Deck 16: Capital Structure

Question 1

A project will give a one-time cash flow of $35 000 after one year. If the project risk requires a return of 11%, what is the levered value of the firm with perfect capital markets?

A)$31 532
B)$29 000
C)$30 000
D)More information is needed

Answer 1

$31 532

Question 2

Investment cash flows are independent of financing choices in a

A)setting with frictions in investment returns.
B)firm with leverage.
C)perfect capital market.
D)market with frictions.

Answer 2

perfect capital market.

Question 3

What considerations should managers have while deciding on their capital structure?
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Answer 3

Managers should first take a look at the industry norm for the firm. Subsequently, they should consider if the securities issued receive fair price in the market, have tax consequences, entail transaction costs, or require a change to future investment opportunities.

Question 4

Equity in a firm with no debt is called 'unlevered equity'.

Question 5

The relative proportions of debt, equity and other securities that a firm has outstanding constitute its capital structure.

Question 6

Leverage can increase a firm's expected earnings per share, but does not necessarily increase the share price.

Question 7

With perfect capital markets, the total value of a firm should not depend on its capital structure.

Question 8

Financial managers prefer to choose the same debt level no matter which industry they operate in.

Question 9

What is the 'capital structure' of a firm?
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Question 10

Which of the following statements is FALSE?

A)The relative proportions of debt, equity and other securities that a firm has outstanding constitute its capital structure.
B)The most common choices are financing through equity alone and financing through a combination of debt and equity.
C)When corporations raise funds from outside investors, they must choose which type of security to issue.
D)The project's net present value (NPV)represents the value to the new investors of the firm created by the project.

Question 11

Even if two firms operate in the same industry, they may prefer different choices of debt-equity ratios.

Question 12

By adding leverage, the returns on the firm are split between debt holders and equity holders, but equity holder risk remains the same because dividends are paid first.

Question 13

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it is referred to as 'homemade leverage'.

Question 14

What role do industries play in the capital structure choice for a firm?
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Question 15

A financial manager makes a choice of the amount and source of capital based on how the choice will impact:

A)debt-equity ratio.
B)earnings per share.
C)debt value.
D)firm value.

Question 16

In a setting where there is no risk that a firm will default, leverage does not change the risk of equity.

Question 17

With perfect capital markets, because different choices of capital structure offer a benefit to investors, they affect the value of the firm.

Question 18

Which of the following do firms consider in the choice of securities issued?

A)Whether the chosen security will have a fair price in the market
B)The transactions costs of the chosen security
C)The tax consequences of the chosen security
D)All of the above are considered.

Question 19

A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.

A)debt-to-equity
B)debt-to-value
C)asset
D)liability

Question 20

Equity in a firm with debt is called 'risky equity'.

Question 21

Which of the following statements is FALSE?

A)The market value balance sheet captures the idea that value is created by a firm's choice of assets and investments.
B)One application of MM Proposition I is the useful device known as the market value balance sheet of the firm.
C)On the market value balance sheet the total value of all securities issued by the firm must equal the total value of the firm's assets.
D)Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.

Question 22

In general, issuing equity may not dilute the ownership of existing shareholders if

A)the value of new shares is equal to the value of debt.
B)the firm uses debt conservatively.
C)the firm has no debt financing.
D)the new shares are sold at a fair price.

Question 23

A firm requires an investment of $30 000 and borrows $10 000 at 6%. If the return on equity is 15%, what is the firm's pre-tax WACC?

A)11%
B)12%
C)14%
D)13%

Question 24

A firm has a market value of assets of $50 000. It borrows $10 000 at 7%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A)18%
B)19%
C)16%
D)17%

Question 25

Which of the following statements is FALSE?

A)An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.
B)If securities are fairly priced, then buying or selling securities has a net present value (NPV)of zero and, therefore, should not change the value of a firm.
C)The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.
D)As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.

Question 26

It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm because

A)leverage changes the unlevered cost of equity.
B)cost of debt decreases in this setting.
C)leverage decreases the risk of equity of the firm.
D)leverage increases the risk of the equity of the firm.

Question 27

A firm requires an investment of $30 000 and will return $35 000 after 1 year. If the firm borrows $20 000 at 10%, what is the return on levered equity?

A)43%
B)37%
C)30%
D)39%

Question 28

A firm requires an investment of $20 000 and will return $25 000 after one year. If the firm borrows $10 000 at 7%, what is the return on levered equity?

A)43%
B)39%
C)29%
D)37%

Question 29

Which of the following statements is FALSE?

A)With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.
B)The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.
C)In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
D)In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets.

Question 30

A project will give a one-time cash flow of $20 000 after one year. If the project risk requires a return of 8%, what is the levered value of the firm with perfect capital markets?

