Question 1

Andrea's Markets has debt of $318,200,equity of $493,500,an aftertax cost of debt of 6.80 percent,a cost of equity of 13.39 percent,and a tax rate of 34 percent.What is the firm's weighted average cost of capital?

Accepted Answer

V = $318,200 + $493,500 = $811,700 R_WACC = 0.1339($493,500 / $811,700)+ 0.068($318,200 / $811,700)= 0.1081,or 10.81%

Question 2

Travel Express has a debt-equity ratio of 0.42.The pretax cost of debt is 7.1 percent while the unlevered cost of capital is 13.6 percent.What is the cost of equity if the tax rate is 34 percent?

Accepted Answer

R_S = 0.136 + 0.42(1 - 0.34)(0.136 - 0.071)= 0.1540,or 15.40%

Question 3

Models and More has a bond issue outstanding with a face value of $215,000.These bonds have a coupon rate of 5.65 percent,pay interest semiannually,and have a current market price quote of 1.01.The tax rate is 34 percent.What is the amount of the annual interest tax shield?

Accepted Answer

Annual interest tax shield = $215,000 × 0.0565 × 0.34 = $4,130.15

Question 4

An all-equity firm has a cost of capital of 13.3 percent.The firm is considering switching to a debt-equity ratio of 0.35 with a pretax cost of debt of 7.5 percent.The tax rate is 35 percent.What will be the firm's levered cost of equity?

Accepted Answer

R_S = 0.133 + 0.35(1 - 0.35)(0.133 - 0.075)= 0.1462,or 14.62%

Question 5

The Pizza Shoppe has debt with both a face and market value of $24,000 and a coupon rate of 6.4 percent.The expected earnings before interest and taxes are $21,400,the tax rate is 35 percent,and the unlevered cost of capital is 11.4 percent.What is the firm's cost of equity?

Accepted Answer

V_U = [$21,400 × (1 - 0.35)] / 0.114 = $122,017.54 V_L = $122,017.54 + (0.35 × $24,000)= $130,417.54 V_S = $130,417.54 - 24,000 = $106,417.54 R_S = 0.114 + ($24,000 / $106,417.54)(1 - 0.35)(0.114 - 0.064)= 0.1213 or 12.13%

Question 6

JL Lumber has a debt-equity ratio of 0.47.The firm's required return on assets is 11.8 percent and its current cost of equity is 14.23 percent.What is the firm's pretax cost of debt? Ignore taxes.

Accepted Answer

0.1423 = 0.118 + 0.47(0.118 - R_B) R_B = 0.0663,or 6.63%

Question 7

DL Trucking has a cost of equity of 15.4 percent and an unlevered cost of capital of 13.2 percent.The company has $24,000 in debt that is selling at par value.The levered value of the firm is $59,000 and the tax rate is 34 percent.What is the pretax cost of debt?

Accepted Answer

V_E = $59,000 - $24,000 = $35,000 0.154 = 0.132 + ($24,000 / $35,000)(1 - 0.34)(0.132 - R_B) R_B = 0.0834,or 8.34%

Question 8

An unlevered firm has a cost of capital of 12.46 percent and a tax rate of 35 percent.The firm is considering a new capital structure with 35 percent debt.The interest rate on the debt would be 6.68 percent.What would be the firm's levered cost of capital?

Accepted Answer

R_S = 0.1246 + [0.35 / (1 - 0.35)](1 - 0.35)(0.1246 - 0.0668)= 0.1448,or 14.48%

Question 9

An unlevered firm has a cost of capital of 13.8 percent and earnings before interest and taxes of $214,560.Assume the firm borrows $430,000 at an interest rate of 5.85 percent.The applicable tax rate is 35 percent.What is the value of the levered firm?

Accepted Answer

V_U = [$214,560 × (1 - 0.35)] / 0.138 = $1,010,608.70 V_L = $1,010,608.70 + (0.35 × $430,000)= $1,161,108.70

Question 10

The Border Cafe has a cost of equity of 13.2 percent and a pretax cost of debt of 7.5 percent.The debt-equity ratio is 0.6 and the tax rate is 35 percent.What is the unlevered cost of capital?

