Deck 13: Leverage and Capital Structure

Question 1

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

A) M&M Proposition I.
B) capital restructuring.
C) homemade leverage.
D) M&M Proposition II.
E) financial risk management.

Answer 1

homemade leverage.

Question 2

Which one of the following statements matches M&M Proposition I?

A) The cost of equity capital has a positive linear relationship with a firm's capital structure.
B) The dividends paid by a firm determine the firm's value.
C) The cost of equity capital varies in response to changes in a firm's capital structure.
D) The value of a firm is independent of the firm's capital structure.
E) The value of a firm is dependent on the firm's capital structure.

Answer 2

The value of a firm is independent of the firm's capital structure.

Question 3

In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first?

A) Technical insolvency definition
B) Absolute priority rule
C) Accounting insolvency definition
D) Chapter 7 of the Federal Bankruptcy Reform Act of 1978
E) Securities and Exchange Commission

Answer 3

Absolute priority rule

Question 4

Which one of the following terms refers to the termination of a firm as a going concern?

A) Insolvency
B) Reorganization
C) Chapter 11 bankruptcy
D) Prepack
E) Liquidation

Question 5

Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure?

A) Static theory of capital structure
B) M&M Proposition I
C) M&M Proposition II
D) Homemade leverage theory
E) WACC

Question 6

Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt?

A) M&M Proposition I, with taxes
B) M&M Proposition II, with taxes
C) M&M Proposition I, without taxes
D) Homemade leverage proposition
E) Static theory of capital structure

Question 7

Which one of the following statements concerning financial leverage is correct?

A) The benefits of leverage are unaffected by the amount of a firm's earnings.
B) The use of leverage will always increase a firm's earnings per share.
C) The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage.
D) Changes in the capital structure of a firm will generally change the firm's earnings per share.
E) Financial leverage is beneficial to a firm only when the firm has negative earnings.

Question 8

Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship?

A) Static theory of interest rates
B) M&M Proposition I
C) Financial risk
D) Interest tax shield
E) Homemade leverage

Question 9

Which one of the following is minimized when the value of a firm is maximized?

A) Return on equity
B) WACC
C) Debt
D) Taxes
E) Bankruptcy costs

Question 10

Which one of the following is the equity risk arising from the daily operations of a firm?

A) Strategic risk
B) Financial risk
C) Liquidity risk
D) Industry risk
E) Business risk

Question 11

Which one of the following is a direct bankruptcy cost?

A) Loss of customer goodwill resulting from a bankruptcy filing
B) Legal and accounting fees related to a bankruptcy proceeding
C) Management time spent on a bankruptcy proceeding
D) Any financial distress cost
E) Costs a firm spends trying to avoid bankruptcy

Question 12

Which one of the following terms applies to the costs incurred by a firm which is trying to avoid filing for bankruptcy?

A) Indirect bankruptcy costs
B) Direct bankruptcy costs
C) Static theory cost
D) Optimal capital structure cost
E) Reorganization costs

Question 13

Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms?

A) The levered firm has higher EPS than the unlevered firm at the break-even point.
B) The levered firm will have higher EPS than the unlevered firm at all levels of EBIT.
C) The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT.
D) The EPS for the unlevered firm will always exceed those of the levered firm.
E) The unlevered firm will have higher EPS at relatively low levels of EBIT.

Question 14

You are comparing two possible capital structures for a firm. The first option is an all-equity firm. The second option involves the use of $3.8 million of debt. The break-even point between these two financing options occurs when the earnings before interest and taxes (EBIT) are $428,000. Given this, you know that leverage is beneficial to the firm:

A) whenever EBIT is less than $428,000.
B) only when EBIT is $428,000.
C) whenever EBIT exceeds $428,000.
D) only if the debt is decreased by $428,000.
E) only if the debt is increased by $428,000.

Question 15

T.L.C. Enterprises just revised its capital structure from a debt-equity ratio of 0.30 to a debt-equity ratio of 0.45. The firm's shareholders who prefer the old capital structure should:

A) sell some shares and hold the sale proceeds in cash.
B) sell all of their shares and loan out the entire sale proceeds.
C) do nothing.
D) sell some shares and loan out the sale proceeds.
E) borrow funds and purchase more shares.

