brew after restructuring? Assume corporate taxes of 34%. a. $5,000,000 b. $5,340,000 c. $3,300,000 d. $1,000,000 ANS: B 500,000/.10 + 1,000,000(.34) = $5,340,000 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew

10. What is the present value of Bavarian Brew’s debt tax shield after the restructuring? Assume corporate taxes of 34%. a. $340,000 b. $1,000,000 c. $660,000 d. $0 ANS: A 1,000,000(.34) = $340,000 DIF: E REF: The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Bavarian Brew 11. What is Bavarian Brew’s required return on equity before the restructuring. Assume no corporate taxes. a. 10% b. 6% c. 11% d. 12% ANS: A .10 + (.10-.06)(0/5,000,000) = .10 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew 12. What is the Bavarian Brew’s required return on levered equity after the restructuring? a. 10.25% b. 10.92% c. 6.00% d. 12.75% ANS: B .10 + (.10-.06)(1,000,000/4,340,000) = .1092 DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NAR: Bavarian Brew 13. What is the value of Bavarian Brew after the restructuring, if the PV of bankruptcy cost is $750,000? Assume a corporate tax rate of 34%. a. $5,000,000 b. $5,340,000 c. $4,590,000 d. $4,250,000 ANS: C 500,000/.10 + 1,000,000(.34) - $750,000 = $4,590,000 DIF: E REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage NAR: Bavarian Brew 14. Refer to Bavarian Brew. What is the PV of bankruptcy costs for which the company is indifferent about the proposed change in capital structure? a. $450,000

b. $750,000 c. $340,000 d. $275,000 ANS: C there are indifferent when the debt tax shield = PV of bankruptcy costs 1,000,000(.34) = $340,000 DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage NAR: Bavarian Brew 15. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition the personal tax rate on dividends for investors is 15% and the personal income tax on interest income equals 40%. a. $340,000 b. $65,000 c. $150,000 d. $400,000 ANS: B 1-{(1-.034)(1-.15)/(1-.4)}(1,000,000) = 65,000 DIF: E REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Bavarian Brew 16. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition, assume that the personal tax rate on interest income equals 40% and that there is no tax on dividend income. a. -$100,000 b. $100,000 c. $340,000 d. -$340,000 ANS: A {1-(1-.34)(1-0)/(1-.4)}(1,000,000) = -$100,000 DIF: M REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Bavarian Brew 17. Refer to Bavarian Brew. If the corporate tax rate equals 34% and dividend income is tax free, at which personal tax rate on interest income is there no gain from leverage? a. 34% b. 40% c. 15% d. 0% ANS: A 1-(1-.34)(1-0)/(1-t) = 0 t = .34 DIF: M REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes

NAR: Bavarian Brew 18. Refer to Bavarian Brew. If the corporate tax rate equals 34% and the personal tax rate on interest income equals 40%, for which tax rate on dividend income is the gain from leverage equal to zero? a. 15.2% b. 9.1% c. 12.6% d. 6.6% ANS: B 1-(1-.34)(1-t)/(1-.4) = 0 t = .0909 DIF: H REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Bavarian Brew NARRBEGIN: Bavarian Brew EPS Bavarian Brew EPS Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase 50,000 shares of outstanding stock. NARREND 19. Calculate Bavarian Brew’s earnings per share after the restructuring. Assume no corporate taxes. a. $2.20 b. $2.50 c. $2.00 d. $2.25 ANS: A 500,000 - (1,000,000)(.06)/200,000 = 2.20 DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It? NAR: Bavarian Brew EPS 20. What are Bavarian Brew’s earnings per share before the restructuring Assume corporate taxes of 34% a. $1.32 b. $1.35 c. $1.42 d. $1.45 ANS: A 500,000(1-.34)/250,000 = 1.32 DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It? NAR: Bavarian Brew EPS 21. What are Bavarian Brew’s earnings per share before the restructuring? Assume no corporate taxes. a. $2.50 b. $2.25 c. $2.00 d. $1.75

