Deck 14: Capital Structure: Basic Concepts

Question 1

In an EPS-EBI graphical relationship,the slope of the debt ray is steeper than the equity ray.The debt ray has a lower intercept because:

A)more shares are outstanding for the same level of EBI.
B)the break-even point is higher with debt.
C)a fixed interest charge must be paid even at low earnings.
D)the amount of interest per share has only a positive effect on the intercept.
E)the higher the interest rate the greater the slope.

Answer 1

a fixed interest charge must be paid even at low earnings.

Question 2

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called:

A)private debt placement.
B)the weighted average cost of capital.
C)dividend recapture.
D)homemade leverage.
E)personal offset.

Answer 2

homemade leverage.

Question 3

A levered firm is a company that has:

A)accounts Payable as the only liability on the balance sheet.
B)has some debt in the capital structure.
C)has all equity in the capital structure.
D)All of the above.
E)None of the above.

Answer 3

has some debt in the capital structure.

Question 4

The firm's capital structure refers to:

A)the way a firm invests its assets.
B)the amount of capital in the firm.
C)the amount of dividends a firm pays.
D)the mix of debt and equity used to finance the firm's assets.
E)how much cash the firm holds.

Question 5

The proposition that the cost of equity is a positive linear function of capital structure is called:

A)the capital asset pricing model.
B)MM Proposition I.
C)MM Proposition II.
D)the law of one price.
E)the efficient market hypothesis.

Question 6

A manager should attempt to maximize the value of the firm by:

A)changing the capital structure if and only if the value of the firm increases only to the benefit the debtholders.
B)changing the capital structure if and only if the value of the firm increases to the benefit of inside management.
C)changing the capital structure if and only if the value of the firm increases.
D)changing the capital structure if and only if the value of the firm increases and stockholder wealth is constant.
E)changing the capital structure if and only if the value of the firm increases although it decreases the stockholders' value.

Question 7

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

A)the firm's value is minimized.
B)the firm's bondholders are made well off.
C)the firm's value is maximized.
D)the firms dividend payout is maximized.
E)the firms suppliers of raw materials are satisfied.

Question 8

The unlevered cost of capital is:

A)the cost of capital for a firm with no debt in its capital structure.
B)the cost of capital for a firm with no equity in its capital structure.
C)the interest tax shield times pretax net income.
D)equal to the profit margin for a firm with some debt in its capital structure.
E)the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure.

Question 9

The Modigliani-Miller Proposition I without taxes states:

A)A firm cannot change the total value of its outstanding securities by changing its capital structure proportions.
B)When new projects are added to the firm the firm value is the sum of the old value plus the new.
C)Managers can make correct corporate decisions that will satisfy all shareholders if they select projects that maximize value.
D)The determination of value must consider the timing and risk of the cash flows.
E)None of the above.

Question 10

The proposition that the value of the firm is independent of its capital structure is called:

A)the capital asset pricing model.
B)MM Proposition I.
C)MM Proposition II.
D)the law of one price.
E)the efficient market hypothesis.

Question 11

In an EPS-EBI graphical relationship,the debt ray and equity ray cross.At this point the equity and debt are:

A)equivalent with respect to EPS but above and below this point equity is always superior.
B)at breakeven and MM Proposition II states that debt is the better choice.
C)equal but away from breakeven equity is better as fewer shares are outstanding.
D)at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
E)at breakeven and debt is the better choice below breakeven because small payments can be made.

Question 12

The difference between a market value balance sheet and a book value balance sheet is that a market value balance sheet:

A)places assets on the right hand side.
B)places liabilities on the left-hand side.
C)does not equate the right hand with the left-hand side.
D)lists items in terms of market values, not historical costs.
E)uses the market rate of return.

Question 13

The cost of capital for a firm,r_WACC,in a zero tax environment is:

A)equal to the expected earnings divided by market value of the unlevered firm.
B)equal to the rate of return for that business risk class.
C)equal to the overall rate of return required on the levered firm.
D)is constant regardless of the amount of leverage.
E)All of the above.

Question 14

MM Proposition I without taxes is used to illustrate:

A)the value of an unlevered firm equals that of a levered firm.
B)that one capital structure is as good as another.
C)leverage does not affect the value of the firm.
D)capital structure changes have no effect on stockholder's welfare.
E)All of the above.

