Question 1

An unlevered firm has expected earnings of $37,584 and a market value of equity of $324,000.The firm is planning to issue $65,000 of debt at 6.6 percent interest and use the proceeds to repurchase shares at their current market value.Ignore taxes.What will be the cost of equity after the repurchase?

Accepted Answer

R₀ = $37,584 / $324,000 = 0.116 R_s = 0.116 + [$65,000 / ($324,000 - $65,000)](0.116 - 0.066)= 0.1285,or 12.85%

Question 2

Durbin,Inc.,is an unlevered firm with a total market value of $460,000 and 40,000 shares of stock outstanding.The firm has expected EBIT of $48,000 if the economy is normal and $56,000 if the economy booms.The firm is considering a bond issue of $57,500 with an attached interest rate of 6.8 percent.The bond proceeds will be used to repurchase shares.Ignore taxes.What will be the earnings per share after the repurchase if the economy booms?

Accepted Answer

Price per share = $460,000 / 40,000 = $11.50 Number of shares repurchased = $57,500 / $11.50 = 5,000 shares EPS_Boom = [$56,000 - (0.068 × $57,500)] / (40,000 - 5,000)= $1.49

Question 3

Presley Cleaners has an all-equity capital structure with an equity value of $94,260.The expected earnings are $11,320 based on estimated sales of $60,000.The firm pays no taxes and can borrow at 6.4 percent.What is the value of R_WACC?

Accepted Answer

R_WACC = R₀ = $11,320 / $94,260 = 0.1201,or 12.01%

Question 4

A firm has zero debt and an overall cost of capital of 11.7 percent.The firm is considering a new capital structure with 45 percent debt at an interest rate of 6.8 percent.Assume there are no taxes or other imperfections.What will be the levered cost of equity?

Accepted Answer

R_S = 0.117 + [0.45 / (1 - 0.45)](0.117 - 0.068)= 0.1571,or 15.71%

Question 5

A firm has a debt-equity ratio of 0.45,an unlevered WACC of 12.68 percent,and a pretax cost of debt of 6.8 percent.What is the levered cost of equity if there are no taxes or other imperfections?

Accepted Answer

R_S = 0.1268 + 0.45(0.1268 - 0.068)= 0.1533 or 15.33%

Question 6

A firm has a debt-equity ratio of 1.Its cost of equity is 17.4 percent and its pretax cost of debt is 7.2 percent.Assume there are no taxes or other imperfections.What would be its cost of equity if the debt-equity ratio were zero?

Accepted Answer

0.174 = R₀ + 1(R₀ - 0.072) R₀ = 0.123,or 12.3%

Question 7

The interest tax shield has no value for a firm when the I.tax rate is equal to zero.
II)debt-equity ratio is exactly equal to 1.
III)firm is unlevered.
IV)firm elects an all-equity capital structure.

Accepted Answer

The interest tax shield is the tax benefit that a company receives by deducting the interest paid on debt from its taxable income. If the tax rate is zero, then there is no tax to be shielded, and therefore, no value to the firm.

If the debt-equity ratio is exactly equal to 1, then the firm is equally financed by debt and equity. This means that the firm is levered, and thus, there is some value to the interest tax shield. Therefore, option II is not correct.

If the firm is unlevered, then it has no debt in its capital structure. As a result, there is no interest tax shield, and option III is correct.

If the firm elects an all-equity capital structure, then it has no debt to benefit from the interest tax shield. Therefore, option IV is correct.

In summary, options I, III and IV are correct, making option C the best choice.

Question 8

Simpson's is an all-equity firm that has 400,000 shares of stock outstanding.The company is in the process of borrowing $1.5 million at 5 percent interest to repurchase 30,000 of the firm's outstanding shares.Ignore taxes.What will be the market value of equity after the repurchase?

Accepted Answer

Price per share = $1,500,000 / 30,000 = $50
Equity value after repurchase = $50(400,000 - 30,000)= $18,500,000,or $18.5 million

Question 9

The interest tax shield is a key reason why

Accepted Answer

The interest tax shield allows firms to deduct the interest paid on debt from their taxable income, which effectively reduces the net cost of debt to the firm. This is why the net cost of debt is generally lower than the cost of equity.

