Question 1

Provide a definition of liquidation.

Accepted Answer

Termination of the firm as a going concern.

Question 2

Which one of the following statements concerning financial leverage is correct in a world without taxes?

Accepted Answer

A)  Leverage is beneficial only when EBIT is relatively low. 
B)  EPS is decreased when leverage is used and the expected level of EBIT is achieved. 
C)  Financial leverage lowers the risk level of a firm. 
D)  The amount of financial leverage employed has a major effect on the value of the firm. 
E)  M&M Proposition I states that financial leverage is irrelevant to the value of a firm. 
A)  Leverage is beneficial only when EBIT is relatively low. 
B)  EPS is decreased when leverage is used and the expected level of EBIT is achieved. 
C)  Financial leverage lowers the risk level of a firm. 
D)  The amount of financial leverage employed has a major effect on the value of the firm. 
E)  M&M Proposition I states that financial leverage is irrelevant to the value of a firm. E

Question 3

The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000 paying an 8.5% annual coupon, and an unlevered cost of capital of 12%. If the tax rate is 34%, what is the value of the Brassy's equity?

Accepted Answer

A)  $3,258 
B)  $3,685 
C)  $5,685 
D)  $6,325 
E)  $7,005 
A)  $3,258 
B)  $3,685 
C)  $5,685 
D)  $6,325 
E)  $7,005 B

Question 4

Jensen Boat Works is an all equity firm that has 340,000 shares of stock outstanding. The company is in the process of borrowing $4 million at 8% interest to repurchase 80,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Accepted Answer

A)  $15.8 million 
B)  $16.4 million 
C)  $17.0 million 
D)  $17.5 million 
E)  $18.1 million 
A)  $15.8 million 
B)  $16.4 million 
C)  $17.0 million 
D)  $17.5 million 
E)  $18.1 million

Question 5

Which of the following is NOT true about bankruptcy and its costs?

Accepted Answer

A)  As the debt/equity ratio falls, the probability that a firm will be able to meet the promised payments on bonds decreases. 
B)  If a firm is economically bankrupt, then an ensuing legal bankruptcy will likely result in the bondholders receiving less than what they are owed. 
C)  The amount of debt a firm can raise decreases as the probability of bankruptcy increases. 
D)  A firm is economically bankrupt when the value of its assets is less than the value of its debt. 
E)  Direct bankruptcy costs are a disincentive to debt financing. 
A)  As the debt/equity ratio falls, the probability that a firm will be able to meet the promised payments on bonds decreases. 
B)  If a firm is economically bankrupt, then an ensuing legal bankruptcy will likely result in the bondholders receiving less than what they are owed. 
C)  The amount of debt a firm can raise decreases as the probability of bankruptcy increases. 
D)  A firm is economically bankrupt when the value of its assets is less than the value of its debt. 
E)  Direct bankruptcy costs are a disincentive to debt financing.

Question 6

According to M&M Proposition I with taxes, the interest tax shield:

Accepted Answer

A)  Affects the net earnings, but not the value of a firm. 
B)  Increases the pre-tax rate of return on debt. 
C)  Increases the value of a firm. 
D)  Lowers the firm's cost of equity. 
E)  Increases the firm's weighted average cost of capital. 
A)  Affects the net earnings, but not the value of a firm. 
B)  Increases the pre-tax rate of return on debt. 
C)  Increases the value of a firm. 
D)  Lowers the firm's cost of equity. 
E)  Increases the firm's weighted average cost of capital.

Question 7

M&M Proposition II is the proposition that:

Accepted Answer

A)  The value of a firm is independent of the firm's capital structure. 
B)  States the value of a firm is dependent upon the interest tax shield. 
C)  The levered value of a firm is equal to the unlevered value plus the interest tax shield. 
D)  A firm's cost of equity capital is a positive linear function of the firm's capital structure. 
E)  The levered value of a firm is equal to the unlevered value plus the present value of the interest tax shield. 
A)  The value of a firm is independent of the firm's capital structure. 
B)  States the value of a firm is dependent upon the interest tax shield. 
C)  The levered value of a firm is equal to the unlevered value plus the interest tax shield. 
D)  A firm's cost of equity capital is a positive linear function of the firm's capital structure. 
E)  The levered value of a firm is equal to the unlevered value plus the present value of the interest tax shield.

Question 8

Prescription Express has a debt-equity ratio of.70. The pre-tax cost of debt is 8.5% while the unlevered cost of capital is 15%. What is the cost of equity if the tax rate is 35%?

Accepted Answer

A)  13.79% 
B)  14.28% 
C)  17.96% 
D)  18.40% 
E)  18.87% 
A)  13.79% 
B)  14.28% 
C)  17.96% 
D)  18.40% 
E)  18.87%

Question 9

Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to her capital structure. The debt will be sold at par value. What is the levered value of the equity?

Accepted Answer

A)  $2.4 million 
B)  $2.7 million 
C)  $3.3 million 
D)  $3.7 million 
E)  $3.9 million 
A)  $2.4 million 
B)  $2.7 million 
C)  $3.3 million 
D)  $3.7 million 
E)  $3.9 million

Question 10

Your firm has a debt-equity ratio of.60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

Accepted Answer

A)  9.50% 
B)  10.50% 
C)  11.00% 
D)  11.25% 
E)  12.00% 
A)  9.50% 
B)  10.50% 
C)  11.00% 
D)  11.25% 
E)  12.00%

Question 11

In a world of corporate taxes only, show that the WACC can be written as WACC = RU * [1 - TC *(D/V)].