ANS: C 500,000/250,000 = 2.00 DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It? NAR: Bavarian Brew EPS 22. What are Bavarian Brew’s earnings per share after the restructuring? Assume corporate taxes of 34%. a. $1.32 b. $1.35 c. $1.42 d. $1.45 ANS: D [(500,000-60,000)(1-.34)]/200,000 = 1.45 DIF: M REF: 12.1 What is Financial Leverage, and Why Do Firms Use It? NAR: Bavarian Brew EPS 23. If a company issues $25,000 worth of debt and has a corporate tax rate of 40%, what is the PV of the debt tax shield? a. $25,000 b. $10,000 c. $15,000 d. $20,000 ANS: B 25,000(.4) = 10,000 DIF: E REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NARRBEGIN: Miller’s Drugstore Miller’s Drugstore Miller’s drugstore has an EBIT of $15,000, debt with a market value of $25,000 and a required return on assets of 12%. NARREND 24. Assuming no taxes, what is Miller’s Drugstore’s value? a. $15,000 b. $125,000 c. $25,000 d. $75,000 ANS: B 15,000(1-0)/.12 + 25,000(0) = $125,000 DIF: E REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Miller’s Drugstore 25. Assuming a corporate tax rate of 35%, what is Miller’s Drugstore’s value? a. $125,000 b. $25,000 c. $133,750 d. $75,000

ANS: C 15,000/.12 + 25,000(.35) = 133,750 DIF: E REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes NAR: Miller’s Drugstore 26. State Company had determined its earnings before interest and taxes (EBIT) in four possible states of the world. In the Great State, EBIT will be $3,000,000 and in the Good, Normal and Poor States EBIT will be $2,000,000, $1,500,000, and $1,000,000 in that order. If each state has an equal probability of occuring, then what is State Company’s expected EBIT? a. $3,000,000 b. $2,500,000 c. $1,875,000 d. none of the above ANS: C .25(3,000,000 + 2,000,000 + 1,500,000 + 1,000,000) = 1,875,000 DIF: E

REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?

27. If a firm increases its use of financial leverage, then what would we generally expect for the effect of that increased leverage to have on the dispersion of the firm’s Net Income distribution? a. less dispersion b. no effect on dispersion c. greater dispersion d. there is not enough information to determine ANS: C DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It? 28. If a firm increases its financial leverage, then what would we generally expect for the effect of that increased leverage on EPS to be if the firm’s EPS is already quite high? a. EPS would be lower with financial leverage b. EPS would always be the same with financial leverage c. EPS would be higher with financial leverage d. it is not possible to determine ANS: C

DIF: E

REF: 12.1 What is Financial Leverage?

29. If a firm increases its use of financial leverage, then what would we generally expect for the effect of that increased leverage to have on an EPS that is already very low? a. EPS would be lower with financial leverage b. EPS would always be the same with financial leverage c. EPS would be higher with financial leverage d. it is not possible to determine ANS: A

DIF: E


30. If a firm increases its use of financial leverage, then what would we generally expect for the shareholders of that firm to a. lower their demand for return on their investment. b. remain indifferent with respect to their return on investment. c. increase their demand for return on their investment.

d. it is not possible to tell what will happen. ANS: C

DIF: M


31. Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase equity. If you assume that the Modigliani and Miller assumptions hold then the effect of this increasing financial leverage transaction should a. increase the market value of Firm X’s shares. b. have no effect on the market value of Firm X’s shares. c. decrease the market value of Firm X’s shares. d. it is not possible to tell what will happen. ANS: B

DIF: M


32. Perfect capital markets describe markets without frictions such as a. taxes. b. trading costs. c. problems transferring information between managers and investors. d. all of the above. ANS: D DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions 33. In a world without taxes, distress costs, or agency problems, calculate the value of Lever Co. if its perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s cost of debt is 5% and its required return on firm’s assets is 10%. a. $19,800,000 b. $10,000,000 c. $9,900,000 d. none of the above ANS: B 1,000,000 / .1= 10,000,000 DIF: M

REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

34. Roy’s Toy, Inc. currently has no debt outstanding. Its current cost of equity is 12% and the current value of the company is $20,000,000. Roy is proposing to finance 1/4 of its assets with debt at a cost of 8% per annum. What will be Roy’s cost of levered equity if things go as planned? Ignore any tax effects. a. 12.00% b. 13.00% c. 13.33% d. none of the above ANS: C Current cost of equity = return on assets rl = r + (r - rd)(D/E) ====> rl = .12 + (.12 - .08)(5,000,000 / 15,000,000) = .1333 DIF: H


35. Nuclear Widgets has a current cost of levered equity equal to 13%. Its’ return on assets is 12% and its cost of debt is 8%. Nuclear widgets has borrowed a total of $5,000,000. What is the current value of Nucler Widgets equity? Ignore the effect of taxes.

a. b. c. d.

