Deck 12: Capital Structure

Question 1

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew after restructuring.Assume no corporate taxes.

A) $3,300,000
B) $5,000,000
C) $500,000
D) $1,000,000

Answer 1

$5,000,000

Question 2

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew after restructuring? Assume corporate taxes of 34%.

A) $5,000,000
B) $5,340,000
C) $3,300,000
D) $1,000,000

Answer 2

$5,340,000

Question 3

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew before restructuring? Assume a corporate tax rate of 34%.

A) $5,000,000
B) $500,000
C) $3,300,000
D) $1,000,000

Answer 3

$3,300,000

Question 4

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew before restructuring? Assume no corporate taxes.

A) $500,000
B) $5,000,000
C) $1,000,000
D) $3,300,000

Question 5

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew after the restructuring,if the PV of bankruptcy cost is $750,000? Assume a corporate tax rate of 34%.

A) $5,000,000
B) $5,340,000
C) $4,590,000
D) $4,250,000

Question 6

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

A) M&M proposition I
B) M&M proposition II
C) the capital asset pricing model
D) none of the above

Question 7

Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase 50,000 shares of outstanding stock.

Calculate Bavarian Brew's earnings per share after the restructuring.Assume no corporate taxes.

A) $2.20
B) $2.50
C) $2.00
D) $2.25

Question 8

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
Refer to Bavarian Brew.If the corporate tax rate equals 34% and dividend income is tax free,at which personal tax rate on interest income is there no gain from leverage?

A) 34%
B) 40%
C) 15%
D) 0%

Question 9

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the present value of Bavarian Brew's debt tax shield after the restructuring? Assume corporate taxes of 34%.

A) $340,000
B) $1,000,000
C) $660,000
D) $0

Question 10

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

A) diversion of management's time
B) constrained capital investment spending
C) lost sales
D) none of the above

Question 11

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
Refer to Bavarian Brew.If the corporate tax rate equals 34% and the personal tax rate on interest income equals 40%,for which tax rate on dividend income is the gain from leverage equal to zero?

A) 15.2%
B) 9.1%
C) 12.6%
D) 6.6%

Question 12

Which of the following is considered an indirect cost of bankruptcy?

A) document printing expenses
B) professional fees paid to lawyers
C) loss of key employees
D) none of the above

Question 13

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%.In addition,assume that the personal tax rate on interest income equals 40% and that there is no tax on dividend income.

A) -$100,000
B) $100,000
C) $340,000
D) -$340,000

Question 14

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
Refer to Bavarian Brew.What is the PV of bankruptcy costs for which the company is indifferent about the proposed change in capital structure?

A) $450,000
B) $750,000
C) $340,000
D) $275,000

Question 15

The uncertainty caused by the variability of a firm's cash flows is called ...

A) financial risk
B) business risk
C) financial leverage
D) none of the above

Question 16

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the Bavarian Brew's required return on levered equity after the restructuring?

A) 10.25%
B) 10.92%
C) 6.00%
D) 12.75%

Question 17

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%.In addition the personal tax rate on dividends for investors is 15% and the personal income tax on interest income equals 40%.

A) $340,000
B) $65,000
C) $150,000
D) $400,000

Question 18

A situation where shareholders refuse financing a "good" investment,because they think that only the bondholders will benefit will lead to ...

A) asset substitution
B) underinvestment
C) overinvestment
D) none of the above

Question 19

Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase 50,000 shares of outstanding stock.

What are Bavarian Brew's earnings per share before the restructuring Assume corporate taxes of 34%

A) $1.32
B) $1.35
C) $1.42
D) $1.45

Question 20

NARRBEGIN: Bavarian Brew
Bavarian Brew
Bavarian Brew,an unlevered firm,has an expected EBIT of $500,000.The required return on assets for the firm's assets is 10%.The company has 250,000 shares outstanding.The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is Bavarian Brew's required return on equity before the restructuring.Assume no corporate taxes.

A) 10%
B) 6%
C) 11%
D) 12%

Question 21

Big Corp.anticipates issuing $5,000,000 of debt to repurchase equity.If Big can issue the debt to yield 8% per year,then what is the increase in value to Big if it issues the debt and is subject to a 34% marginal tax rate?

