Question 1

How much debt is outstanding in a firm that has calculated the present value of a perpetual tax shield to be $300,000 if the tax rate is 35% and the debt carries a 10% rate of return?

Accepted Answer

$300,000 = D × 0.35; D = $857,143

Question 2

A firm currently has operating income of $4 million, interest expense of $2 million, and EPS of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes.

Accepted Answer

Given,

Operating Income (OI) = $4 million
Interest Expense (IE) = $2 million
EPS = $2

Let's assume the new OI to be x.

Now, we know that:

EPS = (OI - IE) / Number of Shares

Since the number of shares is not given, we can ignore it for this question.

Now, we can rearrange the above formula to get:

OI = (EPS * Number of Shares) + IE

We know that we want to reduce the EPS to $1. So,

1 = [(EPS * Number of Shares) + IE] / Number of Shares

1 = EPS + (IE / Number of Shares)

(EPS - 1) = (IE / Number of Shares)

(EPS - 1) * Number of Shares = IE

Substituting the given values,

(2 - 1) * Number of Shares = 2

Number of Shares = 2

Now, we can substitute the number of shares in the original formula and solve for x:

1 = (x - $2 million) / 2

x - $2 million = 2

x = $4 million

So, the operating income can drop to $4 million - $2 million = $2 million before the EPS is reduced to $1.

To reduce the EPS by half to $1, the OI has to be reduced by half to $2 million.

Therefore, the answer is B) $3.0 million.

Question 3

MM proposition I states that a firm's value is unaffected by its:

Accepted Answer

MM proposition I posits that in a world without taxes, transaction costs, or bankruptcy costs, the value of a firm is not affected by how the firm is financed, meaning its capital structure (mixture of debt and equity) does not impact its value.

Question 4

The reason that financial leverage increases shareholder risk is that there is:

Accepted Answer

By using financial leverage, a company increases the amount of debt it has relative to equity. This means there is less equity available to absorb operating risk, which increases the risk for shareholders. In other words, if the company faces financial difficulties and cannot meet its debt obligations, shareholders' equity would be impacted first as they are the last to be paid in the event of bankruptcy. Thus, the more financial leverage used by a company, the greater the risk for shareholders.

Question 5

A firm's business risk depends upon:

Accepted Answer

Business risk is the risk associated with the operations of the firm and the nature of its assets. It can be affected by factors such as competition, market conditions, technological changes, and regulatory environment. The use of debt, types of debt financing, and financial distress can impact the firm's financial risk.

Question 6

According to MM, an increase in expected earnings per share can leave the share price unchanged if the:

Accepted Answer

According to Modigliani and Miller's (MM) theory, in a world without taxes, the value of a firm is not affected by its capital structure. Therefore, an increase in expected earnings per share (EPS) can leave the share price unchanged if the required return on equity increases. This is because the increase in required return on equity would offset the positive impact of higher EPS on the share price, keeping the valuation unchanged.

Question 7

What is the expected rate of return to equityholders if the firm has a tax rate of 35%, an interest rate on debt of 10%, a WACC of 15%, and a debt-asset ratio of 60%?

Accepted Answer

0.15 = (1 - 0.60)R_e + 0.60(0.10)(1 - 0.35); R_e = 0.2775, or 27.75%

Question 8

The interest tax shield is equal to the:

Accepted Answer

The interest tax shield is the amount of tax savings a company receives due to its deductible interest expense. It is calculated as the product of the interest expense and the tax rate, so choice C is the correct answer. Choices A, B, and D do not accurately describe the interest tax shield.

Question 9

When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm _____ the PV of the tax shield _____ the costs of financial distress.

Accepted Answer

The market value of a firm is equal to the value of the all-equity firm PLUS the PV of the tax shield MINUS the costs of financial distress. Corporate taxes provide a tax shield, which is the present value of the tax savings from debt, and is a benefit to the firm. However, there are also costs associated with financial distress, such as increased bankruptcy and agency costs, which reduce the value of the firm. Therefore, the net effect of these factors is to increase the value of the firm when considering both tax shields and financial distress.

Question 10

The present value of a perpetual tax shield increases as the firm's tax rate _____ and the amount of principal _____.