$1,250,000 $20,000,000 the problem yields a negative number which means the problem is not realistic not enough information is given

ANS: B rl = r + (r - rd)(D/E) ====> .13= .12 + (.12 - .08)(5,000,000 / E) = =====> E = 20,000,000 DIF: H


36. A newly appointed CFO of a company tells you that he needs to determine the required return on unlevered equity should his firm completely delever. He further tells you that the required return on assets is 10% and that his cost of debt is 3% based upon a current borrowed amount of $50,000,000 but he doesn’t know the market value of his equity. What is the required retun on equity should his firm eliminate all of its debt? a. 10.0% b. 11.5% c. 13.0% d. it is impossible to tell ANS: A rl = r + (r - rd)(D/E) ====> rl= .10+ (.10 - .03)(0 / E) = .1 DIF: M


37. In a world without distress costs or agency problems, calculate the value of Bilever Co. if its perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s cost of debt is 5% and its required return on firm’s assets is 10%. Assume that Bilever is in the 30% marginal tax rate a. $14,000,000 b. $7,000,000 c. $5,600,000 d. none of the above ANS: B (1,000,000  .7) / .1 = 7,000,000 DIF: M

REF: 12.3 Capital Structure with Corporate and Personal Taxes

38. Big Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Big can issue the debt to yield 8% per year, then what is the increase in value to Big if it issues the debt and is subject to a 34% marginal tax rate? a. $136,000 b. $400,000 c. $1,700,000 d. none of the above ANS: C 5,000,000  .34 = 1,700,000 DIF: M


39. Large Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Large can issue the debt to yield 8% per year, then what is the single year increase in cash flow to Large if it issues the debt and is subject to a 34% marginal tax rate? a. $136,000 b. $400,000 c. $2,720,000 d. none of the above ANS: A 5,000,000  .08  .34 = 136,000 DIF: M


40. If we start with the M&M perfect capital markets assumption and then relax the no tax assumption on corporations, then we would expect for firms that go from no leverage to some leverage to a. have the levered version of the firm at least as valuable as the no-leverage firm. b. have the no-leverage version of the firm at least as valuable as the levered firm. c. change in value depending upon the level of personal taxes. d. none of the above. ANS: A DIF: M REF: 12.3 Capital Structure with Corporate and Personal Taxes 41. You need to calculate the gains from using $1,000,000 of additional leverage on the average company in the U.S. economy. You are told that the average investors personal tax rate on income from stock is 15% and that investors can generally avoid personal taxes on income from debt. You are also told that the average corporation is subject to the 35% marginal corporate tax rate. What is the benefit to firm value for this additonal debt load? a. $650,000 b. $447,500 c. $350,000 d. none of the above ANS: B GL = [ 1- {(1-Tc)(1-Tps)/(1-Tpd)}]  D = [ 1- {(1-.35)(1-.15)/(1-0)}]  1,000,000 = 447,500 DIF: H


42. On-the-Fence Co. (OTF) is considering issuing an additional $5,000,000 perpetual debt. It is subject to a 35% marginal corporate tax rate but is being told that the costs of financial distress on that additional debt is $1,000,000. What should OTF do? a. Do not issue the debt b. Issue the debt c. It doesn’t matter what it does as M&M with perfect markets holds d. none of the above ANS: B PV of Tax shield: 5,000,000  .35 = 1,750,000 Less costs of financial disress = 1,000,000 equals the additional value = 750,000 ====> issue the debt DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