Question 15

A key assumption of MM's Proposition I without taxes is:

A)that individuals must be able to borrow on their own account at rates equal to the firm.
B)managers are acting to maximize the value of the firm.
C)that financial leverage increases risk.
D)that individuals can borrow on their own account at rates less than the firm.
E)All of the above.

Question 16

The tax savings of the firm derived from the deductibility of interest expense is called the:

A)interest tax shield.
B)depreciable basis.
C)financing umbrella.
D)current yield.
E)tax-loss carryforward savings.

Question 17

Financial leverage impacts the performance of the firm by:

A)increasing the volatility of the firm's EBIT.
B)decreasing the volatility of the firm's EBIT.
C)decreasing the volatility of the firm's net income.
D)increasing the volatility of the firm's net income
E)None of the above.

Question 18

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

A)Below the indifference or break-even point in EBIT the non-levered structure is superior.
B)Financial leverage increases the slope of the EPS line.
C)Above the indifference or break-even point the increase in EPS for all equity plans is less than debt-equity plans.
D)Above the indifference or break-even point the increase in EPS for all equity plans is greater than debt-equity plans.
E)The rate of return on operating assets is unaffected by leverage.

Question 19

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

A)higher EPS as EBIT increases.
B)increased use of homemade leverage.
C)a higher variability of EPS with debt than all equity.
D)equivalence value between levered and unlevered firms in the presence of taxes.
E)None of the above.

Question 20

When comparing levered vs.unlevered capital structures,leverage works to increase EPS for high levels of EBIT because:

A)interest payments on the debt vary with EBIT levels.
B)interest payments on the debt stay fixed, leaving more income to be distributed over less shares.
C)interest payments on the debt stay fixed, leaving less income to be distributed over less shares.
D)interest payments on the debt stay fixed, leaving less income to be distributed over more shares.
E)interest payments on the debt stay fixed, leaving more income to be distributed over more shares.

Question 21

MM Proposition II is the proposition that:

A)supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
B)a firm's cost of equity capital is a positive linear function of the firm's capital structure.
C)the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.
D)the cost of equity is equivalent to the required return on the total assets of a firm.
E)supports the argument that the size of the pie does not depend on how the pie is sliced.

Question 22

The interest tax shield has no value for a firm when:
I.the tax rate is equal to zero.
II.the debt-equity ratio is exactly equal to 1.
III.the firm is unlevered.
IV.a firm elects 100% equity as its capital structure.

A)I and III only
B)II and IV only
C)I, III, and IV only
D)II, III, and IV only
E)I, II, and IV only

Question 23

The change in firm value in the presence of corporate taxes only is:

A)positive as equity holders face a lower effective tax rate.
B)negative as equity holders gain the tax shield on the debt interest.
C)negative because of the increased risk of default and fewer shares outstanding.
D)negative because of a reduction of equity outstanding.
E)None of the above.

Question 24

MM 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)the capital structure of the firm does not matter because investors can use homemade leverage.
C)the firm is better off with debt based on the weighted average cost of capital.
D)the value of the firm increases as total debt increases because of the interest tax shield.
E)the cost of equity increases as the debt-equity ratio of a firm increases.

Question 25

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding.The company is in the process of borrowing $10 million at 9% interest to repurchase 200,000 shares of the outstanding stock.What is the value of this firm if you ignore taxes?

A)$23.0 million
B)$24.8 million
C)$25.0 million
D)$26.2 million
E)$27.3 million

Question 26

MM Proposition I with no tax supports the argument that:

A)business risk determines the return on assets.
B)the cost of equity rises as leverage rises.
C)it is completely irrelevant how a firm arranges its finances.
D)a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E)financial risk is determined by the debt-equity ratio.

Question 27

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:

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

Question 28

The interest tax shield is a key reason why:

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

Question 29

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 this is known as:

A)MM Proposition III that the cost of stock is less than the cost of debt.
B)MM Proposition I that leverage is invariant to market value.
C)MM Proposition II that the cost of equity is always constant.
D)MM Proposition I that the market value of the firm is invariant to the capital structure.
E)MM Proposition III that there is no risk associated with leverage in a no tax world.

