Exam 16: Capital Structure

Consider the Modigliani and Miller world of corporate taxes.An unlevered (all-equity)firm value is $200 million.By adding debt,the annual interest expense is $40 million,the corporate tax rate is 25%,and the discount rate on the tax shield is 6%.What is the value of the firm after adding debt?

The Pecking Order Hypothesis suggests that as a last resort,firms will sell equity to fund investment opportunities.

Pacifica Inc.is an import-export company specializing in products from Canada,Australia,and the West Coast.It can borrow in the debt market at 6%.Its cost of equity with 30% D/V ratio is 11%.Its corporate tax rate is 25%.If the M&M world of taxes holds true,what is the WACC for the firm with a 30% D/V financing?

Investors Al and Bea lend $100,000 to each new idea.Al's history is that he selects low-risk projects or ideas that hit 50% of the time.Bea's history is that she takes on high-risk projects that hit 20% of the time.What rate of return must each successful project pay Al and Bea for them to break even?

At the optimal debt-to-equity ratio,the cost of capital (WACC)is ________ for the firm.This point reflects the maximum benefit of leverage.

Theoretically,the more the earnings,the more a firm should use debt for financing purposes.

Fuji Inc.is registered as a business in the film-making industry and has a required return on its assets of 12%.It can borrow in the debt market at 6%.If there are no taxes and M&M's proposition II holds,what is the cost of equity if there is 100% equity financing?

A simple way of stating the original M&M proposition 1 is that it doesn't matter how you slice the pie-the size of the pie is still the same.

With the background ideas of using the cheapest source first and the impact of asymmetric information,the Pecking Order Hypothesis predicts which of the following?

Pain-Free Inc.is a business dealing in pain reduction medication.It has a required return on its assets of 18%.It can borrow in the debt market at 10%.If there are no taxes and M&M's proposition II holds,what is the cost of equity if there is 50% equity financing and 50% debt financing?

The indirect costs of bankruptcy can include which of the following?

Summarize the Modigliani and Miller contribution to the debate on the optimal capital structure.

Refer to the scenario above.If Southern Cornbread's EBIT is $1,800,compare EPS before and after the new debt.

The Pecking Order Hypothesis predicts which of the following?

________ is the degree to which a firm or individual utilizes borrowed money to make money.

If company earnings give a rate of return less than the cost of debt,then it may be advantageous for the firm to be ________.

With regard to the formula WACC = × Re + × Rd × (1 - Tc),which of the statements below is FALSE?

Landry Corp.is looking at two possible capital structures.Currently,the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding.The market value of each stock is $6.00.The CEO of Landry is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares,leaving 100,000 outstanding.The cost of debt is 10% annually,and the current corporate tax rate for Landry is 30%.If the CEO believes that Landry's EBIT will be $120,000,should the CEO leverage the firm? Explain.

In their later proposition II with taxes,Modigliani and Miller concluded that as more debt is added,the WACC of the firm falls,and the firm's overall value increases for the equity holder.

Below the break-even EBIT,the owners can benefit from financial leverage.