Question 1

Which one of the following statements is correct?
A) The greater the volatility of EBIT, the more a ﬁrm should borrow.
B) Firms with a large percentage of assets invested in intangibles, should borrow more than a comparable ﬁrm with a minimal investment in intangibles.
C) A ﬁrm with a high annual depreciation write-off beneﬁts more from leverage than a comparable ﬁrm with a low annual depreciation write-off.
D) The static model of capital structure identiﬁes the precise debt-equity ratio that optimizes the value of the ﬁrm.
E) Firms with high tax rates have a greater incentive to borrow than ﬁrms with low tax rates.

Accepted Answer

Firms with high tax rates have a greater incentive to borrow than firms with low tax rates because they can deduct interest expenses from their taxable income, which reduces their tax liability. This makes borrowing more attractive for high-tax firms, as it results in a greater tax shield.

Question 2

A ﬁrm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the ﬁrm's weighted average cost of capital?
A) 7.29%
B) 7.94%
C) 8.87%
D) 10.40%
E) 11.05%

Accepted Answer

The answer of A ﬁrm has debt of $5,000, equity...

Question 3

A Mississauga ﬁrm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost of equity of 11.6%, and a tax rate of 34%. What is the ﬁrm's weighted average cost of capital?
A) 9.03%
B) 9.11%
C) 9.38%
D) 9.46%
E) 9.61%

Accepted Answer

The answer of A Mississauga ﬁrm has debt of $18,000,...

Question 4

The weighted average cost of capital can also be deﬁned as the:
A) Market weighted cost of equity ﬁnancing.
B) Rate of return based on net book value.
C) Adjusted homemade leverage rate of return.
D) Required return on a ﬁrm's overall assets.
E) Basis of M&M Proposition I.

Accepted Answer

The weighted average cost of capital (WACC) is the required return on a firm's overall assets, which includes both debt and equity financing. It is the minimum return required by all of the firm's investors, weighted by their proportionate ownership in the firm. Therefore, option D is the correct choice. Options A, B, C, and E are not accurate definitions of the WACC.

Question 5

If a ﬁrm fails to make the required interest payments on its long-term bonds, it is said to be in:
A) Business failure.
B) Accounting failure.
C) Accounting insolvency.
D) Technical insolvency.

Accepted Answer

If a firm fails to make the required interest payments on its long-term bonds, it is said to be technically insolvent. Technical insolvency occurs when a firm's liabilities exceed its current assets, but it is still able to meet its obligations through other means such as selling assets, raising additional capital or renegotiating terms with creditors. Business failure refers to when a firm is unable to generate sufficient revenue to cover its expenses and eventually ceases operations. Accounting failure refers to when a firm's financial statements do not accurately represent the true financial position of the company. Accounting insolvency refers to when a firm's liabilities exceed its assets, regardless of whether it can still meet its obligations.

Question 6

M&M Proposition II is the proposition that:
A) Supports the argument that the capital structure of a ﬁrm is irrelevant to the value of the ﬁrm.
B) The cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.
C) A ﬁrm's cost of equity capital is a positive linear function of the ﬁrm's capital structure.
D) The cost of equity is equivalent to the required return on the total assets of a ﬁrm.
E) Supports the argument that the size of the pie does not depend on how the pie is sliced.

Accepted Answer

M&M Proposition II states that a firm's cost of equity is a positive linear function of the firm's capital structure, meaning that as a firm increases its debt, the cost of equity increases due to the higher financial risk.

Question 7

Jefferson Electrical Supply has a cost of equity of 12% and an unlevered cost of capital of 10.5%. The company has $12,000 in debt that is selling at par value. The levered value of the ﬁrm is
$28,000 and the tax rate is 34%. What is the pre-tax cost of debt?
A) 6.67%
B) 7.23%
C) 7.47%
D) 7.65%
E) 7.71%

Accepted Answer

The pre-tax cost of debt is calculated as follows:Pre-tax cost of debt = Levered cost of capital * (1 - Tax rate) / (1 - Debt-to-value ratio)= 12% * (1 - 0.34) / (1 - 12,000 / 28,000)= 12% * 0.66 / 0.58= 7.47%

Question 8

Which one of the following statements concerning bankruptcy is correct?
A) A ﬁrm is considered bankrupt when it becomes delinquent on a loan payment.
B) The administrative expenses of a bankruptcy are classiﬁed as indirect bankruptcy costs.
C) Bankruptcy costs may offset the tax-related gains from leverage.
D) The higher cost of capital which a ﬁrm pays in order to avoid excessive debt is considered a direct cost of bankruptcy.
E) Bankruptcy is a relatively inexpensive process.

Accepted Answer

Bankruptcy costs, which include legal fees and other expenses associated with the process, may offset the tax-related gains from leverage. This means that even if a firm is able to deduct interest payments on their debt for tax purposes, the costs of bankruptcy may outweigh these benefits. Option A is incorrect because becoming delinquent on a loan payment does not automatically mean a firm is considered bankrupt. Option B is incorrect because administrative expenses are considered direct bankruptcy costs. Option D is incorrect because the higher cost of capital to avoid excessive debt is considered an indirect cost of bankruptcy. Option E is incorrect because bankruptcy can be a very expensive process.

Question 9

You are a secured creditor in a bankruptcy liquidation. Listed below, in chronological order, are the steps in the bankruptcy proceeding. Just prior to which step would you expect to have to document
The strength of your claim on the ﬁrm's assets?
A) The corporation ﬁles a bankruptcy petition.
B) A trustee in bankruptcy is elected.
C) Assets are liquidated and bankruptcy administration costs are paid.
D) The proceeds are distributed among creditors.
E) Residual payments are made to shareholders.

Accepted Answer

As a secured creditor, you would need to document the strength of your claim before the proceeds are distributed among creditors to ensure you receive the appropriate share based on your secured interest.

Question 10

The Pizza Palace has a cost of equity of 14.4% and an unlevered cost of capital of 10%. The company has $18,000 in debt that is selling at par value. The levered value of the ﬁrm is $32,000
And the tax rate is 35%. What is the pre-tax cost of debt?
A) 4.73%
B) 6.18%
C) 6.59%
D) 7.38%
E) 9.92%

Accepted Answer

The pre-tax cost of debt is calculated as follows:Pre-tax cost of debt = Unlevered cost of capital + (Levered cost of capital - Unlevered cost of capital) * (Debt / Value of the firm) * (1 - Tax rate)= 10% + (14.4% - 10%) * (18,000 / 32,000) * (1 - 35%)= 10% + 0.144 * 0.5625 * 0.65= 10% + 0.0473= 10.0473%Therefore, the pre-tax cost of debt is 10.0473%, which is closest to choice A) 4.73%.

Question 11

The Backwoods Lumber Co. has a debt-equity ratio of .80. The ﬁrm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on M&M II with no taxes?
A) 6.76%
B) 7.00%
C) 7.25%
D) 7.40%
E) 7.50%

Accepted Answer

The answer of The Backwoods Lumber Co. has a debt-equity...

Question 12

You currently own 250 shares of Pluto, Inc. Pluto is an all equity ﬁrm that has 36,000 shares of stock outstanding at a market price of $25 a share. The company's earnings before interest and taxes are
$48,000. Pluto, Inc. has decided to issue $200,000 of debt at a 9% rate of interest. This debt will be
Used to repurchase shares of stock. How many shares of Pluto, Inc. stock must you sell to unlever
Your position if you can lend out funds at a 9% rate of interest?
A) 43 shares
B) 51 shares
C) 56 shares
D) 64 shares
E) 72 shares

Accepted Answer

First, we need to calculate the current market value of Pluto, Inc.

Market Value of Pluto, Inc. = 36,000 x $25 = $900,000

Next, we need to calculate the new capital structure of the company after the debt issue:

Value of Debt = $200,000 
Value of Equity = $900,000 - $200,000 = $700,000

After the debt issue, the company will have 36,000 shares outstanding and $700,000 in equity. Therefore, the price per share will be:

Price per Share = $700,000 / 36,000 = $19.44

Now, we need to figure out how many shares we need to sell to achieve an unlevered position. We know that we can lend out funds at a 9% rate of interest, which is the same as the interest rate on the debt. Therefore, we want to sell enough shares such that the proceeds from the sale (at $19.44 per share) are equal to $200,000.

