Exam 16: Capital Structure: Basic Concepts

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure? I. A reduction in tax rates II. A large tax loss carryforward III. A large depreciation tax deduction IV. A sizeable increase in taxable income

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. After seeing Steve's analysis,Mike tells Steve that while his analysis looks good on paper,Steve will never be able to borrow at 8%,but would have to pay a more realistic rate of 12%. If Mike is right,what will Steve's payout be?

If a firm is unlevered and has a cost of equity capital of 12%,what would the cost of equity be if its debt-equity ratio became 2? The expected cost of debt is 8%.

Discuss Modigliani and Miller's Propositions I and II in a world without taxes. List the basic assumptions,results,and intuition of the model.

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

MM Proposition I with taxes supports the theory that:

A firm has debt of $5,000,equity of $16,000,a leveraged value of $8,900,a cost of debt of 8%,a cost of equity of 12%,and a tax rate of 34%. What is the firm's weighted average cost of capital?

The Modigliani-Miller Proposition I without taxes states:

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

A firm has a debt-to-equity ratio of .5. Its cost of equity is 22%,and its cost of debt is 16%. If the corporate tax rate is .40,what would the cost of equity be if the debt-to-equity ratio were 0?

Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while the unlevered cost of capital is 14%. What is the cost of equity if the tax rate is 34%?

Anderson's Furniture Outlet has an unlevered cost of capital of 10%,a tax rate of 34%,and expected earnings before interest and taxes of $1,600. The company has $3,000 in bonds outstanding that have an 8% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

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?

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

The proposition that the value of the firm is independent of its capital structure is called:

Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital?

The weighted average cost of capital is invariant to the use of leverage under MM conditions of no taxes. Graph the relationship of the weighted average cost of capital and leverage; be sure to include the cost of equity and debt. Explain why this relationship holds.

The interest tax shield is a key reason why:

In each of the theories of capital structure the cost of equity rises as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all,isn't the goal of the firm to maximize share value and minimize shareholder costs?

Longmont Inc. has a cost of equity of 12% and a pre-tax cost of debt of 6%. The required return on the assets is 10%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes?