Question 1

L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm?

Accepted Answer

V_U = [$48,900 F1F1F1S1F1F1F10 (1 - 0.34)]/0.145 = $222,579.31V_L = $222,579.31 + 0.34 ($8,000) = $225,299.31

Question 2

Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $11,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

Accepted Answer

V_U = [$15,700 F1F1F1S1F1F1F10 (1- 0.38)]/0.12 = $81,116.67V_L = $81,116.67 + (0.38 F1F1F1S1F1F1F10 $11,000) = $85,296.67V_E = $85,296.67 - $11,000 = $74,296.67R_E = 0.12 + [(0.12 - 0.06) F1F1F1S1F1F1F10 ($11,000/$74,296.67) F1F1F1S1F1F1F10 (1 - 0.38)] = 12.55 percent

Question 3

Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio?

Accepted Answer

R_E = 0.18 = 0.146 + (0.146 - 0.084) F1F1F1S1F1F1F10 D/E F1F1F1S1F1F1F10 (1 - 0.37); D/E = 0.87

Question 4

Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity?

Accepted Answer

V_U = [$2,100 F1F1F1S1F1F1F10 (1 - 0.30)]/0.117 = $12,564.10V_L = $12,564.10 + (0.30 F1F1F1S1F1F1F10 $12,000) = $16,164.10V_E = $16,164.10 - $12,000 = $4,164.10R_E = 0.117 + [(0.117 - 0.06) F1F1F1S1F1F1F10 ($12,000/$4,164.10) F1F1F1S1F1F1F10 (1 - 0.30)] = 23.20 percent

Question 5

The Green Paddle has a cost of equity of 13.73 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?

Accepted Answer

R_E = 0.1373 = R_U + (R_U - 0.076) F1F1F1S1F1F1F10 0.65 F1F1F1S1F1F1F10 (1 - 0.32); R_U = 11.85 percent

Question 6

An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500. A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon. The applicable tax rate is 38 percent. What is the value of the levered firm?

Accepted Answer

V_U = [$327,500 F1F1F1S1F1F1F10 (1 - 0.38)]/0.175 = $1,160,285.71V_L = $1,160,285.71 + 0.38($650k) = $1,407,286

Question 7

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 36 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

Accepted Answer

V_L = (320,000 F1F1F1S1F1F1F10 $19) + (0.36 F1F1F1S1F1F1F10 $1.2m) = $6.512mV_E = $6.512m - $1.2m = $5.312m

Question 8

Winter's Toyland has a debt-equity ratio of 0.72. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes?

Accepted Answer

R_E = 0.161 + (0.161 - 0.087) F1F1F1S1F1F1F10 0.72 = 21.43 percent

Question 9

Exports Unlimited is an unlevered firm with an aftertax net income of $47,800. The unlevered cost of capital is 14.1 percent and the tax rate is 32 percent. What is the value of this firm?

Accepted Answer

V_U = $47,800/0.141 = $339,007

Question 10

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm?

Accepted Answer

V_U = [$48,600 F1F1F1S1F1F1F10 (1 - 0.34)] /0.132 = $243,000V_L = $243,000 + (0.34 F1F1F1S1F1F1F10 $25,000) = $251,500

Question 11

Douglass & Frank has a debt-equity ratio of 0.45. The pre-tax cost of debt is 7.6 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent?

Accepted Answer

R_E = 0.133 + (0.133 - 0.076) F1F1F1S1F1F1F10 0.45 F1F1F1S1F1F1F10 (1 - 0.39) = 14.86 percent

Question 12

Georga's Restaurants has 4,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent?

Accepted Answer

Annual interest tax shield = 4,500 F1F1F1S1F1F1F10 $1,000 F1F1F1S1F1F1F10 0.0825 F1F1F1S1F1F1F10 0.37 = $137,362.50

Question 13

The Corner Bakery has a debt-equity ratio of 0.54. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M&M Proposition II with no taxes?

Accepted Answer

R_E = 0.161 = 0.142 + (0.142 - R_d) F1F1F1S1F1F1F10 0.54; R_d = 10.68 percent

Question 14

Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

Accepted Answer

R_E = 0.146 = 0.132 + (0.132 - 0.078) F1F1F1S1F1F1F10 D/E; D/E = 0.26

Question 15

Down Bedding has an unlevered cost of capital of 13 percent, a cost of debt of 7.8 percent, and a tax rate of 32 percent. What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent?

Accepted Answer

R_E = 0.1551 = 0.13 + (0.13 - 0.078) F1F1F1S1F1F1F10 D/E F1F1F1S1F1F1F10 (1 - 0.32); D/E = 0.71

Question 16

D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield?

Accepted Answer

Present value of the tax shield = 0.32 F1F1F1S1F1F1F10 $21,000 = $6,720

Question 17

The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield?

Accepted Answer

Annual interest tax shield = $270,000 F1F1F1S1F1F1F10 0.075 F1F1F1S1F1F1F10 0.39 = $7,897.50

Question 18

Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 13 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?

Accepted Answer

V_U = [$6,200 F1F1F1S1F1F1F10 (1 - 0.34)]/0.13 = $31,476.92V_L = $31,476.92 + (0.34 F1F1F1S1F1F1F10 $2,500) = $32,326.92V_E = $32,326.92 - $2,500 = $29,826.92R_E = 0.13 + (0.13 - 0.09) F1F1F1S1F1F1F10 ($2,500/$29,826.92) F1F1F1S1F1F1F10 (1 - 0.34) = 0.132213WACC = [($29,826.92/$32,326.92) F1F1F1S1F1F1F10 0.132213] + [($2,500/$32,326.92) F1F1F1S1F1F1F10 0.09 F1F1F1S1F1F1F10 (1 - 0.34)] = 12.66 percent

Question 19

The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $41,000 and the tax rate is 34 percent. What is the pre-tax cost of debt?

Accepted Answer

R_E = 0.153 = 0.118 + (0.118 - R_D) F1F1F1S1F1F1F10 [$22,000/($41,000 - $22,000)] F1F1F1S1F1F1F10 (1 - 0.34);R_D = 7.22 percent

Question 20

Stacy owns 38 percent of The Town Centre. She has decided to retire and wants to sell all of her shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock. What is the total market value of The Town Centre? Ignore taxes.

Accepted Answer

Firm value = $650,000/0.38 = $1,710,526

Quiz 16: Financial Leverage and Capital Structure Policy