Question 1

Health and Wealth Company is financed entirely by common stock that is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing? (Ignore taxes.)

Accepted Answer

Before refinancing, the company is financed entirely by common stock with an expected return of 15 percent. After repurchasing 25 percent of the common stock and substituting debt yielding 6 percent, the company's cost of equity (expected return) will increase due to higher financial risk. To calculate the new expected return on the common stock, we can use the following formula:

Cost of equity = Cost of capital - (Weight of debt x Cost of debt)

We know that the cost of capital (or weighted average cost of capital, WACC) remains unchanged at 15 percent because the total value of the firm doesn't change and the cost of debt is fixed at 6 percent. Therefore, we can solve for the new expected return on the common stock as follows:

Cost of equity = 15% - (0.25 x 6%) = 13.5%

So, the expected return on the common stock after refinancing is 13.5 percent, which is lower than the original rate of 15 percent. Therefore, the answer is A) 18.0 percent, which is not among the choices given.

Question 2

For an all-equity firm,

Accepted Answer

For an all-equity firm, there are no interest payments to deduct from the earnings before calculating the earnings per share. Therefore, as EBIT increases, the EPS increases by the same percentage, as there are no other factors affecting the calculation.

Question 3

The effect of financial leverage on the performance of the firm depends on the

Accepted Answer

Financial leverage affects a firm's performance primarily through its impact on operating income, as it determines the firm's ability to cover fixed financial costs and influences profitability.

Question 4

Wealth and Health Company is financed entirely by common stock that is priced to offer a 15 percent expected return. The common stock price is $40/share. The earnings per share (EPS)is expected to be $6. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

Accepted Answer

First, calculate the current expected dividend per share (DPS):
DPS = EPS * payout ratio = $6 * 1 = $6

Next, calculate the current expected return on equity (ROE):
ROE = DPS/Stock Price + g = $6/$40 + 0 = 0.15 or 15%

Since the company repurchases 25% of its common stock, the new number of shares outstanding is 0.75 times the original amount. The amount of debt issued to fund the stock repurchase is equal in value to the repurchased shares, or 0.25 times the original market value of the equity.

The new cost of equity can be calculated using the capital asset pricing model (CAPM):
cost of equity = risk-free rate + beta * (market rate of return - risk-free rate) = 6% + 1.0 * (10% - 6%) = 10%

The new cost of debt is 6%.

Next, calculate the new weighted average cost of capital (WACC):
WACC = (E/V * cost of equity) + (D/V * cost of debt) * (1 - tax rate)
where:
E = market value of equity
D = market value of debt
V = total value of the firm (E + D)
tax rate = 0 (since taxes are ignored)

Since the debt issued is equal in value to 0.25 times the market value of the equity, we can express the market value of debt as:
D = 0.25 * E

Substituting in the values:
WACC = (E/E+D * 10%) + (D/E+D * 6%) = (0.75 * 10%) + (0.25 * 6%) = 8.4%

Finally, calculate the expected EPS after refinancing using the Gordon growth model:
EPS = (DPS * (1 + g)) / (WACC - g)
where:
g = expected growth rate

Assuming a constant growth rate of 5% in perpetuity:
EPS = ($6 * (1 + 5%)) / (8.4% - 5%) = $7.20

Question 5

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

Accepted Answer

The cost of equity if the debt-to-equity ratio were zero (i.e., the firm is completely equity financed) can be found using the Modigliani-Miller proposition without taxes. The formula for the cost of equity in a levered firm (Re) is Re = Ru + (Ru - Rd) * (D/E), where Ru is the unlevered cost of equity, Rd is the cost of debt, D/E is the debt-to-equity ratio. Given that the firm's levered cost of equity (Re) is 16%, its cost of debt (Rd) is 8%, and its debt-to-equity ratio (D/E) is 1, we can rearrange the formula to solve for Ru (the unlevered cost of equity, which is the cost of equity if the debt-to-equity ratio were zero). Plugging in the given values, we find that Ru = 12%, indicating that the cost of equity if the firm were completely equity financed would be 12 percent.

Question 6

A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?

Accepted Answer

Using the formula for the weighted average cost of capital (WACC): WACC = (E/V) × rE + (D/V) × rD × (1 - Tc), where E = market value of equity, D = market value of debt, V = total value (equity + debt), rE = cost of equity, rD = cost of debt, and Tc = corporate tax rate.

Since debt-to-equity ratio is 1.0, we know that D = E. Therefore, V = E + D = 2E.

Let's assume that the market value of equity is $100, which means the market value of debt is also $100.

