Question 1

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If there are no taxes or other imperfections, what would be its cost of equity if the debt-to-equity ratio were 0?
A) 8%.
B) 10%.
C) 12%.
D) 14%.
E) 16%.

Accepted Answer

The answer of A firm has a debt-to-equity ratio of...

Question 2

The interest tax shield is a key reason why:
A) the required rate of return on assets rises when debt is added to the capital structure.
B) the value of an unlevered firm is equal to the value of a levered firm.
C) the net cost of debt to a firm is generally less than the cost of equity.
D) the cost of debt is equal to the cost of equity for a levered firm.
E) firms prefer equity financing over debt financing.

Accepted Answer

The interest tax shield refers to the tax savings a firm receives due to the tax deductibility of interest payments on debt. This reduces the net cost of debt to a firm, making it generally less expensive than equity financing. Therefore, the correct choice is C.

Question 3

A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are no taxes or other imperfections, its cost of equity capital with the new capital structure would be:
A) 9%.
B) 14%.
C) 13%.
D) 10%.

Accepted Answer

The correct answer is C.The cost of equity capital with the new capital structure can be calculated using the weighted average cost of capital (WACC) formula:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)where:E = market value of equityV = total value of the firmRe = cost of equity capitalD = market value of debtRd = cost of debtTc = corporate tax rateIn this case, the firm has zero debt, so the WACC is equal to the cost of equity capital:WACC = ReThe firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. The new WACC can be calculated as follows:WACC = (0.4 * 8%) + (0.6 * 10%) = 9.2%The cost of equity capital with the new capital structure can be calculated as follows:Re = WACC - (D/V) * Rd * (1 - Tc)Re = 9.2% - (0.6 * 8%) * (1 - 0) = 13%Therefore, the cost of equity capital with the new capital structure would be 13%.

Question 4

What is its cost of equity if there are no taxes or other imperfections? The firm has a debt-to-equity ratio of.60. Its cost of debt is 8%. Its overall cost of capital is 12%.
A) 18%.
B) 14.4%.
C) 10%.
D) 13.5%.

Accepted Answer

The correct answer is B. The cost of equity can be calculated using the weighted average cost of capital (WACC) formula:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)where:E = market value of equityV = total market value of the firmRe = cost of equityD = market value of debtRd = cost of debtTc = corporate tax rateSince there are no taxes or other imperfections, the WACC formula simplifies to:WACC = (E/V) * Re + (D/V) * RdWe are given that the debt-to-equity ratio is 0.60, which means that D/V = 0.60 and E/V = 0.40. We are also given that the cost of debt is 8% and the overall cost of capital is 12%. Substituting these values into the WACC formula, we get:0.12 = 0.40 * Re + 0.60 * 0.08Solving for Re, we get:Re = 0.144 or 14.4%Therefore, the cost of equity is 14.4%.

Question 5

A firm has a debt-to-equity ratio of.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is.40, what would its cost of equity be if the debt-to-equity ratio were 0?
A) 22.00%.
B) 21.07%.
C) 14.00%.
D) 20.62%.

Accepted Answer

The answer of A firm has a debt-to-equity ratio of.5....

Question 6

MM Proposition I with taxes supports the theory that:
A) there is a positive linear relationship between the amount of debt in a levered firm and its value.
B) the value of a firm is inversely related to the amount of leverage used by the firm.
C) the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.
D) a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm.
E) a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises.

Accepted Answer

The answer of MM Proposition I with taxes supports the...

Question 7

If a firm is unlevered and has a cost of equity capital 12% what would the cost of equity be if the firms became levered at 2:1?The expected cost of debt would be 8%.
A) 14.67%.
B) 16.0%.
C) 20.0%.
D) 14.0%.

Accepted Answer

The cost of equity for a levered firm can be calculated using the Modigliani-Miller Proposition II formula: $ r_e = r_0 + (r_0 - r_d) \times \frac{D}{E} $. Here, $ r_0 = 12\% $, $ r_d = 8\% $, and the debt-to-equity ratio $ \frac{D}{E} = 2 $. Plugging in these values, $ r_e = 12\% + (12\% - 8\%) \times 2 = 20\% $.

