Question 1

Triad Labs has total assets of $120 million and $40 million of debt in its capital structure. Its current cost of equity is 13%, and its cost of debt is 8.5%. Triad is considering increasing its debt to $70 million and purchasing its own stock with proceeds from the sale of $30 million in debt with a cost of 9.5%, reducing equity to $50 million. The cost of equity will increase to 14.5%. Net operating income (EBIT) will remain at $12 million. If Triad has a marginal tax rate of 40%, should the firm increase its debt? Assume that both debt and EBIT are perpetual.

Accepted Answer

The value of the firm increases due to the tax shield from the additional debt. The increase in firm value is calculated using the formula for the value of a leveraged firm: V_L = V_U + (Tax Rate * Debt). The increase in debt provides a tax shield that increases the firm's value by $14.1 million.

Question 2

Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:$\begin{array}{lll}\% \text { of Debt } & \text { Cost of Debt }(\%) &\text { Cost of Equity }(\%)\
35 & 5.4 & 13.8 \
40 & 5.6 & 14.0 \
45 & 5.9 & 14.3 \
50 & 6.4 & 14.7
\end{array}$
If Biotec pays a current dividend of $1.00 and expects dividends to grow at a constant rate of 7%, what is Biotec's stock price if it obtains its optimal capital structure?

Accepted Answer

The answer of Biotec has estimated the costs of debt...

Question 3

The airline industry is extremely price competitive, as well as having huge fixed costs and very low variable costs. This is an example of ____.

Accepted Answer

The fact that the airline industry has huge fixed costs and very low variable costs means that it has high operating leverage, which is a measure of how sensitive a company's profits are to changes in its sales volume. As for the other options, low asset performance and low fixed threshold are not applicable to the airline industry, while high profitability is not necessarily true for all airlines, as some operate on thin profit margins.

Question 4

Seduak has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:$\begin{array}{rrr}\% \text { of Debt } & \text { Cost of Debt }(\%) &\text { Cost of Equity }(\%)\
0 & - & 13.0 \
10 & 5.4 & 13.3 \
20 & 5.4 & 13.8 \
30 & 5.8 & 14.4 \
40 & 6.3 & 15.2 \
50 & 7.0 & 16.0 \
60 & 8.2 & 17.0
\end{array}$
Based on these estimates, determine Seduak's optimal capital structure.

Accepted Answer

The answer of Seduak has estimated the costs of debt...

Question 5

RoTek has a capital structure of $300,000 in equity and $300,000 in perpetual debt. The firm's cost of equity is 14% and its cost of debt is 9%. If the firm has an expected, perpetual net operating income of $120,000 and a marginal tax rate of 40%, what is the market value of RoTek? Assume all net income is paid out as dividends.

Accepted Answer

The correct answer is A. The market value of RoTek is $698,571. This is calculated as follows:Market value of equity = $300,000 / (14% - 40% * 14%) = $600,000Market value of debt = $300,000 / (9% - 40% * 9%) = $98,571Market value of RoTek = $600,000 + $98,571 = $698,571

Question 6

What is the present value of the tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on perpetual debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%?

Accepted Answer

The present value of the tax shield can be calculated using the formula: PV of tax shield = Debt * Tax Rate * Interest Rate on Debt. The firm's debt is $80 million (total assets) - $55 million (net worth) = $25 million. Therefore, the PV of the tax shield = $25 million * 35% * 8.5% = $0.7375 million, which rounds up to $0.744 million. However, the correct interpretation involves recognizing that the tax shield should be considered on a perpetual basis, not just for one year. The correct formula for the perpetual tax shield is Debt * Tax Rate = $25 million * 35% = $8.75 million, which matches choice A. The initial calculation was incorrect because it mistakenly applied the interest rate to the tax shield calculation for a perpetual scenario.

Question 7

Calculate the market value of Lotle Group, a firm with total assets of $80 million and $30 million of perpetual debt in its capital structure. The firm's cost of equity is 14%, and the cost of debt is 9%. Lotle expects annual, perpetual net operating income (EBIT) of $9 million and a marginal tax rate of 40%.

Accepted Answer

The answer of Calculate the market value of Lotle Group,...