Plugging into the WACC formula: 
WACC = [(100/200) × 0.12] + [(100/200) × 0.09] 
WACC = 0.105 or 10.5%

Now we need to find the cost of equity if there were no taxes. We can use the Capital Asset Pricing Model (CAPM) formula: rE = rRF + β × (rM - rRF), where rRF = risk-free rate, β = beta, and rM = market return.

Since there's no information given on the risk-free rate, beta, or market return, we'll assume they're all constant for our analysis.

We know that rD = 0.09, and we can use the formula for the cost of debt in a no-tax scenario: rD = rD(1 - Tc). Therefore: 
0.09 = rD(1 - 0) 
rD = 0.09

Now we can use the WACC formula again, but this time assume rD = 0 since there's no debt. 
WACC = [(100/100) × rE] + [(0/100) × 0] 
WACC = rE

Therefore: 
rE = 0.105

Now we can use the CAPM formula: 
0.12 = rRF + β × (rM - rRF)

Assuming a risk-free rate of 2%, a beta of 1, and a market return of 10% (these are just example numbers), we can solve for rRF: 
0.12 = 0.02 + 1 × (0.10 - 0.02) 
0.12 = 0.08 + 0.08 
rRF = 0.04 or 4%

Now we can use the CAPM formula again to find the cost of equity with no taxes: 
rE = 0.04 + 1 × (0.10 - 0.04) 
rE = 0.10 or 10%

Therefore, the cost of equity with no taxes is 10%, which is answer choice C.

Question 7

A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)

Accepted Answer

The answer of A firm is unlevered and has a...

Question 8

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?

Accepted Answer

The expected return on common stock after refinancing increases due to the leverage effect. Initially, the entire company is financed by equity with a 20% expected return. After repurchasing 50% of the stock and substituting it with debt at 8%, the cost of debt is lower than the cost of equity, which increases the return on the remaining equity. This can be calculated using the Modigliani-Miller proposition with taxes ignored. The new expected return on equity can be found using the formula: $E(R_{equity}) = E(R_{assets}) + (D/E) \times (E(R_{assets}) - R_{debt})$, where $D/E$ is the debt-to-equity ratio after refinancing. Since the company substitutes 50% of equity with debt, $D/E = 1$, and $E(R_{assets}) = 20\%$, $R_{debt} = 8\%$. Substituting these values gives $E(R_{equity}) = 20\% + (1) \times (20\% - 8\%) = 32\%$.

Question 9

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?

Accepted Answer

By selling 50 shares and reinvesting the proceeds in the debt yielding 8 percent, the investor will be able to maintain the same expected rate of return but will reduce the risk by substituting a less risky asset (debt) for a riskier asset (common stock). This will also help to offset the potential negative impact on the stock price due to the repurchase of shares. Option A is not a good choice since it involves borrowing and increasing risk. Option B is not a good choice as it does not take into account the effect of the refinancing on the risk-return tradeoff. Option D is not a good choice as it involves a relatively small amount of money and does not adequately address the impact of the refinancing on the investor's portfolio.

Question 10

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

Accepted Answer

The formula for levered beta is:
Levered beta = Unlevered beta * (1 + (1 - tax rate) * debt/equity)
Since there are no taxes, the formula simplifies to:
Levered beta = Unlevered beta * (1 + debt/equity)
Plugging in the numbers:
1.1 = Unlevered beta * (1 + (0.5))
Unlevered beta = 0.7333
The equity beta is:
Equity beta = Unlevered beta / (1 + (1 - tax rate) * debt/equity)
Since there are no taxes, the formula simplifies to:
Equity beta = Unlevered beta / (1 + debt/equity)
Plugging in the numbers:
Equity beta = 0.7333 / (1 + (0.5))
Equity beta = 0.7333 / 1.5
Equity beta = 0.4889
Therefore, the answer is A) 1.50.

Question 11

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

Accepted Answer

The asset beta (unlevered beta) can be calculated using the formula: Asset Beta = (Equity Beta / (1 + (1 - Tax Rate) * (Debt/Equity Ratio))) + (Debt Beta * (Debt/Equity Ratio) / (1 + (1 - Tax Rate) * (Debt/Equity Ratio))). With a tax rate of zero, the formula simplifies to: Asset Beta = (1.2 / (1 + 0.5)) + (0.2 * 0.5 / (1 + 0.5)) = 0.87.

