Deck 26: Analysis of Capital Structure Theory

Question 1

Which of the following statements concerning capital structure theory is
NOT CORRECT?

A) 23
B) 27
C) 32
D) 38

Answer 1

D

Question 2

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Answer 2

True

Question 3

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Answer 3

True

Question 4

In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

Question 5

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

A) The tax shields should be discounted at the unlevered cost of equity.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.
E) The total value of the firm is independent of the amount of debt it uses.

Question 6

The Miller model begins with the MM model with taxes and then adds personal taxes.

Question 7

The MM model is the same as the Miller model, but with zero corporate taxes.

Question 8

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

Question 9

In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Question 10

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

A) The tax shields should be discounted at the cost of debt.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.
E) The total value of the firm increases with the amount of debt.

Question 11

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Question 12

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Question 13

The major contribution of the Miller model is that it demonstrates that

A) personal taxes increase the value of using corporate debt.
B) personal taxes decrease the value of using corporate debt.
C) financial distress and agency costs reduce the value of using corporate debt.
D) equity costs increase with financial leverage.
E) debt costs increase with financial leverage.

Question 14

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Question 15

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Question 16

Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L's cost of equity?

A) 11.4%
B) 12.0%
C) 12.6%
D) 13.3%
E) 14.0%

Question 17

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Question 18

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

Question 19

What is the value of the firm according to MM with corporate taxes?

A) $475,875
B) $528,750
C) $587,500
D) $646,250
E) $710,875

Question 20

In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Question 21

(The following data apply to following Problems. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
According to the MM extension with growth, what is the value of Gomez's tax shield?

A) $156,385
B) $164,616
C) $173,280
D) $182,400
E) $192,000

Question 22

(The following data apply to following Problems. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
According to the MM extension with growth, what is Gomez's value of equity?

A) $1,492,000
B) $1,529,300
C) $1,567,533
D) $1,606,721
E) $1,646,889

Question 23

Assume that the firm's gain from leverage according to the Miller model is
$126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?

A) 16.4%
B) 18.2%
C) 20.2%
D) 22.5%
E) 25.0%

Question 24

(The following data apply to following Problems. The problems MUST be kept together.)
Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%.
According to the MM extension with growth, what is Gomez's unlevered value?

A) $1,296,000
B) $1,440,000
C) $1,600,000
D) $1,760,000
E) $1,936,000

Question 25

Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility ( $\sigma$ ) of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

-What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?

A) $167.57
B) $186.19
C) $204.81
D) $225.29
E) $247.82

Question 26

Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility ( $\sigma$ ) of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050.

-What is the value (in millions) of Trumbull's equity if it is viewed as an option?

A) $228.77
B) $254.19
C) $282.43
D) $313.81
E) $345.19

Question 27

What is the firm's cost of equity?

A) 21.0%
B) 23.3%
C) 25.9%
D) 28.8%
E) 32.0%