Question 1

The effect of financial leverage depends on the operating earnings of the company. Which if the following is not true?

Accepted Answer

A)  Below the indifference or break-even point in EBIT the non-levered structure is superior. 
B)  Financial leverage increases the slope of the EPS line. 
C)  Above the indifference or break-even point the increase in EPS for all equity plans is less than debt-equity plans. 
D)  Above the indifference or break-even point the increase in EPS for all equity plans is greater than debt-equity plans. 
E)  The rate of return on operating assets is unaffected by leverage. 
A)  Below the indifference or break-even point in EBIT the non-levered structure is superior. 
B)  Financial leverage increases the slope of the EPS line. 
C)  Above the indifference or break-even point the increase in EPS for all equity plans is less than debt-equity plans. 
D)  Above the indifference or break-even point the increase in EPS for all equity plans is greater than debt-equity plans. 
E)  The rate of return on operating assets is unaffected by leverage. D

Question 2

In an EPS- EBIT graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because:

Accepted Answer

A)  more shares are outstanding for the same level of EBIT. 
B)  the break-even point is higher with debt. 
C)  a fixed interest charge must be paid even at low earnings. 
D)  the amount of interest per share has only a positive effect on the intercept. 
E)  the higher the interest rate the greater the slope. 
A)  more shares are outstanding for the same level of EBIT. 
B)  the break-even point is higher with debt. 
C)  a fixed interest charge must be paid even at low earnings. 
D)  the amount of interest per share has only a positive effect on the intercept. 
E)  the higher the interest rate the greater the slope. C

Question 3

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in their capital structure would increase their value. The current 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 their effective marginal tax bracket is zero. What will Nantucket's new WACC be?

Accepted Answer

New Firm Value: $640,000 + (.0) ($300,000) => $640,000
Capital Structure = D + E = 300,000 + 340,000
r_s = .12 + (300/340) * (.12 - .08) = .12 + .0353 = .1553
WACC = (300/640) * (.08) + (340/640) * (.1553) = .0375 + .0825 = .12
The value of the firm stays at $640,000 (MM I), the cost of levered equity rises to 15.53% and the WACC remains at 12%.

Question 4

You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes?

Accepted Answer

A)  $4.8 million. 
B)  $5.1 million. 
C)  $5.4 million. 
D)  $5.7 million. 
E)  $6.0 million. 
A)  $4.8 million. 
B)  $5.1 million. 
C)  $5.4 million. 
D)  $5.7 million. 
E)  $6.0 million.

Question 5

Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.
Given a level of operating income of $2,500, show the specific strategy that Mike has in mind.

Accepted Answer

Mike is entitled to.2 ($2,500 - $1,600)

Question 6

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

Accepted Answer

A)  homemade leverage. 
B)  dividend recapture. 
C)  the weighted average cost of capital. 
D)  private debt placement. 
A)  homemade leverage. 
B)  dividend recapture. 
C)  the weighted average cost of capital. 
D)  private debt placement.

Question 7

What is its cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 12%.

Accepted Answer

A)  22.0%. 
B)  18.4%. 
C)  17.44. 
D)  19.6%. 
A)  22.0%. 
B)  18.4%. 
C)  17.44. 
D)  19.6%.

Question 8

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Accepted Answer

A)  $20.0 million. 
B)  $20.8 million. 
C)  $21.0 million. 
D)  $21.2 million. 
E)  $21.3 million 
A)  $20.0 million. 
B)  $20.8 million. 
C)  $21.0 million. 
D)  $21.2 million. 
E)  $21.3 million

Question 9

The change in firm value due to infusion of debt in the presence of corporate taxes is:

Accepted Answer

A)  positive as equity holders face a lower effective tax rate. 
B)  positive as equity holders gain the tax shield on the debt interest. 
C)  negative because of the increased risk of default and fewer shares outstanding. 
D)  negative because of a reduction of equity outstanding. 
A)  positive as equity holders face a lower effective tax rate. 
B)  positive as equity holders gain the tax shield on the debt interest. 
C)  negative because of the increased risk of default and fewer shares outstanding. 
D)  negative because of a reduction of equity outstanding.

Question 10

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon. The debt is selling at par value. What is the value of this firm?

Accepted Answer

A)  $9,900. 
B)  $10,852. 
C)  $11,748. 
D)  $12,054. 
E)  $12,700. 
A)  $9,900. 
B)  $10,852. 
C)  $11,748. 
D)  $12,054. 
E)  $12,700.

Question 11

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is.25, what would its cost of equity be if the debt-to-equity ratio were 0?

Accepted Answer

A)  11.11%. 
B)  12.57%. 
C)  13.33%. 
D)  16.00%. 
A)  11.11%. 
B)  12.57%. 
C)  13.33%. 
D)  16.00%.