A) $136,000
B) $400,000
C) $1,700,000
D) none of the above

Question 22

In a world without distress costs or agency problems,calculate the value of Bilever Co.if its perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000.The firm's cost of debt is 5% and its required return on firm's assets is 10%.Assume that Bilever is in the 30% marginal tax rate.

A) $14,000,000
B) $7,000,000
C) $5,600,000
D) none of the above

Question 23

Large Corp.anticipates issuing $5,000,000 of debt to repurchase equity.If Large can issue the debt to yield 8% per year,then what is the single year increase in cash flow to Large if it issues the debt and is subject to a 34% marginal tax rate?

A) $136,000
B) $400,000
C) $2,720,000
D) none of the above

Question 24

Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase 50,000 shares of outstanding stock.

What are Bavarian Brew's earnings per share after the restructuring? Assume corporate taxes of 34%.

A) $1.32
B) $1.35
C) $1.42
D) $1.45

Question 25

Miller’s Drugstore
Miller’s drugstore has an EBIT of $15,000, debt with a market value of $25,000 and a required return on assets of 12%.

Assuming a corporate tax rate of 35%,what is Miller's Drugstore's value?

A) $125,000
B) $25,000
C) $133,750
D) $75,000

Question 26

Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The company is considering raising $1 million in debt with a required return of 6% and would use the proceeds to repurchase 50,000 shares of outstanding stock.

What are Bavarian Brew's earnings per share before the restructuring? Assume no corporate taxes.

A) $2.50
B) $2.25
C) $2.00
D) $1.75

Question 27

In a world without taxes,distress costs,or agency problems,calculate the value of Lever Co.if its perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000.The firm's cost of debt is 5% and its required return on firm's assets is 10%.

A) $19,800,000
B) $10,000,000
C) $9,900,000
D) none of the above

Question 28

If a firm increases its financial leverage,then what would we generally expect for the effect of that increased leverage on EPS to be if the firm's EPS is already quite high?

A) EPS would be lower with financial leverage
B) EPS would always be the same with financial leverage
C) EPS would be higher with financial leverage
D) it is not possible to determine

Question 29

A newly appointed CFO of a company tells you that he needs to determine the required return on unlevered equity should his firm completely deliver.He further tells you that the required return on assets is 10% and that his cost of debt is 3% based upon a current borrowed amount of $50,000,000 but he doesn't know the market value of his equity.What is the required return on equity should his firm eliminate all of its debt?

A) 10.0%
B) 11.5%
C) 13.0%
D) it is impossible to tell

Question 30

Miller’s Drugstore
Miller’s drugstore has an EBIT of $15,000, debt with a market value of $25,000 and a required return on assets of 12%.

Assuming no taxes,what is Miller's Drugstore's value?

A) $15,000
B) $125,000
C) $25,000
D) $75,000

Question 31

If a firm increases its use of financial leverage,then what would we generally expect for the shareholders of that firm to

A) lower their demand for return on their investment.
B) remain indifferent with respect to their return on investment.
C) increase their demand for return on their investment.
D) it is not possible to tell what will happen.

Question 32

Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase equity.If you assume that the Modigliani and Miller assumptions hold,then the effect of this increasing financial leverage transaction should

A) increase the market value of Firm X's shares.
B) have no effect on the market value of Firm X's shares.
C) decrease the market value of Firm X's shares.
D) it is not possible to tell what will happen.

Question 33

Roy's Toy,Inc.currently has no debt outstanding.Its current cost of equity is 12% and the current value of the company is $20,000,000.Roy is proposing to finance 1/4 of its assets with debt at a cost of 8% per annum.What will be Roy's cost of levered equity if things go as planned? Ignore any tax effects.

A) 12.00%
B) 13.00%
C) 13.33%
D) none of the above

Question 34

If a firm increases its use of financial leverage,then what would we generally expect for the effect of that increased leverage to have on an EPS that is already very low?

A) EPS would be lower with financial leverage
B) EPS would always be the same with financial leverage
C) EPS would be higher with financial leverage
D) it is not possible to determine

Question 35

Perfect capital markets describe markets without frictions such as

A) taxes.
B) trading costs.
C) problems transferring information between managers and investors.
D) all of the above.