Question 30

The reason that MM Proposition I does not hold in the presence of corporate taxation is because:

A)bondholders require higher rates of return compared with stockholders.
B)levered firms pay less taxes compared with identical unlevered firms.
C)dividends are no longer relevant with taxes.
D)earnings per share are no longer relevant with taxes.
E)All of the above.

Question 31

MM Proposition II with taxes:

A)reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.
B)reveals how the interest tax shield relates to the value of a firm.
C)supports the argument that business risk is determined by the capital structure employed by a firm.
D)supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E)has the same general implications as MM Proposition II without taxes.

Question 32

The capital structure chosen by a firm doesn't really matter because of:

A)taxes.
B)the effects of leverage on the cost of equity.
C)homemade leverage.
D)the interest tax shield.
E)the relationship between dividends and earnings per share.

Question 33

A firm should select the capital structure which:

A)produces the highest cost of capital.
B)has no debt.
C)is fully unlevered.
D)minimizes taxes.
E)maximizes the value of the firm.

Question 34

The concept of homemade leverage is most associated with:

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

Question 35

MM Proposition I with corporate taxes states that:

A)capital structure can affect firm value.
B)by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.
C)firm value is maximized at an all debt capital structure.
D)All of the above.
E)None of the above.

Question 36

Bryan invested in Bryco,Inc.stock when the firm was financed solely with equity.The firm is now utilizing debt in its capital structure.To unlever his position,Bryan needs to:

A)borrow some money and purchase additional shares of Bryco stock.
B)sell some shares of Bryco stock and loan it out such that he creates a personal debt- equity ratio equal to that of the firm.
C)sell some shares of Bryco stock and hold the proceeds in cash.
D)maintain his current position as the debt of the firm did not affect his personal leverage position.
E)create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.

Question 37

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure?
I.a reduction in tax rates
II.a large tax loss carryforward
III.a large depreciation tax deduction
IV.a sizeable increase in taxable income

A)I and II only
B)I and III only
C)II and III only
D)I, II, and III only
E)I, II, III, and IV

Question 38

Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding.The company has decided to borrow $1 million to buy out the shares of a deceased stockholder who holds 2,500 shares.What is the total value of this firm if you ignore taxes?

A)$15.5 million
B)$15.6 million
C)$16.0 million
D)$16.8 million
E)$17.2 million

Question 39

Which of the following statements are correct in relation to MM Proposition II with no taxes?
I.The 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.

A)I and III only
B)II and IV only
C)I and II only
D)III and IV only
E)I and IV only

Question 40

MM Proposition I with taxes supports the theory that:

A)the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.
B)the value of a firm is inversely related to the amount of leverage used by the firm.
C)there is a positive linear relationship between the amount of debt in a levered firm and its value.
D)a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm.
E)a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises.

Question 41

You own 25% of Unique Vactions,Inc.You have decided to retire and want to sell your shares in this closely held,all equity firm.The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock.What is the total value of this firm today if you ignore taxes?

A)$4.8 million
B)$5.1 million
C)$5.4 million
D)$5.7 million
E)$6.0 million

Question 42

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%?

A)7.52%
B)8.78%
C)15.98%
D)16.83%
E)17.30%

Question 43

The Backwoods Lumber Co.has a debt-equity ratio of .80.The firm's required return on assets is 12% and its cost of equity is 16.00%.What is the pre-tax cost of debt based on MM Proposition II with no taxes?

A)6.76%
B)7.00%
C)7.25%
D)7.40%
E)7.50%

Question 44

Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share.The current cost of equity is 12% and the tax rate is 34%.Gail is considering adding $1.25 million of debt with a coupon rate of 8% to her capital structure.The debt will be sold at par value.What is the levered value of the equity?

A)$2.5 million
B)$2.7 million
C)$3.3 million
D)$3.7 million
E)$3.9 million

Question 45

Scott's Leisure Time Sports is an unlevered firm with an after-tax net income of $94,600.The unlevered cost of capital is 10% and the tax rate is 34%.What is the value of this firm?

A)$567,600
B)$781,818
C)$860,000
D)$946,000
E)$1,152,400

Question 46

Anderson's Furniture Outlet has an unlevered cost of capital of 10%,a tax rate of 34%,and expected earnings before interest and taxes of $1,600.The company has $3,000 in bonds outstanding that have an 8% coupon and pay interest annually.The bonds are selling at par value.What is the cost of equity?

