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Exam 17: Dynamic Capital Structures and Corporate Valuation

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Question 1

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The market value of Firm L's debt is $200,000 and its yield is 9%.The firm's equity has a market value of $300,000,its earnings are growing at a 5% rate,and its tax rate is 40%.A similar firm with no debt has a cost of equity of 12%.Under the MM extension with growth,what would Firm L's total value be if it had no debt?

A) $358,421
B) $377,286
C) $397,143
D) $417,000
E) $437,850

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Question 2

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Which of the following statements concerning capital structure theory is NOT CORRECT?

A) Under MM with zero taxes, financial leverage has no effect on a firm's value.
B) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
C) Under MM with corporate taxes, r_s increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
D) Under MM with corporate taxes, the effect of business risk is automatically incorporated because r_sL is a function of r_sU.
E) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

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Question 3

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MM showed that in a world with taxes,a firm's optimal capital structure would be almost 100% debt.

The Miller model begins with the MM model with taxes and then adds personal taxes.

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

In a world with no taxes,MM show that a firm's capital structure does not affect the firm's value.However,when taxes are considered,MM show a positive relationship between debt and value,i.e.,its value rises as its debt is increased.

The market value of Firm L's debt is $200,000 and its yield is 9%.The firm's equity has a market value of $300,000,its earnings are growing at a rate of 5%,and its tax rate is 40%.A similar firm with no debt has a cost of equity of 12%.Under the MM extension with growth,what is Firm L's cost of equity?

Exhibit 17.1 Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to Exhibit 17.1.Assume that the firm's gain from leverage according to the Miller model is $126,667.If the effective personal tax rate on stock income is T_S = 20%,what is the implied personal tax rate on debt income?

Exhibit 17.3 The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d₁) = 0.9720 and N(d₂) = 0.9050. -Refer to Exhibit 17.3.What is the value (in millions) of Wilson Dover's debt if its equity is viewed as an option?

In the MM extension with growth,the appropriate discount rate for the tax shield is the after-tax cost of debt.

Exhibit 17.2 Kitto Electronics has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Kitto must reinvest 20% of its EBIT in net operating assets. Kitto has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -Refer to Exhibit 17.2.According to the MM extension with growth,what is Kitto's value of equity?

In the MM extension with growth,the appropriate discount rate for the tax shield is the unlevered cost of equity.

MM showed that in a world without taxes,a firm's value is not affected by its capital structure.

Exhibit 17.1 Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to Exhibit 17.1.What is the value of the firm according to MM with corporate taxes?

When a firm has risky debt,its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

The MM model with corporate taxes is the same as the Miller model,but with zero personal taxes.

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

Exhibit 17.3 The total value (debt plus equity) of Wilson Dover Inc. is $500 million and the face value of its 1-year coupon debt is $200 million. The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%. Assume that N(d₁) = 0.9720 and N(d₂) = 0.9050. -Refer to Exhibit 17.3.What is the value (in millions) of Wilson Dover's equity if it is viewed as an option?

The MM model is the same as the Miller model,but with zero corporate taxes.

According to MM,in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.