Exam 17: Does Debt Policy Matter

A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?

The after-tax weighted average cost of capital (WACC)is given by (corporate tax rate = T_C):

The cost of capital for a firm, r_WACC, in a tax-free environment is I.equal to the market value weighted average of the return on equity and the return on debt; II.equal to r_A, the rate of return for that business risk class; III.equal to the overall rate of return required on the levered firm

The law of conservation of value implies that I.the mix of senior and subordinated debt does not affect the value of the firm; II.the mix of convertible and nonconvertible debt does not affect the value of the firm; III.the mix of common stock and preferred stock does not affect the value of the firm

Briefly describe the traditionalists' position on capital structure.

An investor can undo the effect of leverage on his/her own account by I.investing in the equity of an unlevered firm; II.borrowing on his/her own account; III.investing in risk-free debt like T-bills

According to Modigliani and Miller Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged.

If an individual wants to borrow with limited liability, he/she should

Generally, which of the following is true? (b = beta)

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)

The firm's debt beta is usually approximately 1.0.

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?

A firm's return on assets is 12 percent and the cost of the firm's debt is 7 percent. Given a 0.7 debt-equity-ratio, what is the levered cost of equity? Assume that there are no taxes.

Explain why, as a function of the debt-equity ratio, the cost of debt graph is concave at high levels of debt.

The total market value (V)of the securities of a firm that has both debt (D)and equity (E)is

What circumstances violate MM's Proposition I? Briefly discuss.

Wealth and Health Company is financed entirely by common stock that is priced to offer a 15 percent expected return. The common stock price is $40/share. The earnings per share (EPS)is expected to be $6. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

Modigliani and Miller Proposition II states that the rate of return required by shareholders increases steadily as the firm's debt-equity ratio increases.

A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)