Question 1

Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?

Accepted Answer

The interest tax shield is calculated as the interest payment multiplied by the tax rate, discounted at the cost of debt. The annual tax shield is $10 million * 30% = $3 million. The present value of this annuity over 5 years at a 6% discount rate is $3 million * [(1 - (1 + 0.06)^-5) / 0.06] = $12.64 million.

Question 2

Which of the following statements is FALSE?

Accepted Answer

Homemade leverage allows investors to adjust their personal leverage to match their preferences, but it does not allow them to perfectly recreate the payoffs of unlevered equity by borrowing and purchasing equity.

Question 3

In general, issuing equity may not dilute the ownership of existing shareholders i?

Accepted Answer

Issuing new equity may not dilute the ownership of existing shareholders if the new shares are sold at a fair price, which means the price of the new shares reflects the true value of the company. If the new shares are sold at a price that is lower than the true value of the firm, the existing shareholders will face dilution of their ownership. Therefore, it is important to price the new shares correctly to avoid dilution of ownership.

Question 4

The trade-off theory of optimal capital structure weighs the benefits of debt against the costs o?

Accepted Answer

The trade-off theory of optimal capital structure weighs the benefits of debt, such as tax shields and increased leverage, against the costs of financial distress, such as bankruptcy and agency costs. Therefore, the best choice is A, financial distress.

Question 5

Which of the following statements is FALSE?

Accepted Answer

The answer of Which of the following statements is FALSE?
...

Question 6

Which of the following statements is FALSE?

Accepted Answer

The Law of One Price states that identical assets should have the same price in the market. In a perfect capital market, all investors have the same access to information and opportunities to borrow and lend at the same rate. Therefore, the market value of a firm should be independent of its choice of capital structure. Therefore, statement D is false.

Question 7

Managers should make use of the interest tax shield if the firm ha?

Accepted Answer

Consistent taxable income allows a firm to benefit from the interest tax shield, as it ensures that the firm can utilize the tax deductibility of interest payments effectively.

Question 8

By adding leverage, the returns on the firm are split between debt holders and equity holders, but equity holder risk increases because

Accepted Answer

Interest payments have first priority, meaning that debt holders are paid before equity holders, increasing the risk for equity holders if the firm cannot meet its obligations.

Question 9

A firm requires an investment of $20,000 and borrows $10,000 at 8%. If the return on equity is 20% and the tax rate is 30%, what is the firm's WACC?

Accepted Answer

WACC can be calculated using the following formula:

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

Where: 
E = market value of the firm's equity 
V = total market value of the firm (equity + debt) 
Re = cost of equity 
D = market value of the firm's debt 
Rd = cost of debt 
Tc = tax rate

Given information: 
E = 20,000 
D = 10,000 
Re = 20% 
Rd = 8% 
Tc = 30%

Step 1: Calculate the total market value of the firm 
V = E + D = 20,000 + 10,000 = 30,000

Step 2: Calculate the WACC 
WACC = (E/V) x Re + (D/V) x Rd x (1-Tc) 
WACC = (20,000/30,000) x 0.20 + (10,000/30,000) x 0.08 x (1-0.30) 
WACC = 0.6667 x 0.20 + 0.3333 x 0.056 = 0.1333 or 13.3%

Therefore, the firm's WACC is 12.8% (rounded to one decimal place), which is closest to answer choice C.

Question 10

When a firm's investment decisions have different consequences for the value of equity and thevalue of debt, managers may take actions

Accepted Answer

If managers have to choose between actions that will benefit shareholders (increase equity value) or debt holders (increase debt value), they may prioritize actions that benefit shareholders at the expense of debt holders as they are accountable to shareholders. This can lead to a conflict of interest between shareholders and debt holders.

Question 11

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity
firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12
million in debt at an interest rate of 5%.
-Assume that MM's perfect capital markets conditions are met and that you can borrow and lend atthe same 5% rate as With. You have $5000 of your own money to invest and you plan on buying With shares. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without shares?

Accepted Answer

Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share.
So, $5000 investment can buy $5000/$24 = 208.33 shares.
With has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
So the total value of With firm = $24*2,000,000 + $12,000,000 = $60,000,000
Total value of equity in With = $60,000,000 - $12,000,000 = $48,000,000
Price per share of With = $48,000,000/2,000,000 = $24
To get the payoff of Without by investing in With, we need to construct a homemade leverage by borrowing enough money so that we can buy twice the number of With shares. That is, we need to borrow $24*208.33 = $4999.92 at the 5% risk-free rate to buy 2*208.33 = 416.67 With shares. 
Now, if the value of With shares go up, the investor will receive $24 per share, out of which they will have to pay $24*5% = $1.2 in interest. So the net payoff will be $22.8 per share. If the value of With shares go down, the investor will only receive $22.8 per share. Thus, the investor's account will be the same as investing $5000 in Without shares. Therefore, the investor needs to invest $4999.92-$5000 = -$0.08, which is approximately $0. Therefore the answer is B) $2500.

Question 12

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%,what is the firm's pretax WACC?

Accepted Answer

The answer of A firm requires an investment of $30,000...

Question 13

The Trade-off Theory suggest?

Accepted Answer

The Trade-off Theory suggests that firms should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. This means that there is an optimal level of debt for each firm where the benefits of debt (such as tax shields) are balanced with the costs (such as financial distress). Choosing a debt level that is too high or too low can result in suboptimal outcomes for the firm. Therefore, option D is the correct answer.

Question 14

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,it is referred to as

Accepted Answer

Homemade leverage refers to the use of personal borrowing or investing to adjust the overall leverage of a portfolio. Since this involves adjusting the leverage choice made by the firm through personal means, it is the most appropriate option among the given choices. The other choices, such as payout ratio or retained earnings, do not involve the use of personal leverage. Outside debt, on the other hand, refers to borrowing from external sources such as banks or financial institutions, and is not related to the investor's personal leverage choice.

Question 15

One of the factors that determines the present value (PV) of financial distress costs i?

Accepted Answer

The probability of financial distress is one of the key factors that determine the present value of financial distress costs. As the probability of financial distress increases, the PV of financial distress costs also increases. Factors such as employee compensation, costs of unpaid interest arrears, and loss of dividend payments may also contribute to the overall financial distress costs, but they are not the primary determinants of PV of financial distress.

Question 16

As the level of debt increases, the tax benefits of debt increase unti?

Accepted Answer

Tax benefits of debt increase as the level of debt increases due to the tax shield effect. However, after a certain point, the costs associated with debt (such as financial distress) outweigh the tax benefits, resulting in a decrease in overall value. This point is referred to as the optimal capital structure.

Question 17

The presence of a large amount of debt can encourage shareholders to take excessive risk becaus?

Accepted Answer

When a firm has a large amount of debt, the costs of failure are typically borne by the debt holders. This creates an incentive for equity holders to take excessive risk because they have relatively little to lose if the company fails. In contrast, debt holders are more likely to prefer a conservative approach to risk management in order to protect their investment. Therefore, option D is the best choice.

Question 18

Which of the following statements is FALSE?

Accepted Answer

The cost of debt is generally lower than the cost of equity due to its tax deductibility, making it less expensive for firms to borrow money. Therefore, statement C is false.

Question 19

Which of the following statements is FALSE?

Accepted Answer

The project's net present value (NPV) represents the value created by the project for the firm, not for new investors. NPV is the difference between the present value of cash inflows and the present value of cash outflows associated with a project.

Question 20

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

Accepted Answer

The WACC is calculated as (E/V * Re) + (D/V * Rd * (1-T)). Here, E = $20,000, D = $10,000, V = $30,000, Re = 15%, Rd = 6%, T = 30%. WACC = (20,000/30,000 * 15%) + (10,000/30,000 * 6% * (1-0.3)) = 11.4%.

Quiz 16: Capital Structure

Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?

Which of the following statements is FALSE?

In general, issuing equity may not dilute the ownership of existing shareholders i?

The trade-off theory of optimal capital structure weighs the benefits of debt against the costs o?

Which of the following statements is FALSE?

Which of the following statements is FALSE?

Managers should make use of the interest tax shield if the firm ha?

By adding leverage, the returns on the firm are split between debt holders and equity holders, but equity holder risk increases because

A firm requires an investment of $20,000 and borrows $10,000 at 8%. If the return on equity is 20% and the tax rate is 30%, what is the firm's WACC?

When a firm's investment decisions have different consequences for the value of equity and thevalue of debt, managers may take actions

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%,what is the firm's pretax WACC?

The Trade-off Theory suggest?

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,it is referred to as

One of the factors that determines the present value (PV) of financial distress costs i?

As the level of debt increases, the tax benefits of debt increase unti?

The presence of a large amount of debt can encourage shareholders to take excessive risk becaus?

Which of the following statements is FALSE?

Which of the following statements is FALSE?

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?