private debt placement.
the weighted average cost of capital.
(2)
32. MM Proposition I without taxes is used to illustrate:
that one capital structure is as good as another.
All of these.
capital structure changes have no effect on stockholders' welfare.
the value of an unlevered firm equals that of a levered firm. leverage does not affect the value of the firm.
(2)
33. 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?
11.05%
8.87% 7.94% 7.29% 10.40%
WACC = [($16k ÷ $21k) × .12] + [($5k ÷ $21k) × .08 × (1 - .34) = .091429 + .012571 = .1040 = 10.40%
(2)
34. 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?
$10,852
$12,054 $9,900
$11,748 $12,700
VU = [$2,100 × (1 - .34)] ÷ .14 = $9,900; VL = $9,900 + (.34 × $2,800) = $10,852
(2)
35. The costs of avoiding a bankruptcy filing by a financially distressed firm
are classified as _____ costs.
capital structure
flotation direct bankruptcy indirect bankruptcy financial solvency
(2)
36. 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 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?
$3.7 million
$2.4 million $3.9 million $2.7 million $3.3 million
VL = (80,000 × $42) + (.34 × $1m) = $3.36m + .34m = $3.7m; VE = $3.7m - $1m = $2.7m
(2)
37. In a world with taxes and financial distress, when a firm is operating with
the optimal capital structure:
I. the debt-equity ratio will also be optimal.
II. the weighted average cost of capital will be at its minimal point. III. the required return on assets will be at its maximum point.
IV. the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.
II, III, and IV only
II and III only I and II only I, II, and IV only I and IV only
(2)
38. 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 the cost of equity be if the debt-to-equity ratio were 0?
12.57%
None of these. 13.33% 11.11% 16.00%
Rs = Ro + (B/S)(1 - Tc)( Ro - rB )
.16 = Ro + (1) (1 - .25) (Ro - .08) .16 = ro + .75ro - .06 .22 = 1.75Ro Ro = 12.57%
(2)
39. Which of the following is true?
Investors will generally view an increase in debt as a positive sign for the firm's value.
Rational firms raise debt levels when profits are expected to decline.
Rational investors are likely to infer a higher firm value from a zero debt level.
A firm with low anticipated profit will likely take on a high level of debt.
A successful firm will probably take on zero debt.
(2)
40. Although the use of debt provides tax benefits to the firm, debt also puts
pressure on the firm to:
meet both interest and dividend payments which when met increase the firm cash flow.
None of these.
meet interest and principal payments which, if not met, can put the company into financial distress.
meet increased tax payments thereby increasing firm value.
(2)
make dividend payments which if not met can put the company into financial distress.
41. A general rule for managers to follow is to set the firm's capital structure
such that:
the firm's value is minimized.
the firm's bondholders are made well off. the firms suppliers of raw materials are satisfied. the firms dividend payout is maximized. the firm's value is maximized.
(2)
42. The reason that MM Proposition I does not hold in the presence of
corporate taxation is because:
dividends are no longer relevant with taxes.
levered firms pay less taxes compared with identical unlevered firms.
bondholders require higher rates of return compared with stockholders.
All of these.
earnings per share are no longer relevant with taxes.
(2)
43. Bigelow, Inc. has a cost of equity of 13.56% 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?
.72 .60 .75 .80 .64
.1356 = .11 + (.11 - .07) × D/E; D/E = .64
(2)
44. The proposition that the value of the firm is independent of its capital structure is called:
MM Proposition II.
MM Proposition I.
the capital asset pricing model. the efficient markets hypothesis. the law of one price.
(2)
45. Salmon 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?
13.25%
13.89% 13.92% 14.14% 14.25%
VU = [EBIT × (1 - Tc)] ÷ RU = [$1,200 × (1- .34)] ÷.12 = $6,600 VL = VU + (Tc × D) = $6,600 + (.34 × $3,000) = $7,620