Question 1

In this problem, we admit only one real-world factor in an otherwise ideal capital market.This real world factor is corporate taxation; specifically that interest payments on debt are deductible while dividend payments are not deductible.Suppose Delaware East, Inc.has until now been an all-equity firm with a market value of $100 mn.Now, the firm decides to increase its leverage by issuing $40 mn.in debt, with the proceeds being used to pay a dividend to shareholders.Assuming that this debt will be a permanent part of the firm's capital structure, and that the firm's tax rate is 34%, and accounting for the deductibility of the interest on the debt, what is the total market value of the firm after the recapitalization?

A)$113.6 mn.
B)$100 mn.
C)$73.6 mn.
D)$13.6 mn.

$113.6 mn.

Accepted Answer

The total market value of the firm after the recapitalization increases due to the tax shield on the debt. The tax shield is calculated as the debt amount ($40 mn) times the tax rate (34%), which equals $13.6 mn. Adding this to the original market value of $100 mn gives a new total market value of $113.6 mn.

Question 2

The tradeoff in the traditional tradeoff theory of optimal capital structure is between:&#10;A)agency costs of debt and information asymmetry costs of debt.&#10;B)the tax benefit of debt and the expected costs of future financial distress.&#10;C)the tax benefit of debt and agency costs of debt.

Accepted Answer

The traditional tradeoff theory of optimal capital structure suggests that firms balance the tax benefits of debt financing against the expected costs of financial distress. This theory posits that there is an optimal level of debt that maximizes firm value by balancing these two factors.

Question 3

According to the ________hypothesis, short-term assets should be financed with short-term capital and long-term assets with long-term capital.&#10;A)maturity matching&#10;B)hedging&#10;C)risk-return&#10;D)capital asset

Accepted Answer

The maturity matching hypothesis suggests that the maturities of assets and liabilities should be aligned, meaning short-term assets should be financed with short-term capital and long-term assets with long-term capital. This approach helps in managing liquidity and interest rate risk.

Question 4

Compute the present value of the tax shield generated when Smith Company issues $100 mn.in perpetual debt with an 8% coupon rate, and uses the proceeds to retire equity.The corporate tax rate is 34%.&#10;A)$2.72 mn.&#10;B)$8 mn.&#10;C)$34 mn.&#10;D)272 mn.

Accepted Answer

The present value of the tax shield is calculated as the tax rate multiplied by the debt amount. Here, it is 34% of $100 million, which equals $34 million.

Question 5

The current market value of the assets of levered firm ABC, Inc.is $100 million.The annual standard deviation of returns on the assets is 30%.The firm's capital structure consists of equity and pure discount debt for which payment of $80 million is due in 5 years.The risk-free rate is 5%.Using the Black-Scholes Option Pricing Model to calculate the value of the firm's debt.

A)$44
B)$55
C)$66
D)$77

Accepted Answer

The answer of The current market value of the assets...

Question 6

The ______hypothesis is stated as follows: Among long-term assets, the firm should finance long-term tangible assets, such as PP&E, with long-term debt, while other long-term assets, such as investments and intangibles, must be financed with equity.

A)tangible asset
B)debt-equity
C)collateral
D)Fisher

Accepted Answer

The answer of The ______hypothesis is stated as follows: Among...

Deck 6: The Leverage Decision