43. Costs associated with the requirement that management divert its attention away from strategically managing a corporation in favor of spending time with financial attorneys could be best described as a. direct bankruptcy costs. b. indirect bankruptcy costs. c. mangerial-shareholder related agency costs. d. none of the above. ANS: B DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 44. Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget manufacturing plant. Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas. Which of the following best describes the general problem that Y’s investors must deal with? a. The Underinvestment Problem b. The Overinvestment Problem c. The Asset Substitution Problem d. The Enron Problem ANS: C DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 45. Lord Brack has recently sold 90% of his company to the general public but he remains the CEO of the firm. Unfortunately, the Lord prefers to each $1,000 lunches in the corporate dining room (for which he does not reimburse the company). What is Lord Brack’s cost of these lunches? a. $1,000 b. $900 c. $100 d. none of the above ANS: C DIF: H REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 46. Molotov Cranberry Cocktail Corp finds that the value of the firm is equal to $100,000,000 with no debt. It knows that if it issues new debt, the value of the tax shield will be $3,000,000 while the value of the bankruptcy costs, outside agency costs and inside agency costs will be $1,000,000, $2,000,000, and $4,000,000 in that order. What will the value of Molotov be if it issues the debt? a. $0 b. $96,000,000 c. $100,000,000 d. none of the above ANS: C 100MM + 3MM -1MM + 2MM - 4MM= 100MM DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 47. Fidget Inc. is currently worth $10,000,000. It is told that if it issues $1,000,000 of perpetual debt (and uses the proceeds to repurchase equity) the value of the firm will increase by $290,000. If the total bankruptcy costs and agency costs combine to be a cost of $20,000, what is Fidget’s marginal corporate tax rate? Ignore personal taxes. a. 29% b. 30% c. 31%

d. none of the above ANS: C 290,000 = (1,000,000  Tc) - 20,000 Tc = .31 DIF: M REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 48. You are evaluating a company and have found a new way to calculate the present value of bankruptcy costs, agency costs of outside equity as well as debt. You find that the agency costs of outside equity is $100 while the agency cost of outside debt is $1,000,000. The costs of bankruptcy are also $1,000,000. What type of firm does most likely describe? a. a firm with too little leverage b. a firm with too much leverage c. a firm with too much equity d. a firm that should disregard its agency costs ANS: B DIF: H REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage 49. If you were to look at leverage for companies in a country where the there is a very high cost of attorneys and accountants, all other things being equal you would expect a. that firms in those countries would utilized less leverage than in other countries. b. that firms in those countries would utilized more leverage than in other countries. c. that firms in those coutnries would utilize no leverage. d. that firms in those countries would utilize as much leverage as is mathematically possible. ANS: A DIF: H REF: 12.5 Patterns Observed in Corporate Capital Structures 50. DebtCo. has $100,000,000 of perpetual debt outstanding with a cost of 9%. DebtCo. is currently subject to a 30% marginal tax rate. If a new president is elected who suprisingly announces that firm’s like DebtCo. will now be subject to a 35% marginal tax rate, what should be the effect of the immediate value change on DebtCo.? a. -$35,000,000 b. -$5,000,000 c. $5,000,000 d. $35,000,000 ANS: C Old value: 100,000,000  .3 = 30,000,000 New value: 100,000,000  .35 = 35,000,000 Change in value: 5,000,000 DIF: M

REF: 12.5 Patterns Observed in Corporate Capital Structures

NARRBEGIN: Kennesaw Steel Corp. Kennesaw Steel Corporation

As Chief Financial Officer of the Kennesaw Steel Corporation (KSC), you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage. KSC now has 100,000 shares of common stock outstanding, which are selling for $50.00 each, and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock. NARREND 51. Refer to Kennesaw Steel Corporation. What is the new debt-to-equity ratio if the recapitalization is completed? (assume that the stock can be repurchased at $50 per share) a. 1.50 b. 1.00 c. 0.67 d. 0.33 ANS: C Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000 D/E = $2,000,000/$3,000,000 = 0.67 DIF: E


NAR: Kennesaw Steel Corp.

52. Refer to Kennesaw Steel Corporation. How many shares will be left outstanding after the recapitalization? (assume that the stock can be repurchased at $50 per share) a. 60,000 b. 50,000 c. 45,000 d. 40,000 ANS: A Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000 # of shares = $3,000,000 / $50 = 60,000 DIF: M



53. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What level of EBIT will earnings per share equal zero for shareholders under the new capital structure? (assume that the stock can be repurchased at $50 per share) a. $0 b. $60,000 c. $120,000 d. $160,000 ANS: D

Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000) After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000 # of shares = $3,000,000 / $50 = 60,000 EPS = $0 = ($X - $160,000) * (1-.40) = $0 ; X=$160,000 DIF: M



54. Refer to Kennesaw Steel Corporation. The tax rate is 40%. At what level of EBIT will earnings per share be equal for shareholders under each capital structure? (assume that the stock can be repurchased at $50 per share) a. $350,000 b. $400,000 c. $450,000 d. $500,000 ANS: B Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000) After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000 # of shares = $3,000,000 / $50 = 60,000 BREAKEVEN = ($X - $0)* (1-.4) / 100,000 = ($X - $160,000)* (1-.4) / 75,000 X = $400,000 DIF: M



55. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What is the earnings per share under the new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share) a. $4.40 b. $4.20 c. $4.00 d. $3.80 ANS: A Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000) After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000 # of shares = $3,000,000 / $50 = 60,000

NI: ($600,000 - $160,000)*(1-.40) = $264,000 EPS = $264,000 / 60,000 = $4.40 DIF: M



56. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What is the return on equity under the new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share) a. 7.4% b. 8.1% c. 8.8% d. 9.5% ANS: C Before re-capitalization: Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000) After: Equity = $5,000,000 - $2,000,000 = $3,000,000 Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000 # of shares = $3,000,000 / $50 = 60,000 NI: ($600,000 - $160,000)*(1-.40) = $264,000 Shareholder equity = 60,000 * $50 = $3,000,000 ROE = 8.8% DIF: M



57. Which statement is TRUE regarding a firm that increases financial leverage? a. Average earnings per share increases, while shareholder risk increases. b. Average earnings per share increases, while shareholder risk decreases. c. Average earnings per share decreases, while shareholder risk decreases. d. Average earnings per share decreases, while shareholder risk increases. ANS: A

DIF: E


58. The Globe Incorporated has EBIT of $20 million for the current year. On the firm balance sheet, there is $80 million of debt outstanding that carries a coupon rate of 8 percent. Investors seek a return of 12 percent on the firm, and the firm has a corporate tax rate of 40%. What is the value of the firm? a. $124,000,000 b. $128,000,000 c. $132,000,000 d. $136,000,000 ANS: C EBIT INT EBT Taxes NI + Interest Available to Investors

$80*8% at 40%

LEVERED $20,000,000 $ 6,400,000 $13,600,000 $ 5,440,000 $ 8,160,000 $ 6,400,000 $14,560,000

UNLEVERED $20,000,000 $ 0 $20,000,000 $ 8,000,000 $12,000,000 $ 0 $12,000,000

PV of Tax Shield = $80,000,000*0.40 = $32,000,000 Value of Unlevered Firm = $12,000,000/.12 = $100,000,000 Value of Levered Firm = $100,000,000+$32,000,000 DIF: H


59. The Globe Incorporated has EBIT of $30 million for the current year. On the firm balance sheet, there is $90 million of debt outstanding that carries a coupon rate of 9 percent. Investors seek a return of 12 percent on the firm, and the firm has a corporate tax rate of 40%. What is the value of the firm? a. $152,000,000 b. $160,000,000 c. $174,000,000 d. $186,000,000 ANS: D EBIT INT EBT Taxes NI + Interest Available to Investors

$80*8% at 40%

LEVERED $30,000,000 $ 8,100,000 $21,900,000 $ 8,760,000 $13,140,000 $ 8,100,000 $21,240,000

UNLEVERED $30,000,000 $ 0 $30,000,000 $12,000,000 $18,000,000 $ 0 $18,000,000

PV of Tax Shield = $90,000,000*0.40 = $36,000,000 Value of Unlevered Firm = $18,000,000/.12 = $150,000,000 Value of Levered Firm = $150,000,000+$36,000,000 DIF: H


60. The Globe Incorporated has EBIT of $20 million for the current year. On the firm balance sheet, there is $80 million of debt outstanding that carries a coupon rate of 8 percent. Investors seek a return of 12 percent on the firm, and the firm has a corporate tax rate of 40%. What is the present value of the firm’s tax shields? a. $32,000,000 b. $30,000,000 c. $24,000,000 d. $6,400,000 ANS: A PV of Tax Shield = $80,000,000*0.40 = $32,000,000 DIF: E


61. TransMetro Incorporated has EBIT of $1 million for the current year. On the firm balance sheet, there is $6 million of debt outstanding that carries a coupon rate of 15 percent. Investors seek a return of 20 percent on the firm, and the firm has a corporate tax rate of 40%. What is the present value of the firm’s tax shields? a. $2,000,000 b. $2,200,000 c. $2,400,000 d. $2,700,000 ANS: C

