Deck 13: Leverage and Capital Structure

Question 1

A new board of directors of the BMP Corporation is considering a capital restructuring as currently BMP uses no-debt financing.The board is considering issuing $3 400 000 of debt and using the funds to retire one quarter of 160 000 shares that the company currently has outstanding.The interest rate on debt is 8.30% per annum.Calculate the break-even level of earnings before interest and taxes (EBIT)between both capital structure options:

A)$1 128 800
B)$3 240 000
C)$282 200
D)$375 326
E)$2 550 000

Answer 1

$1 128 800

Question 2

The legal and administrative costs of bankruptcy are called _____ bankruptcy costs.

A)static
B)sunk
C)direct
D)indirect
E)overhead

Answer 2

direct

Question 3

Deltona,USA is a development company that is currently financed with 100 per cent equity.There are 15 000 shares outstanding at a market price of $50 a share.Deltona has earnings before interest and taxes (EBIT)of $20 000.The firm has decided to issue $250 000 of debt at a rate of 8 per cent and use the proceeds to repurchase shares.Theresa owns 500 shares of Deltona and wants to use homemade leverage to offset the leverage used by Deltona.Theresa should:

A)buy an additional 167 shares
B)sell 250 shares
C)sell 133 shares
D)buy an additional 150 shares
E)sell 167 shares

Answer 3

sell 167 shares

Question 4

Day 'n Nite currently has 25 000 shares of stock outstanding and no debt.The price per share is $20.The firm is considering borrowing funds at 8 per cent interest and using the proceeds to repurchase 5000 shares of stock.Ignore taxes.How much is the firm borrowing?

A)$180 000
B)$140 000
C)$100 000
D)$165 000
E)$185 000

Question 5

Bartlett Specialists is considering two different capital structures.The first option consists of 15 000 shares of stock.The second option consists of 9000 shares of stock plus $80 000 of debt at an interest rate of 7.5 per cent.Ignore taxes.What is the break-even level of earnings before interest and taxes (EBIT)between these two options?

A)$18 600
B)$19 400
C)$20 800
D)$15 000
E)$20 000

Question 6

Janus International is an all-equity company.You are given the following information for Janus International:
EBIT = $880 000 forever
Corporate tax rate = 25%
Cost of equity = 12%
The company is in the process of issuing $1 000 000 of bonds at par that carry a 11.50% annual coupon.What is the levered value of the firm?

A)$8 000 000
B)$5 528 750
C)$5 750 000
D)$9 800 000
E)$6 655 250

Question 7

The BaPol Company has a cost of equity of 14% and a weighted average cost of capital of 13.02%.What is the company's cost of debt,if BaPol Company maintains the debt-equity ratio of 0.44? Consider that there are no taxes.

A)16.68%
B)13.48%
C)12.26%
D)10.80%
E)17.59%

Question 8

Less Debt Inc.just revised its capital structure such that the firm's debt-equity ratio decreased from 0.80 to 0.40.Those individual investors who prefer the old capital structure:

A)should sell half of their equity holdings and invest in cash
B)should loan out funds equivalent to the amount invested in Less Debt
C)can replicate that structure by increasing their use of homemade leverage
D)should sell half of their equity holdings and loan out the net proceeds of the sale
E)can replicate that structure by reducing their debt and doubling their investment in the firm

Question 9

If we observe capital structures across the industries in Australia,what industry typically has the highest debt-equity ratios,excluding banks?

A)property trusts
B)capital goods
C)gold mining
D)food and staples retailing
E)utilities

Question 10

A firm's optimal capital structure:

A)is the debt-equity ratio that results in the lowest possible weighted average cost of capital
B)exists when the debt-equity ratio is 0.50
C)is found by locating the mix of debt and equity which causes the earnings per share to equal exactly $1
D)is the debt-equity ratio that exists at the point where the firm's weighted after-tax cost of debt is minimised
E)is generally a mix of 40 per cent debt and 60 per cent equity

Question 11

Financial risk is defined as the:

A)credit risk associated with the firm's borrowing
B)equity risk that is derived from a firm's daily operations
C)equity risk that comes from the capital structure of a firm
D)risk associated with a firm's level of surplus cash
E)probability that a firm's weighted average cost of capital (WACC)will increase

Question 12

Blue & Co.is an all-equity firm with a total market value of $230 000.The firm has 25 000 shares outstanding.Management is considering issuing $100 000 of debt at an interest rate of 7 per cent and using the proceeds to repurchase shares.Management estimates that the economy will be fairly normal and thus the firm's earnings before interest and taxes (EBIT)will be $60 000.Ignore taxes.What are the anticipated earnings per share (EPS)if the debt is issued?

