Exam 11: Understanding Financing and Payout Decisions

Under terms of the U.S.federal bankruptcy code,chapter ________ call for a ________ procedure.

The interest tax shield represents the value of the reduction in taxes that results from allowable deductions from taxable income.

Miller and Modigliani also studied dividend policy and determined that in their world of perfect capital markets (no taxes,no bankruptcy costs,no asymmetric information)that dividend policy DOES matter.

Under conditions of perfect capital markets,M&M suggest that the average cost of capital for the firm will ________ with the ________ of debt.

Which of the following is NOT generally considered to be a dividend clientele?

Figure 11.1: Selected information for Silicon Solutions Inc. ALL EQUITY EQUTTY AND DEBT Number of shares 1,000,000 750,000 Price per share \ 10 \ 10 Market value of shares \ 10,000,000 \ 7,500,000 Market value of debt - \ 2,500,000 Anticipated operating income \ 1,000,000 \ 1,000,000 Interest - \ 150,000 Earnings (after interest) \ 1,000,000 \ 850,000 Earnings per share \ 1.00 \ 1.13 Return on shares Average cost of capital Return on debt -Use the information for Silicon Solutions found in Figure 11.1 and assume perfect capital markets (PCM)to determine the average cost of capital for the unlevered firm.Then determine the return on shares,the return on debt,and the average cost of capital for the levered firm.What do you think will happen to the return on equity,return on debt,and the average cost of capital for the levered firm if the ratio of debt to equity is increased? Silicon Solutions pays all of its operating income to shareholders as a dividend,which represents the return to the shareholders.Estimates for the firm's operating income next year,and in all subsequent years,is anticipated to be $1.0 million.Note that this is not a guaranteed amount,but simply the best guess of what the operating income will be.Because the firm does not expect the operating income to grow,and because all operating income is paid in dividends,the return to all shareholders will be the dividend yield they receive: $1.0 million relative to the $10 million market value of equity.

$\begin{array}{c}\begin{array}{|l|}\hline \\\hline \\ \hline \text {Anticipated operating income }\\ \hline \text {Interest}\\ \hline \text {Earnings before tax}\\ \hline \text {Tax at 30 \% }\\ \hline \text {Earnings after tax}\\\hline \\ \hline \text {Combined debt and equity income }\\ \text {(interest plus earnings after tax)}\\ \hline \end{array}\begin{array}{l|} \hline \text {ALL EQUTTY}\\ \hline \\ \hline \$ 1,000,000 \\\hline\underline{\quad\quad}\\ \hline\$1,00,000\\ \hline\underline{\$300,000}\\ \hline \$ 700,000 \\ \hline\\ \hline\\\$700,000\\ \hline\end{array}\begin{array}{l|} \hline \text {EQUITY AND DEBT}\\\hline\\\hline\$ 1,000,000 \\\hline\underline{\$ 200,000} \\\hline\$ 800,000 \\\hline\underline{\$-}\\\hline\$\\\hline\\\hline\\\$\\\hline\end{array}\end{array}$ -What are taxes payable for the Equity and Debt firm?

Modigliani and Miller (M&M)proposed a model in which,given certain restrictive assumptions,the capital structure of a firm does not impact the value of the firm.

We can interpret the optimal level of debt as the firm's ________,or the highest amount the firm can borrow before the value of the firm begins to decline.

As we waive the conditions of perfect capital markets and include taxes,M&M suggest that the average cost of capital for the firm will remain unchanged with the addition of debt.

Assume perfect capital markets except that taxes DO exist.Why does the value of the interest tax shield accrue entirely to the shareholders and none of the value goes to the bondholders?

Which of the following is NOT a reason why banks are more willing to lend to some firms than to others?

Modigliani and Miller (M&M)Proposition I states:

A leveraged buyout (LBO)is when we tend to find firms at their lowest debt levels.

Dividend policy can be interpreted as either (1)the cash amount of dividends a firm decides to pay to its shareholders or (2)the percentage of earnings the firm decides to pay as dividends,also known as the dividend payout ratio.

According to data presented by the author,corporate tax rates in the United States are among the lowest across major economies.

$\begin{array}{c}\begin{array}{|l|}\hline \\\hline \\ \hline \text {Anticipated operating income }\\ \hline \text {Interest}\\ \hline \text {Earnings before tax}\\ \hline \text {Tax at 30 \% }\\ \hline \text {Earnings after tax}\\\hline \\ \hline \text {Combined debt and equity income }\\ \text {(interest plus earnings after tax)}\\ \hline \end{array}\begin{array}{l|} \hline \text {ALL EQUTTY}\\ \hline \\ \hline \$ 1,000,000 \\\hline\underline{\quad\quad}\\ \hline\$1,00,000\\ \hline\underline{\$300,000}\\ \hline \$ 700,000 \\ \hline\\ \hline\\\$700,000\\ \hline\end{array}\begin{array}{l|} \hline \text {EQUITY AND DEBT}\\\hline\\\hline\$ 1,000,000 \\\hline\underline{\$ 200,000} \\\hline\$ 800,000 \\\hline\underline{\$-}\\\hline\$\\\hline\\\hline\\\$\\\hline\end{array}\end{array}$ -In the Modigliani and Miller world where we now assume that taxes exist,and that interest payments are tax deductible for firms,then which of the following statements is true?

Capital structure is important,but it CANNOT impact the overall value of a firm.

$\begin{array}{c}\begin{array}{|l|}\hline \\\hline \\ \hline \text {Anticipated operating income }\\ \hline \text {Interest}\\ \hline \text {Earnings before tax}\\ \hline \text {Tax at 30 \% }\\ \hline \text {Earnings after tax}\\\hline \\ \hline \text {Combined debt and equity income }\\ \text {(interest plus earnings after tax)}\\ \hline \end{array}\begin{array}{l|} \hline \text {ALL EQUTTY}\\ \hline \\ \hline \$ 1,000,000 \\\hline\underline{\quad\quad}\\ \hline\$1,00,000\\ \hline\underline{\$300,000}\\ \hline \$ 700,000 \\ \hline\\ \hline\\\$700,000\\ \hline\end{array}\begin{array}{l|} \hline \text {EQUITY AND DEBT}\\\hline\\\hline\$ 1,000,000 \\\hline\underline{\$ 200,000} \\\hline\$ 800,000 \\\hline\underline{\$-}\\\hline\$\\\hline\\\hline\\\$\\\hline\end{array}\end{array}$ -The interest tax shield is equal to:

According to Modigliani and Miller (M&M),in a world of perfect capital markets,except that interest on debt is tax deductible,what will be the expected equity return (or cost of equity)for a firm that has a cost of capital of 14 percent,a cost of debt of 8 percent,a tax rate of 30%,debt valued at $3.0 million,and equity valued at $4.0 million? What would happen to the cost of equity as the amount of debt increased? What would happen to the cost of debt if the amount of debt was increased?