Deck 16: Financial Leverage and Capital Structure Policy

Question 1

Which one of the following is the equity risk that is most related to the daily operations of a firm?

A) Market risk
B) Systematic risk
C) Extrinsic risk
D) Business risk
E) Financial risk

Answer 1

Business risk

Question 2

Homemade leverage is:

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the use of personal borrowing to alter an individual's exposure to financial leverage.
D) best defined as an increase in a company's debt level.
E) the term used to describe the capital structure of a levered firm.

Answer 2

the use of personal borrowing to alter an individual's exposure to financial leverage.

Question 3

A firm should select the capital structure that:

A) produces the highest cost of capital.
B) maximizes the value of the firm.
C) minimizes taxes.
D) is fully unlevered.
E) equates the value of debt with the value of equity.

Answer 3

maximizes the value of the firm.

Question 4

Which one of the following makes the capital structure of a company irrelevant?

A) Taxes
B) Interest tax shield
C) 100 percent dividend payout ratio
D) Debt-equity ratio that is greater than 0 but less than 1
E) Homemade leverage

Question 5

Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before interest and taxes (EBIT). The steeper the slope of the plotted line the:

A) lower the impact of financial leverage.
B) lower the debt-equity ratio.
C) higher the tax rate.
D) greater the sensitivity of EPS to changes in EBIT.
E) lower the probability of a negative EPS.

Question 6

Which one of the following states that the value of a company is unrelated to the company's capital structure?

A) Homemade leverage
B) M&M Proposition I, no tax
C) M&M Proposition II, no tax
D) Pecking-order theory
E) Static theory of capital structure

Question 7

The optimal capital structure has been achieved when the:

A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) debt-equity ratio results in the lowest possible weighted average cost of capital.

Question 8

The value of a firm is maximized when the:

A) cost of equity is maximized.
B) tax rate equals the cost of capital.
C) levered cost of capital is maximized.
D) weighted average cost of capital is minimized.
E) debt-equity ratio is minimized.

Question 9

Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to:

A) borrow some money and purchase additional shares of QRT stock.
B) maintain her current equity position as the debt of the firm does not affect her personally.
C) sell 36 percent of her shares of QRT stock and hold the proceeds in cash.
D) sell 36 percent of her shares of QRT stock and loan out the sale proceeds.
E) create a personal debt-equity ratio of .36.

Question 10

Financial risk is:

A) the risk inherent in a company's operations.
B) a type of unsystematic risk.
C) inversely related to the cost of equity.
D) dependent upon a company's capital structure.
E) irrelevant to the value of a company.

Question 11

Which one of the following statements is correct in relation to M&M Proposition II, without taxes?

A) The cost of equity remains constant as the debt-equity ratio increases.
B) The cost of equity is inversely related to the debt-equity ratio.
C) The required return on assets is equal to the weighted average cost of capital.
D) Financial risk determines the return on assets.
E) Financial risk is unaffected by the debt-equity ratio.

Question 12

M&M Proposition I with no tax supports the argument that:

A) business risk has no effect on the return on assets.
B) the cost of equity rises as leverage rises.
C) a company's debt-equity ratio is completely irrelevant.
D) business risk is irrelevant.
E) homemade leverage is irrelevant.

Question 13

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.

A) At the break-even point, there is no advantage to debt.
B) The earnings per share will equal zero when EBIT is zero for a levered firm.
C) The advantages of leverage are inversely related to the level of EBIT.
D) The use of leverage at any level of EBIT increases the EPS.
E) EPS are more sensitive to changes in EBIT when a firm is unlevered.

Question 14

M&M Proposition II, without taxes, is the proposition that:

A) the capital structure of a company has no effect on that company's value.
B) the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
C) a company's cost of equity is a linear function with a slope equal to (RA − RD).
D) the cost of equity is equivalent to the required rate of return on assets.
E) the size of the pie does not depend on how the pie is sliced.

Question 15

Which one of these statements is correct?

A) Capital structure has no effect on shareholder value.
B) The optimal capital structure occurs when the cost of equity is minimized.
C) The optimal capital structure maximizes shareholder value.
D) Shareholder value is maximized when WACC is also maximized.
E) Unlevered firms have more value than levered firms when firms are profitable.

Question 16

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the:

A) company is earning just enough to pay for the cost of the debt.
B) company's earnings before interest and taxes are equal to zero.
C) earnings per share for the levered option are exactly double those of the unlevered option.
D) advantages of leverage exceed the disadvantages of leverage.
E) company has a debt-equity ratio of .50.

Question 17

The concept of homemade leverage is most associated with:

A) M&M Proposition I with no tax.
B) M&M Proposition II with no tax.
C) M&M Proposition I with tax.
D) M&M Proposition II with tax.
E) the static theory proposition.

Question 18

Which one of the following is the equity risk related to capital structure policy?

A) Market risk
B) Systematic risk
C) Static risk
D) Business risk
E) Financial risk

Question 19

The business risk of a company:

A) depends on the company's level of unsystematic risk.
B) is inversely related to the required return on the company's assets.
C) is dependent upon the relative weights of the debt and equity used to finance the company.
D) has a positive relationship with the company's cost of equity.
E) has no relationship with the required return on a company's assets according to M&M theory.

Question 20

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?

A) Static theory of capital structure
B) M&M Proposition I
C) M&M Proposition II
D) Homemade leverage
E) Pecking-order theory

Question 21

The static theory of capital structure advocates that the optimal capital structure for a company:

A) is highly dependent upon a constant debt-equity ratio over time.
B) remains fixed over time.
C) is independent of the company's tax rate.
D) is independent of the company's debt-equity ratio.
E) equates marginal tax savings from additional debt to the marginal increased bankruptcy costs of that debt.

Question 22

M&M Proposition II with taxes:

A) has the same general implications as M&M Proposition II without taxes.
B) states that capital structure is irrelevant to shareholders.
C) supports the argument that business risk is determined by the capital structure decision.
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E) concludes that the capital structure decision is irrelevant to the value of a firm.

Question 23

M&M Proposition I with taxes is based on the concept that:

A) the optimal capital structure is the one that is totally financed with equity.
B) capital structure is irrelevant because investors and companies have differing tax rates.
C) WACC is unaffected by a change in the company's capital structure.
D) the value of a taxable company increases as the level of debt increases.
E) the cost of equity increases as the debt-equity ratio increases.

Question 24

The symbol "RU" refers to the cost of capital for a(n) ________ while "RA" represents the:

A) privately owned entity; unlevered cost of capital.
B) all-equity company; weighted average cost of capital.
C) levered company; cost of capital for an all-equity company.
D) levered company; weighted average cost of capital.
E) unlevered company; average cost of equity.

Question 25

The proposition that a company borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called:

A) the static theory of capital structure.
B) M&M Proposition I, with taxes.
C) M&M Proposition II, with taxes.
D) the pecking-order theory.
E) the open markets theorem.

Question 26

Which one of the following is a direct cost of bankruptcy?

A) Bypassing a positive NPV project to avoid additional debt
B) Investing in cash reserves
C) Maintaining a debt-equity ratio that is lower than the optimal ratio
D) Losing a key company employee
E) Paying an outside accountant to prepare bankruptcy reports

Question 27

The interest tax shield is a key reason why:

A) the required rate of return on assets rises when debt is added to the capital structure.
B) the value of an unlevered company is equal to the value of a levered company.
C) the net cost of debt is generally less than the cost of equity.
D) the cost of debt is equal to the cost of equity for a levered company.
E) companies prefer equity financing over debt financing.

Question 28

The capital structure that maximizes the value of a company also:

A) minimizes financial distress costs.
B) minimizes the cost of capital.
C) maximizes the present value of the tax shield on debt.
D) maximizes the value of the debt.
E) maximizes the present value of the bankruptcy costs.

Question 29

The optimal capital structure of a company:

A) minimizes the company's tax payments.
B) maximizes the value of that company's marketed claims.
C) minimizes both the marketed and nonmarketed claims against that company.
D) eliminates all nonmarketed claims against that company.
E) equates the company's marketed and nonmarketed claims.

Question 30

Which one of the following provides the greatest tendency to increase the percentage of debt included in a company's optimal capital structure?

A) Exceptionally high depreciation expenses
B) Very low marginal tax rate
C) Substantial tax shields from other sources
D) Low probability of financial distress
E) Minimal taxable income

Question 31

The present value of the interest tax shield is expressed as:

A) TCD/RA.
B) VU + TCD.
C) TCDRA.
D) [EBIT(TCD)]/RA.
E) TCD.

Question 32

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings?

A) Interest tax shield
B) Interest credit
C) Homemade leverage shield
D) Current tax yield
E) Tax-loss interest

Question 33

The basic lesson of M&M theory is that the value of a company is dependent upon:

A) the company's capital structure.
B) the total cash flows of that company.
C) minimizing the marketed claims.
D) the amount of the company's marketed claims.
E) size of the stockholders' claims.

Question 34

M&M Proposition I with tax implies that the:

A) weighted average cost of capital decreases as the debt-equity ratio increases.
B) value of a company is inversely related to the amount of leverage used by that company.
C) value of an unlevered company equals the value of a levered company plus the value of the interest tax shield.
D) cost of capital is the same regardless of the mix of debt and equity used.
E) cost of equity increases as the debt-equity ratio decreases.

Question 35

If a company has the optimal amount of debt, then the:

A) direct financial distress costs must equal the present value of the interest tax shield.
B) value of the levered company will exceed the value of the unlevered company.
C) company has no financial distress costs.
D) Value of the firm is equal to VL + TCD.
E) debt-equity ratio is equal to 1.

Question 36

The costs incurred by a business in an effort to avoid bankruptcy are classified as ________ costs.

A) flotation
B) direct bankruptcy
C) indirect bankruptcy
D) financial solvency
E) capital structure

Question 37

Based on M&M Proposition I with taxes, the weighted average cost of capital:

A) is equal to the aftertax cost of debt.
B) has a linear relationship with the cost of equity capital.
C) is unaffected by the tax rate.
D) decreases as the debt-equity ratio increases.
E) is equal to RU(1 − TC).

Question 38

The optimal capital structure:

A) will be the same for all companies within the same industry.
B) will remain constant over time unless the company changes its primary operations.
C) will vary over time as taxes and market conditions change.
D) places more emphasis on operations than on financing.
E) is unaffected by changes in the financial markets.

Question 39

Which one of the following is a marketed claim against the cash flows of a company?

A) Tax payment to the IRS
B) Dividend payment to shareholders
C) Payment of employees' wages
D) Payment for warranty work on a product produced by the company
E) Payment of legal claim against the company

Question 40

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as ________ costs.

A) flotation
B) issue
C) direct bankruptcy
D) indirect bankruptcy
E) unlevered

Question 41

Katlin Markets is debating between a levered and an unlevered capital structure. The all-equity capital structure would consist of 60,000 shares of stock. The debt and equity option would consist of 45,000 shares of stock plus $250,000 of debt with an interest rate of 7.25 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

A) $50,500
B) $68,200
C) $81,400
D) $66,667
E) $72,500

Question 42

Paradise Travels is an all-equity firm that has 9,000 shares of stock outstanding at a market price of $27 a share. Management has decided to issue $25,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 7.3 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.

A) $2.28
B) $1.97
C) $1.67
D) $2.12
E) $1.92

Question 43

Naylor's is an all-equity firm with 48,000 shares of stock outstanding at a market price of $25 a share. The company has earnings before interest and taxes of $87,000. Naylor's has decided to issue $400,000 of debt at 7.3 percent and use the proceeds to repurchase shares. Currently, Angela owns 600 shares of Naylor's stock. How many shares of this stock will she continue to own if she unlevers this position? Assume she can loan out funds at 7.3 percent interest. Ignore taxes.

A) 200
B) 333
C) 400
D) 425
E) 267

Question 44

Which one of these statements related to Chapter 11 bankruptcy is correct?

A) Prepacks apply only to Chapter 7, not Chapter 11, bankruptcies.
B) Senior management must be replaced prior to exiting a Chapter 11 bankruptcy.
C) A company can only file for Chapter 11 after it becomes totally insolvent.
D) Companies sometimes file for Chapter 11 in an attempt to gain a competitive advantage.
E) Chapter 11 involves the total liquidation of the bankrupt firm.

Question 45

Miller's Dry Goods is an all-equity firm with 40,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $160,000. Miller's has decided to add leverage to its financial operations by issuing $200,000 of debt at 7 percent interest and using the proceeds to repurchase shares of stock. Jen owns 500 shares of Miller's stock and can loan out funds at 7 percent interest. How many shares of Miller's stock must Jen sell to offset the leverage that Miller's is assuming? (Assume Jen loans out all of the funds she receives from the sale of stock. Ignore taxes.)

A) 125 shares
B) 100 shares
C) 50 shares
D) 25 shares
E) 75 shares

Question 46

Theo currently owns 700 shares of JKL, which is an all-equity firm with 320,000 shares of stock outstanding at a market price of $25 a share. The company's earnings before interest and taxes are $160,000. JKL has decided to issue $500,000 of debt at 7.5 percent interest and use the proceeds to repurchase shares of stock. How many shares of JKL stock must Theo sell to unlever his position if he can loan out funds at 7.5 percent interest? (Assume partial shares can be sold.)

A) 38.50
B) 42.50
C) 50.00
D) 43.75
E) 46.67

Question 47

Holly's is currently an all-equity firm that has 7,200 shares of stock outstanding at a market price of $41 a share. The firm has decided to leverage its operations by issuing $60,000 of debt at an interest rate of 7.6 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes.

A) $22,435
B) $19,516
C) $26,400
D) $17,141
E) $25,020

Question 48

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long after a company firm files for bankruptcy protection do creditors have to wait before submitting their own reorganization plan to the court?

A) 60 days
B) 45 days
C) 180 days
D) 12 months
E) 18 months

Question 49

The absolute priority rule determines:

A) when a firm must be declared officially bankrupt.
B) how a distressed firm is reorganized.
C) which judge is assigned to a particular bankruptcy case.
D) how long a reorganized firm is allowed to remain under bankruptcy protection.
E) which parties receive payment first in a bankruptcy proceeding.

Question 50

In general, the capital structures of U.S. firms:

A) tend to overweigh debt in relation to equity.
B) generally result in debt-equity ratios between .45 and .55.
C) are fairly standard for all SIC codes.
D) tend to exceed a debt-equity ratio of .45.
E) vary significantly across industries.

Question 51

With the exception of a few industries, most corporations in the U.S. tend to:

A) minimize taxes.
B) underutilize debt.
C) rely equally on debt and equity.
D) have relatively similar debt-equity ratios across industry lines.
E) rely more heavily on debt than on equity.

Question 52

A company is technically insolvent when:

A) it has a negative book value.
B) its total debt exceeds its total equity.
C) it is unable to meet its financial obligations.
D) it files for bankruptcy protection.
E) the market value of its stock is less than its book value.

Question 53

Which one of the following is correct according to pecking-order theory?

A) There is a direct relationship between a company's profits and its debt levels.
B) Companies avoid external debt except as a last resort.
C) A company's capital structure is independent of its need for external funding.
D) Companies stockpile internally generated cash.
E) Every company has an optimal capital structure.

Question 54

Which form of financing do companies prefer to use first according to the pecking-order theory?