A)8.67%
B)9.34%
C)9.72%
D)9.99%
E)10.46%

Question 47

Rosita's has a cost of equity of 12.41% and a pre-tax cost of debt of 8.5%.The debt-equity ratio is .60 and the tax rate is .34.What is Rosita's unlevered cost of capital?

A)11.30%
B)12.33%
C)13.97%
D)14.08%
E)14.60%

Question 48

Bigelow,Inc.has a cost of equity of 13.00% 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?

A).50
B).64
C).72
D).75
E).80

Question 49

The Spartan Co.has an unlevered cost of capital of 11%,a cost of debt of 8%,and a tax rate of 35%.What is the target debt-equity ratio if the targeted cost of equity is 12.5%?

A).44
B).49
C).51
D).66
E).77

Question 50

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?

A)7.29%
B)7.94%
C)8.87%
D)10.40%
E)11.05%

Question 51

Juanita's Steak House has $14,000 of debt outstanding that is selling at par and has a coupon rate of 8%.The tax rate is 34%.What is the present value of the tax shield?

A)$2,823
B)$2,887
C)$4,080
D)$4,500
E)$4,760

Question 52

Hey Guys!,Inc.has debt with both a face and a market value of $3,000.This debt has a coupon rate of 7% and pays interest annually.The expected earnings before interest and taxes is $1,200,the tax rate is 34%,and the unlevered cost of capital is 12%.What is the firm's cost of equity?

A)13.25%
B)13.89%
C)13.92%
D)14.14%
E)14.25%

Question 53

Your firm has a pre-tax cost of debt of 8% and an unlevered cost of capital of 13%.Your tax rate is 35% and your cost of equity is 15.26%.What is your debt-equity ratio?

A).61
B).66
C).70
D).74
E).78

Question 54

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?

A)$696,429
B)$907,679
C)$941,429
D)$1,184,929
E)$1,396,429

Question 55

Bertha's Boutique has 3,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 9%.The interest is paid semi-annually.What is the amount of the annual interest tax shield if the tax rate is 34%?

A)$98,500
B)$90,100
C)$90,750
D)$91,800
E)$92,250

Question 56

The Montana Mount 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?

A)$48,600
B)$50,000
C)$52,680
D)$56,667
E)$60,600

Question 57

Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of 12%.The company has $5,000 in debt that is selling at par value.The levered value of the firm is $12,000 and the tax rate is 34%.What is the pre-tax cost of debt?

A)7.92%
B)8.10%
C)8.16%
D)8.84%
E)9.00%

Question 58

Your firm has a debt-equity ratio of .75.Your pre-tax cost of debt is 8.5% and your required return on assets is 15%.What is your cost of equity if you ignore taxes?

A)11.25%
B)12.21%
C)16.67%
D)19.88%
E)21.38%

Question 59

The Winter Wear Company has expected earnings before interest and taxes of $2,100,an unlevered cost of capital of 14% and a tax rate of 34%.The company also has $2,800 of debt that carries a 7% coupon.The debt is selling at par value.What is the value of this firm?

A)$9,900
B)$10,852
C)$11,748
D)$12,054
E)$12,700

Question 60

Your firm has a $300,000 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%?

A)$6,125
B)$6,309
C)$7,350
D)$17,500
E)$18,025

Question 61

A firm has a debt-to-equity ratio of 1.30.If it had no debt,its cost of equity would be 15%.Its cost of debt is 10%.What is its cost of equity if there are no taxes or other imperfections?

A)10.0%
B)15.5%
C)18.4%
D)21.5%
E)None of the above.

Question 62

Based on MM with taxes and without taxes,how much time should a financial manager spend analyzing the capital structure of his firm?

Question 63

A firm has a debt-to-equity ratio of 1.Its cost of equity is 16%,and its cost of debt is 8%.If there are no taxes or other imperfections,what would be its cost of equity if the debt-to-equity ratio were 0?

A)8%
B)10%
C)12%
D)14%
E)16%

Question 64

A firm has $60,000 of debt outstanding that is selling at par and has a coupon rate of 8%.The tax rate is 40%.What is the present value of the tax shield?