Accepted Answer

0.132 = R₀ + 0.6(1 - 0.35)(R₀ - 0.075) R₀ = 0.1160,or 11.60%

Question 11

Ernie's has 4,200 bonds outstanding with a face value of $1,000 each,a market value of $1,060 each,and a coupon rate of 7.6 percent.What is the amount of the annual interest tax shield if the tax rate is 35 percent?

Accepted Answer

Annual interest tax shield = 4,200 × $1,000 × 0.076 × 0.35 = $111,720

Question 12

A levered firm has a pretax cost of debt of 6.8 percent and an unlevered cost of capital of 13.4 percent.The tax rate is 34 percent,and the cost of equity is 16.06 percent.What is the debt-equity ratio?

Accepted Answer

0.1606 = 0.134 + (B / S)(1 - 0.34)(0.134 - 0.068)
B / S = 0.61

Question 13

Leisure Vacations is an unlevered firm with aftertax net income of $57,980,a cost of capital of 13.2 percent,and a tax rate of 35 percent.What is the value of this firm?

Accepted Answer

V_U = $57,980 / 0.132 = $439,242.42

Question 14

The Studio is currently an all-equity firm that has 68,000 shares of stock outstanding with a market price of $36.80 a share.The current cost of equity is 11.7 percent,and the tax rate is 35 percent.The firm is considering adding $750,000 of debt with a coupon rate of 5.8 percent to its capital structure.The debt will be sold at par value.What is the levered value of the equity?

Accepted Answer

V_L = (68,000 × $36.80)+ (0.35 × $750,000)= $2,764,900 V_E = $2,764,900 - $750,000 = $2,014,900

Question 15

Sun Sports has an unlevered cost of capital of 14.3 percent,a cost of debt of 8.7 percent,and a tax rate of 35 percent.What is the target debt-equity ratio if the targeted levered cost of equity is 16.34 percent?

Accepted Answer

0.1634 = 0.143 + (B / S)(1 - 0.35)(0.143 - 0.087)
B / S = 0.56

Question 16

Dakota Co.has expected earnings before interest and taxes of $37,800,an unlevered cost of capital of 12.2 percent,debt with a coupon rate of 5.6 percent,and both a book and face value of $24,000.The tax rate is 35 percent.What is the value of the firm?

Accepted Answer

V_U = [$37,800 × (1 - 0.35)] / 0.122 = $201,393.44 V_L = $201,393.44 + (0.35 × $24,000)= $209,793.44

Question 17

Baker Breads has $428,000 of debt outstanding that is selling at par and has a coupon rate of 6.25 percent.The tax rate is 34 percent.What is the present value of the tax shield?

Accepted Answer

Present value of the tax shield = 0.34 × $428,000 = $145,520

Question 18

The Outlet has an unlevered cost of capital of 15.1 percent,a tax rate of 34 percent,and expected earnings before interest and taxes of $26,100.The company has $25,000 in bonds outstanding that have a coupon rate of 7.6 percent.The bonds are selling at par.What is the cost of equity?

Accepted Answer

V_U = [$26,100 × (1 - 0.34)] /0.151 = $114,079.47 V_L = $114,079.47 + (0.34 × $25,000)= $122,579.47 V_S = $122,579.47 - $25,000 = $97,579.47 R_s = 0.151 + ($25,000 / $97,579.47)(1 - 0.34)(0.151- 0.076)= 0.1637,or 16.37%

Question 19

Alto and Tenor have 17,400 shares of stock outstanding at a market price of $27 per share.The firm also has $140,000 of 6.2 percent bonds outstanding that are selling at par.The firm does not expect to pay taxes for the foreseeable future.The cost of equity is 15.3 percent.What is the value of R_WACC?

Accepted Answer

S = 17,400 × $27 = $469,800 R_WACC = 0.153[$469,800 / ($140,000 + $469,800)] + 0.062[$140,000 / ($140,000 + $469,800)] R_WACC = 0.1321,or 13.21%

Question 20

Houston Tools has expected earnings before interest and taxes of $189,400,an unlevered cost of capital of 12.87 percent,and a tax rate of 34 percent.The company has $318,000 of debt that carries a coupon rate of 6.2 percent.The debt is selling at par value.What is the value of this firm?

Accepted Answer

V_U = [$189,400 × (1 - 0.34)] / 0.1287 = $971,282.05 V_L = $971,282.05 + (0.34 × $318,000)= $1,079,402.05

Quiz 14: Capital Structure: Basic Concepts