A) Regular debt
B) Convertible debt
C) Common stock
D) Preferred stock
E) Internal funds

Question 55

Bankruptcy:

A) occurs when total equity is negative.
B) is a legal proceeding.
C) occurs when a company cannot meet its financial obligations.
D) refers to a loss of value for debt holders.
E) is an inexpensive means of reorganizing a company.

Question 56

Which one of these actions generally occurs first in a bankruptcy reorganization?

A) Filing proofs of claim
B) Dividing creditors into classes
C) Confirming the reorganization plan
D) Distributing cash, property, and securities to creditors
E) Submitting a reorganization plan

Question 57

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this company underwent is known as a:

A) merger.
B) repurchase program.
C) liquidation.
D) reorganization.
E) divestiture.

Question 58

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:

A) permits creditors to file a prepack immediately after a firm files for bankruptcy protection.
B) prevents creditors from submitting any reorganization plans.
C) prevents companies from filing for bankruptcy protection more than once.
D) permits key employee retention plans only if the affected employee(s) has another job offer.
E) allows the payment of bonuses to all key employees to entice those employees to remain in the company's employ.

Question 59

Which one of the following statements related to Chapter 7 bankruptcy is correct?

A) A company in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern.
B) Under a Chapter 7 bankruptcy, a trustee will assume control of the company's assets until those assets can be liquidated.
C) Chapter 7 bankruptcies are always involuntary on the part of the firm.
D) Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy.
E) Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock can be issued.

Question 60

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

A) Consumer claims
B) Dividend payment to preferred shareholders
C) Company contribution to the employees' retirement account
D) Payment to an unsecured creditor
E) Payment of employees' wages

Question 61

Johnson Tire Distributors has debt with both a face and a market value of $35,000. This debt has a coupon rate of 6.6 percent and pays interest annually. The expected earnings before interest and taxes are $8,300, the tax rate is 21 percent, and the unlevered cost of capital is 10.9 percent. What is the cost of equity?

A) 12.46 percent
B) 12.87 percent
C) 14.56 percent
D) 13.59 percent
E) 15.14 percent

Question 62

The Book Worm is an unlevered company with an aftertax net income of $118,406. The unlevered cost of capital is 13.8 percent and the tax rate is 21 percent. What is the value of this company?

A) $557,709
B) $1,320,022
C) $858,014
D) $1,378,414
E) $952,607

Question 63

The Jean Outlet is an all-equity firm that has 64,000 shares of stock outstanding. The company has decided to borrow $120,000 to repurchase 1,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes?

A) $5,340,000
B) $4,638,000
C) $5,068,700
D) $4,950,000
E) $5,120,000

Question 64

ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. The cost of equity for ABC is ________ percent and for XYZ it is ________ percent.

A) 11.74; 9.82
B) 11.74; 12.48
C) 11.74; 14.47
D) 12.09; 9.82
E) 12.09; 12.48

Question 65

Ignoring taxes, Pewter & Glass has a weighted average cost of capital of 10.82 percent. The company can borrow at 7.4 percent. What is the cost of equity if the debt-equity ratio is .68?

A) 12.87%
B) 13.15%
C) 11.09%
D) 15.85%
E) 12.49%

Question 66

Lester's has expected earnings before interest and taxes of $74,800, an unlevered cost of capital of 11.6 percent, and debt with both a book and face value of $84,000. The debt has a coupon rate of 6.35 percent and the tax rate is 24 percent. What is the value of this company?

A) $403,136
B) $347,600
C) $510,229
D) $387,094
E) $428,507

Question 67

Mountain Groves has an unlevered cost of capital of 13.2 percent, a cost of debt of 8.3 percent, and a tax rate of 21 percent. What is the target debt-equity ratio if the targeted cost of equity is 14.5 percent?

A) .54
B) .29
C) .34
D) .48
E) .33

Question 68

An unlevered company has a cost of capital of 14.6 percent and earnings before interest and taxes of $240,090. A levered company with the same operations and assets has a face value of debt of $85,000 with a coupon rate of 7.5 percent that sells at par. The applicable tax rate is 22 percent. What is the value of the levered company?