A)$1,760
B)$4,400
C)$24,000
D)$33,000
E)$60,000

Question 65

Given a level of operating income of $2,500,show the specific strategy that Steve has in mind.

Question 66

A firm has a debt-to-equity ratio of 1.Its cost of equity is 16%,and its cost of debt is 8%.If the corporate tax rate is 25%,what would its cost of equity be if the debt-to-equity ratio were 0?

A)11.11%
B)12.57%
C)13.33%
D)16.00%
E)None of the above.

Question 67

In each of the theories of capital structure the cost of equity rises as the amount of debt increases.So why don't financial managers use as little debt as possible to keep the cost of equity down?
After all,isn't the goal of the firm to maximize share value and minimize shareholder costs?

Question 68

A firm has zero debt in its capital structure.Its overall cost of capital is 9%.The firm is considering a new capital structure with 40% debt.The interest rate on the debt would be 4%.Assuming that the corporate tax rate is 34%,what would its cost of equity capital with the new capital structure be?

A)10.3%
B)11.0%
C)11.2%
D)13.9%
E)None of the above.

Question 69

A firm has zero debt in its capital structure.Its overall cost of capital is 10%.The firm is considering a new capital structure with 60% debt.The interest rate on the debt would be 8%.Assuming there are no taxes or other imperfections,its cost of equity capital with the new capital structure would be:

A)9%
B)10%
C)13%
D)14%
E)None of the above.

Question 70

If a firm is unlevered and has a cost of equity capital of 12%,what would its cost of equity be if its debt-equity ratio became 2? The expected cost of debt is 9%.

A)14.0%
B)14.67%
C)16.0%
D)20.0%
E)None of the above.

Question 71

A firm has debt of $10,000,equity of $15,000,a cost of debt of 7%,a cost of equity of 14%,and a tax rate of 40%.What is the firm's weighted average cost of capital?

A)6.30%
B)7.00%
C)10.08%
D)10.40%
E)14.00%

Question 72

A firm has a debt-to-equity ratio of .5.Its cost of equity is 22%,and its cost of debt is 16%.If the corporate tax rate is .40,what would its cost of equity be if the debt-to-equity ratio were 0?

A)14.00%
B)20.61%
C)21.07%
D)22.00%
E)None of the above.

Question 73

A firm has 3,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.5%.The interest is paid semi-annually.What is the amount of the annual interest tax shield if the tax rate is 40%?

A)$81,600
B)$90,100
C)$101,200
D)$119,000
E)$122,000

Question 74

What is the cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5.If it had no debt,its cost of equity would be 14%.Its current cost of debt is 10%.

A)17.6%
B)18.4%
C)19.6%
D)21.4%
E)None of the above.

Question 75

After seeing Steve's analysis,Mike tells Steve that while his analysis looks good on paper,Steve will never be able to borrow at 8%,but would have to pay a more realistic rate of 12%.If Mike is right,what will Steve's payout be?

Question 76

A firm has a debt-to-equity ratio of 1.75.If it had no debt,its cost of equity would be 14%.Its cost of debt is 10%.What is its cost of equity if the corporate tax rate is 50%?

A)14.0%
B)16.0%
C)17.5%
D)21.0%
E)None of the above.

Question 77

A firm has a debt-to-equity ratio of 1.75.If it had no debt,its cost of equity would be 9%.Its cost of debt is 7%.What is its cost of equity if the corporate tax rate is 50%?

A)7.73%
B)10.0%
C)10.75%
D)12.5%
E)None of the above.

Question 78

Explain homemade leverage and why it matters.

Question 79

A firm has a debt-to-equity ratio of .60.Its cost of debt is 8%.Its overall cost of capital is 12%.What is its cost of equity if there are no taxes or other imperfections?

A)10.0%
B)13.5%
C)14.4%
D)18.0%
E)None of the above.

Question 80

A firm has zero debt in its capital structure.Its overall cost of capital is 13%.The firm is considering a new capital structure with 55% debt.The interest rate on the debt would be 7%.Assuming there are no taxes or other imperfections,its cost of equity capital with the new capital structure would be:

A)12.00%
B)13.67%
C)17.53%
D)20.33%
E)None of the above.