Question 10

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios?

Accepted Answer

The answer of The MM propositions would suggest that firms...

Question 11

Hazlett's is an unlevered firm with a total market value of $280,000 and 10,000 shares of stock outstanding.The firm has expected EBIT of $16,000 if the economy is normal and $19,000 if the economy booms.The firm is considering a bond issue of $42,000 with an attached interest rate of 7.3 percent.The bond proceeds will be used to repurchase shares.The tax rate is 35 percent.What will be the earnings per share after the repurchase if the economy is normal?

Accepted Answer

Price per share = $280,000 / 10,000 = $28 Number of shares repurchased = $42,000 / $28 = 1,500 shares EPS_Normal = {[$16,000 - (0.073 × $42,000)](1 - 0.35)} / (10,000 - 1,500)= $0.99

Question 12

An all-equity firm has expected earnings of $14,200 and a market value of $82,271.The firm is planning to issue $15,000 of debt at 6.3 percent interest and use the proceeds to repurchase shares at their current market value.Ignore taxes.What will be the cost of equity after the repurchase?

Accepted Answer

R₀ = $14,200 / $82,271 = 0.1726 R_s = 0.1726 + [$15,000 / ($82,271 - 15,000)](0.1726 - 0.063) R_s = 0.1970,or 19.70%

Question 13

LT Transport is an unlevered firm with a total market value of $672,000 and 50,000 shares of stock outstanding.The firm has expected EBIT of $64,500 if the economy is normal and $73,000 if the economy booms.The firm is considering a bond issue of $33,600 with an attached interest rate of 7.6 percent.The bond proceeds will be used to repurchase shares.The tax rate is 34 percent.What is the percentage increase in EPS if the economy booms rather than be normal?

Accepted Answer

Price per share = $672,000 / 50,000 = $13.44 Number of shares repurchased = $33,600 / $13.44 = 2,500 shares EPS_Normal = {[$64,500 - (0.076 × $33,600)](1 - 0.34)} / (50,000 - 2,500)= $0.8607 EPS_Boom = {[$73,000 - (0.076 × $33,600)](1 - 0.34)} / (50,000 - 2,500)= $0.9788 %Δ in EPS = ($0.9788 - 0.8607)/ $0.8607 = 0.1372,or 13.72%

Question 14

Delta Mills and Franklin Mill are identical firms except for their capital structures.Delta is an unlevered firm with $680,000 of equity.Franklin is a levered firm with $425,000 of equity and $255,000 of debt at an interest rate of 6.2 percent.Both Delta and Franklin have an expected EBIT of $84,000.Ignore taxes.Delta has a WACC of ________ percent and Franklin's WACC is ________ percent.

Accepted Answer

WACC_Delta = RS_Delta = $84,000/$680,000 = 0.1235,or 12.35% RS_Franklin = [$84,000 − (0.062 × $255,000)]/$425,000 = 0.1604,or 16.04% The levered cost of equity can also be computed as: RS_Franklin= 0.1235 + ($255,000 / $425,000)(0.1235 − 0.062)= 0.1604,or 16.04% WACC_Franklin = 0.1604[$425,000/($425,000 + 255,000)] + 0.062[$255,000/($425,000 + 255,000)] = 0.1235,or 12.35%

Question 15

Brown's is an unlevered firm with a total market value of $368,000 and 18,400 shares of stock outstanding.The firm has expected EBIT of $17,500 if the economy is normal and $19,000 if the economy booms.The firm is considering a bond issue of $120,000 with an attached interest rate of 5.9 percent.The bond proceeds will be used to repurchase shares.The tax rate is 34 percent.What will be the earnings per share after the repurchase if the economy booms?