Question 12

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:

Accepted Answer

A)  borrow some money and purchase additional shares of Bryco stock. 
B)  maintain his current position as the debt of the firm did not affect his personal leverage position. 
C)  sell some shares of Bryco stock and hold the proceeds in cash. 
D)  sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity ratio equal to that of the firm. 
E)  create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm. 
A)  borrow some money and purchase additional shares of Bryco stock. 
B)  maintain his current position as the debt of the firm did not affect his personal leverage position. 
C)  sell some shares of Bryco stock and hold the proceeds in cash. 
D)  sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity ratio equal to that of the firm. 
E)  create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.

Question 13

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. 
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 14

A general rule for managers to follow is to set the firm's capital structure such that:

Accepted Answer

A)  the firm's value is minimized. 
B)  the firm's value is maximized. 
C)  the firm's bondholders are made well off. 
D)  the firms suppliers of raw materials are satisfied. 
E)  the firms dividend payout is maximized. 
A)  the firm's value is minimized. 
B)  the firm's value is maximized. 
C)  the firm's bondholders are made well off. 
D)  the firms suppliers of raw materials are satisfied. 
E)  the firms dividend payout is maximized.

Question 15

Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 of debt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is an illusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicate Mike's payout from firm L.
Suppose the tax authorities allow firms to deduct their interest expense from operating income. Both firm U and firm L are in the 34% tax bracket. Show what happens to the market value of both firms if the debt held by firm L is permanent.

Accepted Answer

Firm U: No Change -

Question 16

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because:

Accepted Answer

A)  interest payments on the debt vary with EBIT levels. 
B)  interest payments on the debt stay fixed, leaving less income to be distributed over less shares. 
C)  interest payments on the debt stay fixed, leaving more income to be distributed over less shares. 
D)  interest payments on the debt stay fixed, leaving less income to be distributed over more shares. 
E)  interest payments on the debt stay fixed, leaving more income to be distributed over more shares. 
A)  interest payments on the debt vary with EBIT levels. 
B)  interest payments on the debt stay fixed, leaving less income to be distributed over less shares. 
C)  interest payments on the debt stay fixed, leaving more income to be distributed over less shares. 
D)  interest payments on the debt stay fixed, leaving less income to be distributed over more shares. 
E)  interest payments on the debt stay fixed, leaving more income to be distributed over more shares.

Question 17

The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. A firm is all equity with 5,000 shares outstanding worth $7 each. They are planning on issuing $10,000 of new perpetual debt at the 8% market rate of interest. The effective tax rate is 25%. What is the change in equity value if they make the debt for equity exchange?

Accepted Answer

A)  $.50 per share 
B)  $200 
C)  $800 
D)  $.16 per share 
A)  $.50 per share 
B)  $200 
C)  $800 
D)  $.16 per share

Question 18

The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. How many shares will be purchased?

Accepted Answer

A)  93.75 shares. 
B)  66.67 shares. 
C)  50.00 shares. 
D)  83.33 shares. 
A)  93.75 shares. 
B)  66.67 shares. 
C)  50.00 shares. 
D)  83.33 shares.

Question 19

In an EPS-EBIT graphical relationship, the debt ray and equity 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. 
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 20

A levered firm is a company that:

Accepted Answer

A)  is financed by common stock. 
B)  has some debt in the capital structure. 
C)  has all equity in the capital structure. 
D)  has no debt in the capital structure. 
A)  is financed by common stock. 
B)  has some debt in the capital structure. 
C)  has all equity in the capital structure. 
D)  has no debt in the capital structure.

Exam 16: Capital Structure: Basic Concepts

The effect of financial leverage depends on the operating earnings of the company. Which if the following is not true?

In an EPS- EBIT graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because:

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

What is its cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 12%.

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

The change in firm value due to infusion of debt in the presence of corporate taxes is:

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon. The debt is selling at par value. What is the value of this firm?

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is.25, what would its cost of equity be if the debt-to-equity ratio were 0?

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:

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

A general rule for managers to follow is to set the firm's capital structure such that:

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because:

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

A levered firm is a company that:

Introduction to Corporate Finance

Accounting Statements and Cash Flow

Financial Planning and Growth

Financial Markets and Net Present Value: First Principles of Finance

The Time Value of Money

How to Value Bonds and Stocks

Net Present Value and Other Investment Rules

Net Present Value and Capital Budgeting

Risk Analysis, Real Options, and Capital Budgeting

Risk and Return: Lessons From Market History

Risk and Return: the Capital Asset Pricing Model

An Alternative View of Risk and Return: the Arbitrage Pricing Theory

Risk, Return, and Capital Budgeting

Corporate Financing Decisions and Efficient Capital Markets

Long-Term Financing: an Introduction

Capital Structure: Limits to the Use of Debt

Valuation and Capital Budgeting for the Levered Firm

Dividends and Other Payouts

Issuing Equity Securities to the Public

Long-Term Debt

Leasing

Options and Corporate Finance: Basic Concepts

Options and Corporate Finance: Extensions and Applications

Warrants and Convertibles

Derivatives and Hedging Risk

Short-Term Finance and Planning

Cash Management

Credit Management

Mergers and Acquisitions

Financial Distress

International Corporate Finance

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