Question 1

The cost of equity: What is its value without debt in the capital structure?

Accepted Answer

The answer of The cost of equity: What is its...

Question 2

The cost of equity: What is Millennium's value after the debt issuance?

Accepted Answer

To find Millennium's value after the debt issuance, we need to calculate the total value of the company which is the sum of the value of equity and the value of debt.

From the first part of the question, we know that the value of equity is $4,000 and the cost of equity is 12%.

Using the formula for cost of equity, we can calculate the equity required rate of return:
Required rate of return = Risk-free rate + Beta*(Market rate of return - Risk-free rate)
= 4% + 1.2*(10% - 4%)
= 4% + 1.2*6%
= 4% + 7.2%
= 11.2%

Next, we need to calculate the value of debt. The question tells us that the company issued $2,000 in debt at a 8% interest rate.

Using the formula for present value of a single amount, we can calculate the value of debt:
Value of debt = $2,000 / (1 + 8%) 
= $2,000 / 1.08 
= $1,851.85

Now we can calculate the total value of the company:
Total value = Value of equity + Value of debt
= $4,000 + $1,851.85
= $5,851.85

Therefore, the closest answer choice is B) $5,942.

Question 3

Agency costs: Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?

Accepted Answer

In order for the expected value of equity with the project to be equal to the expected value of equity without the project, the agency cost needs to be zero.

To calculate the agency cost, we need to compare the expected value of equity with the project to the expected value of equity without the project.

Let P be the percent chance of success of the project. Then, the expected value of equity with the project is:

(0.6P - 0.4)($3,000,000) = $1,800,000P - $1,200,000

The expected value of equity without the project is simply:

$1,200,000

Setting these two equal and solving for P, we get:

$1,800,000P - $1,200,000 = $1,200,000

$1,800,000P = $2,400,000

P = 4/6 = 2/3

The agency cost is:

$1,800,000(2/3) - $1,200,000 = $400,000/3

Therefore, in order for the agency cost to be zero, the percent chance of success needs to be:

$400,000/3 ÷ $3,000,000 = 1/6

Thus, the answer is D.

Question 4

M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are variable with the added debt?

Accepted Answer

The answer of M&M Proposition 2: What percent of the...

Question 5

Agency costs: Suppose that JMK, Inc., has debt with a face value of $100mm and assets worth $70mm. Firm management has just identified a project that will require an initial outlay of $10mm and will return a NPV of $16mm, risk-free. The firm currently has no cash. What would be the net return to shareholders if they took on this project?

Accepted Answer

The answer of Agency costs: Suppose that JMK, Inc., has...

Question 6

M&M Proposition 2: Using the information for Bellamee from Question 64, what is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on their debt to 7%?

Accepted Answer

According to M&M Proposition 2, the required return on equity increases with leverage. Given the debt-to-equity ratio of 2/5 and a required return on debt of 7%, the required return on equity can be calculated using the formula: Re = Ra + (Ra - Rd) * (D/E). Assuming Ra is constant, the calculation aligns with option A.

Question 7

Agency costs: What will the equity value of UBM be in one-year without shareholders taking on the project?

Accepted Answer

The answer of Agency costs: What will the equity value...

Question 8

The benefits of debt: Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be 6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?

Accepted Answer

The correct answer is A because the after-tax earnings are $238. The interest expense is $2,000 * 6.5% = $130. The tax savings from the interest expense is $130 * 30% = $39. The after-tax interest expense is $130 - $39 = $91. The after-tax earnings are $500 - $91 = $238.

Question 9

M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?

Accepted Answer

According to M&M Proposition 2, the required rate of return on equity (Ke) can be calculated using the formula: Ke = Kd + (Kd-Kt) x (D/E), where Kd is the cost of debt, Kt is the corporate tax rate, and D/E is the debt-to-equity ratio. Since the tax rate is not given in the question, we assume it to be zero. Thus, Ke = 6.25% + (6.25% - 0%) x (1/5) = 6.25% + 1.25% = 7.5%. Therefore, the required rate of return on their equity is 12% + 7.5% = 19.5%. But the given options do not include this value. The closest value is 13.15%, which is Option B.

Question 10

M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70% equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal corporate income tax rate is 35%. What is the appropriate WACC?

Accepted Answer

The correct answer is A because the WACC is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)where:E = market value of equityV = market value of the firmRe = cost of equityD = market value of debtRd = cost of debtTc = corporate income tax rateIn this case, we have:E/V = 70%Re = 10%D/V = 30%Rd = 6%Tc = 35%Plugging these values into the formula, we get:WACC = (0.70) * 0.10 + (0.30) * 0.06 * (1 - 0.35)= 0.07 + 0.0126= 0.0826 or 8.26%

Question 11

M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the firm is financed with equity?

Accepted Answer

According to M&M Proposition 2, the weighted average cost of capital (WACC) is equal to the cost of equity multiplied by the percentage of equity financing, plus the after-tax cost of debt multiplied by the percentage of debt financing. Mathematically, it can be written as:
WACC = E/V * Re + D/V * Rd * (1 - Tc)
where
E/V = percentage of equity financing
D/V = percentage of debt financing
Re = cost of equity
Rd = pretax cost of debt
Tc = marginal corporate tax rate

In this case, we have:
WACC = 8.5%
Re = 12%
Rd = 5%
Tc = 35%

Substituting these values and solving for E/V, we get:
8.5% = E/V * 12% + (1 - E/V) * 5% * (1 - 35%)
8.5% = 0.12E/V + 0.0325 - 0.0325E/V
0.0325E/V = 0.085 - 0.0325
E/V = 0.6

Therefore, 60% of the firm is financed with equity. The answer is B.

Question 12

Agency costs: What is the expected value of the bonds to the lenders if the stockholders sell the debt?

Accepted Answer

The expected value of the bonds to the lenders if the stockholders sell the debt is $48.8 mm. This is because the stockholders will sell the debt for $88.8 mm, and the lenders will receive 55% of this amount, or $48.8 mm.

Question 13

The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?

Accepted Answer

The present value of the tax savings from debt is calculated as the tax rate multiplied by the amount of debt. Here, it is 35% of $1 million, which equals $350,000.

Question 14

M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the appropriate WACC?

Accepted Answer

The answer of M&M Proposition 2: A firm has $300mm...

Question 15

M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in net income with and without the debt? Assume that the total variable productions costs remain the same.

Accepted Answer

The answer of M&M Proposition 2: Suppose revenues fall by...

Question 16

M&M Proposition 2: What is the net income of Banana without and with the debt?

Accepted Answer

The answer of M&M Proposition 2: What is the net...

Question 17

The pecking order theory: A firm wishes to undertake a project that costs $150mm. It currently has $10mm in cash on hand and believes that it can raise $75mm in debt and $100mm in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt?

Accepted Answer

The answer of The pecking order theory: A firm wishes...

Question 18

M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E is changed to 1/3?

Accepted Answer

The answer of M&M Proposition 2: Suppose a firm has...

Question 19

Agency costs: What is the expected value of the equity if the stockholders sell the debt?

Accepted Answer

The expected value of the equity when stockholders sell the debt is not provided in the given options, hence "None of the above" is correct.

Question 20

The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the firm's annual tax liability?

Accepted Answer

The annual interest expense on the debt issuance would be: $1,000,000 x 9% = $90,000

The tax savings would be:
Marginal tax rate savings: $90,000 x 25% = $22,500
Average tax rate savings: $90,000 x 15% = $13,500

Since the marginal tax rate is higher than the average tax rate, the firm would save more on taxes by using the marginal tax rate. Therefore, the debt issuance would reduce the firm's annual tax liability by $22,500.

Quiz 16: Capital Structure Policy