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Exam 13: Leverage and Capital Structure

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Question 1

Multiple Choice

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Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure?

A) Static theory of capital structure
B) M&M Proposition I without taxes
C) M&M Proposition II without taxes
D) Homemade leverage theory
E) M&M Proposition I with taxes

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C

Question 2

Multiple Choice

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Roller Coaster's has a WACC of 11.6 percent, ignoring taxes.It has a target capital structure of 60 percent equity and 40 percent debt and a cost of equity of 14.27 percent.What is the cost of debt?

A) 5.5 percent
B) 7.6 percent
C) 9.3 percent
D) 9.4 percent
E) 18.7 percent

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Question 3

Multiple Choice

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A prepack:

T.L.C.Enterprises just revised its capital structure from a debt-equity ratio of .37 to a debt-equity ratio of .48.The firm's shareholders who prefer the old capital structure should:

Bruno's is considering changing from its current all-equity capital structure to 30 percent debt.There are currently 7,500 shares outstanding at a price per share of $39.EBIT is expected to remain constant at $23,000.The interest rate on new debt is 7.5 percent and there are no taxes.Tracie owns $12,675 worth of stock in the company.The firm has a 100 percent payout.What would Tracie's cash flow be under the new capital structure assuming that she keeps all of her shares?

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

When is a firm insolvent from an accounting perspective?

Ready To Go is an all-equity firm specializing in hot ready-to-eat meals.Management has estimated the firm's earnings before interest and taxes will be $68,000 annually forever.The present cost of equity is 14.1 percent.Currently, the firm has no debt but is considering borrowing $450,000 at 8 percent interest.The tax rate is 34 percent.What is the value of the unlevered firm?

An all-equity firm has a return on assets of 17.5 percent.The firm is considering converting to a debt-equity ratio of .40.The pretax cost of debt is 7.5 percent.Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?

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

Alderanian's is an all-equity firm that has 200,000 shares of stock outstanding.Neal, the financial vice president, is considering borrowing $300,000 at 8.5 percent interest to repurchase 50,000 shares.Ignoring taxes, what is the current value of the firm?

Peter's Tools recently defaulted on a bank loan.To avoid a bankruptcy proceeding, the bank agreed to a composition.This composition would do which one of the following?

Newborn Nursery has 12,000 bonds outstanding with a face value of $1,000 each.The coupon rate is 6.9 percent and the tax rate is 34 percent.What is the present value of the interest tax shield?

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?

Jones Inspection Services is an all-equity firm with a total market value of $1,245,000 and 25,000 shares of stock outstanding.Management is considering issuing $200,000 of debt at an interest rate of 6 percent and using the proceeds on a stock repurchase.As an all-equity firm, management believes its earnings before interest and taxes (EBIT) will be $210,000 if the economy is normal, $70,000 if it is in a recession, and $325,000 if the economy booms.Ignore taxes.What will the EPS be if the economy falls into a recession and the firm maintains its all-equity status?

Petrol Service Stations has a tax rate of .percent.Its total interest payment for the year just ended was $41,000.What is the interest tax shield for the year?

Which one of the following best defines legal bankruptcy?

M&M Proposition I with taxes states that:

Triangle Enterprises has no debt but can borrow at 8 percent.The firm's WACC is currently 13.2 percent, and there is no corporate tax.If the firm converts to 30 percent debt, what will its cost of equity be?

Delta Mowers has a debt-equity ratio of .6.Its WACC is 11.8 percent, and its cost of debt is 7.7 percent.There is no corporate tax.What is the firm's cost of equity capital?