Question 1

Equity Inc., is currently an all-equity firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock. Assuming that individuals have the same borrowing opportunities as corporations, explain how an investor can undo the leverage that is proposed by Equity Inc., Under these conditions, what is the value of restructuring to a firm?

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Question 2

How do corporate income taxes modify MM's leverage irrelevance proposition? D. Future interest tax shields are usually valued by discounting at the borrowing rate r_debt. In the special case of permanent debt, PV tax shield = T_c(r_debt × D)/r_debt = T_cD

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Question 3

Assume a firm maintains debt at a permanent $2.3 million level at an interest rate of 7%. The corporate tax rate is 35% and there is no chance of financial distress. What would be the unlevered value of this firm if the levered value is $2.28 million?

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Question 4

What happens when firms cannot pay their creditors?

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Question 5

Is there a rule for finding optimal capital structure?

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Question 6

An increase in a corporation's tax rate will cause:

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Question 7

Which one of these statements corresponds to MM proposition I without taxes?

Accepted Answer

MM Proposition I without taxes posits that the capital structure of a company does not affect its overall value. This means that while debt interest may reduce the income available to equity holders, it does not change the total value of the firm.

Question 8

Determine the expected return on equity for a firm with a WACC of 12%, $500,000 in 9% debt, and $800,000 in equity. Both debt and equity are shown at market values, and the firm pays no taxes. How can the expected return on equity be reduced?

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Question 9

Show how leverage increases financial risk by calculating the EPS and return on shares for a firm with $1 million in 10% debt. The firm also has 50,000 shares outstanding that sell for $40 each. Three states of the economy are possible: a slump under which the firm would have operating income of $150,000, a normal state under which the firm will earn $420,000, and a boom under which the firm will earn $600,000. The firm pays no taxes.

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Question 10

Is financial slack always valuable?

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Question 11

Discuss how agency problems can develop between shareholders and bondholders when the firm is experiencing financial distress.

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Question 12

Identify the assumptions underlying the MM proposition that a firm's value is unaffected by the firm's capital structure.

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Question 13

Discuss the trade-off theory of capital structure, including the determination of an optimal debt level.

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Question 14

Explain the pecking-order theory of capital structure. How might this affect the optimal capital structure for a firm?

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Question 15

Calculate the WACC for a firm with a debt-equity ratio of 1.5. The debt pays 10% interest and the equity is expected to return 16%. Assume a 35% tax rate and risk-free debt.

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Question 16

Equity Inc., is currently an all-equity firm. It has 10,000 shares outstanding that sell for $20 each. The firm has an operating income of $30,000 and pays no taxes. The firm contemplates a restructuring that would issue $50,000 in 8% debt which will be used to repurchase stock. Show the value of the firm, EPS, and rate of return on the stock before and after the proposed restructuring. What changed?

Accepted Answer

The answer of Equity Inc., is currently an all-equity firm....

Question 17

Which one of these statements correctly applies to an unlevered firm that pays no taxes?

Accepted Answer

Since the firm is unlevered and pays no taxes, the return on assets (ROA) will equal the return on equity (ROE). Since there is no debt, the cost of capital will only consist of equity, i.e. WACC = ROE. Therefore, both ROA and ROE will equal WACC.

Question 18

Which one of these is a disadvantage to tax-paying individual investors?

Accepted Answer

Receiving interest income rather than dividends can be a disadvantage to tax-paying individual investors because interest income is often taxed at a higher rate than qualified dividends. Qualified dividends are typically taxed at the capital gains tax rate, which is lower than the ordinary income tax rate that applies to interest income.

Question 19

If interest tax shields are valuable, why don't all tax-paying firms borrow as much as possible?

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Question 20

What is the goal of the capital structure decision? What is the financial manager trying to achieve with this goal?

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Quiz 16: Debt Policy

How do corporate income taxes modify MM's leverage irrelevance proposition? D. Future interest tax shields are usually valued by discounting at the borrowing rate rdebt. In the special case of permanent debt, PV tax shield = Tc(rdebt × D)/rdebt = TcD