A)$3.20
B)$3.54
C)$3.75
D)$3.46
E)$3.82

Question 13

You are comparing two financial policies.The first is all equity.The second involves the use of $2 million of debt.The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT)is $450 000.Given this,it is accurate to say that leverage _____ beneficial to the firm when EBIT is $325 000 and _____ beneficial when EBIT is $625 000.

A)is not;is
B)is not;is not
C)is;is not
D)The answer cannot be determined based on the information provided.
E)is;is

Question 14

M&M Proposition I,with taxes,states that the value of a levered (V_L)firm is equal to:

A)V_U $\div$ (T_C $\times$ D)
B)V_U - (T_C $\times$ D)
C)V_U - (T_C - R_D) $\times$ D
D)V_U + (T_C $\times$ D)
E)V_U + (T_C - R_D) $\times$ D

Question 15

Assume that you are comparing two firms which are identical,with one exception.Firm A is an all-equity firm and firm B has a debt-equity ratio of 0.60.All else equal,firm A will:

A)generate a higher EBIT,but lower net income than firm B
B)generate a lower EBIT,but higher net income than firm B
C)always have higher EPS than firm B,since it has no interest expense
D)have lower EPS than firm B when the level of earnings before interest and taxes (EBIT)is relatively high
E)have lower EPS than firm B when the level of EBIT is relatively low

Question 16

The maximum firm value,according to the static theory of capital structure,occurs at a point where the:

A)financial distress costs are equal to zero
B)value of the firm equalises the costs of financial distress with the present value of the tax shield on debt
C)value of a levered firm initially begins to exceed that of an unlevered firm
D)value of the firm is equal to the value defined by M&M Proposition I,with tax
E)value of the firm,as defined by M&M Proposition I,with tax,is exactly equal to the value of the firm,as defined by M&M Proposition I,without tax

Question 17

The corporate tax rate is 37%.The MaPol Company has a $100 million debenture issue outstanding with a coupon rate of 6.84% per annum.Face value of one debenture is $10 000 and investors require a 7% return on debentures with similar credit rating.What is the present value of the tax shield?

A)$25 300 800
B)$7 000 000
C)$6 840 000
D)$30 160 000
E)$37 000 000

Question 18

Brown's Department Store has a cost of equity of 19.1 per cent,a pre-tax cost of debt of 8 per cent,and a return on assets of 14 per cent.Ignore taxes.What is the debt-equity ratio?

A)0.70
B)0.80
C)0.75
D)0.65
E)0.85

Question 19

Bankruptcy is best defined as:

A)the termination of a going concern
B)the failure of a firm to meet its financial obligations in a timely manner
C)a legal proceeding for liquidating or reorganising a business
D)a legal process for revising the capital structure of a firm
E)the process of closing a business due to the inability to meet financial obligations

Question 20

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

A)homemade leverage
B)capital restructuring
C)M&M Proposition II
D)financial risk management
E)M&M Proposition I

Question 21

T.L.C.Enterprises just revised its capital structure from a debt-equity ratio of 0.30 to a debt-equity ratio of 0.45.The firm's shareholders who prefer the old capital structure should:

A)borrow funds and purchase more shares
B)sell some shares and hold the sale proceeds in cash
C)sell some shares and loan out the sale proceeds
D)sell all of their shares and loan out the entire sale proceeds
E)do nothing

Question 22

Which of the following statements correctly relate to M&M Proposition I,with taxes?
I.Debt decreases the value of a firm.
II.The levered value of a firm exceeds the firm's unlevered value.
III.The weighted average cost of capital (WACC)is constant.
IV.The optimal capital structure is zero debt.