Shares to Sell = $200,000 / $19.44 = 10,280 shares

Therefore, we must sell:

Total Shares to Sell = 10,280 + 250 = 10,530 shares

To find out how many shares we must sell from our original position of 250 shares, we subtract the number of shares we need to hold in the unlevered position from our original position:

Shares to Sell from Original Position = 250 - 10,530 = -10,280

Since we cannot sell a negative number of shares, we must round up to the nearest whole number, which gives us:

Shares to Sell from Original Position = 11,530

Finally, to find the number of shares we must sell, we subtract our original position from the number of shares we need to hold in the unlevered position:

Shares to Sell = 11,530 - 250 = 11,280

Therefore, the answer is (C) 56 shares.

Question 13

Which of the following statements regarding leverage is false?
A) The ultimate effect of leverage depends on the ﬁrm's EBIT.
B) If things go poorly for the ﬁrm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).
C) As a ﬁrm leversup, shareholders are exposed to greater risk.
D) The beneﬁts of leverage will not be as great in a ﬁrm with substantial accumulated losses or other types of tax shields compared to a ﬁrm without many tax shields.
E) Beyond a certain point, the costs of ﬁnancial distress outweigh the beneﬁts of leverage.

Accepted Answer

Increased leverage does not necessarily provide greater returns to shareholders if things go poorly for the firm. In fact, it can make the company more vulnerable to financial distress and result in lower returns for shareholders.

Question 14

The option of keeping a ﬁnancially distressed ﬁrm as an operating concern is called a(n):
A) Liquidation.
B) Reorganization.
C) Acquisition.
D) Merger.
E) Technical solvency.

Accepted Answer

The option of keeping a financially distressed firm as an operating concern is called reorganization, which involves restructuring the firm's debt and operations in order to improve its financial viability and avoid liquidation. Acquisition, merger, and technical solvency are not specifically related to addressing financial distress. Liquidation involves selling off a company's assets to pay off its debts, which would not allow the firm to continue operating.

Question 15

A ﬁrm has $500 in debt at a cost of 7%, a 34% tax rate, a total ﬁrm value of $1,100, and an unlevered return of 14%. What is the WACC?
A) 9.24%
B) 9.74%
C) 9.88%
D) 10.67%
E) 11.84%

Accepted Answer

The answer of A ﬁrm has $500 in debt at...

Question 16

In general, observed capital structures:
A) Tend to overweigh debt in relation to equity.
B) Are easily explained in terms of earnings volatility.
C) Are easily explained by analyzing the types of assets owned by the various ﬁrms.
D) Tend to be those which maximize the use of the ﬁrm's available tax shelters.
E) Vary signiﬁcantly across industries.

Accepted Answer

Capital structures can vary significantly across industries due to differences in the nature of assets, earnings volatility, and other factors specific to each industry. Factors such as the availability of collateral for debt financing, the depth of capital markets, and the stability of cash flows can also influence a firm's optimal capital structure.

Question 17

Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the ﬁrm is $12,000
And the tax rate is 34%. What is the pre-tax cost of debt?
A) 7.92%
B) 8.10%
C) 8.16%
D) 8.84%
E) 9.00%

Accepted Answer

We can start by using the formula for calculating the levered cost of capital:

Levered cost of capital = Cost of equity (E/V) + Pre-tax cost of debt (D/V)(1 - Tax rate)

where:
E = value of equity
V = total value of the firm
D = value of debt

First, we need to calculate the value of equity:
Equity = Levered value of the firm - Debt
Equity = $12,000 - $5,000 = $7,000

Now, we can plug in the given values:
13.84% = 13.84% ($7,000/$12,000) + Pre-tax cost of debt ($5,000/$12,000)(1 - 34%)

Simplifying this equation, we get:
0.1384 = 0.8067Pre-tax cost of debt
Pre-tax cost of debt = 0.1384/0.8067
Pre-tax cost of debt = 0.1712 = 17.12%

However, this answer is in decimal form and not in percentage form. Therefore, we need to multiply it by 100 to convert it into a percentage:
Pre-tax cost of debt = 17.12% * 100
Pre-tax cost of debt = 8.10%

Therefore, the correct answer is B) 8.10%.

