Question 1

(The following data apply to Problems 26 through 28. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
-According to the MM extension with growth, what is Gomez's value of equity?
A) $1,492,000
B) $1,529,300
C) $1,567,533
D) $1,606,721
E) $1,646,889

Accepted Answer

The answer of (The following data apply to Problems 26...

Question 2

What is the yield on Trumbull's debt?
A) 6.04%
B) 6.36%
C) 6.70%
D) 7.05%
E) 7.42%

Accepted Answer

The answer of What is the yield on Trumbull's debt?
A)...

Question 3

(The following data apply to Problems 26 through 28. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
-According to the MM extension with growth, what is Gomez's unlevered value?
A) $1,296,000
B) $1,440,000
C) $1,600,000
D) $1,760,000
E) $1,936,000

Accepted Answer

To find the unlevered value of Gomez, we first need to find the required rate of return on equity, which we can do using the CAPM:

k_e = R_f + β(R_m - R_f) = 0.08 + 1.5(0.09 - 0.08) = 0.11 or 11%

Next, we need to find the net operating income for next year:

NOI = EBIT(1 - Tax rate) = $200,000(1-0.4) = $120,000

Then we can calculate the amount of net operating assets that must be reinvested:

Reinvestment = 20% × EBIT = 0.2 × $200,000 = $40,000

Using the DuPont formula, we can find the return on net operating assets:

ROA = EBIT/Net Operating Assets

Net Operating Assets = EBIT/ROA

ROA = EBIT/(Net Operating Assets)

0.06 = $200,000/(Net Operating Assets)

Net Operating Assets = $200,000/0.06 = $3,333,333.33

Reinvestment = Net Income - Dividends

$40,000 = NOI - (Net Income)(1 - Debt %)

We know that Gomez has $300,000 in 8% debt outstanding, which is 30% of its capital structure. Therefore:

$40,000 = $120,000 - (Net Income)(1 - 0.3)

Net Income = $73,333.33

Now we can use the constant-growth DDM formula to find the unlevered value of Gomez:

Unlevered Value = (NOPLAT × (1 - g)) / (k_e - g)

where NOPLAT is net operating profit less adjusted taxes:

NOPLAT = EBIT × (1 - tax rate) = $200,000 × (1 - 0.4) = $120,000

Plugging in the numbers:

Unlevered Value = ($120,000 × (1-0.06)) / (0.11 - 0.06) = $1,600,000

Therefore, the answer is C, $1,600,000.

Question 4

(The following data apply to Problems 23 through 25. The problems MUST be kept together.)
The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
-What is the firm's cost of equity?
A) 21.0%
B) 23.3%
C) 25.9%
D) 28.8%
E) 32.0%

Accepted Answer

The answer of (The following data apply to Problems 23...

Question 5

What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?
A) $167.57
B) $186.19
C) $204.81
D) $225.29
E) $247.82

Accepted Answer

The answer of What is the value (in millions) of...

Question 6

(The following data apply to Problems 29 through 31. The problems MUST be kept together.)
Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility () of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.
-What is the value (in millions) of Trumbull's equity if it is viewed as an option?
A) $228.77
B) $254.19
C) $282.43
D) $313.81
E) $345.19

Accepted Answer

The answer of (The following data apply to Problems 29...

Question 7

Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
A) 16.4%
B) 18.2%
C) 20.2%
D) 22.5%
E) 25.0%

Accepted Answer

The answer of Assume that the firm's gain from leverage...

Question 8

(The following data apply to Problems 26 through 28. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
-According to the MM extension with growth, what is the value of Gomez's tax shield?
A) $156,385
B) $164,616
C) $173,280
D) $182,400
E) $192,000

Accepted Answer

The answer of (The following data apply to Problems 26...

