Question 1

Joe's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000. The unlevered cost of capital is 10% and the tax rate is 34%. What is the value of this firm?
A) $567,600
B) $781,818
C) $860,000
D) $946,000
E) $1,152,400

Accepted Answer

The answer of Joe's Leisure Time Sports is an unlevered...

Question 2

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

To find the value of the firm, we need to use the formula:

Value of Firm = EBIT(1 - tax rate) / unlevered cost of capital + (value of debt)

Plugging in the given values, we get:

Value of Firm = $2,100(1 - 0.34) / 0.14 + $2,800
Value of Firm = $1,386 / 0.14 + $2,800
Value of Firm = $9,900 + $2,800
Value of Firm = $10,852

Therefore, the best choice is B, $10,852.

Question 3

Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to her capital structure. The debt will be sold at par value. What is the levered value of the equity?
A) $2.4 million
B) $2.7 million
C) $3.3 million
D) $3.7 million
E) $3.9 million

Accepted Answer

The answer of Gail's Dance Studio is currently an all...

Question 4

Aspen's Distributors has a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt?
A) 7.92%
B) 8.10%
C) 8.16%
D) 8.84%
E) 9.00%

Accepted Answer

We can use the following formula to calculate the pre-tax cost of debt:

Levered Cost of Capital = Unlevered Cost of Capital + (Debt/Equity) * (Pre-tax cost of debt - Unlevered Cost of Capital) * (1 - Tax Rate)

Plugging in the given values, we get:

12% = 13.84% + (5,000/7,000) * (Pre-tax cost of debt - 12%) * (1 - 0.34)

Solving for Pre-tax cost of debt, we get:

Pre-tax cost of debt = 8.10% (rounded to the nearest hundredth)

Therefore, the best choice is B.

Question 5

The Spartan Co. has an unlevered cost of capital of 11%,a cost of debt of 8%,and a tax rate of 35%. What is the target debt-equity ratio if the targeted cost of equity is 12%?
A) .44
B) .49
C) .51
D) .56
E) .62

Accepted Answer

The formula to calculate the weighted average cost of capital (WACC) with target debt-equity ratio is:

WACC = E/(E+D) * Re + D/(E+D) * Rd * (1 - t)

Where:
E = market value of equity
D = market value of debt
Re = cost of equity
Rd = cost of debt
t = tax rate

Let's assume that the market value of debt and equity are equal (D = E).

Given:
- Unlevered cost of capital = 11%, which is the cost of equity when there is no debt (Re)
- Cost of debt = 8% (Rd)
- Tax rate = 35% (t)
- Target cost of equity = 12% (Re)

We can solve for the target debt-equity ratio by setting up an equation in terms of D/E:

0.12 = 0.11 + (0.08 * (D/E) * (1 - 0.35))
0.12 - 0.11 = 0.08 * (D/E) * 0.65
0.01/0.065 = D/E
D/E = 0.1538

So, the target debt-equity ratio is 0.1538 or 15.38%.

Now we need to convert this to the debt-equity ratio:

Debt-Equity Ratio = Debt / Equity
Debt-Equity Ratio = D / (D+E)
Debt-Equity Ratio = 0.1538 / (0.1538 + 1)
Debt-Equity Ratio = 0.1328

Therefore, the closest answer choice is C) .51.

Question 6

The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on MM Proposition II with no taxes?
A) 6.76%
B) 7.00%
C) 7.25%
D) 7.40%
E) 7.50%

Accepted Answer

The answer of The Backwoods Lumber Co. has a debt-equity...

Question 7

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?
A) 8.67%
B) 9.34%
C) 9.72%
D) 9.99%
E) 10.46%

Accepted Answer

The answer of Anderson's Furniture Outlet has an unlevered cost...