A) $1,085,338
B) $1,398,257
C) $1,402,509
D) $1,301,373
E) $1,001,010

Question 69

Lamey Co. has an unlevered cost of capital of 12.3 percent, a total tax rate of 25 percent, and expected earnings before interest and taxes of $32,840. The company has $60,000 in bonds outstanding that sell at par and have a coupon rate of 7.2 percent. What is the cost of equity?

A) 13.78 percent
B) 13.36 percent
C) 13.94 percent
D) 14.07 percent
E) 14.29 percent

Question 70

Roy's Welding has a cost of equity of 14.1 percent and a pretax cost of debt of 7.7 percent. The required return on the assets is 13.2 percent. What is the debt-equity ratio based on M&M II with no taxes?

A) .164
B) .217
C) .408
D) .108
E) .583

Question 71

L.A. Clothing has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company?

A) $342,579
B) $273,333
C) $284,108
D) $334,101
E) $305,476

Question 72

Key Motors has a cost of equity of 14.26 percent and an unlevered cost of capital of 11.34 percent. The company has $35,000 in debt that is selling at par value. The levered value of the company is $79,000 and the tax rate is 21 percent. What is the pretax cost of debt?

A) 5.73 percent
B) 6.18 percent
C) 6.58 percent
D) 6.69 percent
E) 5.92 percent

Question 73

Hanover Tech is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

A) $2.209 million
B) $2.005 million
C) $2.312 million
D) $2.012 million
E) $2.108 million

Question 74

Eastern Markets has no debt outstanding and a total market value of $346,500. Earnings before interest and taxes, EBIT, are projected to be $14,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 32 percent lower. The firm is considering a debt issue of $16,000 with an interest rate of 6.8 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,500 shares outstanding. Ignore taxes. What will be the percentage change in EPS if the economy enters a recessionary period?

A) −35 percent
B) −41 percent
C) −32 percent
D) −28 percent
E) −30 percent

Question 75

Lamont Corp. is debt-free and has a weighted average cost of capital of 12.7 percent. The current market value of the equity is $2.3 million and there are no taxes. According to M&M Proposition I, what will be the value of the company if it changes to a debt-equity ratio of .85?

A) $18,110,236
B) $1,955,000
C) $15,393,701
D) $2,705,882
E) $2,300,000

Question 76

Winter's Toyland has a debt-equity ratio of .57. The pretax cost of debt is 8.2 percent and the required return on assets is 14.7 percent. What is the company's cost of equity if you ignore taxes?

A) 14.70 percent
B) 19.74 percent
C) 15.29 percent
D) 17.46 percent
E) 18.41 percent

Question 77

Noelle owns 12 percent of The Toy Factory. She has decided to retire and wants to sell all of her shares in this closely held, all-equity firm. The other shareholders have agreed to have the company borrow the $248,000 needed to repurchase her shares of stock. What is the total market value of the company? Ignore taxes.

A) $2,066,667
B) $2,489,111
C) $2,608,515
D) $2,414,141
E) $2,333,333

Question 78

North Side Inc. has no debt outstanding and a total market value of $168,000. Earnings before interest and taxes, EBIT, are projected to be $18,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 35 percent lower. The company is considering a $50,000 debt issue with an interest rate of 7.4 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding and the tax rate is 21 percent. What will be the percentage change in EPS if the economy has a strong expansion?

A) 28.80 percent
B) 31.26 percent
C) 27.69 percent
D) 25.45 percent
E) 22.00 percent

Question 79

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 112,000 shares of stock outstanding. Under Plan II, there would be 75,000 shares of stock outstanding and $600,000 in debt. The interest rate on the debt is 6.7 percent and there are no taxes. What is the break-even EBIT?

A) $87,879
B) $121,686
C) $101,111
D) $133,333
E) $91,414

Question 80

The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.8 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

A) 8.78 percent
B) 10.68 percent
C) 9.16 percent
D) 7.56 percent
E) 8.40 percent