Question 1

Home Decor has a debt-equity ratio of .54. The cost of equity is 15.7 percent, the pretax cost of debt is 6.8 percent, and the tax rate is 22 percent. What will be the cost of equity if the debt-equity ratio is revised to .65?

Accepted Answer

A)  16.89 percent 
B)  17.07 percent 
C)  14.70 percent 
D)  15.69 percent 
E)  16.44 percent

Question 2

The absolute priority rule determines:

Accepted Answer

A)  when a firm must be declared officially bankrupt. 
B)  how a distressed firm is reorganized. 
C)  which judge is assigned to a particular bankruptcy case. 
D)  how long a reorganized firm is allowed to remain under bankruptcy protection. 
E)  which parties receive payment first in a bankruptcy proceeding.

Question 3

The costs incurred by a business in an effort to avoid bankruptcy are classified as ________ costs.

Accepted Answer

A)  flotation 
B)  direct bankruptcy 
C)  indirect bankruptcy 
D)  financial solvency 
E)  capital structure

Question 4

Mountain Groves has an unlevered cost of capital of 13.2 percent, a cost of debt of 8.3 percent, and a tax rate of 21 percent. What is the target debt-equity ratio if the targeted cost of equity is 14.5 percent?

Accepted Answer

A)  .54 
B)  .29 
C)  .34 
D)  .48 
E)  .33

Question 5

Wholesale Supply has earnings before interest and taxes of $148,600. Both the book and the market value of debt is $220,000. The unlevered cost of equity is 13.6 percent while the pretax cost of debt is 7.4 percent. The tax rate is 21 percent. What is the weighted average cost of capital?

Accepted Answer

A)  11.94 percent 
B)  12.65 percent 
C)  12.91 percent 
D)  12.01 percent 
E)  12.27 percent

Question 6

The optimal capital structure has been achieved when the:

Accepted Answer

A)  debt-equity ratio is equal to 1. 
B)  weight of equity is equal to the weight of debt. 
C)  cost of equity is maximized given a pretax cost of debt. 
D)  debt-equity ratio is such that the cost of debt exceeds the cost of equity. 
E)  debt-equity ratio results in the lowest possible weighted average cost of capital.

Question 7

The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.8 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

Accepted Answer

A)  8.78 percent 
B)  10.68 percent 
C)  9.16 percent 
D)  7.56 percent 
E)  8.40 percent

Question 8

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 112,000 shares of stock outstanding. Under Plan II, there would be 75,000 shares of stock outstanding and $600,000 in debt. The interest rate on the debt is 6.7 percent and there are no taxes. What is the break-even EBIT?

Accepted Answer

A)  $87,879 
B)  $121,686 
C)  $101,111 
D)  $133,333 
E)  $91,414

Question 9

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings?

Accepted Answer

A)  Interest tax shield 
B)  Interest credit 
C)  Homemade leverage shield 
D)  Current tax yield 
E)  Tax-loss interest

Question 10

Paradise Travels is an all-equity firm that has 9,000 shares of stock outstanding at a market price of $27 a share. Management has decided to issue $25,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 7.3 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

Accepted Answer

A)  $2.28 
B)  $1.97 
C)  $1.67 
D)  $2.12 
E)  $1.92

Question 11

In general, the capital structures of U.S. firms:

Accepted Answer

A)  tend to overweigh debt in relation to equity. 
B)  generally result in debt-equity ratios between .45 and .55. 
C)  are fairly standard for all SIC codes. 
D)  tend to exceed a debt-equity ratio of .45. 
E)  vary significantly across industries.

Question 12

Based on M&M Proposition I with taxes, the weighted average cost of capital:

Accepted Answer

A)  is equal to the aftertax cost of debt. 
B)  has a linear relationship with the cost of equity capital. 
C)  is unaffected by the tax rate. 
D)  decreases as the debt-equity ratio increases. 
E)  is equal to RU(1 − T
C) .

Question 13

KN Stitches has debt of $26,000, a leveraged value of $78,400, a pretax cost of debt of 7.05 percent, a cost of equity of 15.3 percent, and a tax rate of 21 percent. What is the weighted average cost of capital?

Accepted Answer

A)  11.47 percent 
B)  12.12 percent 
C)  11.69 percent 
D)  12.07 percent 
E)  12.02 percent

Question 14

M&M Proposition II, without taxes, is the proposition that:

Accepted Answer

A)  the capital structure of a company has no effect on that company's value. 
B)  the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. 
C)  a company's cost of equity is a linear function with a slope equal to (RA − R
D) . 
D)  the cost of equity is equivalent to the required rate of return on assets. 
E)  the size of the pie does not depend on how the pie is sliced.

Question 15

Which one of these statements is correct?

Accepted Answer

A)  Capital structure has no effect on shareholder value. 
B)  The optimal capital structure occurs when the cost of equity is minimized. 
C)  The optimal capital structure maximizes shareholder value. 
D)  Shareholder value is maximized when WACC is also maximized. 
E)  Unlevered firms have more value than levered firms when firms are profitable.

Question 16

Lamey Co. has an unlevered cost of capital of 12.3 percent, a total tax rate of 25 percent, and expected earnings before interest and taxes of $32,840. The company has $60,000 in bonds outstanding that sell at par and have a coupon rate of 7.2 percent. What is the cost of equity?

Accepted Answer

A)  13.78 percent 
B)  13.36 percent 
C)  13.94 percent 
D)  14.07 percent 
E)  14.29 percent

Question 17

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a company firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?

Accepted Answer

A)  60 days 
B)  45 days 
C)  180 days 
D)  12 months 
E)  18 months

Question 18

L.A. Clothing has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company?

Accepted Answer

A)  $342,579 
B)  $273,333 
C)  $284,108 
D)  $334,101 
E)  $305,476

Question 19

Roy's Welding has a cost of equity of 14.1 percent and a pretax cost of debt of 7.7 percent. The required return on the assets is 13.2 percent. What is the debt-equity ratio based on M&M II with no taxes?

Accepted Answer

A)  .164 
B)  .217 
C)  .408 
D)  .108 
E)  .583

Question 20

Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before interest and taxes (EBIT). The steeper the slope of the plotted line the:

Accepted Answer

A)  lower the impact of financial leverage. 
B)  lower the debt-equity ratio. 
C)  higher the tax rate. 
D)  greater the sensitivity of EPS to changes in EBIT. 
E)  lower the probability of a negative EPS.

Exam 16: Financial Leverage and Capital Structure Policy