Question 1

Stevenson's Bakery is an all-equity firm that has projected perpetual earnings before interest and taxes of $138,000 a year. The cost of equity is 13.7 percent and the tax rate is 32 percent. The firm can borrow money at 6.75 percent. Currently, the firm is considering converting to a debt-equity ratio of 0.45. What is the firm's levered value?
A) $527,613
B) $689,919
C) $752,987
D) $829,507
E) $903,682

Accepted Answer

First, we need to find the unlevered value of the firm:
VL = EBIT / Cost of Equity
VL = $138,000 / 0.137
VL = $1,007,299

Next, we need to find the value of debt that the firm will take on:
D/V = 0.45
E/V = 1 - D/V
E/V = 1 - 0.45
E/V = 0.55

We can use the equation for WACC to find the cost of equity with leverage:
WACC = (E/V) × Cost of Equity + (D/V) × Cost of Debt × (1 - Tax Rate)
0.137 = 0.55 × Cost of Equity + 0.45 × 0.0675 × (1 - 0.32)

Solving for the Cost of Equity:
Cost of Equity = 0.1531 or 15.31%

Finally, we can find the levered value of the firm:
VL = EBIT / Cost of Capital
VL = $138,000 / 0.1531
VL = $902,987

Therefore, the best choice is C, $752,987.

Question 2

Kelner's Nursery has 8,000 bonds outstanding with a face value of $1,000 each. The coupon rate is 6.5 percent and the tax rate is 34 percent. What is the present value of the interest tax shield?
A) $2.72 million
B) $2.83 million
C) $3.09 million
D) $3.13 million
E) $3.26 million

Accepted Answer

The answer of Kelner's Nursery has 8,000 bonds outstanding with...

Question 3

Clark's Cookies has a return on assets of 15.3 percent and a cost of equity of 17.6 percent. What is the pre-tax cost of debt if the debt-equity ratio is 0.54? Ignore taxes.
A) 8.87 percent
B) 9.29 percent
C) 9.64 percent
D) 10.31 percent
E) 11.04 percent

Accepted Answer

The answer of Clark's Cookies has a return on assets...

Question 4

The Water Works has a return on assets of 13.7 percent, a cost of equity of 18.6 percent, and a pre-tax cost of debt of 7.1 percent. What is the debt-equity ratio? Ignore taxes.
A) 0.44
B) 0.47
C) 0.61
D) 0.68
E) 0.74

Accepted Answer

The answer of The Water Works has a return on...

Question 5

Explain how taxes affect the value of a firm based on M&M Proposition I.

Accepted Answer

The answer of Explain how taxes affect the value of...

Question 6

Coaster's has a cost of equity of 15.4 percent, a return on assets of 10.2 percent, and a cost of debt of 7.3 percent. There are no taxes. What is the firm's weighted average cost of capital?
A) 7.30 percent
B) 10.20 percent
C) 10.97 percent
D) 15.40 percent
E) Cannot be determined from the information provided.

Accepted Answer

The answer of Coaster's has a cost of equity of...

Question 7

Liz's Home Remedy has a $24 million bond issue outstanding with a coupon rate of 7.75 percent and a current yield of 7.67 percent. What is the present value of the tax shield if the tax rate is 34 percent?
A) $632,400
B) $625,872
C) $6.28 million
D) $8.16 million
E) $8.68 million

Accepted Answer

The present value of the tax shield is calculated as the tax rate multiplied by the bond issue amount. Therefore, $24 million * 0.34 = $8.16 million.

Question 8

Great Lakes Shipping is an all-equity firm with anticipated earnings before interest and taxes of $439,000 annually forever. The present cost of equity is 16.4 percent. Currently, the firm has no debt but is considering borrowing $1.25 million at 8.5 percent interest. The tax rate is 36 percent. What is the value of the levered firm?
A) $2,163,171
B) $2,406,519
C) $2,588,547
D) $2,666,667
E) $2,818,181

Accepted Answer

V_U = [$439,000 × (1 - 0.36)]/0.164 = $1,713,170.73V_L = $1,713,170.73 + 0.36 × $1.25m = $2,163,171

Question 9

Tropical Fruit Extracts expects its earnings before interest and taxes to be $218,000 a year forever. Currently, the firm has no debt. The cost of equity is 16.3 percent and the tax rate is 35 percent. The company is in the process of issuing $2 million of bonds at par that carry a 6.5 percent annual coupon. What is the unlevered value of the firm?
A) $371,429
B) $431,971
C) $747,485
D) $869,325
E) $988,315

Accepted Answer

The answer of Tropical Fruit Extracts expects its earnings before...

Question 10

Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $826,000 annually forever. Currently, the firm has no debt but is considering borrowing $650,000 at 6.75 percent interest. The tax rate is 34 percent and the current cost of equity is 17.2 percent. What is the value of the levered firm?
A) $3,187,271
B) $3,169,535
C) $3,307,271
D) $3,390,535
E) $3,506,418

Accepted Answer

V_U = [$826,000 × (1 - 0.34)]/0.172 = $3,169,534.88V_L = $3,169,534.88 + (0.34 × $650,000) = $3,390,535

Question 11

The Gift Mart is an all-equity firm with a current cost of equity of 19.6 percent. The estimated earnings before interest and taxes are $239,000 annually forever. Currently, the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest. The tax rate is 30 percent. What is the value of the unlevered firm?
A) $849,207
B) $853,571
C) $856,411
D) $919,307
E) $926,667

Accepted Answer

First, we need to calculate the value of the firm with debt. We can use the WACC formula for this:

WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc)

Where:
E/V = percentage of equity in the capital structure
Re = cost of equity
D/V = percentage of debt in the capital structure
Rd = cost of debt
Tc = corporate tax rate

We can assume that the firm's capital structure will be 100% debt after borrowing $400,000. Therefore, E/V = 0 and D/V = 1.

WACC = (0/1) x 0.196 + (1/1) x 0.095 x (1 - 0.30) = 0.1235 or 12.35%

Next, we can use the perpetuity formula to calculate the value of the firm:

PV = EBIT / WACC

PV = $239,000 / 0.1235 = $1,934,866.22

Finally, we need to remove the value of debt from this amount to get the unlevered firm value:

Unlevered firm value = $1,934,866.22 - $400,000 = $1,534,866.22, which is closest to option B, $853,571.

Question 12

Southern Fried Foods has a $12 million bond issue outstanding with a coupon rate of 6.75 percent and a yield-to-maturity of 7.27 percent. What is the present value of the tax shield if the tax rate is 35 percent?
A) $283,500
B) $305,340
C) $3,053,400
D) $3,560,000
E) $4,200,000

Accepted Answer

The answer of Southern Fried Foods has a $12 million...

Question 13

An all-equity firm has a return on assets of 15.3 percent. The firm is considering converting to a debt-equity ratio of 0.30. The pre-tax cost of debt is 8.1 percent. Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?
A) 15.57 percent
B) 16.28 percent
C) 16.67 percent
D) 17.46 percent
E) 18.19 percent

Accepted Answer

The answer of An all-equity firm has a return on...

Question 14

Aaron's Tea House has a 32 percent tax rate and an interest tax shield valued at $6,728 for the year. How much did the firm pay in annual interest?
A) $2,153
B) $2,304
C) $2,468
D) $20,507
E) $21,025

Accepted Answer

The interest tax shield is calculated as the interest expense multiplied by the tax rate. Given the interest tax shield is $6,728 and the tax rate is 32%, the interest paid is $6,728 / 0.32 = $21,025.

Question 15

A firm has a weighted average cost of capital of 11.68 percent and a cost of equity of 15.5 percent. The debt-equity ratio is 0.65. There are no taxes. What is the firm's cost of debt?
A) 5.80 percent
B) 6.27 percent
C) 6.44 percent
D) 7.23 percent
E) 7.81 percent

Accepted Answer

0.1168 = [(1/1.65 × 0.155] + [(0.65/1.65) × R_D]R_D = 5.80 percent

Question 16

Weston Mines has a cost of equity of 19.8 percent, a pre-tax cost of debt of 9.4 percent, and a return on assets of 17.1 percent. Ignore taxes. What is the debt-equity ratio?
A) 0.35
B) 0.41
C) 0.47
D) 0.56
E) 0.62

Accepted Answer

The answer of Weston Mines has a cost of equity...

