Question 1

The weighted average cost of capital can also be defined as the:

Accepted Answer

The weighted average cost of capital (WACC) is essentially the required return on a firm's overall assets, as it represents the average rate that a company is expected to pay to finance its assets, weighted by the proportion of each source of capital (debt and equity).

Question 2

M&M Proposition II is the proposition that:

Accepted Answer

M&M Proposition II states that a firm's cost of equity capital is a positive linear function of its capital structure, meaning as a firm increases its leverage, its cost of equity also increases. This reflects the increased risk to equity holders as debt levels rise.

Question 3

Which of the following statements regarding leverage is false?

Accepted Answer

Increased leverage means that a firm is using more debt relative to equity. If things go poorly for the firm, increased leverage actually increases the risk of loss to shareholders, not greater returns. Leverage amplifies outcomes, both positive and negative, but in the case of poor performance, it increases the risk of losses, not returns.

Question 4

A firm has $500 in debt at a cost of 7%, a 34% tax rate, a total firm value of $1,100, and an unlevered return of 14%. What is the WACC?

Accepted Answer

The answer of A firm has $500 in debt at...

Question 5

You currently own 250 shares of Pluto, Inc. Pluto is an all equity firm that has 36,000 shares of stock outstanding at a market price of $25 a share. The company's earnings before interest and taxes are $48,000. Pluto, Inc. has decided to issue $200,000 of debt at a 9% rate of interest. This debt will be used to repurchase shares of stock. How many shares of Pluto, Inc. stock must you sell to unlever your position if you can lend out funds at a 9% rate of interest?

Accepted Answer

The answer of You currently own 250 shares of Pluto,...

Question 6

A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the firm's weighted average cost of capital?

Accepted Answer

The answer of A firm has debt of $5,000, equity...

Question 7

In general, observed capital structures:

Accepted Answer

Capital structures vary significantly across industries due to differences in asset types, business risks, and financial strategies. This variation is not easily explained by a single factor such as earnings volatility or the use of tax shelters, and there is no universal tendency to overweigh debt in relation to equity.

Question 8

Calculate the company's cost of equity given the following information: return on assets 7.0%; return on debt 3.25%; 25% debt; 75% equity.

Accepted Answer

The answer of Calculate the company's cost of equity given...

Question 9

The Backwoods Lumber Co. has a debt-equity ratio of.80. The firm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on M&M II with no taxes?

Accepted Answer

The answer of The Backwoods Lumber Co. has a debt-equity...

Question 10

Which one of the following statements concerning bankruptcy is correct?

Accepted Answer

Bankruptcy costs, including both direct costs (such as legal and administrative fees) and indirect costs (such as loss of customers, suppliers, or employees), can indeed offset the tax benefits that a firm might gain from using debt financing (leverage). This is because the potential for bankruptcy increases the firm's risk, which can lead to higher costs and reduced value.

Question 11

If a firm fails to make the required interest payments on its long-term bonds, it is said to be in:

Accepted Answer

Technical insolvency occurs when a firm cannot meet its current obligations, such as interest payments on debt, indicating a lack of liquidity rather than a total loss of solvency or business viability.

Question 12

You are a secured creditor in a bankruptcy liquidation. Listed below, in chronological order, are the steps in the bankruptcy proceeding. Just prior to which step would you expect to have to document the strength of your claim on the firm's assets?

Accepted Answer

Secured creditors need to document the strength of their claim on the firm's assets just before the proceeds are distributed among creditors (Step D) to ensure they receive the correct amount of the liquidation proceeds based on their secured status.

Question 13

A Mississauga firm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost of equity of 11.6%, and a tax rate of 34%. What is the firm's weighted average cost of capital?

Accepted Answer

The answer of A Mississauga firm has debt of $18,000,...

Question 14

Jefferson Electrical Supply has a cost of equity of 12% and an unlevered cost of capital of 10.5%. The company has $12,000 in debt that is selling at par value. The levered value of the firm is $28,000 and the tax rate is 34%. What is the pre-tax cost of debt?

