Annual interest tax shield = 2,000 × $1,000 × .09 × .34 = $61,200
(2)
16. The interest tax shield is a key reason why:
the cost of debt is equal to the cost of equity for a levered firm.
the value of an unlevered firm is equal to the value of a levered firm.
firms prefer equity financing over debt financing.
the required rate of return on assets rises when debt is added to the capital structure.
the net cost of debt to a firm is generally less than the cost of equity.
17. The explicit costs, such as the legal expenses, associated with corporate
default are classified as _____ costs.
flotation
(2)
direct bankruptcy indirect bankruptcy unlevered beta conversion
(2)
18. In an EPS-EBI graphical relationship, the debt ray and equity ray cross. At
this point the equity and debt are:
at breakeven and MM Proposition II states that debt is the better choice.
at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
at breakeven and debt is the better choice below breakeven because small payments can be made.
equal but away from breakeven equity is better as fewer shares are outstanding.
equivalent with respect to EPS but above and below this point equity is always superior.
19. Given realistic estimates of the probability and cost of bankruptcy, the
future costs of a possible bankruptcy are borne by:
debtholders only because if default occurs interest and principal payments are not made.
(0)
→
shareholders because debtholders will pay less for the debt providing less cash for the shareholders.
management because if the firm defaults they will lose their jobs.
None of these. all investors in the firm.
(2)
20. When comparing levered vs. unlevered capital structures, leverage works
to increase EPS for high levels of EBIT because:
interest payments on the debt vary with EBIT levels.
interest payments on the debt stay fixed, leaving more income to be distributed over less shares.
interest payments on the debt stay fixed, leaving more income to be distributed over more shares.
interest payments on the debt stay fixed, leaving less income to be distributed over less shares.
interest payments on the debt stay fixed, leaving less income to be distributed over more shares.
21. MM Proposition I with corporate taxes states that:
firm value is maximized at an all debt capital structure.
(2)
All of these.
by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.
capital structure can affect firm value. None of these.
(2)
22. The increase in risk to equityholders when financial leverage is introduced
is evidenced by:
higher EPS as EBIT increases.
None of these.
a higher variability of EPS with debt than all equity. increased use of homemade leverage.
(2)
equivalence value between levered and unlevered firms in the presence of taxes.
23. MM Proposition I with taxes supports the theory that:
the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.
a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm.
there is a positive linear relationship between the amount of debt in a levered firm and its value.
a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises.
the value of a firm is inversely related to the amount of leverage used by the firm.
24. 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:
the higher the interest rate the greater the slope.
(2)
a fixed interest charge must be paid even at low earnings. more shares are outstanding for the same level of EBI. the break-even point is higher with debt.
(2)
the amount of interest per share has only a positive effect on the intercept.
25. Rosita's has a cost of equity of 13.8% 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?
14.60%
12.30% 14.08% 8.83% 13.97%
.138 = RU + (RU - .085) × .60 × (1 - .34); .17166 = 1.396RU; RU = .12297
= 12.30%
(2)
26. Reena Industries has $10,000 of debt outstanding that is selling at par and
has a coupon rate of 7%. The tax rate is 34%. What is the present value of the tax shield?
$3,400
$3,000 $3,800 $2,800 $7.000
Present value of the tax shield = .34 × $10,000 = $3,400
(2)
27. When graphing firm value against debt levels, the debt level that maximizes the value of the firm is the level where:
the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield.
distress costs as well as debt tax shields are zero. distress costs as well as debt tax shields are maximized.
the increase in the present value of distress costs from an
additional dollar of debt is less than the increase of the present value of the debt tax shield.
the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield.
28. The optimal capital structure has been achieved when the:
debt-equity ratio is equal to 1.
(2)
weight of equity is equal to the weight of debt.
debt-equity ratio is such that the cost of debt exceeds the cost of equity.
debt-equity ratio selected results in the lowest possible weighed average cost of capital.
cost of equity is maximized given a pre-tax cost of debt.
(2)
29. Which of the following statements are correct in relation to MM
Proposition II with no taxes?
I. The required 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.
I and II only
III and IV only II and IV only I and IV only I and III only
(2)
30. A levered firm is a company that has:
some debt in the capital structure.
None of these.
Accounts Payable as the only liability on the balance sheet. All of these.
all equity in the capital structure.
(2)
31. The use of personal borrowing to change the overall amount of financial
leverage to which an individual is exposed is called:
homemade leverage.
dividend recapture. personal offset.