A)$18 519
B)$19 882
C)$19 915
D)More information is needed

Question 31

A firm requires an investment of $20 000 and borrows $10 000 at 8%. If the return on equity is 20%, what is the firm's pre-tax WACC?

A)14%
B)17%
C)16%
D)15%

Question 32

MM Proposition I states that in a perfect capital market, the total value of a firm is equal to the market value of the ________ generated by its assets.

A)cash flows after taxes
B)earnings after interest
C)free cash flows
D)earnings after taxes

Question 33

A firm has a market value of assets of $50 000. It borrows $10 000 at 5%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A)19.2%
B)20.6%
C)17.5%
D)18.5%

Question 34

Which of the following statements is FALSE?

A)MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
B)When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a 'leveraged recapitalisation'.
C)The choice of capital structure does not change the value of the firm if the cash flows generated by the firm's assets are assumed to remain constant.
D)By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.

Question 35

Which of the following statements is FALSE?

A)The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.
B)When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage.
C)The value of the firm is determined by the present value (PV)of the cash flows from its current and future investments.
D)As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm.

Question 36

A firm requires an investment of $40 000 and borrows $10 000 at 8%. If the return on equity is 20%, what is the firm's pre-tax WACC?

A)15%
B)16%
C)14%
D)17%

Question 37

A firm has a market value of assets of $50 000. It borrows $10 000 at 3%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A)16%
B)18%
C)19%
D)17%

Question 38

Which of the following is NOT one of Modigliani and Miller's conditions for a perfect capital market?

A)A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
B)All investors hold the efficient portfolio of assets.
C)There are no taxes, transaction costs, or issuance costs associated with security trading.
D)Investors and firms can trade the same set of securities at competitive market prices equal to the present value (PV)of their future cash flows.

Question 39

A firm requires an investment of $20 000 and will return $26 500 after one year. If the firm borrows $5 000 at 7%, what is the return on levered equity?

A)43%
B)39%
C)45%
D)41%

Question 40

A firm will give a one-time cash flow of $38 500 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets?

A)$30 000
B)$35 000
C)$38 182
D)More information is needed

Question 41

Consider the following equation for the question(s)below:
E + D = U = A
The A in the equation above represents

A)the value of the firm's unlevered equity.
B)the value of the firm's equity.
C)the value of the firm's debt.
D)the market value of the firm's assets.

Question 42

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
With perfect capital markets, what is the market price per share of Luther's stock after the share repurchase?

A)$24
B)$15
C)$25
D)$20

Question 43

Use the information for the question(s)below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with one million shares outstanding that trade for a price of $24 per share. With has two million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5 000 of your own money to invest and you plan on buying Without shares. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without shares will be the same as a $5 000 investment in With shares. The number of shares of Without you purchased is closest to:

A)2 000
B)1 650
C)425
D)825

Question 44

Consider the following equation for the question(s)below:
E + D = U = A
The E in the equation above represents

A)the market value of the firm's assets.
B)the value of the firm's unlevered equity.
C)the value of the firm's debt.
D)the value of the firm's equity.

Question 45

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)With no debt, the WACC is equal to the unlevered equity cost of capital.
B)As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged.
C)With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is unlevered.
D)Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.

Question 46

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Assume that in addition to 1.25 billion ordinary shares outstanding, Luther has share options given to employees valued at $2 billion. The market value of Luther's non-cash assets is closest to:

A)$20 billion
B)$22 billion
C)$18 billion
D)$25 billion

Question 47

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Assume that in addition to 1.25 billion ordinary shares outstanding, Luther has share options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?

A)1.2 billion
B)1.0 billion
C)0.75 billion
D)1.1 billion

Question 48

Use the information for the question(s)below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with one million shares outstanding that trade for a price of $24 per share. With has two million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5 000 of your own money to invest and you plan on buying With shares. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5 000 investment in Without shares. The number of shares of With you purchased is closest to:

A)425
B)100
C)825
D)1 650

Question 49

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
After the repurchase, how many shares will Luther have outstanding?

A)1.1 billion
B)1.0 billion
C)0.75 billion
D)1.2 billion

Question 50

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)Even if the firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.
B)Since the WACC does not change with the use of leverage, the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.
C)We use the market value of the firms' net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets.
D)Holding cash has the opposite effect of leverage on risk and return.

Question 51

Consider the following equation for the question(s)below:
E + D = U = A
The U in the equation above represents

A)the value of the firm's unlevered equity.
B)the value of the firm's equity.
C)the value of the firm's debt.
D)the market value of the firm's assets.

Question 52

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
The market value of Luther's non-cash assets is closest to:

A)$25 billion
B)$20 billion
C)$24 billion
D)$19 billion

Question 53

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets.
B)When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.
C)If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.
D)The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage.

