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Exam 16: Financial Leverage and Capital Structure Policy

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Question 31

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Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

A) 0.26
B) 0.33
C) 0.37
D) 0.43
E) 0.45

F) B) and D)
G) C) and D)

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Question 32

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Homemade leverage is:

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
D) best defined as an increase in a firm's debt-equity ratio.
E) the term used to describe the capital structure of a levered firm.

F) B) and E)
G) A) and D)

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Question 33

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The business risk of a firm:

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization?

The Green Paddle has a cost of equity of 13.73 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?

Corporations in the U.S. tend to:

Which one of the following is a direct bankruptcy cost?

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?

The concept of homemade leverage is most associated with:

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest?

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 36 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

The static theory of capital structure advocates that the optimal capital structure for a firm:

M&M Proposition II with taxes:

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 11 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.

Based on the M&M propositions 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?

Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $11,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm?

D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield?