Question 1

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

The WACC (Weighted Average Cost of Capital) is calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1-Tc), where E is the market value of equity, V is the total value of equity and debt, Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and Tc is the tax rate. Since there are no taxes, Tc = 0. The market value of equity (E) is 17,400 shares * $27 = $469,800. The market value of debt (D) is $140,000. The total value (V) is $469,800 + $140,000 = $609,800. The WACC is then (469,800/609,800) * 15.3% + (140,000/609,800) * 6.2% = 13.21%.

Question 2

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

We can use the following formula to calculate the target debt-equity ratio:

Target debt-equity ratio = [ (Target levered cost of equity - Unlevered cost of capital) / (Cost of debt - Tax rate) ]

Substituting the given values:

Target debt-equity ratio = [ (16.34% - 14.3%) / (8.7% - 35%) ]
Target debt-equity ratio = 0.56

Therefore, the answer is choice B, with a target debt-equity ratio of 0.56.

Question 3

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

The answer of The Outlet has an unlevered cost of...

Question 4

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

Step 1: Calculate the WACC
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
where
Re = Unlevered cost of capital = 12.87%
Rd = Cost of debt = Coupon rate = 6.2%
Tc = Tax rate = 34%
E = Value of equity
D = Value of debt
V = Total value of the firm = E + D

We are given
Unlevered cost of capital = 12.87%
Tax rate = 34%
Coupon rate = 6.2%
Value of debt = $318,000
Value of equity = ?
Total value of the firm = ?

First, let's calculate the cost of equity using the unlevered cost of capital and the tax rate.
Re = Unlevered cost of capital x (1 + (1 - Tax rate) x (D/E))
where
D/E = Debt/Equity
D/E = $318,000 / E

Re = 12.87% x (1 + (1 - 34%) x ($318,000 / E))
Re = 17.12%

Next, let's calculate the total value of the firm.
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
WACC = (E / (E + $318,000) x 17.12%) + ($318,000 / (E + $318,000) x 6.2% x (1 - 34%))
WACC = 12.87%

12.87% = (E / (E + $318,000) x 17.12%) + ($318,000 / (E + $318,000) x 6.2% x (1 - 34%))

Solving this equation, we get
E = $1,079,402.05

Finally, the value of the firm is
V = E + D
V = $1,079,402.05 + $318,000
V = $1,397,402.05

Therefore, the value of the firm is $1,079,402.05 (Option B).

Question 5

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

The answer of A levered firm has a pretax cost...

Question 6

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 7

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

The answer of The Pizza Shoppe has debt with both...

Question 8

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 9

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 10

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

1. Calculate the weighted average cost of capital (WACC):
WACC = (E/V * Re) + (D/V * Rd) * (1 - Tc)
where E is the market value of equity, V is the total value of the firm (E + D), Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and Tc is the corporate tax rate.
Given:
- Unlevered cost of capital = 12.2%, so Re = 12.2%
- Debt with a coupon rate of 5.6%, and both a book and face value of $24,000, so D = $24,000
- Tax rate = 35%, so Tc = 35%
Firstly, we need to calculate the market value of equity (E). We can use the following formula to calculate E:
E = V - D
We don't know V yet, but we can find it using the following formula:
V = E + D
We can use the following formula to find V:
V = E + D
V = (E/V * Re) + (D/V * Rd) * (1 - Tc)
12.2% * E/V + 5.6% * D/V * (1 - 35%) = WACC
12.2% * E/V + 3.64% * D/V = WACC
E/V = 1 - D/V
12.2% * (1 - D/V) + 3.64% * D/V = WACC
12.2% - 8.56% * D/V = WACC
Since D = $24,000, we can plug it in and solve for V:
12.2% - 8.56% * $24,000/V = WACC
12.2% - 0.0856 * $24,000/V = WACC
12.2% - $2,054.4/V = WACC
Let's assume WACC is equal to the unlevered cost of capital (12.2%).
12.2% - $2,054.4/V = 12.2%
-$2,054.4/V = 0
V = -$2,054.4/0 (undefined)
This answer doesn't make sense, so let's assume WACC is greater than the unlevered cost of capital.
12.2% - $2,054.4/V = 15%
-$2,054.4/V = 2.8%
V = -$2,054.4/0.028 (negative number)
This answer also doesn't make sense, so let's assume WACC is less than the unlevered cost of capital.
12.2% - $2,054.4/V = 10%
-$2,054.4/V = 2.2%
V = -$2,054.4/0.022 (negative number)
This answer also doesn't make sense, so we need to try a different approach.
2. Calculate the value of the firm using the adjusted present value (APV) method:
APV = Unlevered firm value + PV of tax shield
Where:
Unlevered firm value = EBIT / WACC
PV of tax shield = TC * D
Given:
- EBIT = $37,800
- WACC = 12.2%
- Tax rate = 35%
- Debt with a coupon rate of 5.6%, and both a book and face value of $24,000, so D = $24,000
Unlevered firm value = $37,800 / 12.2% = $309,836.07
PV of tax shield = $24,000 * 35% = $8,400
APV = $309,836.07 + $8,400 = $318,236.07
Therefore, the value of the firm is $318,236.07, which is closest to option C ($209,793.44).

Question 11

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

The answer of DL Trucking has a cost of equity...

Question 12

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 13

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

The answer of The Border Cafe has a cost of...

Question 14

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 15

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 16

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

The levered value of the equity is the value of the equity after the firm has added debt to its capital structure. The levered value of the equity can be calculated using the following formula:Levered value of equity = Unlevered value of equity + (PV of tax savings * (1 - Tax rate))The unlevered value of equity is the value of the equity before the firm has added debt to its capital structure. The unlevered value of equity can be calculated using the following formula:Unlevered value of equity = Number of shares outstanding * Market price per shareThe PV of tax savings is the present value of the tax savings that the firm will receive from the interest payments on the debt. The PV of tax savings can be calculated using the following formula:PV of tax savings = Interest payments * Tax rate * (1 / (1 + Cost of equity)^n)where:n is the number of years that the debt will be outstandingIn this case, the number of shares outstanding is 68,000, the market price per share is $36.80, the cost of equity is 11.7 percent, the tax rate is 35 percent, the coupon rate on the debt is 5.8 percent, and the debt will be sold at par value. The number of years that the debt will be outstanding is not given, so we will assume that it is 10 years.Using these values, we can calculate the levered value of the equity as follows:Levered value of equity = Unlevered value of equity + (PV of tax savings * (1 - Tax rate))Levered value of equity = 68,000 * $36.80 + (0.058 * $750,000 * 0.35 * (1 / (1 + 0.117)^10))Levered value of equity = $2,505,600 + $149,300Levered value of equity = $2,654,900Therefore, the levered value of the equity is $2,654,900.

Question 17

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

The answer of JL Lumber has a debt-equity ratio of...

Question 18

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 19

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

Step 1: Calculate the value of unlevered firm

Using WACC formula, WACC = E/V * Re + D/V * Rd * (1-T)
where 
E = Market value of equity = ?
D = Market value of debt = 0 (since it is an unlevered firm)
V = Total value of the firm = E + D
Re = Cost of equity = 13.8%
Rd = Cost of debt = 0 (since it is an unlevered firm)
T = Tax rate = 35%

WACC = Cost of capital = 13.8%
E/V = ?/V
1 - E/V = D/V = 0 (since it is an unlevered firm)
0.138 = E/V * 1 - 0 * (1 - 0.35)
E/V = 0.138 / 0.65 = 0.2123
V = E / 0.2123 = $1,011,688.31

Step 2: Calculate the value of levered firm

V'L = VU + T * D
where 
V'L = Total value of levered firm
VU = Total value of unlevered firm = $1,011,688.31
D = Market value of debt = $430,000
T = Tax rate = 35%

V'L = $1,011,688.31 + 0.35 * $430,000 = $1,161,108.70

Therefore, the value of the levered firm is $1,161,108.70, which is option C.

Question 20

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

The answer of Andrea's Markets has debt of $318,200,equity of...

Quiz 14: Capital Structure: Basic Concepts