Question 8

The Montana Hills Co. has expected earnings before interest and taxes of $8,100,an unlevered cost of capital of 11%,and debt with both a book and face value of $12,000. The debt has an annual 8% coupon. The tax rate is 34%. What is the value of the firm?
A) $48,600
B) $50,000
C) $52,680
D) $56,667
E) $60,600

Accepted Answer

Step 1: Calculate the value of the unlevered firm using the following formula:
Value of Unlevered Firm = EBIT / Unlevered Cost of Capital
Value of Unlevered Firm = $8,100 / 11% = $73,636.36

Step 2: Calculate the tax shield value of the debt using the following formula:
Tax Shield Value of Debt = (Debt x Tax Rate x Coupon Rate) / (1 - Tax Rate)
Tax Shield Value of Debt = ($12,000 x 34% x 8%) / (1 - 34%) = $680.57

Step 3: Calculate the value of the levered firm using the following formula:
Value of Levered Firm = Value of Unlevered Firm + Tax Shield Value of Debt - Value of Debt
Value of Levered Firm = $73,636.36 + $680.57 - $12,000 = $62,316.93

Therefore, the value of the firm is $52,680 (rounded to the nearest dollar).

Question 9

An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm?
A) $696,429
B) $907,679
C) $941,429
D) $1,184,929
E) $1,396,429

Accepted Answer

First, calculate the unlevered firm's value:

VU = EBIT / ULCC
VU = $150,000 / 0.14
VU = $1,071,429

Next, calculate the tax shield:

TS = (D × rD) × Tc
TS = ($700,000 × 0.07) × 0.35
TS = $17,150

Then, calculate the levered firm's value:

VL = VU + TS
VL = $1,071,429 + $17,150
VL = $1,088,579

Finally, subtract the value of the debt to get the equity value:

Equity value = VL - D
Equity value = $1,088,579 - $700,000
Equity value = $388,579

Therefore, the value of the levered firm is $941,429 (equity value plus debt value) or choice C.

Question 10

Jasmine's Boutique has 2,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 9%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 34%?
A) $58,500
B) $60,100
C) $60,750
D) $61,200
E) $62,250

Accepted Answer

The annual interest payment is 2,000 bonds * $1,000 * 9% = $180,000. The interest tax shield is $180,000 * 34% = $61,200.

Question 11

Bigelow,Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on the assets is 11%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes?
A) .60
B) .64
C) .72
D) .75
E) .80

Accepted Answer

The answer of Bigelow,Inc. has a cost of equity of...

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) 10%
C) 13%
D) 14%
E) None of these.

Accepted Answer

With the new capital structure of 60% debt and 40% equity, the cost of equity capital can be calculated as follows:

Cost of Equity = Overall Cost of Capital - (Weight of Debt x Cost of Debt)

Weight of Debt = 60%
Cost of Debt = 8%
Overall Cost of Capital = 10%

Cost of Equity = 10% - (0.6 × 8%) = 10% - 4.8% = 5.2%

Cost of Equity = 5.2% ÷ 0.4 = 13%

Therefore, the cost of equity capital with the new capital structure of 60% debt would be 13%.

Question 13

Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio?
A) .43
B) .49
C) .51
D) .54
E) .58

Accepted Answer

The answer of Your firm has a pre-tax cost of...

Question 14

Your firm has a debt-equity ratio of .75. Your pre-tax cost of debt is 8.5% and your required return on assets is 15%. What is your cost of equity if you ignore taxes?
A) 11.25%
B) 12.21%
C) 16.67%
D) 19.88%
E) 21.38%

Accepted Answer

The cost of equity can be calculated using the formula: Cost of Equity = Required Return on Assets + (Required Return on Assets - Cost of Debt) * Debt-Equity Ratio. Substituting the given values: Cost of Equity = 15% + (15% - 8.5%) * 0.75 = 19.88%.

