Question 1

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

The levered cost of equity can be calculated using the formula: Levered Cost of Equity = All-Equity Cost of Capital + (All-Equity Cost of Capital - Pretax Cost of Debt) * Debt-Equity Ratio. Solving for the Debt-Equity Ratio gives 0.248.

Question 2

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

When the debt-equity ratio is zero, the firm is entirely equity-financed. The cost of equity in this case would be the same as the firm's unlevered cost of capital. Using the Modigliani-Miller Proposition II without taxes, the unlevered cost of equity can be calculated as: Cost of Equity = Cost of Debt + (Debt-Equity Ratio * (Cost of Equity - Cost of Debt)). Solving for the unlevered cost of equity gives 12.3%.

Question 3

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

The answer of The Grist Mill has no debt,a total...

Question 4

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

Since there are no taxes, the WACC for both firms is the same as the cost of equity for Delta, which is 12.35%.

Question 5

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

The cost of equity for an unlevered firm is calculated as the expected earnings divided by the market value of equity. After the firm issues debt and repurchases shares, the cost of equity increases due to the financial risk introduced by the debt. The new cost of equity can be calculated using the formula: Cost of Equity = (Earnings - Interest) / (Equity - Debt). Here, the interest is $65,000 * 6.6% = $4,290. The new equity value is $324,000 - $65,000 = $259,000. Thus, the cost of equity is ($37,584 - $4,290) / $259,000 = 12.85%.

Question 6

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

First, we need to calculate the value of the firm before and after the bond issue.
Before the issue, the total market value is $280,000, and since there are no debts, the firm's enterprise value is also $280,000.
After the issue, the total market value is the sum of the market value of equity and debt, which is $280,000. The market value of equity is the total market value minus the bond issue, which is $238,000 ($280,000 - $42,000). The market value of debt is $42,000.
Next, we need to calculate the earnings before interest and taxes (EBIT) and the interest expense for both scenarios.
If the economy is normal, the EBIT is $16,000. The interest expense is $42,000 x 7.3% = $3,066. Therefore, the earnings before taxes (EBT) is $16,000 - $3,066 = $12,934. After taxes, the earnings available to equity is $12,934 x (1 - 0.35) = $8,421. The earnings per share is $8,421 / 10,000 = $0.8421.
If the economy booms, the EBIT is $19,000. The interest expense is the same, which is $3,066. Therefore, the EBT is $19,000 - $3,066 = $15,934. After taxes, the earnings available to equity is $15,934 x (1 - 0.35) = $10,352. The earnings per share is $10,352 / 10,000 = $1.0352.
Therefore, if the economy is normal, the earnings per share after the repurchase is $0.8421. The best choice is C.

Question 7

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

The answer of LT Transport is an unlevered firm with...

Question 8

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

The answer of Durbin,Inc.,is an unlevered firm with a total...

Question 9

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

The answer of Marley's is an unlevered firm with a...

Question 10

The interest tax shield is a key reason why

Accepted Answer

The interest tax shield is the deduction from taxable income due to interest payments, resulting in a lower tax bill. This benefit reduces the overall cost of debt to a firm and makes it cheaper than equity financing. Thus, the net cost of debt to a firm is generally less than the cost of equity. This is why firms tend to use debt financing to take advantage of the interest tax shield and increase their value. However, maximizing the use of debt financing can also increase financial risk.

Question 11

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 12

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 has no value when the tax rate is zero, the firm is unlevered, or the firm has an all-equity capital structure, as there is no interest expense to shield from taxes.

Question 13

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 14

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

The answer of Simpson's is an all-equity firm that has...

Question 15

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

The answer of The Border Crossing has no debt and...

Question 16

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

The answer of An all-equity firm has expected earnings of...

Question 17

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 18

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 19

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 20

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

The answer of Brown's is an unlevered firm with a...

Quiz 14: Capital Structure: Basic Concepts