Accepted Answer

The pre-tax cost of debt can be calculated using the Modigliani-Miller Proposition II with taxes. The formula is: $r_d = r_0 + (r_0 - r_e) \times \frac{D}{E} \times (1 - T_c)$, where $r_d$ is the pre-tax cost of debt, $r_0$ is the unlevered cost of capital, $r_e$ is the cost of equity, $D$ is the value of debt, $E$ is the value of equity, and $T_c$ is the tax rate. Rearranging the formula to solve for $r_d$ and substituting the given values: $E = V - D = 28000 - 12000 = 16000$, so $r_d = 10.5\% + (10.5\% - 12\%) \times \frac{12000}{16000} \times (1 - 0.34)$. Solving this gives $r_d = 7.47\%$.

Question 15

Salem Mills has an unlevered cost of capital of 14%, a cost of debt of 9%, and a tax rate of 34%. What is the target debt-equity ratio if the targeted cost of equity is 16.5%?

Accepted Answer

The answer of Salem Mills has an unlevered cost of...

Question 16

The option of keeping a financially distressed firm as an operating concern is called a(n):

Accepted Answer

Reorganization is the process where a financially distressed firm is restructured to keep it operating, often involving changes in its financial structure, operations, or strategy to improve its viability.

Question 17

The Pizza Palace has a cost of equity of 14.4% and an unlevered cost of capital of 10%. 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%. What is the pre-tax cost of debt?

Accepted Answer

The pre-tax cost of debt is calculated as follows:Pre-tax cost of debt = Unlevered cost of capital + (Levered cost of capital - Unlevered cost of capital) * (Debt / Value of the firm) * (1 - Tax rate)= 10% + (14.4% - 10%) * (18,000 / 32,000) * (1 - 35%)= 10% + 0.144 * 0.5625 * 0.65= 10% + 0.0473= 10.0473%Therefore, the pre-tax cost of debt is 10.0473%, which is closest to choice A) 4.73%.

Question 18

Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt?

Accepted Answer

The answer of Walter's Distributors have a cost of equity...

Question 19

Which one of the following statements is correct?

Accepted Answer

Firms with high tax rates benefit more from borrowing because the interest payments on debt are tax-deductible, reducing the firm's taxable income and thus its tax liability. This makes debt financing more attractive for firms in higher tax brackets.

Question 20

Your firm has earnings before interest and taxes of $210,000. Both the book and the market value of debt is $500,000. Your unlevered cost of equity is 9% while your cost of debt is 7%. The tax rate is 35%. What is your weighted average cost of capital?

Accepted Answer

The weighted average cost of capital (WACC) is calculated as follows: WACC = [(E/V) * Re] + [(D/V) * Rd * (1-Tc)], where E is the market value of equity, D is the market value of debt, V is the total value (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. First, we need to calculate the firm's equity value (E). Since we have EBIT, we can calculate the firm's net income after taxes and interest, which is not directly needed for WACC but helps in understanding the firm's profitability. The firm's value (V) is not given directly, but we can calculate it using the unlevered cost of equity as a proxy for the firm's overall required return in an unlevered state. However, in this case, we don't need to calculate the firm's equity value directly from the given information to find WACC. We use the given cost of debt, cost of equity, and the tax rate directly in the WACC formula. Assuming the market value of debt (D) is $500,000 and the total value of the firm is the sum of its debt and equity, we can calculate the proportion of debt and equity in the firm's capital structure. However, we are not given the market value of equity directly, which complicates direct calculation without making assumptions. Given the information, we focus on the components we know: the cost of debt, the tax rate, and the unlevered cost of equity. The correct approach involves recognizing that without the market value of equity, we must rely on the given rates and the tax shield benefit of debt. The WACC formula integrates these elements, accounting for the tax benefit of debt financing. The calculation simplifies to a focus on the given rates and the tax impact, leading to the correct selection based on the provided options and the standard WACC formula application. The correct answer reflects the weighted costs of debt and equity, adjusted for the tax benefit of debt.

Quiz 16: Financial Leverage and Capital Structure Policy