Accepted Answer

Price per share = $368,000 / 18,400 = $20 Number of shares repurchased = $120,000 / $20 = 6,000 shares EPS_Boom = {[$19,000 - (0.059 × $120,000)](1 - 0.34)} / (18,400 - 6,000)= $0.63

Question 16

The Grist Mill has no debt,a total market value of $319,200,and 24,000 shares of stock outstanding.The firm has expected EBIT of $21,000 if the economy is normal and $24,000 if the economy booms.The firm is considering a bond issue of $79,800 with an attached interest rate of 5.9 percent.The bond proceeds will be used to repurchase shares.The tax rate is 35 percent.What is the percentage increase in EPS if the economy booms rather than be normal?

Accepted Answer

Price per share = $319,200 / 24,000 = $13.30 Number of shares repurchased = $79,800 / $13.30 = 6,000 shares EPS_Normal = {[$21,000 - (0.059 × $79,800)](1 - 0.35)} / (24,000 - 6,000)= $0.5883 EPS_Boom = {[$24,000 - (0.059 × $79,800)](1 - 0.35)} / (24,000 - 6,000)= $0.6966 %Δ in EPS = ($.6966 - $.5883)/ $.5883 = 0.1841,or 18.41%

Question 17

Sewing World has an all-equity cost of capital of 11.72 percent,a levered cost of equity of 12.94 percent,and a pretax cost of debt of 6.8 percent.What is the firm's levered debt-equity ratio if you ignore taxes?

Accepted Answer

0.1294 = 0.1172 + B/S(0.1172 - 0.068)
B/S = 0.248

Question 18

Wilt's has a debt-equity ratio of 0.48,a pretax cost of debt of 7.3 percent,and an unlevered cost of capital of 14.1 percent.What is its levered cost of equity if there are no taxes or other imperfections?

Accepted Answer

R_S = 0.141 + 0.48(0.141 - 0.073)= 0.1736,or 17.36%

Question 19

Marley's is an unlevered firm with a total market value of $220,000 and 5,000 shares of stock outstanding.The firm has expected EBIT of $10,000 if the economy is normal and $12,000 if the economy booms.The firm is considering a bond issue of $88,000 with an attached interest rate of 5.9 percent.The bond proceeds will be used to repurchase shares.Ignore taxes.What will be the earnings per share after the repurchase if the economy booms?

Accepted Answer

Price per share = $220,000 / 5,000 = $44 Number of shares repurchased = $88,000 / $44 = 2,000 shares EPS_Boom = [$12,000 - (0.059 × $88,000)] / (5,000 - 2,000)= $2.27

Question 20

The Border Crossing has no debt and a cost of capital of 12.2 percent.The shareholders would prefer to earn rate of return of 16.4 percent.What debt-equity ratio will be required to meet the shareholder's preference if the firm pays no taxes and can borrow at 6.2 percent?

Accepted Answer

0.164 = 0.122 + (B / S)(0.122 - 0.062)
B / S = 0.70,or 70%

Quiz 14: Capital Structure: Basic Concepts

An unlevered firm has expected earnings of $37,584 and a market value of equity of $324,000.The firm is planning to issue $65,000 of debt at 6.6 percent interest and use the proceeds to repurchase shares at their current market value.Ignore taxes.What will be the cost of equity after the repurchase?

Presley Cleaners has an all-equity capital structure with an equity value of $94,260.The expected earnings are $11,320 based on estimated sales of $60,000.The firm pays no taxes and can borrow at 6.4 percent.What is the value of R_WACC?

A firm has zero debt and an overall cost of capital of 11.7 percent.The firm is considering a new capital structure with 45 percent debt at an interest rate of 6.8 percent.Assume there are no taxes or other imperfections.What will be the levered cost of equity?

A firm has a debt-equity ratio of 0.45,an unlevered WACC of 12.68 percent,and a pretax cost of debt of 6.8 percent.What is the levered cost of equity if there are no taxes or other imperfections?

A firm has a debt-equity ratio of 1.Its cost of equity is 17.4 percent and its pretax cost of debt is 7.2 percent.Assume there are no taxes or other imperfections.What would be its cost of equity if the debt-equity ratio were zero?

