Question 1

The Montana Hills Co. has expected earnings before interest and taxes of $8,100,an unlevered cost of capital of 11%,and debt with both a book and face value of $12,000. The debt has an annual 8% coupon. The tax rate is 34%. What is the value of the firm?

Accepted Answer

A)   $48,600
B)   $50,000
C)   $52,680
D)   $56,667
E)   $60,600 C

Question 2

Which of the following statements are correct in relation to MM Proposition II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.

Accepted Answer

A)   I and III only
B)   II and IV only
C)   I and II only
D)   III and IV only
E)   I and IV only C

Question 3

According the MM with taxes,the value of the firm is maximized by taking on as much debt as possible. Show graphically how adding debt can increase value through the overall cost of capital. Explain how and under what conditions this impacts the cost of capital and translates into firm value.

Accepted Answer

See graphs pages 514 and 516.
This is MM Proposition I and II with corporate taxes. The tax shield on leverage reduces slope of rs to (1 - Tc) which does not fully offset gain from leverage.

Question 4

The capital structure chosen by a firm doesn't really matter because of:

Accepted Answer

A)   taxes.
B)   the interest tax shield.
C)   the relationship between dividends and earnings per share.
D)   the effects of leverage on the cost of equity.
E)   homemade leveragE.

Question 5

Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon,pay interest semiannually,and have a current market price equal to 103% of face value. What is the amount of the annual interest tax shield given a tax rate of 35%?

Accepted Answer

A)   $6,125
B)   $6,309
C)   $9,500
D)   $17,500
E)   $18,025

Question 6

Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio?

Accepted Answer

A)   .43
B)   .49
C)   .51
D)   .54
E)   .58

Question 7

Financial leverage impacts the performance of the firm by:

Accepted Answer

A)   maintaining the same level of volatility of the firm's EBIT.
B)   decreasing the volatility of the firm's EBIT.
C)   decreasing the volatility of the firm's net income.
D)   increasing the volatility of the firm's net income.
E)   None of these.

Question 8

MM Proposition II is the proposition that:

Accepted Answer

A)   supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
B)   the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.
C)   a firm's cost of equity capital is a positive linear function of the firm's capital structure.
D)   the cost of equity is equivalent to the required return on the total assets of a firm.
E)   supports the argument that the size of the pie does not depend on how the pie is sliced.

Question 9

The proposition that the cost of equity is a positive linear function of capital structure is called:

Accepted Answer

A)   the capital asset pricing model.
B)   MM Proposition I.
C)   MM Proposition II.
D)   the law of one price.
E)   the efficient markets hypothesis.

Question 10

A firm has a debt-to-equity ratio of 1.75. If it had no debt,its cost of equity would be 9%. Its cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%?

Accepted Answer

A)   7.73%
B)   10.00%
C)   10.75%
D)   12.50%
E)   None of these.

Question 11

The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on MM Proposition II with no taxes?

Accepted Answer

A)   6.76%
B)   7.00%
C)   7.25%
D)   7.40%
E)   7.50%

Question 12

A firm has a debt-to-equity ratio of 1.20. If it had no debt,its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections?

Accepted Answer

A)   10%
B)   15%
C)   18%
D)   21%
E)   None of these.

Question 13

In an EPS-EBI graphical relationship,the debt ray and equity ray cross. At this point the equity and debt are:

Accepted Answer

A)   equivalent with respect to EPS but above and below this point equity is always superior.
B)   at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
C)   equal but away from breakeven equity is better as fewer shares are outstanding.
D)   at breakeven and MM Proposition II states that debt is the better choice.
E)   at breakeven and debt is the better choice below breakeven because small payments can be madE.

Question 14

The interest tax shield has no value for a firm when:
I. the tax rate is equal to zero.
II. the debt-equity ratio is exactly equal to 1.
III. the firm is unlevered.
IV. a firm elects 100% equity as its capital structure.

Accepted Answer

A)   I and III only
B)   II and IV only
C)   I, III, and IV only
D)   II, III, and IV only
E)   I, II, and IV only

Question 15

Explain homemade leverage and why it matters.

Accepted Answer

The answer of Explain homemade leverage and why it matters....

Question 16

The increase in risk to equityholders when financial leverage is introduced is evidenced by:

Accepted Answer

A)   higher EPS as EBIT increases.
B)   a higher variability of EPS with debt than all equity.
C)   increased use of homemade leverage.
D)   equivalence value between levered and unlevered firms in the presence of taxes.
E)   None of these.

Question 17

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in its capital structure would increase its value. The current of cost of equity is 12%. Under consideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding and its effective marginal tax bracket is 34%. What will Nantucket's new WACC be?

Accepted Answer

The answer of The Nantucket Nugget is unlevered and is...

Question 18

An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm?

Accepted Answer

A)   $696,429
B)   $907,679
C)   $941,429
D)   $1,184,929
E)   $1,396,429

Question 19

Discuss Modigliani and Miller's Propositions I and II in a world with taxes. List the basic assumptions,results,and intuition of the model.

Accepted Answer

The answer of Discuss Modigliani and Miller's Propositions I and...

Question 20

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

Accepted Answer

A)   the optimal capital structure is the one that is totally financed with equity.
B)   the capital structure of the firm does not matter because investors can use homemade leverage.
C)   the firm is better off with debt based on the weighted average cost of capital.
D)   the value of the firm increases as total debt increases because of the interest tax shield.
E)   the cost of equity increases as the debt-equity ratio of a firm increases.

Exam 16: Capital Structure: Basic Concepts