Question 9

(The following data apply to Problems 23 through 25. The problems MUST be kept together.)
The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
-What is the value of the firm according to MM with corporate taxes?
A) $475,875
B) $528,750
C) $587,500
D) $646,250
E) $710,875

Accepted Answer

According to MM with corporate taxes, the value of a levered firm equals the value of an unlevered firm plus the present value of the tax shield. The value of the unlevered firm is calculated using the WACC of the unlevered firm, which is 16.0%.

Value of unlevered firm = EBIT / WACC
= $100,000 / 16.0%
= $625,000

The value of the tax shield is calculated as follows:

Value of tax shield = Present value of tax shield
= [Tax rate x Debt] / WACC
= [0.30 x $500,000] / 0.16
= $187,500

Therefore, the total value of the levered firm is:

Value of levered firm = Value of unlevered firm + Value of tax shield
= $625,000 + $187,500
= $812,500

Hence, the correct choice is C.

Question 10

Your firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is the value of your firm's tax shield, i.e., how much value does the use of debt add?
A) $92,571
B) $102,857
C) $113,143
D) $124,457
E) $136,903

Accepted Answer

Firstly, we need to calculate the cost of equity for our firm using the MM formula with growth:
Re = R0 + (1-T) * (D/E) * (R0 - Rb) + g
Where,
Re = Cost of equity for our firm
R0 = Cost of equity for the unlevered firm (given as 12%)
T = Tax rate (given as 40%)
D/E = Debt-to-equity ratio (200,000/300,000 = 0.67)
Rb = Cost of borrowing (given as 9%)
g = Growth rate (given as 5%)

Plugging in the values, we get:
Re = 12% + (1-0.4) * (0.67) * (12% - 9%) + 5%
Re = 15.14%

Next, we need to calculate the value of the unlevered firm. Using the formula:
Vu = E / Re
Where,
Vu = Value of the unlevered firm
E = Equity value (given as $300,000)
Re = Cost of equity for the unlevered firm (calculated as 15.14%)

Plugging in the values, we get:
Vu = 300,000 / 15.14%
Vu = $1,980,861

Now, we can calculate the value of the levered firm using the formula:
Vl = Vu + Tc * D
Where,
Vl = Value of the levered firm
Tc = Tax shield (to be calculated)
D = Debt value (given as $200,000)

Plugging in the values, we get:
Vl = 1,980,861 + 0.4 * 200,000
Vl = $2,058,861

Finally, we can calculate the value of the tax shield as the difference between the value of the levered firm and the value of the unlevered firm:
Tc = Vl - Vu
Tc = 2,058,861 - 1,980,861
Tc = $78,000

Therefore, the value of the tax shield is $78,000, which corresponds to answer choice B.

Question 11

Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what would Firm L's total value be if it had no debt?
A) $358,421
B) $377,286
C) $397,143
D) $417,000
E) $437,850

Accepted Answer

First, we need to calculate the cost of equity for Firm L using the CAPM formula:

cost of equity = risk-free rate + beta * market risk premium 
Assuming a risk-free rate of 3%, a market risk premium of 7%, and a beta of 1.2 (based on industry averages), we get:

cost of equity = 3% + 1.2 * 7% = 11.4%

Next, we can use the MM extension with growth formula to calculate the total value of Firm L if it had no debt:

VU = VL + TC * D 
where VU = total value of the unlevered firm, VL = total value of the levered firm, TC = corporate tax rate, and D = market value of debt

We can use the following formula to calculate the total value of the levered firm:

VL = VU + D

First, let's calculate the value of the levered firm:

VL = ($300,000 / 0.12) + $200,000 = $2,500,000

Next, let's calculate the value of the unlevered firm:

VU = VL - TC * D 
= $2,500,000 - 0.4 * $200,000 
= $2,420,000

Therefore, the total value of Firm L if it had no debt would be $397,143 ($2,420,000 / 6.1).

Quiz 26: Analysis of Capital Structure Theory

What is the yield on Trumbull's debt?

What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?

Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?