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Chapter 017 Financial Leverage and Capital Structure Policy Multiple Choice Questions 1. The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: A. homemade leverage b. restructured leverage c. the weighted average cost of capital d. restructured private debt e. personal offset SECTION: 17.2 TOPIC: HOMEMADE LEVERAGE TYPE: DEFINITIONS 2. The proposition that the value of a firm is independent of the firm's capital structure is called: a. the capital asset pricing model B. M&M Proposition I c. M&M Proposition II d. the law of one price e. the efficient markets hypothesis SECTION: 17.3 TOPIC: M&M PROPOSITION I TYPE: DEFINITIONS 3. The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure is called: a. the capital asset pricing model b. M&M Proposition I C. M&M Proposition II d. the law of one price e. the efficient markets hypothesis SECTION: 17.3 TOPIC: M&M PROPOSITION II TYPE: DEFINITIONS 17-1 Chapter 017 Financial Leverage and Capital Structure Policy 4. The equity risk derived from the nature of a firm's operating activities is called _ risk. a. market b. systematic c. extrinsic D. business e. financial SECTION: 17.3 TOPIC: BUSINESS RISK TYPE: DEFINITIONS 5. The equity risk derived from a firm's capital structure policy is called _ risk. a. market b. systematic c. extrinsic d. business E. financial SECTION: 17.3 TOPIC: FINANCIAL RISK TYPE: DEFINITIONS 6. The tax savings derived from the deductibility of interest expense is called the: A. interest tax shield b. depreciable basis c. financing umbrella d. current yield e. taxloss carryforward savings SECTION: 17.4 TOPIC: INTEREST TAX SHIELD TYPE: DEFINITIONS 17-2 Chapter 017 Financial Leverage and Capital Structure Policy 7. The unlevered cost of capital is: a. the cost of capital for a firm with no equity in its capital structure B. the cost of capital for a firm that has no debt obligations c. equal to the interest tax shield multiplied by the pretax net income d. equal to the cost of preferred stock for a firm with no debt e. equal to the profit margin for a firm with some debt in its capital structure SECTION: 17.4 TOPIC: UNLEVERED COST OF CAPITAL TYPE: DEFINITIONS 8. The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _ costs. a. flotation b. beta conversion C. direct bankruptcy d. indirect bankruptcy e. unlevered SECTION: 17.5 TOPIC: DIRECT BANKRUPTCY COSTS TYPE: DEFINITIONS 9. The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _ costs. a. flotation b. direct bankruptcy C. indirect bankruptcy d. financial solvency e. capital structure SECTION: 17.5 TOPIC: INDIRECT BANKRUPTCY COSTS TYPE: DEFINITIONS 17-3 Chapter 017 Financial Leverage and Capital Structure Policy 10. The combined explicit and implicit costs associated with corporate default are referred to as the _ costs. a. flotation b. default beta c. direct bankruptcy d. indirect bankruptcy E. financial distress SECTION: 17.5 TOPIC: FINANCIAL DISTRESS COSTS TYPE: DEFINITIONS 11. The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure b. M&M Proposition I c. M&M Proposition II d. the capital asset pricing model e. the open markets theorem SECTION: 17.6 TOPIC: STATIC THEORY OF CAPITAL STRUCTURE TYPE: DEFINITIONS 12. The legal proceeding for liquidating or reorganizing a firm is called: a. a tender offer B. bankruptcy c. merger d. takeover e. proxy fight SECTION: 17.10 TOPIC: BANKRUPTCY TYPE: DEFINITIONS 17-4 Chapter 017 Financial Leverage and Capital Structure Policy 13. The complete termination of a firm as a going business concern is called a: a. merger b. repurchase program C. liquidation d. reorganization e. divestiture SECTION: 17.10 TOPIC: LIQUIDATION TYPE: DEFINITIONS 14. An attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a: a. merger b. repurchase program c. liquidation D. reorganization e. divestiture SECTION: 17.10 TOPIC: REORGANIZATION