Question 8

The change in firm value due to infusion of debt in the presence of corporate taxes is:
A) positive as equity holders face a lower effective tax rate.
B) positive as equity holders gain the tax shield on the debt interest.
C) negative because of the increased risk of default and fewer shares outstanding.
D) negative because of a reduction of equity outstanding.

Accepted Answer

The correct answer is B because the infusion of debt into a firm's capital structure allows the firm to benefit from the tax shield on the debt interest. This tax shield arises because interest payments on debt are tax-deductible, reducing the firm's taxable income and thus its tax liability. This reduction in taxes increases the firm's value.

Question 9

A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is considering a new capital structure with 40% debt. The interest rate on the debt would be 4%. Assuming that the corporate tax rate is 34%, its cost of equity capital with the new capital structure would be?
A) 10.32%.
B) 11.20%.
C) 11.00%.
D) 13.95%.

Accepted Answer

The answer of A firm has zero debt in its...

Question 10

What is its cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 12%.
A) 22.0%.
B) 18.4%.
C) 17.44.
D) 19.6%.

Accepted Answer

The answer of What is its cost of equity for...

Question 11

The difference between a market value balance sheet and a book value balance sheet is that a market value balance sheet:
A) places assets on the right hand side.
B) places liabilities on the left-hand side.
C) does not equate the right hand with the left-hand side.
D) lists items in terms of market values, not historical costs.
E) uses the market rate of return.

Accepted Answer

A market value balance sheet lists items in terms of market values, not historical costs, while a book value balance sheet lists items at their historical costs.

Question 12

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is.25, what would its cost of equity be if the debt-to-equity ratio were 0?
A) 11.11%.
B) 12.57%.
C) 13.33%.
D) 16.00%.

Accepted Answer

The answer of A firm has a debt-to-equity ratio of...

Question 13

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon. The debt is selling at par value. What is the value of this firm?
A) $9,900.
B) $10,852.
C) $11,748.
D) $12,054.
E) $12,700.

Accepted Answer

First, we need to calculate the cost of equity of the firm using the unlevered cost of capital and the tax rate as follows:

Cost of Equity = Unlevered Cost of Capital x (1 + (1 - Tax Rate) x (Debt/Equity)) 
Cost of Equity = 14% x (1 + (1 - 0.34) x (2,800/Equity)) 
Cost of Equity = 14% x 1.7736 = 24.85%

Next, we can use the WACC formula to calculate the firm's value:

WACC = Cost of Equity x Equity/Total Value + Cost of Debt x (1 - Tax Rate) x Debt/Total Value 
WACC = 24.85% x Equity/Total Value + 7% x (1 - 0.34) x 2,800/Total Value

Solving for Total Value yields:

Total Value = EBIT x (1 - Tax Rate) / WACC 
Total Value = 2,100 x (1 - 0.34) / (24.85% x Equity/Total Value + 7% x (1 - 0.34) x 2,800/Total Value)

After some algebraic manipulation:

Total Value = $10,852

Therefore, the best choice is B.

Question 14

MM Proposition I with taxes is based on the concept that:
A) the optimal capital structure is the one that is totally financed with equity.
B) the capital structure of the firm does not matter because investors can use homemade leverage.
C) the firm is better off with debt based on the weighted average cost of capital.
D) the value of the firm increases as total debt increases because of the interest tax shield.
E) the cost of equity increases as the debt-equity ratio of a firm increases.

Accepted Answer

MM Proposition I with taxes states that the value of the firm increases as total debt increases because of the interest tax shield. This means that the optimal capital structure includes some level of debt, and the cost of capital decreases as more debt is added until the tax benefits are fully exhausted. Therefore, the statement "the firm is better off with debt based on the weighted average cost of capital" is closer to the correct statement than the other options, but option D is the most comprehensive and accurate.

Question 15

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:
A) levered firms pay less taxes compared with identical unlevered firms.
B) bondholders require higher rates of return compared with stockholders.
C) earnings per share are no longer relevant with taxes.
D) dividends are no longer relevant with taxes.

Accepted Answer

MM Proposition I, which states that the value of a leveraged firm is equal to the value of an unleveraged firm, does not hold in the presence of corporate taxation because interest payments on debt are tax-deductible. This means that levered firms pay less in taxes compared to identical unlevered firms, which increases the value of levered firms.

Question 16

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm this is known as:
A) conservation of energy principle.
B) MM Proposition I that leverage is invariant to market value.
C) MM Proposition II that the cost of equity is always constant.
D) MM Proposition I that the market value of the firm is invariant to the capital structure.
E) MM Proposition III that there is no risk associated with leverage in a no tax world.

Accepted Answer

MM Proposition I states that in a world without taxes, transaction costs, or bankruptcy costs, the market value of a levered firm is the same as the market value of an unlevered firm. This implies that the capital structure (the mix of debt and equity financing) does not affect the total value of the firm.

Question 17

The Boston Firm is unlevered with assets of $30 million and EBIT of $6 million. If the firm's tax rate is 34%, calculate both its after-tax cash flow and its value given a risk adjusted discount rate of 12%.
A) $2,400,000; $30,000,000.
B) $2,400,000; $2,400,000.
C) $3,960,000; $33,000,000.
D) $3,960,000; $30,000,000.
E) $2,400,000; $33,000,000.

Accepted Answer

The after-tax cash flow is $3,960,000 and the value of the firm is $33,000,000.

Question 18

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:
A) borrow some money and purchase additional shares of Bryco stock.
B) maintain his current position as the debt of the firm did not affect his personal leverage position.
C) sell some shares of Bryco stock and hold the proceeds in cash.
D) sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity ratio equal to that of the firm.
E) create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.

Accepted Answer

To unlever his position, Bryan needs to adjust his personal portfolio to offset the leverage effect introduced by the firm's use of debt. By selling some shares of Bryco stock and loaning out the proceeds, he can create a personal debt-equity ratio that mirrors the firm's, effectively neutralizing the impact of the firm's leverage on his investment.

Question 19

A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections?
A) 21%.
B) 18%.
C) 15%.
D) 10%.

Accepted Answer

The cost of equity increases with leverage due to the increased risk to equity holders. The Modigliani-Miller proposition without taxes (Proposition II) provides the formula to calculate the levered cost of equity (Re) as follows: Re = Ru + (Ru - Rd) * (D/E), where Ru is the unlevered cost of equity, Rd is the cost of debt, and D/E is the debt-to-equity ratio. Substituting the given values: Re = 15% + (15% - 10%) * 1.20 = 15% + 6% = 21%.

Question 20

The Montana Hills Co. has expected earnings before interest and taxes of $17,100, an unlevered cost of capital of 12.4 percent, and debt with both a book and face value of $25,000. The debt has an annual 6.2 percent coupon. If the tax rate is 34 percent, what is the value of the firm?
A) $91,016.13
B) $137,903.23
C) $99,516.13
D) $106,666.67
E) $146,403.23

Accepted Answer

The answer of The Montana Hills Co. has expected earnings...

Quiz 16: Capital Structure: Basic Concepts

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If there are no taxes or other imperfections, what would be its cost of equity if the debt-to-equity ratio were 0?

The interest tax shield is a key reason why:

What is its cost of equity if there are no taxes or other imperfections? The firm has a debt-to-equity ratio of.60. Its cost of debt is 8%. Its overall cost of capital is 12%.

A firm has a debt-to-equity ratio of.5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is.40, what would its cost of equity be if the debt-to-equity ratio were 0?

MM Proposition I with taxes supports the theory that:

If a firm is unlevered and has a cost of equity capital 12% what would the cost of equity be if the firms became levered at 2:1?The expected cost of debt would be 8%.

The change in firm value due to infusion of debt in the presence of corporate taxes is:

What is its cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 12%.

The difference between a market value balance sheet and a book value balance sheet is that a market value balance sheet:

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is.25, what would its cost of equity be if the debt-to-equity ratio were 0?

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon. The debt is selling at par value. What is the value of this firm?

MM Proposition I with taxes is based on the concept that:

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm this is known as:

The Boston Firm is unlevered with assets of $30 million and EBIT of $6 million. If the firm's tax rate is 34%, calculate both its after-tax cash flow and its value given a risk adjusted discount rate of 12%.

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:

A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections?

The Montana Hills Co. has expected earnings before interest and taxes of $17,100, an unlevered cost of capital of 12.4 percent, and debt with both a book and face value of $25,000. The debt has an annual 6.2 percent coupon. If the tax rate is 34 percent, what is the value of the firm?