Question 16

Which one of the following statements concerning financial leverage is correct?

A) Financial leverage increases profits and decreases losses.
B) Financial leverage has no effect on a firm's return on equity.
C) Financial leverage refers to the use of common stock.
D) Financial leverage magnifies both profits and losses.
E) Increasing financial leverage will always decrease the earnings per share.

Question 17

Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation?

A) Chapter 7 bankruptcy
B) Liquidation
C) Technical insolvency
D) Accounting insolvency
E) Reorganization

Question 18

Which one of the following best defines legal bankruptcy?

A) Negotiating new payment terms with a firm's creditors
B) A temporary technical insolvency A legal proceeding for liquidating or reorganizing a business
C) The internal process of revising the capital structure of a firm
D) The failure of a firm to meet its financial obligations in a timely manner

Question 19

Which one of the following terms is inclusive of both direct and indirect bankruptcy costs?

A) Financial distress costs
B) Capital structure costs
C) Financial leverage
D) Homemade leverage
E) Cost of capital

Question 20

Which one of the following is the equity risk arising from the capital structure selected by a firm?

A) Strategic risk
B) Financial risk
C) Liquidity risk
D) Industry risk
E) Business risk

Question 21

Which one of the following statements is the core principle of M&M Proposition I, without taxes?

A) A firm's cost of equity is directly related to the firm's debt-equity ratio.
B) A firm's WACC is directly related to the firm's debt-equity ratio.
C) The interest tax shield increases the value of a firm.
D) The capital structure of a firm is totally irrelevant.
E) Levered firms have greater value than unlevered firms.

Question 22

Peterboro recently defaulted on a bank loan. To avoid a bankruptcy proceeding, the bank agreed to a composition. This composition would do which one of the following?

A) Forgive the loan payment in its entirety
B) Extend the due date on the missed loan payment
C) Reduce the amount of the loan payments so Peterboro can pay timely
D) Transfer some of Peterboro's assets to the bank in lieu of the loan payment
E) Transfer all the equity shares in Peterboro to the lending bank

Question 23

Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming the absolute priority rule is followed?

A) Claims by unsecured creditors
B) Employee wages
C) Government tax claims
D) Contributions to employee retirement plans
E) Bankruptcy administrative expenses

Question 24

Which one of the following is an example of a direct bankruptcy cost?

A) Operating at a debt-equity ratio that is less than the optimal ratio
B) Reducing the dividend payout ratio as a means of increasing a firm's equity
C) Forgoing a positive net present value project to conserve current cash
D) Incurring legal fees for the preparation of bankruptcy filings
E) Losing a key customer due to concerns over a firm's financial viability

Question 25

Which of the following will increase the value of a levered firm according to M&M Proposition I, with taxes? I. decrease in the amount of the debt
II) increase in the value of the unlevered firm
III) decrease in the tax rate
IV) increase in the interest rate on the debt

A) II only
B) I and IV only
C) II and III only
D) II and IV only
E) II, III, and IV only

Question 26

Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases?

A) M&M Proposition I, without taxes
B) M&M Proposition II, without taxes
C) M&M Proposition I, with taxes
D) Static theory of capital structure
E) No theory suggests this.

Question 27

When is a firm insolvent from an accounting perspective?

A) When the firm is unable to meet its financial obligations in a timely manner
B) When the firm's debt exceeds the value of the firm's equity
C) When the firm has a negative net worth
D) When the firm's revenues cease
E) When the market value of the firm's equity equals zero

Question 28

Which one of the following is correct based on the static theory of capital structure?

A) A firm receives the greatest benefit from debt financing when its tax rate is relatively low.
B) A debt-equity ratio of 1 is considered to be the optimal capital structure.
C) The costs of financial distress decrease the value of a firm.
D) The more debt a firm assumes, the greater the incentive to acquire even more debt until such time as the firm is financed with 100 percent debt.
E) At the optimal level of debt a firm also optimizes its tax shield on debt.

Question 29

M&M Proposition II, without taxes, states that the:

A) capital structure of a firm is highly relevant.
B) weighted average cost of capital decreases as the debt-equity ratio decreases.
C) cost of equity increases as a firm increases its debt-equity ratio.
D) return on equity is equal to the return on assets multiplied by the debt-equity ratio.
E) return on equity remains constant as the debt-equity ratio increases.