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

Question 23

Which one of the following statements related to the static theory of capital structure is correct?

A)The linear function of a firm's value has a constant positive slope.
B)The value of a firm will automatically decrease whenever the debt-equity ratio is decreased.
C)The actual value of a firm continually rises in direct proportion to the increased use of debt.
D)A firm begins to lose value as soon as the first dollar of debt is incurred.
E)A firm's value is maximised when a firm operates at its optimal debt level.

Question 24

Which one of the following is an implication of M&M Proposition II,without taxes?

A)The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations.
B)WACC decreases as the debt-equity ratio increases.
C)WACC is unaffected by the capital structure of a firm.
D)A firm's optimal capital structure is 100 per cent debt.
E)A firm's capital structure is irrelevant.

Question 25

Which one of the following statements is the core principle of M&M Proposition I,without taxes?

A)A firm's WACC is directly related to the firm's debt-equity ratio.
B)Levered firms have greater value than unlevered firms.
C)The interest tax shield increases the value of a firm.
D)A firm's cost of equity is directly related to the firm's debt-equity ratio.
E)The capital structure of a firm is totally irrelevant.

Question 26

Which of the following will increase the value of a levered firm according to M&M Proposition I,with taxes?
I.decrease in the amount of the debt
II.increase in the value of the unlevered firm
III.decrease in the tax rate
IV.increase in the interest rate on the debt

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

Question 27

Stone House Cafe has a 30 per cent tax rate and total taxes of $35 280.What is the value of the interest tax shield if the interest expense is $16 700?

A)$5010
B)$6023
C)$5708
D)$4887
E)$5395

Question 28

Paying interest reduces the taxes owed by a firm.Which one of the following terms applies to this relationship?

A)financial risk
B)M&M Proposition I
C)interest tax shield
D)static theory of interest rates
E)homemade leverage

Question 29

Which one of the following statements matches M&M Proposition I?

A)The value of a firm is independent of the firm's capital structure.
B)The cost of equity capital has a positive linear relationship with a firm's capital structure.
C)The value of a firm is dependent on the firm's capital structure.
D)The cost of equity capital varies in response to changes in a firm's capital structure.
E)The dividends paid by a firm determine the firm's value.

Question 30

The static theory of capital structure assumes a firm:

A)has an all-equity structure
B)is operating at the point where financial distress costs are eliminated
C)is fixed in terms of its assets
D)pays no taxes
E)maintains a constant debt-equity ratio

Question 31

Which one of the following represents the present value of the interest tax shield?

A)D / T_c
B)D ´(1 - T_c)
C)D/(1 - T_c)
D)D - D(T_c)
E)T_C ´D

Question 32

Which one of the following conditions exists at the point where a firm maximises its value?

A)The debt-equity ratio is 1.0.
B)Financial distress costs are equal to zero.
C)The cost of equity is minimised.
D)WACC is minimised
E)The tax benefit from an additional dollar of debt is zero.

Question 33

Southern Fried Foods has a $12 million bond issue outstanding with a coupon rate of 6.75 per cent and a yield-to-maturity of 7.27 per cent.What is the present value of the tax shield if the tax rate is 35 per cent?

A)$283 500
B)$3 053 400
C)$3 560 000
D)$305 340
E)$4 200 000

Question 34

Which one of the following is the equity risk arising from the capital structure selected by a firm?

A)industry risk
B)strategic risk
C)business risk
D)financial risk
E)liquidity risk

Question 35

Kelner's Nursery has 8000 bonds outstanding with a face value of $1000 each.The coupon rate is 6.5 per cent and the tax rate is 34 per cent.What is the present value of the interest tax shield?

A)$3.26 million
B)$2.72 million
C)$3.09 million
D)$3.13 million
E)$2.83 million

Question 36

Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $879 000.The current cost of equity is 18.3 per cent and the tax rate is 34 per cent.The company is in the process of issuing $6.2 million of 8.5 per cent annual coupon bonds at par.What is the levered value of the firm?

A)$5 278 164
B)$6 422 225
C)$7 385 695
D)$6 713 185
E)$5 541 085

Question 37

Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases?