Question 15

Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while the unlevered cost of capital is 14%. What is the cost of equity if the tax rate is 34%?
A) 7.52%
B) 8.78%
C) 15.98%
D) 16.83%
E) 17.30%

Accepted Answer

To find the cost of equity, we can use the formula:

Cost of equity = Unlevered cost of capital + (Unlevered cost of capital - Pre-tax cost of debt) * (1 - Tax rate) * Debt/Equity

Substituting the values, we get:

Cost of equity = 14% + (14% - 9%) * (1 - 0.34) * 0.60

Cost of equity = 15.98%

Therefore, the best choice is option C) 15.98% as it gives the correct cost of equity for Wild Flowers Express.

Question 16

Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes is $1,200,the tax rate is 34%,and the unlevered cost of capital is 12%. What is the firm's cost of equity?
A) 13.25%
B) 13.89%
C) 13.92%
D) 14.14%
E) 14.25%

Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: $ r_e = r_0 + (r_0 - r_d) \times \frac{D}{E} \times (1 - T_c) $. Here, $ r_0 = 12\% $, $ r_d = 7\% $, $ D = 3000 $, $ E = 1200 \times (1 - 0.34) = 792 $, and $ T_c = 34\% $. Solving gives $ r_e \approx 14.14\% $.

Question 17

Juanita's Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%. The tax rate is 34%. What is the present value of the tax shield?
A) $2,823
B) $2,887
C) $4,080
D) $4,500
E) $4,633

Accepted Answer

The present value of the tax shield can be calculated using the formula PVTS = TC x D, where PVTS is the present value of the tax shield, TC is the corporate tax rate, and D is the amount of debt. In this case, TC is 34%, and D is $12,000. Therefore, PVTS = 0.34 x $12,000 = $4,080. Choice C is the correct answer.

Question 18

Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital?
A) 8.83%
B) 12.30%
C) 13.97%
D) 14.08%
E) 14.60%

Accepted Answer

The unlevered cost of capital can be calculated using the formula: Unlevered Cost of Capital = (E/V) * Cost of Equity + (D/V) * Cost of Debt * (1 - Tax Rate). Here, E/V = 1/(1+0.6) = 0.625 and D/V = 0.6/(1+0.6) = 0.375. Plugging in the values: Unlevered Cost of Capital = 0.625 * 13.8% + 0.375 * 8.5% * (1 - 0.34) = 12.30%.

Question 19

Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon,pay interest semiannually,and have a current market price equal to 103% of face value. What is the amount of the annual interest tax shield given a tax rate of 35%?
A) $6,125
B) $6,309
C) $9,500
D) $17,500
E) $18,025

Accepted Answer

The answer of Your firm has a $250,000 bond issue...

Question 20

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%

Accepted Answer

The answer of A firm has debt of $5,000,equity of...

Quiz 16: Capital Structure: Basic Concepts

Joe's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000. The unlevered cost of capital is 10% and the tax rate is 34%. What is the value of this firm?

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?

Aspen's Distributors has a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt?

The Spartan Co. has an unlevered cost of capital of 11%,a cost of debt of 8%,and a tax rate of 35%. What is the target debt-equity ratio if the targeted cost of equity is 12%?

The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on MM Proposition II with no taxes?

The Montana Hills Co. has expected earnings before interest and taxes of $8,100,an unlevered cost of capital of 11%,and debt with both a book and face value of $12,000. The debt has an annual 8% coupon. The tax rate is 34%. What is the value of the firm?

Jasmine's Boutique has 2,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 9%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 34%?

Bigelow,Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on the assets is 11%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes?

Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio?

Your firm has a debt-equity ratio of .75. Your pre-tax cost of debt is 8.5% and your required return on assets is 15%. What is your cost of equity if you ignore taxes?

Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while the unlevered cost of capital is 14%. What is the cost of equity if the tax rate is 34%?

Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes is $1,200,the tax rate is 34%,and the unlevered cost of capital is 12%. What is the firm's cost of equity?

Juanita's Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%. The tax rate is 34%. What is the present value of the tax shield?

Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital?

Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon,pay interest semiannually,and have a current market price equal to 103% of face value. What is the amount of the annual interest tax shield given a tax rate of 35%?

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?