The interest tax shield has no value for a firm when the I.tax rate is equal to zero. II) debt-equity ratio is exactly equal to 1. III) firm is unlevered. IV) firm elects an all-equity capital structure.

Simpson's is an all-equity firm that has 400,000 shares of stock outstanding.The company is in the process of borrowing $1.5 million at 5 percent interest to repurchase 30,000 of the firm's outstanding shares.Ignore taxes.What will be the market value of equity after the repurchase?

The interest tax shield is a key reason why

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios?

An all-equity firm has expected earnings of $14,200 and a market value of $82,271.The firm is planning to issue $15,000 of debt at 6.3 percent interest and use the proceeds to repurchase shares at their current market value.Ignore taxes.What will be the cost of equity after the repurchase?

Sewing World has an all-equity cost of capital of 11.72 percent,a levered cost of equity of 12.94 percent,and a pretax cost of debt of 6.8 percent.What is the firm's levered debt-equity ratio if you ignore taxes?

Wilt's has a debt-equity ratio of 0.48,a pretax cost of debt of 7.3 percent,and an unlevered cost of capital of 14.1 percent.What is its levered cost of equity if there are no taxes or other imperfections?

The Border Crossing has no debt and a cost of capital of 12.2 percent.The shareholders would prefer to earn rate of return of 16.4 percent.What debt-equity ratio will be required to meet the shareholder's preference if the firm pays no taxes and can borrow at 6.2 percent?

Quiz 14: Capital Structure: Basic Concepts

Presley Cleaners has an all-equity capital structure with an equity value of $94,260.The expected earnings are $11,320 based on estimated sales of $60,000.The firm pays no taxes and can borrow at 6.4 percent.What is the value of RWACC?

A firm has zero debt and an overall cost of capital of 11.7 percent.The firm is considering a new capital structure with 45 percent debt at an interest rate of 6.8 percent.Assume there are no taxes or other imperfections.What will be the levered cost of equity?

A firm has a debt-equity ratio of 0.45,an unlevered WACC of 12.68 percent,and a pretax cost of debt of 6.8 percent.What is the levered cost of equity if there are no taxes or other imperfections?

A firm has a debt-equity ratio of 1.Its cost of equity is 17.4 percent and its pretax cost of debt is 7.2 percent.Assume there are no taxes or other imperfections.What would be its cost of equity if the debt-equity ratio were zero?

The interest tax shield has no value for a firm when the I.tax rate is equal to zero. II) debt-equity ratio is exactly equal to 1. III) firm is unlevered. IV) firm elects an all-equity capital structure.

Simpson's is an all-equity firm that has 400,000 shares of stock outstanding.The company is in the process of borrowing $1.5 million at 5 percent interest to repurchase 30,000 of the firm's outstanding shares.Ignore taxes.What will be the market value of equity after the repurchase?

The interest tax shield is a key reason why

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios?

An all-equity firm has expected earnings of $14,200 and a market value of $82,271.The firm is planning to issue $15,000 of debt at 6.3 percent interest and use the proceeds to repurchase shares at their current market value.Ignore taxes.What will be the cost of equity after the repurchase?

Sewing World has an all-equity cost of capital of 11.72 percent,a levered cost of equity of 12.94 percent,and a pretax cost of debt of 6.8 percent.What is the firm's levered debt-equity ratio if you ignore taxes?

Wilt's has a debt-equity ratio of 0.48,a pretax cost of debt of 7.3 percent,and an unlevered cost of capital of 14.1 percent.What is its levered cost of equity if there are no taxes or other imperfections?

The Border Crossing has no debt and a cost of capital of 12.2 percent.The shareholders would prefer to earn rate of return of 16.4 percent.What debt-equity ratio will be required to meet the shareholder's preference if the firm pays no taxes and can borrow at 6.2 percent?

Presley Cleaners has an all-equity capital structure with an equity value of $94,260.The expected earnings are $11,320 based on estimated sales of $60,000.The firm pays no taxes and can borrow at 6.4 percent.What is the value of R_WACC?