Question 1

MM Proposition I with taxes states that:

Accepted Answer

MM Proposition I with taxes suggests that the value of a firm increases with leverage due to the tax shield provided by interest payments on debt.

Question 2

Thompson & Thomson is an all-equity firm that has 280,000 shares of stock outstanding.The company is in the process of borrowing $2.4 million at 5.5 percent interest to repurchase 75,000 shares of the outstanding stock.What is the value of this firm if you ignore taxes?

Accepted Answer

The value of the firm is the sum of the value of the equity and the value of the debt. The value of the equity is the number of shares outstanding times the price per share. The price per share is the value of the firm divided by the number of shares outstanding. The value of the debt is the amount of the debt times the interest rate.In this case, the value of the equity is 280,000 shares times the price per share. The price per share is the value of the firm divided by the number of shares outstanding. The value of the debt is $2.4 million times 5.5 percent.The value of the firm is the sum of the value of the equity and the value of the debt. The value of the equity is 280,000 shares times the price per share. The price per share is the value of the firm divided by the number of shares outstanding. The value of the debt is $2.4 million times 5.5 percent.The value of the firm is $8,960,000.

Question 3

A firm has a debt-equity ratio of .64,a pretax cost of debt of 8.5 percent,and a required return on assets of 12.6 percent.What is the cost of equity if you ignore taxes?

Accepted Answer

The cost of equity can be calculated using the formula: $r_E = r_A + (r_A - r_D) \times (\frac{D}{E})$, where $r_E$ is the cost of equity, $r_A$ is the required return on assets, $r_D$ is the cost of debt, and $\frac{D}{E}$ is the debt-equity ratio. Plugging in the given values: $r_E = 12.6\% + (12.6\% - 8.5\%) \times 0.64 = 12.6\% + 4.1\% \times 0.64 = 12.6\% + 2.624\% = 15.224\%$. Rounding to two decimal places gives 15.22 percent.

Question 4

You own 25 percent of Unique Vacations,Inc.You have decided to retire and want to sell your shares in this closely held,all-equity firm.The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock.What is the total value of this firm if you ignore taxes?

Accepted Answer

The answer of You own 25 percent of Unique Vacations,Inc.You...

Question 5

MM Proposition II is the proposition that:

Accepted Answer

MM Proposition II states that a firm's cost of equity capital is a positive linear function of its capital structure, meaning as a firm increases its leverage, its cost of equity also increases.

Question 6

The tax shield on debt has no value for a firm when:

Accepted Answer

The tax shield on debt is only applicable when a firm has debt. If the firm is unlevered, there is no debt to provide a tax shield. Therefore, option C is the correct choice. Option A and B are incorrect because as long as there is debt, there will be a tax shield, regardless of the specific debt-equity ratio. Option D is also incorrect because even if shareholders fully utilize homemade leverage, the firm may still have debt and therefore can benefit from a tax shield. Option E is irrelevant to the question since it does not relate to the tax shield on debt.

Question 7

CT Stores has debt with a book value of $325,000 and a market value of $319,000.The firm's equity has a book value of $526,000 and a market value of $684,000.The tax rate is 21 percent and the cost of capital is 11.2 percent.What is the market value of this firm based on MM Proposition I without taxes?

Accepted Answer

MM Proposition I without taxes states that the value of a leveraged firm is equal to the value of an unleveraged firm, meaning the capital structure does not affect the firm's value. Therefore, the market value of the firm is simply the sum of the market value of debt and equity. Market value of debt = $319,000 and market value of equity = $684,000. Thus, the total market value = $319,000 + $684,000 = $1,003,000.

Question 8

Bigelow has a levered cost of equity of 14.29 percent and a pretax cost of debt of 7.23 percent.The required return on the assets is 11 percent.What is the firm's debt-equity ratio based on MM Proposition II with no taxes?

Accepted Answer

MM Proposition II without taxes states that the cost of equity (Re) is equal to the cost of assets (Ra) plus the debt-equity ratio (D/E) times the spread between the cost of assets and the cost of debt (Rd). The formula is Re = Ra + (D/E)(Ra - Rd). Rearranging the formula to solve for D/E gives us D/E = (Re - Ra) / (Ra - Rd). Plugging in the given values: (14.29% - 11%) / (11% - 7.23%) = 3.29 / 3.77 = 0.872. Therefore, the firm's debt-equity ratio is approximately 0.87 or 87%.

Question 9

The reason that MM Proposition I without taxes does not hold in the presence of corporate taxation is because:

Accepted Answer

With corporate taxation, interest payments on debt are tax-deductible, which reduces the amount of taxable income for levered firms. This means that levered firms pay less taxes compared with identical unlevered firms. As a result, the value of a levered firm with taxes is higher than that of an identical unlevered firm, contrary to MM Proposition I without taxes.

Question 10

MM Proposition I with taxes is based on the concept that the:

Accepted Answer

MM Proposition I with taxes states that the presence of taxes makes debt valuable to a firm because interest payments are tax-deductible, lowering the cost of debt financing. Therefore, as the firm increases its debt level, the overall cost of capital decreases, increasing the firm's value.

Question 11

MM Proposition II with no taxes supports the argument that a firm's:

Accepted Answer

MM Proposition II without taxes posits that the Weighted Average Cost of Capital (WACC) of a firm remains constant regardless of the firm's capital structure. This is because any increase in debt (which is cheaper than equity) is offset by an increase in the cost of equity, due to the increased financial risk from leveraging.