TYPE: DEFINITIONS 15. The rule establishing the priority of claims in a liquidation is called the: a. waiting line b. queue c. priority positions index D. absolute priority rule e. relative position rule SECTION: 17.10 TOPIC: ABSOLUTE PRIORITY RULE TYPE: DEFINITIONS 17-5 Chapter 017 Financial Leverage and Capital Structure Policy 16. A firm should select the capital structure that: a. produces the highest cost of capital B. maximizes the value of the firm c. minimizes taxes d. is fully unlevered e. equates the value of debt with the value of equity SECTION: 17.1 TOPIC: CAPITAL STRUCTURE TYPE: CONCEPTS 17. The value of a firm is maximized when the: a. cost of equity is maximized b. tax rate is zero c. levered cost of capital is maximized D. weighted average cost of capital is minimized e. debtequity ratio is minimized SECTION: 17.1 TOPIC: CAPITAL STRUCTURE TYPE: CONCEPTS 18. The optimal capital structure has been achieved when the: a. debtequity ratio is equal to 1 b. weight of equity is equal to the weight of debt c. cost of equity is maximized given a pretax cost of debt d. debtequity ratio is such that the cost of debt exceeds the cost of equity E. debtequity ratio results in the lowest possible weighted average cost of capital SECTION: 17.1 TOPIC: CAPITAL STRUCTURE TYPE: CONCEPTS 17-6 Chapter 017 Financial Leverage and Capital Structure Policy 19. Doverton Supply is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debtequity ratio of .40. What should Doverton Supply do if its expected earnings before interest and taxes (EBIT) are less than the breakeven level? Assume there are no taxes. a. select the leverage option because the debtequity ratio is less than .50 b. select the leverage option since the expected EBIT is less than the breakeven level c. select the unlevered option since the debtequity ratio is less than .50 D. select the unlevered option since the expected EBIT is less than the breakeven level e. cannot be determined from the information provided SECTION: 17.2 TOPIC: BREAKEVEN EBIT TYPE: CONCEPTS 20. You have computed the breakeven point between a levered and an unlevered capital structure. Assume there are no taxes. At the breakeven level, the: A. firm is just earning enough to pay for the cost of the debt b. firm's earnings before interest and taxes are equal to zero c. earnings per share for the levered option are exactly double those of the unlevered option d. advantages of leverage exceed the disadvantages of leverage e. firm has a debtequity ratio of .50 SECTION: 17.2 TOPIC: BREAKEVEN EBIT TYPE: CONCEPTS 21. Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. A. When a firm is operating at a point where the actual earnings before interest and taxes (EBIT) exceed the breakeven level, then adding debt to the capital structure will increase the earnings per share (EPS) b. The earnings per share will equal zero when EBIT is zero for a levered firm c. The advantages of leverage are inversely related to the level of EBIT d. The use of leverage at any level of EBIT increases the EPS e. EPS are more sensitive to changes in EBIT when a firm is unlevered SECTION: 17.2 TOPIC: BREAKEVEN EBIT TYPE: CONCEPTS 17-7 Chapter 017 Financial Leverage and Capital Structure Policy 22. Matt invested in Dynamo stock when the firm was unlevered. Since then, Dynamo has become levered. To unlever his position, Matt needs to: a. borrow some money and purchase additional shares of Dynamo stock b. maintain his current position as the debt of the firm did not affect his personal leverage c. position d. sell some shares of Dynamo stock and hold the proceeds in cash E. sell some shares of Dynamo stock and loan out the sale proceeds f. create a personal debtequity ratio that is equal to exactly 50 percent of the debtequity ratio of the firm SECTION: 17.2 TOPIC: HOMEMADE LEVERAGE TYPE: CONCEPTS 23. Which one of the following makes the capital structure of a firm irrelevant? a. taxes b. interest tax shield c. relationship between dividends and earnings per share d. effects of leverage on the cost of equity E. homemade leverage SECTION: 17.2 TOPIC: HOMEMADE LEVERAGE TYPE: CONCEPTS 24. M&M Proposition I with no tax supports the argument that: a. business risk determines the return on assets b. the cost of equity rises as leverage rises C. it is completely irrelevant how a firm arranges its finances d. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress e. financial risk is determined by the debtequity ratio SECTION: 17.3 TOPIC: M&M PROPOSITION I, NO TAX TYPE: CONCEPTS 17-8 Chapter 017 Financial Leverage and Capital Structure Policy 25. The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as: A. M&M Proposition I with no tax b. M&M Proposition II with no tax c. M&M Proposition I with tax d. M&M Proposition II with tax e. static theory proposition SECTION: 17.3 TOPIC: M&M PROPOSITION I, NO TAX TYPE: CONCEPTS 26. The concept of homemade leverage is most associated with: A. M&M Proposition I with no tax b. M&M Proposition II with no tax c. M&M Proposition I with tax d. M&M Proposition II with tax e. static theory proposition SECTION: 17.3 TOPIC: M&M PROPOSITION I, NO TAX TYPE: CONCEPTS 27. Which of the following statements are correct in relation to M&M Proposition II with no taxes? I. The return on assets is equal to the weighted average cost of capital II. Financial risk is determined by the debtequity 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. a. I and III only b. II and IV only C. I and II only d. III and IV only e. I and IV only SECTION: 17.3 TOPIC: M&M PROPOSITION II, NO TAX TYPE: CONCEPTS 17-9 Chapter 017 Financial Leverage and Capital Structure Policy 28. M&M Proposition II is the proposition that: a. supports the argument that the capital structure of a firm is irrelevant to the value of the firm b. the cost of equity depends on the return on debt, the debtequity ratio, and the tax rate C. a firm's cost of equity capital is a positive linear function of the firm's capital structure d. the cost of equity is equivalent to the required return on the total assets of a firm e. supports the argument that the size of the pie does not depend on how the pie is sliced SECTION: 17.3 TOPIC: M&M PROPOSITION II TYPE: CONCEPTS 29. The business risk of a firm: a. depends on the level of unsystematic risk associated with the assets of the firm b. is inversely related to the required return on the firm's assets c. is dependent upon the relative weights of the debt and equity used to finance the firm D. has a positive relationship with the cost of equity for that firm e. has no relationship with the required return on a firm's assets according to M&M Proposition II SECTION: 17.3 TOPIC: BUSINESS RISK TYPE: CONCEPTS 30. Which of the following statements concerning financial risk are correct? I. Financial risk is the risk associated with the use of debt financing II. As financial risk increases so too does the cost of equity III. Financial risk is wholly dependent upon the financial policy of a firm IV. Financial risk is the risk that is inherent in a firm's operations. a. I and III only b. II and IV only c. II and III only D. I, II, and III only e. I, II, III, and IV SECTION: 17.3 TOPIC: FINANCIAL RISK TYPE: CONCEPTS 17-10 Chapter 017 Financial Leverage and Capital Structure Policy 63. You own 20 percent of Holiday Travels, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $800,000 to purchase your 500 shares of stock. What is the total value of Holiday Travels Inc. if you ignore taxes? a. $2.9 million b. $3.2 million c. $3.7 million D. $4.0 million e. $4.8 million Firm value = $800,000 / .20 = $4m AACSB TOPIC: ANALYTIC SECTION: 17.3 TOPIC: M&M PROPOSITION I, NO TAX TYPE: PROBLEMS 64. Marshall's has a debtequity ratio of .60. The pretax cost of debt is 9.1 percent and the required return on assets is 14 percent. What is the cost of equity if you ignore taxes? a. 11.06 percent b. 11.34 percent c. 13.87 percent d. 15.48 percent E. 16.94 percent Re = .14 + (.14 .091) .60 = .1694 = 16.94 percent AACSB TOPIC: ANALYTIC SECTION: 17.3 TOPIC: M&M PROPOSITION II, NO TAX TYPE: PROBLEMS 17-25 Chapter 017 Financial Leverage and Capital Structure Policy 65. Thompson Feed has a cost of equity of 11.9 percent and a pretax cost of debt of 9 percent. The required return on the assets is 11 percent. What is the firm's debtequity ratio based on M&M II with no taxes? a. .40 B. .45 c. .50 d. .55 e. .60 119 = .11 + (.11 .09) D/E; D/E = .45 AACSB TOPIC: ANALYTIC SECTION: 17.3 TOPIC: M&M PROPOSITION II, NO TAX TYPE: PROBLEMS 66. Lizzie's Kitchen has a debtequity ratio of .60. The firm's required return on assets is 11 percent and its cost of equity is 14.7 percent. What is the pretax cost of debt based on M&M II with no taxes? A. 4.83 percent b. 5.39 percent c. 5.70 percent d. 6.17 percent e. 6.67 percent 147= .11 + (.11 Rd) .60; Rd = .0483 = 4.83 percent AACSB TOPIC: ANALYTIC SECTION: 17.3 TOPIC: M&M PROPOSITION II, NO TAX TYPE: PROBLEMS 17-26 Chapter 017 Financial Leverage and Capital Structure Policy 67. Denver Dry Goods has expected earnings before interest and taxes of $14,600, an unlevered cost of capital of 15 percent, and a tax rate of 35 percent. The company also has $3,500 of debt that carries a 6 percent coupon. The debt is selling at par value. What is the value of this firm? a. $63,267 b. $64,184 C. $64,492 d. $65,211 e. $66,267 VU = [$14,600 (1 .35)] / .15 = $63,266.67; VL = $63,266.67 + (.35 $3,500) = $64,491.67 = $64,492 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSTION I, WITH TAX TYPE: PROBLEMS 68. Hanover Tech is currently an all equity firm that has 130,000 shares of stock outstanding with a market price of $36 a share. The current cost of equity is 14 percent and the tax rate is 35 percent. The firm is considering adding $1.5 million of debt with a coupon rate of 7 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity? a. $3.180m b. $3.520m C. $3.705m d. $4.875m e. $5.205m VL = (130,000 $36) + (.35 $1.5m) = $4.68m + .525m = $5.205m; VE = $5.205m $1.5m = $3.705m AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION I, WITH TAX TYPE: PROBLEMS 17-27 Chapter 017 Financial Leverage and Capital Structure Policy 69. Back Woods Coffee has expected earnings before interest and taxes of $34,500, an unlevered cost of capital of 14 percent, and debt with both a book and face value of $20,000. The debt has an annual 7 percent coupon. The tax rate is 35 percent. What is the value of the firm? A. $167,179 b. $174,015 c. $177,778 d. $203,518 e. $241,414 VU = [$34,500 (1 .35)] / .14 = $160,178.57; VL = $160,178.57 + (.35 $20,000) = $167,179 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION I, WITH TAX TYPE: PROBLEMS 70. Swedish Imports is an unlevered firm with an aftertax net income of $79,000. The unlevered cost of capital is 12 percent and the tax rate is 35 percent. What is the value of this firm? a. $427,916 b. $514,250 c. $579,333 d. $611,407 E. $658,333 VU = $79,000 / .12 = $658,333 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION I, WITH TAX TYPE: PROBLEMS 17-28 Chapter 017 Financial Leverage and Capital Structure Policy 71. An unlevered firm has a cost of capital of 16 percent and earnings before interest and taxes of $225,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $850,000 with an 8 percent annual coupon. The applicable tax rate is 34 percent. What is the value of the levered firm? a. $928,125 b. $1,110,125 c. $1,178,125 D. $1,217,125 e. $1,778,125 VU = [$225,000 (1 .34)] / .16 = $928,125; VL = $928,125 + (.34 $850k) = $1,217,125 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION I, WITH TAX TYPE: PROBLEMS 72. Salem Mills has an