Question 30

Which one of the following represents the present value of the interest tax shield?

A)
B)
C)
D)
E)

Question 31

Which of the following statements correctly relate to M&M Proposition I, with taxes? I. Debt decreases the value of a firm.
II. The levered value of a firm exceeds the firm's unlevered value.
III. The weighted average cost of capital (WACC) is constant.
IV. The optimal capital structure is zero debt.

A) I only
B) II only
C) II and III only
D) I and IV only
E) I, III, and IV only

Question 32

The static theory of capital structure assumes a firm:

A) maintains a constant debt-equity ratio.
B) has an all-equity structure.
C) is fixed in terms of its assets.
D) pays no taxes.
E) is operating at the point where financial distress costs are eliminated.

Question 33

A prepack:

A) guarantees full payment to all creditors but lengthens the time span of the debt.
B) is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan.
C) protects the interests of both the current creditors and the existing shareholders.
D) applies only if a firm files under Chapter 7 of the bankruptcy code.
E) extends the time that a firm is protected by the bankruptcy process.

Question 34

Which one of the following is a key provision of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005?

A) Disallowance of bankruptcy prepacks
B) Right granted to creditors to file their own reorganization plan once a firm is in bankruptcy for 18 months
C) Disallowance of all management bonus payments while a firm is in bankruptcy
D) Requirement that only creditors can file reorganization plans for a bankrupt firm
E) Requirement for all Chapter 11 bankruptcies to be converted to Chapter 7 bankruptcies after 18 months

Question 35

The level of financial risk to which a firm is exposed is dependent upon the firm's:

A) tax rate.
B) debt-equity ratio.
C) return on assets.
D) level of earnings before interest and taxes.
E) operational level of risk.

Question 36

Which one of the following is an implication of M&M Proposition II, without taxes?

A) A firm's optimal capital structure is 100 percent debt.
B) WACC is unaffected by the capital structure of a firm.
C) WACC decreases as the debt-equity ratio increases.
D) A firm's capital structure is irrelevant.
E) The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations.

Question 37

Which one of the following conditions exists at the point where a firm maximizes its value?

A) The tax benefit from an additional dollar of debt is zero.
B) Financial distress costs are equal to zero.
C) The debt-equity ratio is 1.0.
D) WACC is minimized.
E) The cost of equity is minimized.

Question 38

Which one of the following statements related to the static theory of capital structure is correct?

A) A firm begins to lose value as soon as the first dollar of debt is incurred.
B) The actual value of a firm continually rises in direct proportion to the increased use of debt.
C) The linear function of a firm's value has a constant positive slope.
D) A firm's value is maximized when a firm operates at its optimal debt level.
E) The value of a firm will automatically decrease whenever the debt-equity ratio is decreased.

Question 39

Assume both corporate taxes and financial distress costs apply to a firm. Given this, the static theory of capital structure illustrates that:

A) a firm's value and its weighted average cost of capital are inversely related.
B) a firm's value and its tax rate are inversely related.
C) the maximum value of a firm is obtained when a firm is financed solely with debt.
D) the value of a firm rises as the interest rate on debt rises.
E) the value of a firm rises as both the interest rate on debt and the tax rate rise.

Question 40

Which one of the following statements is correct?

A) A prepack is a plan of liquidation used to distribute a firm's assets.
B) Bankruptcy courts have "cram-down" powers.
C) The absolute priority rule must be strictly followed in all bankruptcy proceedings.
D) Creditors cannot force a firm into bankruptcy even though they might like to do so.
E) A reorganization plan can only be approved if the firm's creditors all agree with the plan.

Question 41

The Outlet has a cost of equity of 16.8 percent, a pre-tax cost of debt of 8.1 percent, and a return on assets of 14.5 percent. Ignore taxes. What is the debt-equity ratio?

A) 0.28
B) 0.36
C) 0.44
D) 0.52
E) 0.57

Question 42

Katz is an all-equity development company that has 36,000 shares of stock outstanding at a market price of $25 a share. The firm's earnings before interest and taxes are $29,000. Katz has decided to issue $200,000 of debt at a rate of 6 percent and use the proceeds to repurchase shares. What should Faith do if she owns 500 shares of Katz stock and wants to use homemade leverage to offset the leverage being assumed by the firm?