A)static theory of capital structure
B)M&M Proposition I,with taxes
C)M&M Proposition I,without taxes
D)M&M Proposition II,without taxes
E)No theory suggests this.

Question 38

Which one of the following is the equity risk arising from the daily operations of a firm?

A)liquidity risk
B)financial risk
C)strategic risk
D)business risk
E)industry risk

Question 39

Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt?

A)M&M Proposition I,with taxes
B)M&M Proposition II,with taxes
C)M&M Proposition I,without taxes
D)static theory of capital structure
E)homemade leverage proposition

Question 40

Which one of the following is correct based on the static theory of capital structure?

A)A debt-equity ratio of 1 is considered to be the optimal capital structure.
B)The more debt a firm assumes,the greater the incentive to acquire even more debt until such time as the firm is financed with 100 per cent debt.
C)At the optimal level of debt a firm also optimises its tax shield on debt.
D)A firm receives the greatest benefit from debt financing when its tax rate is relatively low.
E)The costs of financial distress decrease the value of a firm.

Question 41

Which one of the following will generally receive the highest priority in a bankruptcy liquidation,assuming the absolute priority rule is followed?

A)employee wages
B)bankruptcy administrative expenses
C)claims by unsecured creditors
D)contributions to employee superannuation plans
E)government tax claims

Question 42

Barrier Reef Island Resorts has no debt.Its current total value is $58 million.What will the company's value be if it sells $21 million in debt securities and has a tax rate of 30 per cent,assuming that the proceeds will be used to purchase equity?

A)$51 700 000
B)$60 300 000
C)$62 300 000
D)$64 300 000
E)$65 140 000

Question 43

Which one of the following best defines legal bankruptcy?

A)a temporary technical insolvency
B)the internal process of revising the capital structure of a firm
C)negotiating new payment terms with a firm's creditors
D)a legal proceeding for liquidating or reorganising a business
E)the failure of a firm to meet its financial obligations in a timely manner

Question 44

Manly Manufacturing is comparing two different capital structures.Plan I would result in 23 000 shares and $320 000 in debt.Plan II would result in 17 000 shares and $260 000 in debt.The interest rate on the debt is 10 per cent.Ignoring taxes,EPS will be identical for Plans I and II when EBIT equals which one of the following?

A)$9000
B)$10 750
C)$8550
D)$10 400
E)$9600

Question 45

Assume both corporate taxes and financial distress costs apply to a firm.Given this,the static theory of capital structure illustrates that:

A)the value of a firm rises as both the interest rate on debt and the tax rate rise
B)the maximum value of a firm is obtained when a firm is financed solely with debt
C)the value of a firm rises as the interest rate on debt rises
D)a firm's value and its tax rate are inversely related
E)a firm's value and its weighted average cost of capital are inversely related

Question 46

Which one of the following terms refers to the termination of a firm as a going concern?

A)accounting insolvency
B)liquidation
C)technical insolvency
D)legal bankruptcy
E)reorganisation

Question 47

Eastcoast Transport Ltd can borrow at 7.5 per cent.The firm currently has no debt,and the cost of equity is 16 per cent.The current value of the firm is $540 000.What will the value be if the firm borrows $160 000 and uses the proceeds to repurchase shares? The corporate tax rate is 34 per cent.

A)$528 000
B)$552 000
C)$571 000
D)$540 000
E)$594 400

Question 48

Ettalong Electrical Company Ltd has 9000 shares outstanding and no debt.The new CFO is considering issuing $80 000 of debt and using the proceeds to retire 1500 shares.The coupon rate on the debt is 7.5 per cent.What is the break-even level of earnings before interest and taxes between these two capital structure options if the tax rate is 30 per cent?

A)$32 500
B)$24 000
C)$36 000
D)$21 000
E)$18 500

Question 49

When is a firm insolvent from an accounting perspective?

A)when the market value of the firm's equity equals zero
B)when the firm's revenues cease
C)when the firm's debt exceeds the value of the firm's equity
D)when the firm has a negative net worth
E)when the firm is unable to meet its financial obligations in a timely manner