Accepted Answer

The present value of a perpetual tax shield is calculated as (tax shield amount / cost of capital). As the tax rate increases, the tax shield amount will increase, and as the amount of principal increases, the cost of capital will decrease, both leading to an increase in the present value of the tax shield. Therefore, as the tax rate and amount of principal increase, the present value of the tax shield will increase.

Question 11

According to MM, if individuals cannot obtain the same borrowing terms as firms, then:

Accepted Answer

If individuals cannot obtain the same borrowing terms as firms, it implies that there is a difference in the cost of capital for individuals and firms. This suggests that capital structure may be relevant, as firms can take advantage of debt tax shields and lower their cost of capital compared to individuals. Therefore, the answer is A.

Question 12

With the inclusion of taxes, MM I is incorrect and the capital structure of the firm can be important due to the:

Accepted Answer

The lower tax liability due to interest deductibility is the reason why the capital structure of the firm can be important with the inclusion of taxes. The deductibility of interest payments on debt reduces the taxable income and thus the tax liability of the firm. This makes debt financing more attractive than equity financing which is not tax-deductible. Therefore, the capital structure of the firm affects its tax liability and the after-tax cost of capital.

Question 13

Any financial benefit derived from the interest tax shield accrues to the:

Accepted Answer

The financial benefit derived from the interest tax shield, which is the tax deduction from interest payments, accrues to the shareholders since they are the ones who face taxes on the firm's profits. Bondholders do not receive this benefit because they do not pay taxes on the interest income they earn.

Question 14

With risky debt and MM II, the expected return on assets _____ as the debt-equity ratio _____.

Accepted Answer

According to Modigliani and Miller Proposition II (with taxes), the expected return on assets remains constant regardless of the debt-equity ratio. This is because the cost of equity increases with leverage to exactly offset the cheaper cost of debt, leaving the overall cost of capital unchanged.

Question 15

If a firm's expected return on equity equals its expected return on assets, then the:

Accepted Answer

If a firm's expected return on equity equals its expected return on assets, then the firm has no debt in its capital structure. This is because the expected return on equity is calculated after accounting for the cost of debt, so if they are equal, it means the cost of debt is zero.

Question 16

What is the maximum rate that can be paid on debt and maintain a WACC of 14% with an expected return on equity of 19% in a firm with a debt-to-asset ratio of 60%? Ignore taxes.

Accepted Answer

0.14 = (1 - 0.60)(0.19) + 0.60(R_d); R_d = 0.1067, or 10.67%

Question 17

As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches:

Accepted Answer

As a firm's debt-equity ratio approaches zero, it implies the firm is financed more by equity than by debt. In such a scenario, the expected return on equity approaches the expected return on assets because the firm's risk is minimized to the equity holders, making the return on equity similar to the return on the firm's overall assets.

Question 18

An all-equity firm as operating income of $1.5 million and EPS of $2. If you ignore taxes, and if $1 million of 20% debt were issued with the proceeds used to repurchase two-thirds of the outstanding shares of stock, then the firm's EPS would:

Accepted Answer

The current number of outstanding shares can be calculated by dividing the operating income by the EPS, so it is 1.5 million / 2 = 0.75 million shares. With $1 million of 20% debt, the interest expense would be $200,000, leaving $800,000 to repurchase two-thirds of the outstanding shares, or 0.5 million shares. After the repurchase, the total number of outstanding shares would be 0.25 million, or one-third of the original amount.

The new net income of the firm can be found by subtracting the interest expense ($200,000) from the operating income ($1.5 million), which is $1.3 million. Since the total number of shares has been reduced, the EPS would increase to $1.3 million / 0.25 million = $5.20. Therefore,D is the correct option.

Question 19

Which one of the following would not be expected to change with changes in the firm's capital structure?

Accepted Answer

The expected return on assets is determined by the firm's operating performance and does not depend on the capital structure. The other options, weighted-average cost of capital, expected return on equity, and expected earnings per share, are all affected by changes in the capital structure as they are related to the financing mix of the firm.

Question 20

MM's proposition II without taxes states that the:

Accepted Answer

The answer of MM's proposition II without taxes states that...

Quiz 16: Debt Policy