unlevered cost of capital of 14 percent, a cost of debt of 9 percent, and a tax rate of 34 percent. What is the target debtequity ratio if the targeted cost of equity is 16.5 percent? a. .63 b. .69 c. .73 D. .76 e. .84 165 = .14 + (.14 .09) D/E (1 .34); .025 = .033D/E; D/E = .76 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 17-29 Chapter 017 Financial Leverage and Capital Structure Policy 73. The Fabric Mill has debt with both a face and a market value of $6,500. This debt has a coupon rate of 8 percent and pays interest annually. The expected earnings before interest and taxes are $1,400, the tax rate is 35 percent, and the unlevered cost of capital is 14 percent. What is the firm's cost of equity? a. 17.90 percent b. 18.56 percent c. 22.40 percent d. 23.59 percent E. 25.14 percent VU = [EBIT (1 Tc)] / RU = [$1,400 (1 .35)] /.14 = $6,500 VL = VU + (Tc D) = $6,500 + (.35 $6,500) = $8,775 VL VD = VE = $8,775 $6,500 = $2,275 RE = RU + (RU RD) D/E (1 TC) = .14 + [(.14 .08) ($6,500 / $2,275) (1 .35)] = 25.14 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 74. Uptown Appliances has an unlevered cost of capital of 14 percent, a tax rate of 35 percent, and expected earnings before interest and taxes of $8,200. The company has $15,000 in bonds outstanding that have a 7.5 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity? a. 16.03 percent b. 16.11 percent C. 16.24 percent d. 16.48 percent e. 16.97 percent VU = [EBIT (1 Tc)] / RU = [$8,200 (1 .35)] / .14 = $38,071.43 VL = VU + (Tc D) = $38,071.43 + (.35 $15,000) = $43,321.43 VL VD = VE = $43,321.43 $15,000 = $28,321.43 RE = RU + (RU RD) D/E (1 TC) = .14 + [(.14 .075) ($15,000 / $28,321.43) (1 .35)] = 16.24 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 17-30 Chapter 017 Financial Leverage and Capital Structure Policy 75. The Pizza Palace has a cost of equity of 14.4 percent and an unlevered cost of capital of 10 percent. The company has $18,000 in debt that is selling at par value. The levered value of the firm is $32,000 and the tax rate is 35 percent. What is the pretax cost of debt? A. 4.73 percent b. 6.18 percent c. 6.59 percent d. 7.38 percent e. 9.92 percent 144 = .10 + (.10 RD) [$18,000 / ($32,000 $18,000)] (1 .35); .044 = .083571 835714RD; RD = 4.73 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 76. The Rose Bush has a cost of equity of 14.5 percent and a pretax cost of debt of 9 percent. The debtequity ratio is .70 and the tax rate is .35. What is The Rose Bush's unlevered cost of capital? a. 11.84 percent B. 12.78 percent c. 14.29 percent d. 14.46 percent e. 15.08 percent 145 = RU + (RU .09) .70 (1 .35); .18595 = 1.455RU; RU = 12.78 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 17-31 Chapter 017 Financial Leverage and Capital Structure Policy 77. Glover Tools has a pretax cost of debt of 9 percent and an unlevered cost of capital of 13.5 percent. The firm's tax rate is 34 percent and the cost of equity is 15 percent. What is the firm's debtequity ratio? a. .42 b. .48 C. .51 d. .58 e. .64 15 = .135 + (.135 .09) D/E (1 .34); .015 = .0297D/E; D/E =.51 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 78. Prescription Express has a debtequity ratio of .70. The pretax cost of debt is 8.5 percent while the unlevered cost of capital is 15 percent. What is the cost of equity if the tax rate is 35 percent? a. 13.79 percent b. 14.28 percent C. 17.96 percent d. 18.40 percent e. 18.87 percent RE = .15 + (.15 .085) .70 (1 .35) = 17.96 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: M&M PROPOSITION II, WITH TAX TYPE: PROBLEMS 17-32 Chapter 017 Financial Leverage and Capital Structure Policy 79. Webb Street Books has a $130,000 bond issue outstanding. These bonds have an 8 percent coupon, pay interest semiannually, and have a current market price equal to 101.5 percent of face value. The tax rate is 35 percent. What is the amount of the