Question 36

State Company had determined its earnings before interest and taxes (EBIT)in four possible states of the world.In the Great State,EBIT will be $3,000,000 and in the Good,Normal and Poor States EBIT will be $2,000,000,$1,500,000,and $1,000,000 in that order.If each state has an equal probability of occurring,then what is State Company's expected EBIT?

A) $3,000,000
B) $2,500,000
C) $1,875,000
D) none of the above

Question 37

If a firm increases its use of financial leverage,then what would we generally expect for the effect of that increased leverage to have on the dispersion of the firm's Net Income distribution?

A) less dispersion
B) no effect on dispersion
C) greater dispersion
D) there is not enough information to determine

Question 38

If a company issues $25,000 worth of debt and has a corporate tax rate of 40%,what is the PV of the debt tax shield?

A) $25,000
B) $10,000
C) $15,000
D) $20,000

Question 39

If we start with the M&M perfect capital markets assumption and then relax the no tax assumption on corporations,then we would expect for firms that go from no leverage to some leverage to

A) have the levered version of the firm at least as valuable as the no-leverage firm.
B) have the no-leverage version of the firm at least as valuable as the levered firm.
C) change in value depending upon the level of personal taxes.
D) none of the above.

Question 40

Nuclear Widgets has a current cost of levered equity equal to 13%.Its return on assets is 12% and its cost of debt is 8%.Nuclear Widgets has borrowed a total of $5,000,000.What is the current value of Nuclear Widgets' equity? Ignore the effect of taxes.

A) $1,250,000
B) $20,000,000
C) the problem yields a negative number which means the problem is not realistic
D) not enough information is given

Question 41

On-the-Fence Co.(OTF)is considering issuing an additional $5,000,000 perpetual debt.It is subject to a 35% marginal corporate tax rate but is being told that the costs of financial distress on that additional debt is $1,000,000.What should OTF do?

A) Do not issue the debt
B) Issue the debt
C) It doesn't matter what it does as M&M with perfect markets holds
D) none of the above

Question 42

The Globe Incorporated has EBIT of $20 million for the current year.On the firm balance sheet,there is $80 million of debt outstanding that carries a coupon rate of 8 percent.Investors seek a return of 12 percent on the firm,and the firm has a corporate tax rate of 40%.What is the present value of the firm's tax shields?

A) $32,000,000
B) $30,000,000
C) $24,000,000
D) $6,400,000

Question 43

You need to calculate the gains from using $1,000,000 of additional leverage on the average company in the U.S.economy.You are told that the average investor's personal tax rate on income from stock is 15% and that investors can generally avoid personal taxes on income from debt.You are also told that the average corporation is subject to the 35% marginal corporate tax rate.What is the benefit to firm value for this additional debt load?

A) $650,000
B) $447,500
C) $350,000
D) none of the above

Question 44

Which statement is TRUE regarding a firm that increases financial leverage?

A) Average earnings per share increases,while shareholder risk increases.
B) Average earnings per share increases,while shareholder risk decreases.
C) Average earnings per share decreases,while shareholder risk decreases.
D) Average earnings per share decreases,while shareholder risk increases.

Question 45

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.How many shares will be left outstanding after the re-capitalization? (assume that the stock can be repurchased at $50 per share)

A) 60,000
B) 50,000
C) 45,000
D) 40,000

Question 46

If you were to look at leverage for companies in a country where there is a very high cost of attorneys and accountants,all other things being equal you would expect

A) that firms in those countries would utilized less leverage than in other countries.
B) that firms in those countries would utilized more leverage than in other countries.
C) that firms in those countries would utilize no leverage.
D) that firms in those countries would utilize as much leverage as is mathematically possible.

Question 47

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.The tax rate is 40%.What is the earnings per share under the new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share)

A) $4.40
B) $4.20
C) $4.00
D) $3.80

Question 48

The Globe Incorporated has EBIT of $20 million for the current year.On the firm balance sheet,there is $80 million of debt outstanding that carries a coupon rate of 8 percent.Investors seek a return of 12 percent on the firm,and the firm has a corporate tax rate of 40%.What is the value of the firm?