A) Borrow money and buy an additional 22 shares
B) Borrow money and buy an additional 111 shares
C) Sell 22 shares and loan out the proceeds
D) Sell 56 shares and loan out the proceeds
E) Sell 111 shares and loan out the proceeds

Question 43

Ernst Electrical has 9,000 shares of stock outstanding and no debt. The new CFO is considering issuing $80,000 of debt and using the proceeds to retire 1,500 shares of stock. The coupon rate on the debt is 7.5 percent. What is the break-even level of earnings before interest and taxes between these two capital structure options?

A) $18,500
B) $21,000
C) $24,000
D) $32,500
E) $36,000

Question 44

Room and Board has determined that $36,000 is the breakeven level of earnings before interest and taxes for the two capital structures it is considering. The one structure consists of all equity with 14,000 shares of stock. The second structure consists of 10,000 shares of stock and $80,000 of debt. What is the interest rate on the debt?

A) 7.72 percent
B) 8.19 percent
C) 9.97 percent
D) 11.43 percent
E) 12.86 percent

Question 45

Charleston Mills is an all-equity firm with a total market value of $221,000. The firm has 8,000 shares of stock outstanding. Management is considering issuing $50,000 of debt at an interest rate of 7 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares can the firm repurchase if it issues the debt securities?

A) 1,810 shares
B) 1,818 shares
C) 1,847 shares
D) 1,856 shares
E) 1,899 shares

Question 46

Which one of the following statements is correct?

A) All Chapter 7 bankruptcy filings must include a "workout" agreement.
B) Firms must remain in bankruptcy for at least 18 months.
C) Key employee retention plans (KERPS) are no longer legal.
D) Labor contracts cannot be modified through the bankruptcy process.
E) A firm can file for Chapter 11 bankruptcy even if the firm is solvent.

Question 47

Western Shores is comparing two separate capital structures. The first structure consists of 260,000 shares of stock and no debt. The second structure consists of 210,000 shares of stock and $1.5 million of debt. What is the price per share of equity?

A) $18
B) $22
C) $27
D) $30
E) $33

Question 48

Northern Wood Products is an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $26,000 if the economy is normal, $3,000 if the economy is in a recession, and $33,000 if the economy booms. Ignore taxes. Management is considering issuing $88,000 of debt with a 6 percent coupon rate. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession?

A) -$0.27
B) -$0.19
C) $0.03
D) $0.26
E) $0.31

Question 49

The Doll House has a pre-tax cost of debt of 7.9 percent and a return on assets of 11.7 percent. The debt-equity ratio 0.45. Ignore taxes. What is the cost of equity?

A) 11.87 percent
B) 12.03 percent
C) 12.47 percent
D) 12.98 percent
E) 13.41 percent

Question 50

Tree Farms, Inc. currently has 45,000 shares of stock outstanding and no debt. The price per share is $17.50. The firm is considering borrowing funds at 7.5 percent interest and using the proceeds to repurchase 3,000 shares of stock. Ignore taxes. How much is the firm borrowing?

A) $52,500
B) $75,000
C) $110,500
D) $125,000
E) $135,000

Question 51

Cross Town Cookies is an all-equity firm with a total market value of $720,000. The firm has 150,000 shares of stock outstanding. Management is considering issuing $200,000 of debt at an interest rate of 7 percent and using the proceeds to repurchase shares. The projected earnings before interest and taxes are $58,600. What are the anticipated earnings per share if the debt is issued? Ignore taxes.

A) $0.25
B) $0.33
C) $0.38
D) $0.41
E) $0.47

Question 52

Gabella's is an all-equity firm that has 21,000 shares of stock outstanding at a market price of $40 a share. The firm has earnings before interest and taxes of $84,000 and has a 100 percent dividend payout ratio. Ignore taxes. Gabella's has decided to issue $160,000 of debt at a rate of 12 percent and use the proceeds to repurchase shares. Travis owns 500 shares of Gabella's stock and has decided to continue holding those shares. How will Gabella's debt issue affect Travis' annual dividend income?

