Deck 16: Capital Structure

Question 1

Even if two firms operate in the same industry,they may prefer different choices of debt-equity ratios.

Answer 1

True

Question 2

By adding leverage,the returns of the firm are split between debt holders and equity holders,but equity-holder risk increases because

A) interest payments can be rolled over.
B) dividends are paid first.
C) debt and equity have equal priority.
D) interest payments have first priority.
E) interest payments are so high.

Answer 2

interest payments have first priority.

Question 3

Financial managers prefer to choose the same debt level no matter which industry they operate in.

Answer 3

False

Question 4

What considerations should managers have while deciding on their capital structure?

Question 5

Equity in a firm with no debt is called unlevered equity.

Question 6

A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.

A) debt-to-equity
B) asset
C) debt-to-value
D) liability
E) obligations

Question 7

Equity in a firm with debt is called

A) risk-free equity.
B) risky equity.
C) shareholders' equity.
D) unlevered equity.
E) levered equity.

Question 8

Equity in a firm with no debt is called

A) risk-free equity.
B) risky equity.
C) shareholders' equity.
D) unlevered equity.
E) levered equity.

Question 9

With perfect capital markets,because different choices of capital structure offer a benefit to investors,they affect the value of the firm.

Question 10

The relative proportions of debt,equity,and other securities that a firm has outstanding constitute its

A) capital structure.
B) leverage.
C) retained earnings.
D) paid-out capital.
E) debt-to-value ratio.

Question 11

A financial manager makes a choice of the amount and source of capital based on how the choice will impact

A) debt-equity ratio.
B) debt value.
C) earnings per share.
D) firm value.
E) profit.

Question 12

We discount the cash flows of a levered firm with a different discount rate than the cost of equity of the unlevered firm because

A) leverage decreases the risk of equity of the firm.
B) leverage changes the unlevered cost of equity.
C) leverage increases the risk of equity of the firm.
D) cost of debt decreases in this setting.
E) default risk increases.

Question 13

What is the capital structure of a firm?

Question 14

MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market value of the ________ generated by its assets.

A) earnings after taxes
B) earnings after interest
C) cash flows after taxes
D) free cash flows
E) earnings after interest and taxes

Question 15

A new business will generate a one-time cash flow of $22,000 after one year.The business will be financed with 60% equity and 40% debt.If the firm's unlevered equity cost of capital is 11%,what is the levered value of the firm with perfect capital markets?

A) $18,182
B) $20,000
C) $19,820
D) $24,200
E) $19,580

Question 16

A new business will generate a one-time cash flow of $25,000 after one year.The business will be financed with 20% equity and 80% debt.If the firm's unlevered equity cost of capital is 12%,what is the levered value of the firm with perfect capital markets?

A) $19,882
B) $22,321
C) $22,000
D) $28,000
E) $23,000

Question 17

Investment cash flows are independent of financing choices in a

A) market with frictions.
B) perfect capital market.
C) setting with frictions in investment returns.
D) firm with leverage.
E) firm with no leverage.

Question 18

With perfect capital markets,the total value of a firm should not depend on its capital structure.

Question 19

How do capital structure choices differ across industries?

Question 20

A new business will generate a one-time cash flow of $20,000 after one year.The business will be financed with 50% equity and 50% debt.If the firm's unlevered equity cost of capital is 10%,what is the levered value of the firm with perfect capital markets?

A) $18,182
B) $20,000
C) $19,000
D) $22,000
E) $18,000

Question 21

A firm requires an investment of $40,000 and borrows $10,000 at 8%.If the return on equity is 20%,what is the firm's pre tax WACC?

A) 14%
B) 15%
C) 16%
D) 17%
E) 18%

Question 22

A firm has a market value of assets of $50,000.It borrows $10,000 at 3%.If the unlevered cost of equity is 15%,what is the firm's cost of equity capital?

A) 15%
B) 16%
C) 17%
D) 18%
E) 19%

Question 23

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,it is referred to as

A) outside debt.
B) retained earnings.
C) homemade leverage.
D) payout ratio.
E) portfolio rebalancing.

Question 24

A new business requires a $20,000 investment today,and will generate a one-time cash flow of $25,000 after one year.The business will be financed with 50% equity and 50% debt.If the firm can borrow at 7%,what is the pre-tax WACC?

A) 43%
B) 25%
C) 18%
D) 39%
E) 7%

Question 25

A firm requires an investment of $30,000 and borrows $10,000 at 6%.If the return on equity is 15%,what is the firm's pre tax WACC?

A) 14%
B) 13%
C) 12%
D) 11%
E) 10.5%

Question 26

A firm requires an investment of $20,000.The firm's debt cost of capital is 6%,and its return on equity is 15%.If the firm's pre-tax WACC is 10.5%,how much did the firm borrow?

A) $8,000
B) $10,000
C) $12,000
D) $14,000
E) $20,000

Question 27

A new business requires a $20,000 investment today,and will generate a one-time cash flow of $25,000 after one year.The business will be financed with 50% equity and 50% debt.If the firm can borrow at 7%,what is the return on levered equity?

A) 43%
B) 25%
C) 18%
D) 39%
E) 7%

Question 28

A firm requires an investment of $20,000.The firm's debt cost of capital is 5%,and its return on equity is 12%.If the firm's pre-tax WACC is 7.8%,how much equity did the firm use for its investment?

A) $8,000
B) $10,000
C) $12,000
D) $14,000
E) $20,000

Question 29

A firm requires an investment of $20,000 ,and will be financed with 50% equity and 50% debt.If the firm's debt cost of capital is 6%,and its return on equity is 15%,what is the firm's pre-tax WACC?

A) 10.5%
B) 15%
C) 6%
D) 9%
E) 21%

Question 30

Under perfect capital markets,which of the following statements is regarding capital structure is most accurate?

A) As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a positive net present value (NPV) and will, therefore, change the value of a firm.
C) The future repayments that the firm must make on its debt are larger than the amount of the loan it receives up front.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.
E) The firm can increase debt levels to increase firm value.

Question 31

A firm has a market value of assets of $50,000.It borrows $10,000 at 5%.If the unlevered cost of equity is 15%,what is the firm's cost of equity capital?

A) 15%
B) 17.5%
C) 18.5%
D) 19.2%
E) 20.6%

Question 32

A new business requires a $20,000 investment today,and will generate a one-time cash flow of $25,000 after one year.The business will be financed with 20% equity and 80% debt.If the firm can borrow at 4%,what is the return on levered equity?

A) 25%
B) 21%
C) 109%
D) 125%
E) 33%

Question 33

Which of the following is one of the characteristics of perfect capital markets?

A) All investors hold the efficient portfolio of assets.
B) There are no taxes, but there may be transaction costs associated with security trading.
C) A firm's financing decisions may change the cash flows generated by its investments.
D) Investors and firms can trade the same set of securities at competitive market prices equal to the present value (PV) of their future cash flows.
E) No market participants engage in illegal behaviour.

Question 34

A firm has a market value of assets of $50,000.It borrows $10,000 at 7%.If the unlevered cost of equity is 15%,what is the firm's cost of equity capital?

A) 15%
B) 16%
C) 17%
D) 18%
E) 19%

Question 35

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share. With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5000 of your own money to invest and you plan on buying Without stock.Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock.The number of shares of Without stock you purchased is closest to:

A) 1650
B) 425
C) 2000
D) 825
E) 200

Question 36

A new business requires a $20,000 investment today,and will generate a one-time cash flow of $25,000 after one year.The business will be financed with 60% equity and 40% debt.If the firm can borrow at 10%,what is the return on levered equity?

A) 25%
B) 35%
C) 15%
D) 42%
E) 17%

Question 37

Leverage can ________ a firm's expected earnings per share,but does not necessarily increase the share price.

A) decrease
B) dilute
C) increase
D) not change
E) decrease the variation of

Question 38

In general,issuing equity may not dilute the ownership of existing shareholders if

A) the value of new shares is equal to the value of debt.
B) the new shares are sold at a fair price.
C) the firm has no debt financing.
D) the firm uses debt conservatively.
E) the original owners do not sell their shares.

Question 39

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share. With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5000 of your own money to invest and you plan on buying Without stock.Using homemade leverage,how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5000 investment in With stock?

A) $10,000
B) $5250
C) $5000
D) $2500
E) $0

Question 40

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share. With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
According to MM Proposition I,the stock price for With is closest to:

A) $8.00
B) $24.00
C) $6.00
D) $12.00
E) $18.00

Question 41

Suppose a project financed via an issue of debt requires five annual interest payments of $20 million each year.If the tax rate is 30%,and the present value of the interest tax shield is 25.98 million,what is the firm's cost of debt?

A) 3%
B) 4%
C) 5%
D) 6%
E) 7%

Question 42

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Suppose Blank Company has only one project,as forecast above,and an unlevered cost of equity of 8%.What is the value of the company?

A) $23,148.15
B) $32,407.40
C) $41,666.67
D) $43,356.43
E) $51,621.95

Question 43

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Suppose Blank Company has only one project,as forecast above,and an unlevered cost of equity of 8%.If the company uses no leverage,what is expected return to equity holders?

A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
E) 33.3%

Question 44

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share. With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5000 of your own money to invest and you plan on buying With stock.Using homemade (un)leverage,how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock?

A) $5000
B) $0
C) $2500
D) $4000
E) -$5000 (borrow $5000)

Question 45

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Assume that in addition to 1.25 billion common shares outstanding,Luther has stock options given to employees valued at $2 billion.After the repurchase,how many shares will Luther have outstanding?

A) 1.0 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion
E) 1.25 billion

Question 46

Suppose a project financed via an issue of debt requires six annual interest payments of $20 million each year.If the tax rate is 30% and the cost of debt is 8%,what is the value of the interest rate tax shield?

A) $31.35 million
B) $27.74 million
C) $23.20 million
D) $32.64 million
E) $36 million

Question 47

The Vᵁ in the equation above represents

A) the value of the firm's equity.
B) the market value of the firm's assets.
C) the value of the firm's unlevered equity.
D) the value of the firm's debt.
E) the total value of a levered firm.

Question 48

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
The market value of Luther's non-cash assets is closest to:

A) $20 billion
B) $19 billion
C) $25 billion
D) $24 billion
E) $30 billion

Question 49

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
With perfect capital markets,what is the market value of Luther's equity after the share repurchase?

A) $15 billion
B) $10 billion
C) $25 billion
D) $20 billion
E) $5 billion

Question 50

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Suppose Blank Company has only one project,as forecast above,and an unlevered cost of equity of 8%.If the company borrows $10,000 at 5% to make the investment,what is expected return to equity holders?

A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
E) 33.3%

Question 51

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
After the repurchase,how many shares will Luther have outstanding?

A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion
E) 1.25 billion

Question 52

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
With perfect capital markets,what is the market price per share of Luther's stock after the share repurchase?

A) $25
B) $24
C) $15
D) $20
E) $18

Question 53

Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year.If the tax rate is 30% and the cost of debt is 6%,what is the value of the interest rate tax shield?

A) $11.35 million
B) $12.21 million
C) $13.20 million
D) $12.64 million
E) $15 million

Question 54

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Assume that in addition to 1.25 billion common shares outstanding,Luther has stock options given to employees valued at $2 billion.The market value of Luther's non-cash assets is closest to:

A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion
E) $27 billion

Question 55

Suppose a project financed via an issue of debt requires six annual interest payments of $20 million each year.If the cost of debt is 8%,and the present value of the interest rate tax shield is $27.74 million,what is the firm's tax rate?

A) 25%
B) 30%
C) 33%
D) 35%
E) 40%

Question 56

The E in the equation above represents

A) the value of the firm's equity.
B) the value of the firm's debt.
C) the value of the firm's unlevered equity.
D) the market value of the firm's assets.
E) the total value of the firm.

Question 57

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Suppose Blank Company has only one project,as forecast above,and an unlevered cost of equity of 8%.If the company borrows $10,000 at 5% to make the investment,what is the return to equity holders if demand is strong?

A) 8.0%
B) 54.0%
C) 28.6%
D) 38.0%
E) 42.3%

Question 58

In general,the gain to investors from the tax deductibility of interest payments is referred to as the interest rate tax shield.

Question 59

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade at a price of $24 per share. With has 2 million shares outstanding and $12 million of debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With.You have $5000 of your own money to invest and you plan on buying With stock.Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without stock.The number of shares of With stock you purchased is closest to:

A) 100
B) 425
C) 1650
D) 825
E) 1000

Question 60

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Suppose Blank Company has only one project,as forecast above,and an unlevered cost of equity of 8%.If the company borrows $10,000 at 5% to make the investment,what is the return to equity holders if demand is weak?

A) 8.0%
B) -37.5%
C) -58.6%
D) -35.3%
E) -12.5%

Question 61

An unlevered firm currently has a value of $40 million.The firm has a tax rate of 40%.The firm wishes to replace $10 million of its equity with $10 million of permanent debt.What is the value of the levered firm if it goes ahead with this plan?

A) $42 million
B) $50 million
C) $40 million
D) $44 million
E) $45 million

Question 62

A firm requires an investment of $30,000 and borrows $20,000 at 7%.If the return on equity is 15% and the tax rate is 30%,what is the firm's WACC?

