Deck 16: Capital Structure: Basic Concepts

Question 1

You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes?

A) $4.8 million.
B) $5.1 million.
C) $5.4 million.
D) $5.7 million.
E) $6.0 million.

Answer 1

$6.0 million.

Question 2

MM Proposition I with no tax supports the argument that:

A) business risk determines the return on assets.
B) the cost of equity rises as leverage rises.
C) it is completely irrelevant how a firm arranges its finances.
D) a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E) financial risk is determined by the debt-equity ratio.

Answer 2

it is completely irrelevant how a firm arranges its finances.

Question 3

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

A) $20.0 million.
B) $20.8 million.
C) $21.0 million.
D) $21.2 million.
E) $21.3 million

Answer 3

$20.0 million.

Question 4

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

A) homemade leverage.
B) dividend recapture.
C) the weighted average cost of capital.
D) private debt placement.

Question 5

A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the firm's weighted average cost of capital?

A) 7.29%.
B) 7.94%.
C) 8.87%.
D) 10.40%.
E) 11.05%.

Question 6

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because:

A) interest payments on the debt vary with EBIT levels.
B) interest payments on the debt stay fixed, leaving less income to be distributed over less shares.
C) interest payments on the debt stay fixed, leaving more income to be distributed over less shares.
D) interest payments on the debt stay fixed, leaving less income to be distributed over more shares.
E) interest payments on the debt stay fixed, leaving more income to be distributed over more shares.

Question 7

A key assumption of MMs Proposition I (no taxes) is:

A) that financial leverage increases risk.
B) that individuals can borrow on their own account at rates less than the firm.
C) that individuals must be able to borrow on their own account at rates equal to the firm.
D) managers are acting to maximize the value of the firm.

Question 8

A manager should attempt to maximize the value of the firm by:

A) changing the capital structure if and only if the value of the firm decreases.
B) changing the capital structure if and only if the value of the firm increases to the benefit of the stockholders.
C) changing the capital structure if and only if the value of the firm increases only to the benefits the debtholders.
D) changing the capital structure if and only if the value of the firm increases although it decreases the stockholders' value.
E) changing the capital structure if and only if the value of the firm increases and stockholder wealth is constant.

Question 9

The effect of financial leverage depends on the operating earnings of the company. Which if the following is not true?

A) Below the indifference or break-even point in EBIT the non-levered structure is superior.
B) Financial leverage increases the slope of the EPS line.
C) Above the indifference or break-even point the increase in EPS for all equity plans is less than debt-equity plans.
D) Above the indifference or break-even point the increase in EPS for all equity plans is greater than debt-equity plans.
E) The rate of return on operating assets is unaffected by leverage.

Question 10

The increase in risk to equity holders when financial leverage is introduced is evidenced by:

A) higher EPS as EBIT increases.
B) a higher variability of EPS with debt than all equity.
C) increased use of homemade leverage.
D) equivalence value between levered and unlevered firms in the presence of taxes.

Question 11

In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of:

A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leverage.

Question 12

In an EPS- EBIT graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because:

A) more shares are outstanding for the same level of EBIT.
B) the break-even point is higher with debt.
C) a fixed interest charge must be paid even at low earnings.
D) the amount of interest per share has only a positive effect on the intercept.
E) the higher the interest rate the greater the slope.

Question 13

The unlevered cost of capital is:

A) the cost of capital for a firm with no equity in its capital structure.
B) the cost of capital for a firm with no debt in its capital structure.
C) the interest tax shield times pretax net income.
D) the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure.
E) equal to the profit margin for a firm with some debt in its capital structure.

Question 14

A general rule for managers to follow is to set the firm's capital structure such that:

A) the firm's value is minimized.
B) the firm's value is maximized.
C) the firm's bondholders are made well off.
D) the firms suppliers of raw materials are satisfied.
E) the firms dividend payout is maximized.

Question 15

The capital structure chosen by a firm doesn't really matter because of:

A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leverage.

Question 16

The firm's capital structure refers to:

A) the way a firm invests its assets.
B) the amount of equity or capital in the firm.
C) the amount of dividends a firm pays.
D) the way in which a firm's assets are financed.
E) how much cash the firm holds.

Question 17

In an EPS-EBIT graphical relationship, the debt ray and equity cross. At this point the equity and debt are:

A) equivalent with respect to EPS but above and below this point equity is always superior.
B) at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
C) equal but away from breakeven equity is better as fewer shares are outstanding.
D) at breakeven and MM Proposition II states that debt is the better choice.
E) at breakeven and debt is the better choice below breakeven because small payments can be made.