Accepted Answer

The student will need to use the M&M pro

Question 12

It has been observed that, when firms get into financial trouble, they often find it difficult to attract and retain high-quality employees. The additional costs incurred in this situation would be considered direct bankruptcy costs.

Accepted Answer

A) True 
 B)False

Question 13

When a firm is operating with the optimal capital structure, the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

Accepted Answer

A) True 
 B)False

Question 14

Which of the following is the best definition of interest tax shield?

Accepted Answer

A)  The tax saving attained by a firm from interest expense. 
B)  Termination of the firm as a going concern. 
C)  The value of the firm is independent of its capital structure. 
D)  A firm's cost of equity capital is a positive linear function of its capital structure. 
E)  Financial restructuring of a failing firm to attempt to continue operations as a going concern. 
A)  The tax saving attained by a firm from interest expense. 
B)  Termination of the firm as a going concern. 
C)  The value of the firm is independent of its capital structure. 
D)  A firm's cost of equity capital is a positive linear function of its capital structure. 
E)  Financial restructuring of a failing firm to attempt to continue operations as a going concern.

Question 15

Using a graph of firm value against total debt, explain how M&M Proposition I with taxes differs from the static theory of capital structure.

Accepted Answer

Students should duplicate the graph in F

Question 16

A Mississauga firm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost of equity of 11.6%, and a tax rate of 34%. What is the firm's weighted average cost of capital?

Accepted Answer

A)  9.03% 
B)  9.11% 
C)  9.38% 
D)  9.46% 
E)  9.61% 
A)  9.03% 
B)  9.11% 
C)  9.38% 
D)  9.46% 
E)  9.61%

Question 17

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the required rate of return on the firm's assets.

Accepted Answer

A) True 
 B)False

Question 18

Calculate the company's cost of equity given the following information: return on assets 10.5%; return on debt 8.75%; total debt $995,000; total equity $1,520,000. Tax rate 40%.

Accepted Answer

A)  11.19% 
B)  12.29% 
C)  13.39% 
D)  14.49% 
E)  15.59% 
A)  11.19% 
B)  12.29% 
C)  13.39% 
D)  14.49% 
E)  15.59%

Question 19

When taxes are factored in, debt financing lowers a firm's weighted average cost of capital.

Accepted Answer

A) True 
 B)False

Question 20

A firm has a debt-equity ratio of.40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring taxes, what is the cost of equity?

Accepted Answer

A)  7.8% 
B)  9.6% 
C)  11.8% 
D)  15.2% 
E)  17.2% 
A)  7.8% 
B)  9.6% 
C)  11.8% 
D)  15.2% 
E)  17.2%

Exam 16: Financial Leverage and Capital Structure Policy

Provide a definition of liquidation.

Which one of the following statements concerning financial leverage is correct in a world without taxes?

The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000 paying an 8.5% annual coupon, and an unlevered cost of capital of 12%. If the tax rate is 34%, what is the value of the Brassy's equity?

Jensen Boat Works is an all equity firm that has 340,000 shares of stock outstanding. The company is in the process of borrowing $4 million at 8% interest to repurchase 80,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Which of the following is NOT true about bankruptcy and its costs?

According to M&M Proposition I with taxes, the interest tax shield:

M&M Proposition II is the proposition that:

Prescription Express has a debt-equity ratio of.70. The pre-tax cost of debt is 8.5% while the unlevered cost of capital is 15%. What is the cost of equity if the tax rate is 35%?

Your firm has a debt-equity ratio of.60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?

In a world of corporate taxes only, show that the WACC can be written as WACC = RU * [1 - TC *(D/V)].

It has been observed that, when firms get into financial trouble, they often find it difficult to attract and retain high-quality employees. The additional costs incurred in this situation would be considered direct bankruptcy costs.

When a firm is operating with the optimal capital structure, the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

Which of the following is the best definition of interest tax shield?

Using a graph of firm value against total debt, explain how M&M Proposition I with taxes differs from the static theory of capital structure.

A Mississauga firm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost of equity of 11.6%, and a tax rate of 34%. What is the firm's weighted average cost of capital?

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the required rate of return on the firm's assets.

Calculate the company's cost of equity given the following information: return on assets 10.5%; return on debt 8.75%; total debt $995,000; total equity $1,520,000. Tax rate 40%.

When taxes are factored in, debt financing lowers a firm's weighted average cost of capital.

A firm has a debt-equity ratio of.40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring taxes, what is the cost of equity?

Introduction to Corporate Finance

Financial Statements, Cash Flow, and Taxes

Working With Financial Statements

Long-Term Financial Planning and Corporate Growth

Introduction to Valuation: the Time Value of Money

Discounted Cash Flow Valuation

Interest Rates and Bond Valuation

Stock Valuation

Net Present Value and Other Investment Criteria

Making Capital Investment Decisions

Project Analysis and Evaluation

Lessons From Capital Market History

Return, Risk, and the Security Market Line

Cost of Capital

Raising Capital

Dividends and Dividend Policy

Short-Term Finance and Planning

Cash and Liquidity Management

Credit and Inventory Management

International Corporate Finance

Leasing

Mergers and Acquisitions

Enterprise Risk Management

Options and Corporate Securities

Behavioural Finance: Implications for Financial Management

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