Question 54

Use the information for the question(s)below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with one million shares outstanding that trade for a price of $24 per share. With has two million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5 000 of your own money to invest and you plan on buying With shares. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5 000 investment in Without shares?

A)$2 500
B)$0
C)$5 000
D)$4 000

Question 55

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)The levered equity return equals the unlevered return, plus an extra 'kick' due to leverage.
B)The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.
C)By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity.
D)If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

Question 56

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.
B)We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of capital.
C)While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.
D)Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

Question 57

Consider the following equation for the question(s)below:
E + D = U = A
Which of the following statements is FALSE?

A)When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project's free cash flow.
B)The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were unlevered.
C)We can calculate the cost of capital of the firm's assets by computing the weighted average of the firm's equity and debt cost of capital, which we refer to as the firm's 'weighted average cost of capital'.
D)If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.

Question 58

Use the information for the question(s)below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the share repurchase plan. Currently, Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
With perfect capital markets, what is the market value of Luther's equity after the share repurchase?

A)$25 billion
B)$20 billion
C)$10 billion
D)$15 billion

Question 59

Use the information for the question(s)below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with one million shares outstanding that trade for a price of $24 per share. With has two million shares outstanding and $12 million in debt at an interest rate of 5%.
According to MM Proposition I, the stock price for With is closest to:

A)$24.00
B)$6.00
C)$12.00
D)$8.00

Question 60

Use the information for the question(s)below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with one million shares outstanding that trade for a price of $24 per share. With has two million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5 000 of your own money to invest and you plan on buying Without shares. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without shares will be the same as a $5 000 investment in With shares?

A)$2 500
B)$0
C)$5 000
D)$10 000

Question 61

The direct costs of bankruptcy are estimated to be far greater, as a percent of assets, than the indirect costs of bankruptcy.

Question 62

Suppose a project financed via an issue of debt requires six annual interest payments of $20 million each year. If the tax rate is 30% and the cost of debt is 8%, what is the value of the interest rate tax shield?

A)$27.74 million
B)$32.64 million
C)$23.20 million
D)$31.35 million

Question 63

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10 000 at 5% to make the investment, what is the expected return to equity holders?

A)11.6%
B)8.0%
C)9.33%
D)30.0%

Question 64

Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?

A)$13.20 million
B)$11.35 million
C)$12.64 million
D)$12.21 million

Question 65

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. What is the value of the company?

A)$23 148.15
B)$41 666.67
C)$32 407.40
D)cannot be determined with the information given

Question 66

A firm requires an investment of $20 000 and borrows $10 000 at 8%. If the return on equity is 20% and the tax rate is 30%, what is the firm's WACC?

A)11.4%
B)12.1%
C)12.8%
D)13.2%

Question 67

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10 000 at 5% to make the investment, what is the return to equity holders if demand is weak?

A)-37.5%
B)-35.3%
C)-58.6%
D)8.0%

Question 68

A bankruptcy process is complex, time-consuming and costly. The costs of bankruptcy include costs of hiring legal experts, appraisers and auctioneers.

Question 69

Which of the following equations would NOT be appropriate to use in a firm with risky debt?

A)β_E = β_U + β_U
B)β_U = β_E + (β_U - β_D)
C)β_E = β_U + (β_U - β_D)
D)β_U = β_E + β_D

Question 70

How does the interest paid by a firm affect its value to investors?
_____________________________________________________________________________________________
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Question 71

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company uses no leverage, what is the expected return to equity holders?

A)9.33%
B)8.0%
C)11.6%
D)30.0%

Question 72

A firm requires an investment of $30 000 and borrows $10 000 at 6%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

A)12.3%
B)11.4%
C)7.8%
D)10.1%

Question 73

Suppose a project financed via an issue of debt requires five annual interest payments of $20 million each year. If the tax rate is 30% and the cost of debt is 5%, what is the value of the interest rate tax shield?

A)$22.25 million
B)$22.67 million
C)$25.98 million
D)$32.35 million

Question 74

A firm that has trouble meeting its debt obligations is said to be in 'financial distress'.

Question 75

Market frictions such as corporate taxes affect the firm's value to its investors and hence play a critical role in the firm's choice of capital structure.

Question 76

In a world with taxes, the interest tax shield tends to reduce a firm's weighted average cost of capital.

Question 77

The following equation: Can be used to calculate all of the following EXCEPT:

A)the cost of capital for the firm's assets.
B)the weighted average cost of capital.
C)the levered cost of equity.
D)the unlevered cost of equity.

Question 78

A firm requires an investment of $30 000 and borrows $20 000 at 7%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

A)9.13%
B)10.4%
C)8.91%
D)8.27%

Question 79

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10 000 at 5% to make the investment, what is the return to equity holders if demand is strong?

A)38.0%
B)54.0%
C)28.6%
D)8.0%

Question 80

In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest rate tax shield.