Question 18

A levered firm is a company that:

A) is financed by common stock.
B) has some debt in the capital structure.
C) has all equity in the capital structure.
D) has no debt in the capital structure.

Question 19

The Modigliani-Miller Proposition I without taxes states:

A) A firm cannot change the total value of its outstanding securities by changing its capital structure proportions.
B) When new projects are added to the firm the firm value is the sum of the old value plus the new.
C) Managers can make correct corporate decisions that will satisfy all shareholders if they select projects that maximize value.
D) the determination of value must consider the timing and risk of the cashflows.

Question 20

Financial leverage impacts the performance of the firm by:

A) increasing the volatility of the firm's EBIT.
B) decreasing the volatility of the firm's EBIT.
C) decreasing the volatility of the firm's net income.
D) increasing the volatility of the firm's net income.

Question 21

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%.

Question 22

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.

Question 23

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%.

Question 24

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%.

Question 25

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%.

Question 26

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.

Question 27

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%.

Question 28

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.

Question 29

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%.

Question 30

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%.

Question 31

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.

Question 32

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%.

Question 33

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.

Question 34

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.

Question 35

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.

Question 36

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.

Question 37

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.

Question 38

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.

Question 39

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%.

Question 40

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

Question 41

The weighted average cost of capital is invariant to the use of leverage under MM conditions of no taxes. Graph the relationship of the weighted average cost of capital and leverage; be sure to include the cost of equity and debt. Explain why this relationship holds.

Question 42

Anderson's Furniture Outlet has an unlevered cost of capital of 10%, a tax rate of 34%, and expected earnings before interest and taxes of $1,600. The company has $3,000 in bonds outstanding that have an 8% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

Question 43

In each of the theories of capital structure the cost of equity rises as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, isn't the goal of the firm to maximize share value and minimize shareholder costs?

Question 44

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in their capital structure would increase their value. The current of cost of equity is 12%. Under consideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding and their effective marginal tax bracket is 34%. What will Nantucket's new WACC be?

Question 45

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in their capital structure would increase their value. Under consideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding and their effective marginal tax bracket is zero. What is the change in value and how many shares of stock will be repurchased?

Question 46

Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.
Given a level of operating income of $2,500, show the specific strategy that Mike has in mind.

Question 47

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in their capital structure would increase their value. The current cost of equity is 12%. Under consideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding and their effective marginal tax bracket is zero. What will Nantucket's new WACC be?

Question 48

The JumpStart Corporation is unlevered and valued at $500,000. JumpStart has 200,000 shares outstanding. The company announces that in the near future it will issue $200,000 of debt and buy back $200,000 of stock. If the firm is in the 34% tax bracket, how many shares of stock will be repurchased?

Question 49

Based on MM with taxes and without taxes, how much time should a financial manager spend analyzing the capital structure of his firm? What if the analysis is based on the static theory?

Question 50

Assume the corporate tax rate is 50%. A firm has perpetual expected EBIT of $100. The firm has no debt in its capital structure. Its cost of equity is 10%. What would be the value of the firm if it issued $400 in perpetual debt?

A) $700.
B) $800.
C) $900.
D) $1,000.

Question 51

A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%?

A) 10.0%.
B) 10.75%.
C) 12.50%.
D) 7.73%.

Question 52

The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. A firm is all equity with 5,000 shares outstanding worth $7 each. They are planning on issuing $10,000 of new perpetual debt at the 8% market rate of interest. The effective tax rate is 25%. What is the change in equity value if they make the debt for equity exchange?

A) $.50 per share
B) $200
C) $800
D) $.16 per share

Question 53

Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.
Mike tells Steve that while his analysis looks good on paper, Steve will never be able to borrow at 8%, but would have to pay a more realistic rate of 12%. If Mike is right, what will Steve's payout be?

Question 54

The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. How many shares will be purchased?

A) 93.75 shares.
B) 66.67 shares.
C) 50.00 shares.
D) 83.33 shares.

Question 55

The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. What will the stock price now be after the recapitalization?

A) $40.
B) $35.
C) $45.
D) $50.

Question 56

Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.
Suppose the tax authorities allow firms to deduct their interest expense from operating income. Both firm U and firm L are in the 34% tax bracket. Show what happens to the market value of both firms if the debt held by firm L is permanent.