Deck 16: Capital Structure: Basic Concepts

Question 1

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.

Answer 1

lists items in terms of market values, not historical costs.

Question 2

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%

Answer 2

10%.

Question 3

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.

Answer 3

Above the indifference or break-even point the increase in EPS for all equity plans is greater than debt-equity plans.

Question 4

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 5

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) the 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 6

An 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 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%.

Question 8

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 9

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 10

A general rule for managers to follow is to set the firms 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 11

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 12

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 13

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 increases.
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 14

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 15

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 16

In an EPS-EBI 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 EBI.
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 17

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 18

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 19

The increase in risk to equityholders 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 20

In an EPS-EBI 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 21

How many shares will be purchased?

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

Question 22

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 23

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 24

What will the stock price now be after the recapitalization?

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

Question 25

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 26

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 27

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 28

Eigner Engineering is currently unlevered with 2,000 shares outstanding and assets valued at $50,000. The company expects operating income in the current period to be $6,000. Suppose that the company can exchange 400 shares of stock for $10,000 in debt paying 10% interest. From the standpoint of EPS, would the exchange be wise? Assume no taxes.

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) 11.2%.
C) 11.0%.
D) 13.95%.

Question 30

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 31

The change in firm value in the presence of corporate taxes is:

A) positive as equityholders face a lower effective tax rate.
B) positive as equityholders 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 32

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 33

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 34

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 35

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 36

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.

Question 37

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 38

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 39

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 40

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 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

The Blue Mountain Company is an all equity firm worth $32 million and 5 million shares outstanding. A new capital structure is planned to replace $12 million of equity with debt. They believe it can be raised at 6% interest. If the tax rate is 30%, create the market value balance sheets:
i) before any exchange is announced
ii) at the time of announcement, and
iii) at culmination of the exchange

Question 43

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 44

The value of the firm is maximized by taking on as much debt as possible. Show graphically how adding debt can increase value through the overall cost of capital. Explain under what conditions how this impacts the cost of capital and translates into firm value.