A) $124,000,000
B) $128,000,000
C) $132,000,000
D) $136,000,000

Question 49

The Globe Incorporated has EBIT of $30 million for the current year.On the firm balance sheet,there is $90 million of debt outstanding that carries a coupon rate of 9 percent.Investors seek a return of 12 percent on the firm,and the firm has a corporate tax rate of 40%.What is the value of the firm?

A) $152,000,000
B) $160,000,000
C) $174,000,000
D) $186,000,000

Question 50

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.The tax rate is 40%.What level of EBIT will earnings per share equal zero for shareholders under the new capital structure? (assume that the stock can be repurchased at $50 per share)

A) $0
B) $60,000
C) $120,000
D) $160,000

Question 51

Molotov Cranberry Cocktail Corp finds that the value of the firm is equal to $100,000,000 with no debt.It knows that if it issues new debt,the value of the tax shield will be $3,000,000 while the value of the bankruptcy costs,outside agency costs and inside agency costs will be $1,000,000,$2,000,000,and $4,000,000 in that order.What will the value of Molotov be if it issues the debt?

A) $0
B) $96,000,000
C) $100,000,000
D) none of the above

Question 52

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.What is the new debt-to-equity ratio if the recapitalization is completed? (assume that the stock can be repurchased at $50 per share)

A) 1.50
B) 1.00
C) 0.67
D) 0.33

Question 53

Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget manufacturing plant.Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas.Which of the following best describes the general problem that Y's investors must deal with?

A) The Underinvestment Problem
B) The Overinvestment Problem
C) The Asset Substitution Problem
D) The Enron Problem

Question 54

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.The tax rate is 40%.What is the return on equity under the new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share)

A) 7.4%
B) 8.1%
C) 8.8%
D) 9.5%

Question 55

DebtCo.has $100,000,000 of perpetual debt outstanding with a cost of 9%.DebtCo.is currently subject to a 30% marginal tax rate.If a new president is elected who surprisingly announces that firms like DebtCo.will now be subject to a 35% marginal tax rate,what should be the effect of the immediate value change on DebtCo.?

A) -$35,000,000
B) -$5,000,000
C) $5,000,000
D) $35,000,000

Question 56

You are evaluating a company and have found a new way to calculate the present value of bankruptcy costs,agency costs of outside equity as well as debt.You find that the agency costs of outside equity is $100 while the agency cost of outside debt is $1,000,000.The costs of bankruptcy are also $1,000,000.What type of firm does most likely describe?

A) a firm with too little leverage
B) a firm with too much leverage
C) a firm with too much equity
D) a firm that should disregard its agency costs

Question 57

Costs associated with the requirement that management divert its attention away from strategically managing a corporation in favor of spending time with financial attorneys could be best described as

A) direct bankruptcy costs.
B) indirect bankruptcy costs.
C) managerial-shareholder related agency costs.
D) none of the above.

Question 58

Lord Brack has recently sold 90% of his company to the general public but he remains the CEO of the firm.Unfortunately,the Lord prefers to eat $1,000 lunches in the corporate dining room (for which he does not reimburse the company).What is Lord Brack's cost of these lunches?

A) $1,000
B) $900
C) $100
D) none of the above

Question 59

Fidget Inc.is currently worth $10,000,000.It is told that if it issues $1,000,000 of perpetual debt (and uses the proceeds to repurchase equity)the value of the firm will increase by $290,000.If the total bankruptcy costs and agency costs combine to be a cost of $20,000,what is Fidget's marginal corporate tax rate? Ignore personal taxes.

A) 29%
B) 30%
C) 31%
D) none of the above

Question 60

NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC),you are considering a recapitalization plan that would convert KSC from its current all-equity capital structure to one including substantial financial leverage.KSC now has 100,000 shares of common stock outstanding,which are selling for $50.00 each,and the recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation.The tax rate is 40%.At what level of EBIT will earnings per share be equal for shareholders under each capital structure? (assume that the stock can be repurchased at $50 per share)

A) $350,000
B) $400,000
C) $450,000
D) $500,000

Question 61

In a world with only company-level taxation of operating profits,no costs of bankruptcy,and tax-deductible interest payments,what is the optimal corporate strategy?

