Exam 16: Capital Structure: Basic Concepts

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%?

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.Assume MM with taxes.

A firm has debt of $7,000, equity of $12,000, a leveraged value of $8,900, a cost of debt of 7%, a cost of equity of 14%, and a tax rate of 30%.What is the firm's weighted average cost of capital?

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 firm's capital structure refers to:

MM Proposition II with taxes:

An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000.A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon.The applicable tax rate is 35%.What is the value of the levered firm?

MM Proposition I with taxes is based on the concept that:

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.

The Montana Hills Co.has expected earnings before interest and taxes of $8,100, an unlevered cost of capital of 11%, and debt with both a book and face value of $12,000.The debt has an annual 8% coupon.The tax rate is 34%.What is the value of the firm?

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm is known as:

The increase in risk to equityholders when financial leverage is introduced is evidenced by:

Scott's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000.The unlevered cost of capital is 10% and the tax rate is 34%.What is the value of this firm?

Your firm has a $250,000 bond issue outstanding.These bonds have a 7% coupon, pay interest semiannually, and have a current market price equal to 103% of face value.What is the amount of the annual interest tax shield given a tax rate of 35%?

The Nantucket Nugget is unlevered and is valued at $640,000.Nantucket is currently deciding whether including debt in its capital structure would increase its value.The current of 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 its effective marginal tax bracket is 34%.What will Nantucket's new WACC be?

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

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

Bigelow, Inc.has a cost of equity of 13.56% and a pre-tax cost of debt of 7%.The required return on the assets is 11%.What is the firm's debt-equity ratio based on MM Proposition II with no taxes?

Which of the following statements are correct in relation to MM Proposition II with no taxes? I.The required return on assets is equal to the weighted average cost of capital. II.Financial risk is determined by the debt-equity ratio. III.Financial risk determines the return on assets. IV.The cost of equity declines when the amount of leverage used by a firm rises.

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.