Exam 16: Capital Structure Decisions

The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050. -Refer to the data for Wilson Dover Inc. What is the value (in millions) of Wilson Dover's equity if it is viewed as an option?

Which of the following statements is CORRECT?

An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS). Its tax rate is 40%.σσThe company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock. The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.σσAssuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

If debt financing is used, which of the following is CORRECT?

Pennewell Publishing Inc. (PP) is a zero growth company. It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000. PP's current cost of equity is 10%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to the data for Pennewell Publishing Inc. (PP). PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values. The debt would have an interest rate of 8%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%. If this plan were carried out, what would be PP's new value of operations?

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt and 60% equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure?

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Which of the following statements concerning capital structure theory is NOT CORRECT?

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC exceeds their after-tax cost of debt, (1-T) rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) rd. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Inc.What is the value of the firm according to MM with corporate taxes?