Question 12

A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be

Accepted Answer

With the new capital structure, the firm's overall cost of capital = (cost of equity x proportion of equity) + (cost of debt x proportion of debt)
= (cost of equity x 40%) + (8% x 60%) 
= 0.4(cost of equity) + 4.8%
Since the overall cost of capital is still 10%, we can set up an equation:
0.4(cost of equity) + 4.8% = 10%
0.4(cost of equity) = 5.2%
Cost of equity = 13%

Question 13

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt

Accepted Answer

Leverage increases EPS for high levels of operating income because interest payments on the debt remain fixed, which means that as operating income increases, there is more income available to be distributed over a constant number of shares, thus increasing EPS.

Question 14

MM Proposition II states that
I.the expected return on equity is positively related to leverage;
II.the required return on equity is a linear function of the firm's debt to equity ratio;
III.the risk to equity increases with leverage

Accepted Answer

MM Proposition II posits that the expected return on equity increases with leverage because equity becomes riskier as debt increases. This is because the cost of equity is a linear function of the company's debt-to-equity ratio, reflecting the increased risk to equity holders as leverage rises. Thus, all three statements are correct interpretations of MM Proposition II.

Question 15

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?

Accepted Answer

The correct answer is B. The expected earnings per share value after refinancing is $19.20.The company's current earnings per share is $12. If the company repurchases 50 percent of the stock, the number of shares outstanding will be reduced by 50 percent. This will increase the earnings per share by 50 percent, to $18.The company is also substituting an equal value of debt yielding 8 percent. This will reduce the company's interest expense, which will increase the earnings per share. The amount of interest expense that will be saved is equal to the amount of debt that is issued, multiplied by the interest rate. In this case, the amount of debt that is issued is $30 (50 percent of the stock price), and the interest rate is 8 percent. Therefore, the amount of interest expense that will be saved is $2.40.The total increase in earnings per share is $18 + $2.40 = $20.40. However, the number of shares outstanding has been reduced by 50 percent, so the expected earnings per share value after refinancing is $20.40 / 2 = $19.20.

Question 16

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E)is equal to

Accepted Answer

The return on equity for a levered firm can be calculated using the formula: $r_E = r_A + (D/E) \times [r_A - r_D]$, where $r_E$ is the return on equity, $r_A$ is the return on assets, $r_D$ is the return on debt, and $D/E$ is the debt-to-equity ratio. This formula is derived from the Modigliani-Miller theorem on capital structure, which shows how leverage affects a firm's cost of equity.

Question 17

The cost of capital for a firm, r_WACC, in a tax-free environment is I.equal to the market value weighted average of the return on equity and the return on debt; II.equal to r_A, the rate of return for that business risk class; III.equal to the overall rate of return required on the levered firm

Accepted Answer

The cost of capital for a firm in a tax-free environment is indeed equal to the market value weighted average of the return on equity and the return on debt (I), equal to the rate of return for that business risk class (II), and equal to the overall rate of return required on the levered firm (III). These statements collectively describe how the cost of capital is determined by considering both the debt and equity components, the risk associated with the business, and the required return for the leveraged firm.

Question 18

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E)equals

Accepted Answer

The answer of For a levered firm where b_A =...

Question 19

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

Accepted Answer

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

Question 20

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

Accepted Answer

The answer of The beta of an all-equity firm is...

Quiz 17: Does Debt Policy Matter

For an all-equity firm,

The effect of financial leverage on the performance of the firm depends on the

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?

A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt

MM Proposition II states that I.the expected return on equity is positively related to leverage; II.the required return on equity is a linear function of the firm's debt to equity ratio; III.the risk to equity increases with leverage

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E) is equal to

The cost of capital for a firm, r_WACC, in a tax-free environment is I.equal to the market value weighted average of the return on equity and the return on debt; II.equal to r_A, the rate of return for that business risk class; III.equal to the overall rate of return required on the levered firm

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E) equals

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

Quiz 17: Does Debt Policy Matter

For an all-equity firm,

The effect of financial leverage on the performance of the firm depends on the

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?

A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt

MM Proposition II states that I.the expected return on equity is positively related to leverage; II.the required return on equity is a linear function of the firm's debt to equity ratio; III.the risk to equity increases with leverage

For a levered firm where bA = beta of assets and bD = beta of debt, the return on equity (rE) is equal to

The cost of capital for a firm, rWACC, in a tax-free environment is I.equal to the market value weighted average of the return on equity and the return on debt; II.equal to rA, the rate of return for that business risk class; III.equal to the overall rate of return required on the levered firm

For a levered firm where bA = beta of assets and bD = beta of debt, the equity beta (bE) equals

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E) is equal to

The cost of capital for a firm, r_WACC, in a tax-free environment is I.equal to the market value weighted average of the return on equity and the return on debt; II.equal to r_A, the rate of return for that business risk class; III.equal to the overall rate of return required on the levered firm

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E) equals