A) The firm should use all equity to maximize firm value.
B) The firm should use all debt to maximize its value.
C) The firm's value is independent of the way it is financed.
D) The firm should maximize the use of preferred stock to create value.

Question 62

Which of the following statements is true?

A) The use of debt may lead to financial distress and bankruptcy,thus firms that sell expensive,durable products that may have warranties and ongoing service requirements tend to use less debt.
B) The use of debt may lead to financial distress and bankruptcy,thus firms that sell expensive,durable products that may have warranties and ongoing service requirements tend to use more debt.
C) Companies with a large proportion of tangible assets should be more willing to use debt than firms with mostly intangible assets.
D) Companies with a large proportion of tangible assets should be less willing to use debt than firms with mostly intangible assets.
E) Both (a)and (c)

Question 63

Oak Barrel Company has net operating income of $10 million.Further,the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; and the corporate tax rate is 40 percent.What is the gain from leverage if the personal tax rate on stock income is 20 percent and the personal tax rate on debt income is 30 percent?

A) $22.34 million
B) $23.77 million
C) $24.63 million
D) $25.14 million

Question 64

Which statement is FALSE regarding empirical evidence of capital structures?

A) Capital structures show strong industry patterns.
B) Economy wide leverage ratios are consistent across countries.
C) Leverage ratios are negatively related to the cost of financial distress.
D) Within industries,the most profitable companies borrow the least.

Question 65

Oak Barrel Company has net operating income of $10 million.Further,the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; and the corporate tax rate is 40 percent.What is the value of the Oak Barrel Company?

A) $86.55 million
B) $83.77 million
C) $81.46 million
D) $72.28 million

Question 66

The agency costs of (outside)equity can result in:

A) a benefit to society in the sense that the firm can raise external equity thus generating additional funds that can be invested.
B) a cost to society because the market value of corporate assets is reduced.
C) entrepreneurs paying less than 100% of the cost of consuming perquisites.
D) all of these
E) none of these

Question 67

Financial distress can lead to financial and operating "games." Which of the following statements is (are)true?

A) A firm's stockholders may prefer that the firm engage in riskier projects whereas the firm's bondholders may prefer that the firm invest in low-risk projects.
B) The firm may underinvest in projects because the financing must be provided solely by the stockholders since it is unlikely the firm will be able to borrow additional funds.
C) The firm may underinvest in projects because the financing must be provided solely by the bondholders since it is unlikely the firm will be able to issue additional stock.
D) A firm's bondholders may prefer that the firm engage in riskier projects whereas the firm's stockholders may prefer that the firm invest in low-risk projects.
E) Both (a)and (b)

Question 68

TransMetro Incorporated has EBIT of $1 million for the current year.On the firm balance sheet,there is $6 million of debt outstanding that carries a coupon rate of 15 percent.Investors seek a return of 20 percent on the firm,and the firm has a corporate tax rate of 40%.What is the present value of the firm's tax shields?

A) $2,000,000
B) $2,200,000
C) $2,400,000
D) $2,700,000

Question 69

Bulldog Electronics Corporation finances its operations with $75 million in stock with a required return of 12 percent and $45 million in bonds with a required return of 8 percent.Suppose the firm issues $15 million in additional bonds at 8 percent,using the proceeds to retire $15 million worth of equity.If the WACC remains the same,what will be the firm's new cost of equity? (Assume zero taxes and perfect capital markets)

A) 12.50%
B) 13.00%
C) 14.00%
D) 14.40%

Question 70

NARRBEGIN: ABC Corporation
ABC Corporation
ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity.The debt has a coupon rate of 10%,while the industry return on equity is 15%.ABC Corporation is unsure of the state of the economy in the next year.The tax rate facing the company is 40%.

Refer to ABC Corporation.The company is considering the issue of $10 million in new debt at a rate of 10%.The funds from the new debt will be used to retire $10 million in equity.Currently,there are 1 million shares outstanding trading at $40 per share.Assuming the stock price will remain the same,what is the expected earnings per share in the next year if the company goes through with the re-capitalization?