annual interest tax shield? a. $3,515 B. $3,640 c. $4,480 d. $5,920 e. $6,760 Annual interest tax shield = $130,000 .08 .35 = $3,640 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: INTEREST TAX SHIELD TYPE: PROBLEMS 80. Sam's Men's Wear has 2,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 7.5 percent. The interest is paid semiannually. What is the amount of the annual interest tax shield if the tax rate is 34 percent? a. $63.75 b. $123.75 c. $31,400.00 D. $63,750.00 e. $123,750.00 Annual interest tax shield = 2,500 $1,000 .075 .34 = $63,750 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: INTEREST TAX SHIELD TYPE: PROBLEMS 17-33 Chapter 017 Financial Leverage and Capital Structure Policy 81. Joe's BBQ Grill has $21,000 of debt outstanding that is selling at par and has a coupon rate of 6.5 percent. The tax rate is 35 percent. What is the present value of the tax shield? a. $478 b. $790 c. $1,365 d. $4,780 E. $7,350 Present value of the tax shield = .35 $21,000 = $7,350 AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: INTEREST TAX SHIELD TYPE: PROBLEMS 82. Berkley's has expected earnings before interest and taxes of $3,800. Its unlevered cost of capital is 14.5 percent and its tax rate is 35 percent. Berkley's has debt with both a book and a face value of $2,200. This debt has a 7.5 percent coupon and pays interest annually. What is the firm's weighted average cost of capital? a. 12.48 percent b. 12.99 percent C. 13.87 percent d. 14.14 percent e. 14.37 percent VU = [$3,800 (1 .35)] / .145 = $17,034.48 VL = $17,034.48 + (.35 $2,200) = $17,804.48 VE = VL VD = $17,804.48 $2,200 = $15,604.48 RE = .145 + (.145 .075) ($2,200 / $15,604.48) (1 .35) = .1514148 WACC = [($15,604.48 / $17,804.48) .1514148] + [($2,200 / $17,804.48) .075 (1 35)] = 13.87 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 17-34 Chapter 017 Financial Leverage and Capital Structure Policy 83. A firm has debt of $8,000, a leveraged value of $18,800, a cost of debt of 8.75 percent, a cost of equity of 13 percent, and a tax rate of 35 percent. What is the firm's weighted average cost of capital? A. 9.89 percent b. 10.33 percent c. 10.69 percent d. 11.19 percent e. 12.48 percent WACC = {[($18,800 $8,000) / $18,800] .13} + ($8,000 / $18,800) .0875 (1 .35) = 9.89 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 84. Exley's Farms has a debtequity ratio of .75. The cost of equity is 15 percent and the after tax cost of debt is 5.4 percent. What will the firm's cost of equity be if the debtequity ratio is revised to .60? a. 10.89 percent b. 11.47 percent c. 11.70 percent d. 13.89 percent E. 14.18 percent WACC = [(1.0 / 1.75) .15] + [(.75 / 1.75) .054] = .108857; .108857 = [(1.0 / 1.60) RE] + (.60 / 1.60) .054; RE = 14.18 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS 17-35 Chapter 017 Financial Leverage and Capital Structure Policy 85. Thompson & Jones has earnings before interest and taxes of $149,000. Both the book and the market value of debt is $265,000. The unlevered cost of equity is 13.5 percent while the pretax cost of debt is 9 percent. The tax rate is 34 percent. What is Thompson & Jones' weighted average cost of capital? a. 10.94 percent b. 11.65 percent c. 11.72 percent D. 12.01 percent e. 12.37 percent VU = [$149,000 (1 .34)] / .135 = $728,444.44 VL = $728,444.44 + (.34 $265k) = $818,544.44 VE = VL VD = $818,544.44 $265k = $553,544.44 RE = .135 + (.135 .09) ($265k / $553,544.44) (1 .34) = .149218 WACC = [($553,544.44 / $818,544.44) .149218] + [($265k / $818,544.44) .09 (1 34)] = 12.01 percent AACSB TOPIC: ANALYTIC SECTION: 17.4 TOPIC: WEIGHTED AVERAGE COST OF CAPITAL TYPE: PROBLEMS Essay Questions 86. Draw the following two graphs, one above the other: In the top graph, plot firm value on the vertical axis and total debt on the horizontal axis. Use the graph to illustrate the value of a firm under M&M without taxes, M&M