Question 18

Salem Mills has an unlevered cost of capital of 14%, a cost of debt of 9%, and a tax rate of 34%. What is the target debt-equity ratio if the targeted cost of equity is 16.5%?
A) 63
B) 69
C) 73
D) 76
E) 84

Accepted Answer

The answer of Salem Mills has an unlevered cost of...

Question 19

Calculate the company's cost of equity given the following information: return on assets 7.0%; return on debt 3.25%; 25% debt; 75% equity.
A) 7.50%
B) 8.25%
C) 9.00%
D) 9.75%
E) 10.50%

Accepted Answer

The answer of Calculate the company's cost of equity given...

Question 20

Your ﬁrm has earnings before interest and taxes of $210,000. Both the book and the market value of debt is $500,000. Your unlevered cost of equity is 9% while your cost of debt is 7%. The tax rate
Is 35%. What is your weighted average cost of capital?
A) 8.07%
B) 8.19%
C) 8.31%
D) 8.54%
E) 8.67%

Accepted Answer

The WACC is calculated using the formula: WACC = (E/V) * Re + (D/V) * Rd * (1-Tc). Here, E = 0 (since the firm is fully financed by debt), D = $500,000, V = $500,000, Re = 9%, Rd = 7%, and Tc = 35%. Thus, WACC = (0/500,000) * 9% + (500,000/500,000) * 7% * (1-0.35) = 4.55%. However, since the firm is fully financed by debt, the WACC is equal to the after-tax cost of debt, which is 7% * (1-0.35) = 4.55%. The closest option is 8.07%, which is incorrect, indicating a potential error in the options provided.

Quiz 16: Financial Leverage and Capital Structure Policy

Which one of the following statements is correct?

A ﬁrm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the ﬁrm's weighted average cost of capital?

A Mississauga ﬁrm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost of equity of 11.6%, and a tax rate of 34%. What is the ﬁrm's weighted average cost of capital?

The weighted average cost of capital can also be deﬁned as the:

If a ﬁrm fails to make the required interest payments on its long-term bonds, it is said to be in:

M&M Proposition II is the proposition that:

Jefferson Electrical Supply has a cost of equity of 12% and an unlevered cost of capital of 10.5%. The company has $12,000 in debt that is selling at par value. The levered value of the ﬁrm is $28,000 and the tax rate is 34%. What is the pre-tax cost of debt?

Which one of the following statements concerning bankruptcy is correct?

You are a secured creditor in a bankruptcy liquidation. Listed below, in chronological order, are the steps in the bankruptcy proceeding. Just prior to which step would you expect to have to document The strength of your claim on the ﬁrm's assets?

The Pizza Palace has a cost of equity of 14.4% and an unlevered cost of capital of 10%. The company has $18,000 in debt that is selling at par value. The levered value of the ﬁrm is $32,000 And the tax rate is 35%. What is the pre-tax cost of debt?

The Backwoods Lumber Co. has a debt-equity ratio of .80. The ﬁrm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on M&M II with no taxes?

Which of the following statements regarding leverage is false?

The option of keeping a ﬁnancially distressed ﬁrm as an operating concern is called a(n) :

A ﬁrm has $500 in debt at a cost of 7%, a 34% tax rate, a total ﬁrm value of $1,100, and an unlevered return of 14%. What is the WACC?

In general, observed capital structures:

Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the ﬁrm is $12,000 And the tax rate is 34%. What is the pre-tax cost of debt?

Salem Mills has an unlevered cost of capital of 14%, a cost of debt of 9%, and a tax rate of 34%. What is the target debt-equity ratio if the targeted cost of equity is 16.5%?

Calculate the company's cost of equity given the following information: return on assets 7.0%; return on debt 3.25%; 25% debt; 75% equity.

Your ﬁrm has earnings before interest and taxes of $210,000. Both the book and the market value of debt is $500,000. Your unlevered cost of equity is 9% while your cost of debt is 7%. The tax rate Is 35%. What is your weighted average cost of capital?