A) Decrease from $2,400 to $1,840
B) Increase from $2,400 to $2,160
C) Decrease from $2,000 to $1,906
D) Increase from $2,000 to $2,094
E) No change

Question 53

Northwestern Lumber Products currently has 15,000 shares of stock outstanding. Patricia, the financial manager, is considering issuing $120,000 of debt at an interest rate of 6.75 percent. Given this, how many shares of stock will be outstanding once the debt is issued if the break-even level of EBIT between these two capital structure options is $60,000? Ignore taxes.

A) 12,975 shares
B) 13,650 shares
C) 14,025 shares
D) 14,550 shares
E) 15,000 shares

Question 54

A firm is considering two different capital structures. The first option is an all-equity firm with 32,000 shares of stock. The second option is 20,000 shares of stock plus some debt. Ignoring taxes, the breakeven level of earnings before interest and taxes between these two options is $48,000. How much money is the firm considering borrowing if the interest rate is 8 percent?

A) $175,000
B) $225,000
C) $250,000
D) $275,000
E) $300,000

Question 55

Chick 'N Fish is considering two different capital structures. The first option consists of 25,000 shares of stock. The second option consists of 15,000 shares of stock plus $150,000 of debt at an interest rate of 7.5 percent. Ignore taxes. What is the break-even level of earnings before interest and taxes (EBIT) between these two options?

A) $2,813
B) $3,134
C) $16,410
D) $28,125
E) $31,338

Question 56

The Green Briar is an all-equity firm with a total market value of $418,000 and 20,000 shares of stock outstanding. Management is considering issuing $120,000 of debt at an interest rate of 9 percent and using the proceeds on a stock repurchase. Ignore taxes. How many shares will the firm repurchase if it issues the debt securities?

A) 2,871 shares
B) 3,516 shares
C) 3,921 shares
D) 4,607 shares
E) 5,742 shares

Question 57

Glass Ornaments, Inc. is an all-equity firm with a total market value of $386,000 and 15,000 shares of stock outstanding. Management is considering issuing $75,000 of debt at an interest rate of 8 percent and using the proceeds on a stock repurchase. As an all-equity firm, management believes the earnings before interest and taxes (EBIT) will be $31,000 if the economy is normal, $11,000 if it is in a recession, and $37,000 if the economy booms. Ignore taxes. What will the earnings per share (EPS) be if the economy falls into a recession and the firm maintains its all-equity status?

A) $0.68
B) $0.73
C) $1.21
D) $1.67
E) $2.07

Question 58

The Gable Inn is an all-equity firm with 16,000 shares outstanding at a value per share of $14.50. The firm is issuing $50,000 of debt and using the proceeds to reduce the number of outstanding shares. How many shares of stock will be outstanding once the debt is issued? Ignore taxes.

A) 11,970 shares
B) 12,552 shares
C) 12,846 shares
D) 13,030 shares
E) 13,561 shares

Question 59

Shoe Box Stores is currently an all-equity firm with 28,000 shares of stock outstanding. Management is considering changing the capital structure to 40 percent debt. The interest rate on the debt would be 9 percent. Ignore taxes. Jamie owns 300 shares of Shoe Box Stores stock that is priced at $17 a share. What should Jamie do if she prefers the all-equity structure but Shoe Box Stores adopts the new capital structure?

A) Borrow money and buy an additional 120 shares.
B) Borrow money and buy an additional 180 shares.
C) Keep her shares but loan out all of the dividend income at 9 percent.
D) Sell 120 shares and loan out the proceeds at 9 percent.
E) Sell 180 shares and loan out the proceeds at 9 percent.

Question 60

Henderson's is an all-equity firm that has 135,000 shares of stock outstanding. Neal, the financial vice-president, is considering borrowing $220,000 at 7.25 percent interest to repurchase 20,000 shares. Ignoring taxes, what is the value of the firm?

A) $1,260,000
B) $1,400,000
C) $1,485,000
D) $1,620,000
E) $1,750,000

Question 61

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

Question 62

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

Question 63

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

Question 64

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

Question 65

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

Question 66

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.

Question 67

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

Question 68

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

Question 69

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

Question 70

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

Question 71

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

Question 72

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

Question 73

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

Question 74

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

Question 75

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

Question 76

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

Question 77

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

Question 78

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

Question 79

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

Question 80

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