Question 8

Calculate the market value of a firm with total assets of $105 million and $50 million of 10% perpetual debt in the capital structure. The firm's cost of equity is 14% on the $55 million in equity in the capital structure. The perpetual EBIT is expected to be $9 million, and the marginal tax rate is 40%.

Accepted Answer

The answer of Calculate the market value of a firm...

Question 9

What is the annual tax shield to a firm that has a capital structure consisting of $100 million of debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%?

Accepted Answer

The answer of What is the annual tax shield to...

Question 10

Calculate the market value of a firm with total assets of $60 million and a net worth of $35 million. The firm's cost of equity is 15%, and the cost of perpetual debt is 8%. The firm has a perpetual net operating income (EBIT) of $4.5 million and a marginal tax rate of 35%.

Accepted Answer

First, we need to find the market value of the firm's debt. We can use the formula for the cost of debt to find this:

Cost of debt = Perpetual interest / Market value of debt

0.08 = $60,000,000 - $35,000,000 - Market value of debt / Market value of debt

Market value of debt = $312,500,000

Next, we can use the formula for weighted average cost of capital (WACC) to find the market value of the firm:

WACC = (Cost of equity x Equity proportion) + (Cost of debt x Debt proportion) x (1 - Tax rate)

0.15 = (35,000,000 / Market value of firm) + (0.08 x 312,500,000 / Market value of firm) x (1 - 0.35)

Solving for Market value of firm, we get:

Market value of firm = $35,833,333

Therefore, the best choice is C.

Question 11

What is the present value of the tax shield to a firm that has a capital structure consisting of $100 million of perpetual debt and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and the marginal tax rate is 40%?

Accepted Answer

The present value of the tax shield is calculated as the tax rate multiplied by the amount of debt. Thus, 0.40 * $100 million = $40 million.

Question 12

The capital structure decision attempts to minimize ____, which maximizes the value of the firm.

Accepted Answer

The capital structure decision aims to minimize the cost of capital, which is the weighted average cost of debt and equity that a company incurs in order to finance its operations. By minimizing the cost of capital, a company can maximize the value of the firm for its shareholders. Leverage costs, labor costs, and compensation packages are all important considerations for a company, but they are not the primary concern in the capital structure decision.

Question 13

Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure: $\begin{array}{lll}\% \text { of Debt } & \text { Cost of Debt }(\%) &\text { Cost of Equity }(\%)\
35 & 5.4 & 13.8 \
40 & 5.6 & 14.0 \
45 & 5.9 & 14.3 \
50 & 6.4 & 14.7
\end{array}$
Based on these estimates, determine Biotec's optimal capital structure.

Accepted Answer

The optimal capital structure is the one that minimizes the weighted average cost of capital (WACC). The WACC is calculated as follows:WACC = (Cost of Debt * % of Debt) + (Cost of Equity * % of Equity)For Biotec, the WACC for each proportion of debt is as follows:% of Debt	Cost of Debt (%)	Cost of Equity (%)	WACC35	5.4	13.8	9.2740	5.6	14.0	9.4445	5.9	14.3	9.7150	6.4	14.7	10.05As you can see, the WACC is minimized when the proportion of debt is 45%. Therefore, Biotec's optimal capital structure is 45% debt.

Question 14

Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost information:$\begin{array}{lll}\text { Debt/assets } &\mathrm{k}_{d} \text { (Cost of Debt) }& \mathrm{k}_{\mathrm{e}} \text { (Cost of Equity) }\
.30 & .10 & .125 \
.40 & .105 & .13 \
.50 & .11 & .135 \
.60 & .117 & .142 \
.70 & .13 & .155
\end{array}$
?
Based on this information, what capital structure (debt/asset ratio) should management accept? Assume the marginal tax rate is 40%.

Accepted Answer

The answer of Feldspar Inc. is considering the capital structure...

Question 15

The greater the variability of costs, the greater the business risk of the firm. This is determined by the ____.

Accepted Answer

The variability of costs is determined by the cost of inputs used to produce a firm's output. The higher the variability, the greater the business risk because it makes it harder to predict and control expenses. This can lead to unexpected losses or reduced profits.

Question 16

Arbitrage transactions are ____.