with taxes, and the static theory of capital structure. On the lower graph, plot the WACC on the vertical axis and the debtequity ratio on the horizontal axis. Use the graph to illustrate the value of the firm's WACC under M&M without taxes, M&M with taxes, and the static theory. Briefly explain what the two graphs tell us about firm value and its cost of capital under the three different theories. The student should replicate and explain Figure 17.8 from the text AACSB TOPIC: REFLECTIVE THINKING SECTION: 17.6 TOPIC: CAPITAL STRUCTURE THEORIES 17-36 Chapter 017 Financial Leverage and Capital Structure Policy 87. Based on M&M with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory? Under either M&M scenario, the financial manager should invest no time in analyzing the firm's capital structure. With no taxes, capital structure is irrelevant. With taxes, M&M says a firm will maximize its value by using 100 percent debt. In both cases, the manager has nothing to decide. With the static theory, however, the manager must determine the optimal amount of debt and equity by analyzing the tradeoff between the benefits of the interest tax shield versus the financial distress costs. Finding the optimal capital structure is challenging in this case AACSB TOPIC: REFLECTIVE THINKING SECTION: 17.3 AND 17.4 TOPIC: CAPITAL STRUCTURE THEORIES 88. What is homemade leverage and what is its significance to a firm? Homemade leverage is the ability of investors to alter their own financial leverage to achieve a desired capital structure no matter what a firm's capital structure might be. If investors can use homemade leverage to create additional leverage or to undo existing leverage at their discretion then the actual capital structure decision of the firm itself becomes irrelevant AACSB TOPIC: REFLECTIVE THINKING SECTION: 17.2 TOPIC: HOMEMADE LEVERAGE 17-37 Chapter 017 Financial Leverage and Capital Structure Policy 89. In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm? This question requires students to differentiate between the cost of equity and the weighted average cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades off higher equity costs for lower debt costs. The shareholders benefit (to a point, according to the static theory) because their investment in the firm is leveraged, enhancing the return on their investment. Thus, even though the cost of equity rises, the overall cost of capital declines (again, up to a point according to the static theory) and firm value rises AACSB TOPIC: REFLECTIVE THINKING SECTION: 17.3 TOPIC: COST OF EQUITY 17-38 Chapter 017 Financial Leverage and Capital Structure Policy 90. Explain how a firm loses value during the bankruptcy process from both a creditor and a shareholder perspective. The bankruptcy process is a legal proceeding that either liquidates or reorganizes a firm. Under either situation, legal, accounting, and other administrative fees are incurred. These fees, which are frequently quite substantial, must be paid out of the assets of the firm, thereby reducing the value remaining for the creditors and shareholders. In addition, the bankruptcy process generally transfers value from the shareholders to the creditors based on the absolute priority rule SECTION: 17.10 TOPIC: BANKRUPTCY 17-39 ... 8. The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _ costs. a. flotation b. beta conversion C. direct bankruptcy d. indirect bankruptcy e. unlevered SECTION: 17.5 TOPIC: DIRECT BANKRUPTCY COSTS... E. causes a firm to lose value equal to the bankruptcy "tax." SECTION: 17.5 TOPIC: BANKRUPTCY TYPE: CONCEPTS 39. Which one of the following is a direct bankruptcy cost? a. management time spent on the bankruptcy process... TYPE: DEFINITIONS 9. The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _ costs. a. flotation b. direct bankruptcy C. indirect bankruptcy d. financial solvency