PV of Tax Shield = $6,000,000*0.40 = $2,400,000 DIF: E


62. Which statement correctly describes proposition I of Modigliani and Miller? a. The value of the firm is independent of its capital structure. b. If there is no default risk, firms should exclusively use debt to finance projects. c. If there is no default risk, firms should exclusively use equity to finance projects. d. The value of the firm’s tax shields depends solely on the amount of debt issued. ANS: A DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions 63. Lightyear Technology Corporation finances its operations with $75 million in stock with a required return of 12 percent and $45 million in bonds with a required return of 8 percent. Suppose the firm issues $15 million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of equity. What will be the firm’s new debt to equity ratio? (Assume zero taxes and perfect capital markets) a. 0.75 b. 0.90 c. 1.00 d. 1.10 ANS: C Debt Total = $45+$15=$60 Equity = $75-$15 = $60 D/E = 1 DIF: E


64. Burdell Scientific Incorporated finances its operations with $40 million in stock with a required return of 12 percent and $10 million in bonds with a required return of 6 percent. Suppose the firm issues $15 million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of equity. If the WACC remains the same, what will be the firm’s new cost of equity? (Assume zero taxes and perfect capital markets) a. 15.60% b. 15.00% c. 14.40% d. 13.80% ANS: C Old WACC: Rs = R + (R - Rd) * D/E = .12 = R + (R - .06) * $10/$40 .12 = R + .25 R - .015 R = (.12+.015)/1.25 = .1080 New Rs: Rd = $10/$25*.06+$15/$25*.08=.072 Rs = R + (R - Rd) * D/E Rs = .1080 + (.1080 - .072) * $25/$25 = .1080 + .036 = .144 DIF: M


65. Bulldog Electronics Corporation finances its operations with $75 million in stock with a required return of 12 percent and $45 million in bonds with a required return of 8 percent. Suppose the firm issues $15 million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of equity. If the WACC remains the same, what will be the firm’s new cost of equity? (Assume zero taxes and perfect capital markets) a. 12.50% b. 13.00% c. 14.00% d. 14.40% ANS: B Old WACC: Rs = R + (R - Rd) * D/E = .12 = R + (R - .08) * $45/$75 .12 = R + .6 R - .048 R = (.12+.048)/1.6 = .1050 New Rs: Rs = R + (R - Rd) * D/E Rs = .1050 + (.1050 - .08) * $60/$60 = .1050 + .025 = .13 DIF: M


66. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; and the corporate tax rate is 40 percent. What is the gain from leverage if the personal tax rate on stock income is 20 percent and the personal tax rate on debt income is 30 percent? a. $22.34 million b. $23.77 million c. $24.63 million d. $25.14 million ANS: D PV of tax shield = $80*.40=$32 million Value of unlevered firm = NI/r = $10 million * (1-.40) / .11 = $6/.11 = $54.55 million Value of levered firm = $54.55 + $32 = $86.55 million Gain from leverage = (1 - ((1-.4)*(1-.2)/(1-.3)))*$80 = $25.14 million DIF: M

REF: 12.3 The M&M Model with Personal and Corporate Taxes

67. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 12 percent; and the corporate tax rate is 35 percent. What is the gain from leverage if the personal tax rate on stock income is 15 percent and the personal tax rate on debt income is 30 percent? a. $22.34 million b. $19.41 million c. $16.86 million d. $12.19 million ANS: C PV of tax shield = $80*.35=$28 million Value of unlevered firm = NI/r = $10 million * (1-.35) / .12 = $6.5/.12 = $54.17 million Value of levered firm = $54.17 + $28 = $82.17 million Gain from leverage = (1 - ((1-.35)*(1-.15)/(1-.3)))*$80 = $16.86 million

DIF: M


68. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; and the corporate tax rate is 40 percent. What is the value of the Oak Barrel Company? a. $86.55 million b. $83.77 million c. $81.46 million d. $72.28 million ANS: A PV of tax shield = $80*.40=$32 million Value of unlevered firm = NI/r = $10 million * (1-.40) / .11 = $6/.11 = $54.55 million Value of levered firm = $54.55 + $32 = $86.55 million DIF: M