A) $1.32
B) $1.56
C) $1.68
D) $1.76

Question 71

Burdell Scientific Incorporated finances its operations with $40 million in stock with a required return of 12 percent and $10 million in bonds with a required return of 6 percent.Suppose the firm issues $15 million in additional bonds at 8 percent,using the proceeds to retire $15 million worth of equity.If the WACC remains the same,what will be the firm's new cost of equity? (Assume zero taxes and perfect capital markets)

A) 15.60%
B) 15.00%
C) 14.40%
D) 13.80%

Question 72

NARRBEGIN: ABC Corporation
ABC Corporation
ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity.The debt has a coupon rate of 10%,while the industry return on equity is 15%.ABC Corporation is unsure of the state of the economy in the next year.The tax rate facing the company is 40%.

Refer to ABC Corporation.Given the information in the table,what is the expected earnings per share if the company has 1 million shares outstanding?

A) $1.44
B) $1.56
C) $1.68
D) $1.78

Question 73

NARRBEGIN: Exhibit 12-1
Exhibit 12-1
An all-equity firm has 80,000 shares outstanding worth $20 each.The firm is considering a project requiring an investment of $500,000 and has an NPV of $30,000.The company is also considering financing this project with a new issue of equity.
Refer to Exhibit 12-1.What is the price at which the firm needs to issue the new shares so that the existing shareholders are indifferent to whether the firm takes on the project with this equity financing or does not take on the project?

A) $18.44
B) $18.87
C) $19.71
D) $20.00

Question 74

Which statement is FALSE concerning capital structure?

A) Firms with large amounts of tangible assets tend to use a lot of debt in their capital structures.
B) When corporate profits are taxed at the corporate and personal level,the benefits of leverage are greatly reduced.
C) Modern trade off theory predicts that a firm's optimal debt level is set by trading off the tax benefits of leverage against the agency costs of increased debt.
D) Debt is used more frequently abroad (such as Germany and England)as international laws tend to favor debtors.

Question 75

Financial distress can be particularly dangerous to firms that produce R&D-intensive goods and services because:

A) Most of the expenses incurred in production are sunk costs.
B) It is unlikely to be able to fund future R&D expenditures if it is in financial distress meaning that it is probably not going to be able to produce cutting-edge products in the future.
C) Intangible assets such as patents and trademarks are unlikely to survive the bankruptcy or financial distress intact.
D) all of the above
E) both (a)and (b)

Question 76

NARRBEGIN: Exhibit 12-1
Exhibit 12-1
An all-equity firm has 80,000 shares outstanding worth $20 each.The firm is considering a project requiring an investment of $500,000 and has an NPV of $30,000.The company is also considering financing this project with a new issue of equity.
Refer to Exhibit 12-1.What is the price at which the firm needs to issue the new shares so that the existing shareholders capture the full benefit associated with the new project?

A) $20.48
B) $20.38
C) $20.15
D) $20.07

Question 77

Lightyear Technology Corporation finances its operations with $75 million in stock with a required return of 12 percent and $45 million in bonds with a required return of 8 percent.Suppose the firm issues $15 million in additional bonds at 8 percent,using the proceeds to retire $15 million worth of equity.What will be the firm's new debt to equity ratio? (Assume zero taxes and perfect capital markets)

A) 0.75
B) 0.90
C) 1.00
D) 1.10

Question 78

Oak Barrel Company has net operating income of $10 million.Further,the company has $80 million of debt outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 12 percent; and the corporate tax rate is 35 percent.What is the gain from leverage if the personal tax rate on stock income is 15 percent and the personal tax rate on debt income is 30 percent?

A) $22.34 million
B) $19.41 million
C) $16.86 million
D) $12.19 million

Question 79

Which statement correctly describes proposition I of Modigliani and Miller?

A) The value of the firm is independent of its capital structure.
B) If there is no default risk,firms should exclusively use debt to finance projects.
C) If there is no default risk,firms should exclusively use equity to finance projects.
D) The value of the firm's tax shields depends solely on the amount of debt issued.

Question 80

One method of preventing or reducing the chance that corporate management will harm the bondholders to the benefit of the stockholders is to:

A) require that key executives own a certain percentage of the firm's outstanding stock
B) require that key executives own a certain percentage of the firm's outstanding bonds
C) write detailed covenants into bond contracts.
D) all of the above are acceptable methods