A) 8.27%
B) 9.13%
C) 10.4%
D) 8.91%
E) 9.67%

Question 63

A bankruptcy process is complex,time-consuming,and costly.The costs of bankruptcy include

A) dividend payments.
B) raw material costs.
C) costs of hiring legal experts, appraisers, and auctioneers.
D) taxes.
E) interest payments.

Question 64

The direct costs of bankruptcy are estimated to be far greater,as a percent of assets,than the indirect costs of bankruptcy.

Question 65

A firm undertakes an investment that is financed with $10,000 of equity and $30,000 of debt.If the return on equity is 14%,the cost of debt is 7% and the tax rate is 25%,what is the firm's WACC?

A) 6.76%
B) 9.92%
C) 7.00%
D) 8.75%
E) 7.44%

Question 66

What effect does debt have on a firm's weighted average cost of capital?

Question 67

A firm is currently financed with 40% equity and 60% debt.The firm generates perpetual earnings after taxes and interest payments of $2 million per year.The firm's cost of equity is 12%,its cost of debt is 5%,and it has a tax rate of 40%.What is the value of the levered firm?

A) $2 million
B) $30.3 million
C) $25.6 million
D) $46.7 million
E) $10 million

Question 68

Consider a firm whose capital structure includes both debt and equity.If the firm must pay taxes in a given year,which of the following has the highest value?

A) The value of the unlevered firm.
B) The value of the levered firm.
C) The value of the firm's debt.
D) The value of the firm's equity.
E) The value of the interest tax shield.

Question 69

Suppose a firm has $50 million of permanent debt.If the tax rate is 25% and the cost of debt is 7%,what is the value of the interest tax shield each year?

A) $3.5 million
B) $50 million
C) $0.875 million
D) $178.6 million
E) $12.5 million

Question 70

A firm is currently financed with 50% equity and 50% debt.The firm generates perpetual earnings after taxes and interest rates of $10 million per year.The firm's cost of equity is 14%,its cost of debt is 7%,and it has a tax rate of 30%.What is the value of the levered firm?

A) $10 million
B) $73 million
C) $105.8 million
D) $173.5 million
E) $100 million

Question 71

A firm requires an investment of $100,000,financed with $60,000 of equity and the remainder with debt.If the return on equity is 12%,the cost of debt is 4% and the tax rate is 35%,what is the firm's WACC?

A) 6.64%
B) 7.20%
C) 7.96%
D) 8.24%
E) 8.80%

Question 72

Suppose a firm has $80 million of permanent debt.If the tax rate is 35% and the cost of debt is 8%,what is the value of the interest tax shield each year?

A) $2.2 million
B) $6.4 million
C) $28 million
D) $80 million
E) $350 million

Question 73

A firm is currently financed with 40% equity and 60% debt.The firm generates perpetual earnings before interest and taxes of $2 million per year.The firm's cost of equity is 12%,its cost of debt is 5%,and it has a tax rate of 40%.What is the value of the levered firm?

A) $2 million
B) $30.3 million
C) $25.6 million
D) $18.2 million
E) $17.6 million

Question 74

How does the interest paid by a firm affect its value to investors?

Question 75

A firm requires an investment of $30,000 and borrows $10,000 at 6%.If the tax rate is 30%,and the firm's WACC is 11.4%,what is the firm's cost of equity?

A) 15%
B) 14.1%
C) 5.4%
D) 17.4%
E) 15.6%

Question 76

What are some implications of market imperfections?

Question 77

A firm that does not have trouble meeting its debt obligations is said to be in financial distress.

Question 78

An unlevered firm currently has a value of $100 million.The firm has a tax rate of 30%.The firm wishes to replace $50 million of its equity with $50 million of permanent debt.What is the value of the levered firm if it goes ahead with this plan?

A) $115 million
B) $100 million
C) $50 million
D) $150 million
E) $85 million

Question 79

A firm requires an investment of $20,000 and borrows $10,000.If the return on equity is 20%,the tax rate is 30%,and the WACC is 12.8%,what is the firm's cost of debt?

A) 5.6%
B) 8%
C) 18.7%
D) 13.2%
E) 14%

Question 80

A firm requires an investment of $30,000 and borrows $15,000 at 6%.If the cost of equity is 18%,and the firm's WACC is 10.8%,what is the firm's tax rate?

A) 40%
B) 35%
C) 30%
D) 45%
E) 50%