69. Which statement is FALSE regarding empirical evidence of capital structures? a. Capital structures show strong industry patterns. b. Economy wide leverage ratios are consistent across countries. c. Leverage ratios are negatively related to the cost of financial distress. d. Within industries, the most profitable companies borrow the least. ANS: B DIF: H REF: 12.3 The M&M Model with Personal and Corporate Taxes 70. In a world with only company-level taxation of operating profits, no costs of bankruptcy, and taxdeductible interest payments, what is the optimal corporate strategy? a. The firm should use all equity to maximize firm value. b. The firm should use all debt to maximize its value. c. The firm’s value is independent of the way it is financed. d. The firm should maximize the use of preferred stock to create value. ANS: B DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions NARRBEGIN: ABC Corporation ABC Corporation ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity. The debt has a coupon rate of 10%, while the industry return on equity is 15%. ABC Corporation is unsure of the state of the economy in the next year. The tax rate facing the company is 40%. State of the Economy EBIT Probability

BAD $2,000,000 0.40

GOOD $5,000,000 0.40

GREAT $10,000,000 0.20

NARREND 71. Refer to ABC Corporation. Given the information in the table, what is the expected earnings per share if the company has 1 million shares outstanding? a. $1.44 b. $1.56

c. $1.68 d. $1.78 ANS: C Interest payment = $20*.10 = $2 million NI (bad) = ($2-$2)*(1-.4) = $0 NI (good) = ($5-$2)*(1-.4) = $1.8 million NI (great) = ($10 - $2)*(1-.4) = $4.8 million Expected EPS = ($0*.4+$1.8*.4+$4.8*.2)/1 = $1.68 DIF: M


NAR: ABC Corporation

72. Refer to ABC Corporation. The company is considering the issue of $10 million in new debt at a rate of 10%. The funds from the new debt will be used to retire $10 million in equity. Currently, there are 1 million shares outstanding trading at $40 per share. Assuming the stock price will remain the same, what is the expected earnings per share in the next year if the company goes through with the recapitalization? a. $1.32 b. $1.56 c. $1.68 d. $1.76 ANS: D Re-capitalize: Total Debt = $20 + $10 = $30 # of shares = $30 million / $40 per share = 750,000 Interest payment = $30*.10 = $3 million NI (bad) = ($3-$3)*(1-.4) = $0 NI (good) = ($5-$3)*(1-.4) = $1.2 million NI (great) = ($10 - $3)*(1-.4) = $4.2 million Expected EPS = ($0*.4+$1.2*.4+$4.2*.2)/.75 = $1.76 DIF: H


NAR: ABC Corporation

73. Which statement is FALSE concerning capital structure? a. Firms with large amounts of tangible assets tend to use a lot of debt in their capital structures. b. When corporate profits are taxed at the corporate and personal level, the benefits of leverage are greatly reduced. c. Modern trade off theory predicts that a firm’s optimal debt level is set by trading off the tax benefits of leverage against the agency costs of increased debt. d. Debt is used more frequently abroad (such as Germany and England) as international laws tend to favor debtors. ANS: D DIF: M REF: 12.3 The M&M Model with Personal and Corporate Taxes NARRBEGIN: Exhibit 12-1 Exhibit 12-1 An all-equity firm has 80,000 shares outstanding worth $20 each. The firm is considering a project requiring an investment of $500,000 and has an NPV of $30,000. The company is also considering financing this project with a new issue of equity.

NARREND 74. Refer to Exhibit 12-1. What is the price at which the firm needs to issue the new shares so that the existing shareholders are indifferent to whether the firm takes on the project with this equity financing or does not take on the project? a. $18.44 b. $18.87 c. $19.71 d. $20.00 ANS: B Old firm value = $20*80,000 = $1,600,000 New value of the firm = Old firm value + new assets + NPV of project =$1,600,000 + $500,000 + $30,000 = $2,130,000 =2,130,000 = 1,600,000 + $20 * X X = 26,500 shares $500,000 needed / 26,500 shares = $18.87 DIF: H REF: 12.4 Costs of Bankruptcy and Financial Distress NAR: Exhibit 12-1 75. Refer to Exhibit 12-1. What is the price at which the firm needs to issue the new shares so that the existing shareholders capture the full benefit associated with the new project? a. $20.48 b. $20.38 c. $20.15 d. $20.07 ANS: B Old firm value = $20*80,000 = $1,600,000 New value of the firm = Old firm value + new assets + NPV of project =$1,600,000 + $500,000 + $30,000 = $2,130,000 $30,000 in NPV means shareholders capture $30,000/80,000 = $.375 per shareholder Issue at $20.375 DIF: H REF: 12.4 Costs of Bankruptcy and Financial Distress NAR: Exhibit 12-1

Ch-124

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