Question 17

Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $879,000. The current cost of equity is 18.3 percent and the tax rate is 34 percent. The company is in the process of issuing $6.2 million of 8.5 percent annual coupon bonds at par. What is the levered value of the firm?
A) $5,278,164
B) $5,541,085
C) $6,422,225
D) $6,713,185
E) $7,385,695

Accepted Answer

V_U = [$879,000 × (1 - 0.34)]/0.183 = $3,170,163.93V_L = $3,170,163.93 + (0.34 × $6.2m) = $5,278,164

Question 18

A firm has a cost of debt of 7.5 percent and a cost of equity of 16.2 percent. The debt-equity ratio is 0.45. There are no taxes. What is the firm's weighted average cost of capital?
A) 11.75 percent
B) 12.29 percent
C) 13.50 percent
D) 14.47 percent
E) 16.20 percent

Accepted Answer

WACC = [(1/1.45) × 0.162] + [(0.45/1.45) × 0.075] = 13.50 percent

Question 19

Hot To Go is an all-equity firm specializing in hot ready-to-eat meals. Management has estimated the firm's earnings before interest and taxes will be $167,000 annually forever. The present cost of equity is 15.1 percent. Currently, the firm has no debt but is considering borrowing $750,000 at 9 percent interest. The tax rate is 34 percent. What is the value of the unlevered firm?
A) $623,017
B) $646,511
C) $704,141
D) $729,934
E) $755,200

Accepted Answer

The answer of Hot To Go is an all-equity firm...

Question 20

Stone House Cafe has a 30 percent tax rate and total taxes of $35,280. What is the value of the interest tax shield if the interest expense is $16,700?
A) $4,887
B) $5,010
C) $5,395
D) $5,708
E) $6,023

Accepted Answer

The interest tax shield is calculated as the interest expense multiplied by the tax rate: $16,700 * 0.30 = $5,010.

Quiz 13: Leverage and Capital Structure

Kelner's Nursery has 8,000 bonds outstanding with a face value of $1,000 each. The coupon rate is 6.5 percent and the tax rate is 34 percent. What is the present value of the interest tax shield?

Clark's Cookies has a return on assets of 15.3 percent and a cost of equity of 17.6 percent. What is the pre-tax cost of debt if the debt-equity ratio is 0.54? Ignore taxes.

The Water Works has a return on assets of 13.7 percent, a cost of equity of 18.6 percent, and a pre-tax cost of debt of 7.1 percent. What is the debt-equity ratio? Ignore taxes.

Explain how taxes affect the value of a firm based on M&M Proposition I.

Coaster's has a cost of equity of 15.4 percent, a return on assets of 10.2 percent, and a cost of debt of 7.3 percent. There are no taxes. What is the firm's weighted average cost of capital?

Liz's Home Remedy has a $24 million bond issue outstanding with a coupon rate of 7.75 percent and a current yield of 7.67 percent. What is the present value of the tax shield if the tax rate is 34 percent?

Southern Fried Foods has a $12 million bond issue outstanding with a coupon rate of 6.75 percent and a yield-to-maturity of 7.27 percent. What is the present value of the tax shield if the tax rate is 35 percent?

An all-equity firm has a return on assets of 15.3 percent. The firm is considering converting to a debt-equity ratio of 0.30. The pre-tax cost of debt is 8.1 percent. Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?

Aaron's Tea House has a 32 percent tax rate and an interest tax shield valued at $6,728 for the year. How much did the firm pay in annual interest?

A firm has a weighted average cost of capital of 11.68 percent and a cost of equity of 15.5 percent. The debt-equity ratio is 0.65. There are no taxes. What is the firm's cost of debt?

Weston Mines has a cost of equity of 19.8 percent, a pre-tax cost of debt of 9.4 percent, and a return on assets of 17.1 percent. Ignore taxes. What is the debt-equity ratio?

A firm has a cost of debt of 7.5 percent and a cost of equity of 16.2 percent. The debt-equity ratio is 0.45. There are no taxes. What is the firm's weighted average cost of capital?

Stone House Cafe has a 30 percent tax rate and total taxes of $35,280. What is the value of the interest tax shield if the interest expense is $16,700?