Accepted Answer

Arbitrage transactions are designed to take advantage of price differences between two or more markets. When done correctly, they should be risk-free as the profit is already guaranteed due to the pricing discrepancy. However, executing an arbitrage strategy may involve some degree of risk depending on market conditions and other factors. It is not illegal or speculative by nature.

Question 17

What is the annual tax shield to a firm that has total assets of $80 million and a net worth of $55 million, if the average interest rate on debt is 8.5%, the average return on equity is 14%, and the marginal tax rate is 35%?

Accepted Answer

The answer of What is the annual tax shield to...

Question 18

The process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit is called ____.

Accepted Answer

The process described is known as arbitrage. Options pricing is the process of valuing options contracts, diversification is a risk management strategy that involves investing in a variety of assets, and margining refers to borrowing money to invest in securities.

Question 19

What is the market value of Barings, a firm with total assets of $100 million and $30 million in perpetual debt in its capital structure? Barings' cost of equity is 15%, and its cost of debt is 10%. Expected perpetual net operating income (EBIT) will be $17 million, and the marginal tax rate is 40%.

Accepted Answer

The market value of Barings is $86.0 million. This is calculated as follows:Market value of assets = $100 millionMarket value of debt = $30 millionMarket value of equity = $70 millionCost of equity = 15%Cost of debt = 10%Expected perpetual net operating income (EBIT) = $17 millionMarginal tax rate = 40%Weighted average cost of capital (WACC) = (Cost of equity * Equity weight) + (Cost of debt * Debt weight)WACC = (0.15 * 0.7) + (0.10 * 0.3) = 0.121Market value of equity = Expected perpetual net operating income (EBIT) / WACCMarket value of equity = $17 million / 0.121 = $140.5 millionMarket value of Barings = Market value of assets + Market value of debtMarket value of Barings = $100 million + $30 million = $130 million

Question 20

Technico has determined that its optimal capital structure is 40% debt, at which point its weighted cost of capital, k_a, is 13.7%. Due to financial problems, the firm has decided to raise the proportion of debt to 50%, which will increase its weighted cost of capital to 14.4%. What is the effect on the stock price of Technico? The current dividend is $1.60 and the long-term growth rate of dividends is expected to be 8.5%.

Accepted Answer

To find the effect on the stock price, we need to use the following formula: k_a = kD(1-T)(D/S) + kS(1-T)(E/S) where k_a = weighted average cost of capital (WACC) at 40% debt kS = cost of equity kD = cost of debt T = corporate tax rate D/S = debt-to-equity ratio E/S = equity-to-total value ratio We can solve for kS: kS = [k_a - kD(1-T)(D/S)]/[1-T(E/S)] At 40% debt, D/S = 0.4/0.6 = 0.67 E/S = 0.6/0.6 = 1 Substituting the values, we get: kS = (13.7% - kD(1-0.35)(0.67))/(1-0.35) At 50% debt, D/S = 0.5/0.5 = 1 E/S = 0.5/0.5 = 1 We can solve for kS: 14.4% = kD(1-0.35)(1) + kS(1-0.35)(1) kS = (14.4% - kD(0.65))/0.65 We can equate the two equations for kS and solve for kD: (13.7% - kD(1-0.35)(0.67))/(1-0.35) = (14.4% - kD(0.65))/0.65 kD = 8.83% Now we can find the new WACC at 50% debt: WACC = kD(1-T)(D/S) + kS(1-T)(E/S) WACC = 8.83%(1-0.35)(1) + kS(1-0.35)(1) 14.4% = 5.74% + kS(0.65) kS = 14.62% Using the constant growth model, we can find the stock price change: P0 = D1/(kS-g) At 40% debt, D1 = $1.60(1+8.5%) = $1.736 kS = 13.7% g = 8.5% P0 = $1.736/(13.7%-8.5%) = $34.72 At 50% debt, D1 = $1.60(1+8.5%) = $1.736 kS = 14.62% g = 8.5% P0 = $1.736/(14.62%-8.5%) = $30.76 The change in stock price is: $30.76 - $34.72 = -$3.96 Therefore, the correct answer is B) Decrease $3.96.

Quiz 15: Capital Structure Concepts