Question 12

The Backwoods Lumber Co.has a debt-equity ratio of .68.The firm's required return on assets is 11.7 percent and its levered cost of equity is 15.54 percent.What is the pretax cost of debt based on MM Proposition II with no taxes?

Accepted Answer

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

Question 13

A firm has zero debt in its capital structure and has an overall cost of capital of 10 percent.The firm is considering a new capital structure with 60 percent debt at an interest rate of 8 percent.Assuming there are no taxes or other imperfections,what would be the cost of equity with the new capital structure?

Accepted Answer

The cost of capital formula is:

Cost of Capital (WACC) = (Cost of Equity x % Equity) + (Cost of Debt x % Debt)

Since the firm has zero debt in its current capital structure, the cost of equity is equal to the overall cost of capital of 10 percent.

In the new capital structure, the cost of debt is 8 percent and the percent of debt is 60 percent, so the percent of equity is 40 percent.

Plugging in the numbers:

10% = (Cost of Equity x 100%) + (8% x 60%) 
10% = Cost of Equity + 4.8% 
Cost of Equity = 5.2% + 10% 
Cost of Equity = 13%

Therefore, the answer is C) 13 percent.

Question 14

Assume an initial scenario where a levered firm has total assets of $8,000,earnings before interest and taxes of $600,400 shares of stock outstanding,a debt-equity ratio of .25,and a cost of debt of 7 percent.Now assume a second scenario where the firm changes to an all-equity structure by issuing new shares to pay off debt while a shareholder holding 10 percent of the stock borrows funds at 7 percent and uses homemade leverage to offset the firm's change in capital structure.Ignore taxes.What are the net earnings for this shareholder under the initial scenario? Under the second scenario?

Accepted Answer

Under the initial scenario, the net earnings for the shareholder can be found by multiplying the earnings before interest and taxes by the shareholder's ownership percentage, and then subtracting the interest expense on the debt:

Net earnings = (EBIT x ownership percentage) - (debt x cost of debt)
Net earnings = ($600 x 0.1) - ($8,000 x 0.25 x 0.07)
Net earnings = $48.80

Under the second scenario, the firm has no debt and the shareholder has borrowed funds at the same cost of debt to maintain the same level of leverage. The net earnings for the shareholder can be calculated as follows:

Net earnings = (EBIT - interest expense on homemade leverage) x ownership percentage
Net earnings = ($600 - ($8,000 x 0.1 x 0.07)) x 0.1
Net earnings = $48.80

Therefore, the net earnings for the shareholder are the same under both scenarios - $48.80.

Question 15

MM Proposition II with taxes:

Accepted Answer

MM Proposition II with taxes states that the value of a firm increases with the use of financial leverage due to the tax shield provided by debt. This is because interest payments on debt are tax-deductible, reducing the taxable income of the firm and therefore lowering the amount of tax paid. This leads to an increase in the after-tax cash flows available to equity holders, increasing the value of the firm. Therefore, choice B is the correct option.

Question 16

Assume an unlevered firm has total assets of $6,000,earnings before interest and taxes of $600,and 500 shares of stock outstanding.Further assume the firm decides to change 40 percent of its capital structure to debt with an interest rate of 8 percent.Ignore taxes.What will be the amount of the change in the earnings per share as a result of this change in the capital structure?

Accepted Answer

The correct answer is A because the change in the capital structure will increase the firm's earnings per share. The firm will now have $2,400 of debt and $3,600 of equity. The interest expense on the debt will be $192, which will reduce the firm's earnings before interest and taxes to $408. However, the firm will now have only 300 shares of stock outstanding, so the earnings per share will increase to $1.36.

Question 17

The tax shield on debt is one reason why:

Accepted Answer

The tax shield on debt reduces the net cost of debt to a firm, making it generally less than the cost of equity. This is because interest payments on debt are tax-deductible, reducing the amount of taxable income and therefore, the amount of taxes a firm has to pay. This lowers the overall cost of debt to a company compared to equity financing.

Question 18

The tax savings of the firm derived from the deductibility of interest expense is called the:

Accepted Answer

The term for tax savings resulting from the tax deductibility of interest expense is called the "tax shield from debt." This tax shield can help to reduce the overall tax liability of a firm by allowing them to deduct interest expenses from their taxable income, resulting in a lower net income that is subject to taxation.

Question 19

Uptown Interior Designs is an all-equity firm that has 40,000 shares of stock outstanding.The company has decided to borrow $74,000 to buy out the 2,100 shares of a deceased stockholder.What is the total value of this firm if you ignore taxes?

Accepted Answer

To find the total value of the firm, we need to calculate the current value of equity and add the debt to it.

The current value of equity is 40,000 shares x current stock price, which is not given in the problem. Therefore, we cannot calculate the exact value of equity.

However, we can calculate the total market value of equity before the buyout. Before the buyout, there were 40,000 shares outstanding. If we assume that the current value of each share is $35, then the total market value of equity is:

40,000 shares x $35 per share = $1,400,000

Now, we add the debt to the market value of equity:

$1,400,000 + $74,000 = $1,474,000

Therefore, the total value of the firm is $1,474,000, which is closest to answer choice C: $1,409,524.

Question 20

MM Proposition I with taxes supports the theory that:

Accepted Answer

C  MM Proposition I with taxes states that the value of a levered firm is equal to the value of an unlevered firm plus the present value of the tax shield on debt, which implies a positive relationship between debt and firm value due to the tax shield.

Quiz 16: Capital Structure: Basic Concepts