Question 1

Johnson Tire Distributors has debt with both a face and a market value of $35,000. This debt has a coupon rate of 6.6 percent and pays interest annually. The expected earnings before interest and taxes are $8,300, the tax rate is 21 percent, and the unlevered cost of capital is 10.9 percent. What is the cost of equity?

Accepted Answer

The answer of Johnson Tire Distributors has debt with both...

Question 2

The Book Worm is an unlevered company with an aftertax net income of $118,406. The unlevered cost of capital is 13.8 percent and the tax rate is 21 percent. What is the value of this company?

Accepted Answer

The formula to calculate the value of an unlevered company is:
Value of the company = Aftertax net income / Unlevered cost of capital

Plugging in the given values, we get:
Value of the company = $118,406 / 0.138 = $858,014

Therefore, the correct answer is C.

Question 3

The Jean Outlet is an all-equity firm that has 64,000 shares of stock outstanding. The company has decided to borrow $120,000 to repurchase 1,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes?

Accepted Answer

The total value of the firm remains unchanged by the financing decision due to the Modigliani-Miller theorem, which states that in a world without taxes, bankruptcy costs, and asymmetric information, the value of a leveraged firm is the same as the value of an unleveraged firm. Therefore, the firm's value before and after the transaction is the same, and the borrowing is used to repurchase shares without affecting the overall firm value.

Question 4

ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. The cost of equity for ABC is ________ percent and for XYZ it is ________ percent.

Accepted Answer

The cost of equity for ABC is calculated as EBIT/Equity = $62,222 / $530,000 = 11.74%. For XYZ, the cost of equity is calculated using the formula: Cost of Equity = (EBIT - Interest) / Equity = ($62,222 - ($530,000 - $310,000) * 7.9%) / $310,000 = 14.47%.

Question 5

Ignoring taxes, Pewter & Glass has a weighted average cost of capital of 10.82 percent. The company can borrow at 7.4 percent. What is the cost of equity if the debt-equity ratio is .68?

Accepted Answer

First, we need to calculate the cost of debt:

Cost of debt = 7.4%

Next, we can use the debt-equity ratio to calculate the equity portion of the company's capital structure:

Equity proportion = 1 - Debt-equity ratio = 1 - 0.68 = 0.32

Now we can use the weighted average cost of capital formula to calculate the cost of equity:

Weighted average cost of capital = (equity proportion x cost of equity) + (debt proportion x cost of debt)

10.82% = (0.32 x cost of equity) + (0.68 x 7.4%)

Solving for cost of equity, we get:

Cost of equity = (10.82% - 0.68 x 7.4%) / 0.32 = 13.15%

Therefore, the best choice is B (13.15%).

Question 6

Lester's has expected earnings before interest and taxes of $74,800, an unlevered cost of capital of 11.6 percent, and debt with both a book and face value of $84,000. The debt has a coupon rate of 6.35 percent and the tax rate is 24 percent. What is the value of this company?

Accepted Answer

First, we need to find the weighted average cost of capital (WACC) using the unlevered cost of capital and the debt information:
WACC = (11.6% * (1 - 0.24) * (1 - 0.0635) * (84000/74800)) + (0.0635 * (1 - 0.24) * (84000/74800))
WACC = 0.1038 or 10.38%
Next, we can calculate the value of the company using the free cash flow to the firm (FCFF) approach:
FCFF = EBIT(1 - tax rate) + depreciation and amortization - capital expenditures - changes in net working capital
FCFF = 74800(1-0.24) + 0 - 0 - 0 = 56832
Value of the company = FCFF / WACC = 56832 / 0.1038 = $510,229
Therefore, the best choice is C.

Question 7

Mountain Groves has an unlevered cost of capital of 13.2 percent, a cost of debt of 8.3 percent, and a tax rate of 21 percent. What is the target debt-equity ratio if the targeted cost of equity is 14.5 percent?

Accepted Answer

The answer of Mountain Groves has an unlevered cost of...

Question 8

An unlevered company has a cost of capital of 14.6 percent and earnings before interest and taxes of $240,090. A levered company with the same operations and assets has a face value of debt of $85,000 with a coupon rate of 7.5 percent that sells at par. The applicable tax rate is 22 percent. What is the value of the levered company?

Accepted Answer

The answer of An unlevered company has a cost of...

Question 9

Lamey Co. has an unlevered cost of capital of 12.3 percent, a total tax rate of 25 percent, and expected earnings before interest and taxes of $32,840. The company has $60,000 in bonds outstanding that sell at par and have a coupon rate of 7.2 percent. What is the cost of equity?

Accepted Answer

The correct answer is A because the cost of equity is 13.78 percent. This can be calculated using the following formula:Cost of equity = Unlevered cost of capital + (Unlevered cost of capital - Bond yield) * (Debt / Equity) * (1 - Tax rate)Plugging in the given values, we get:Cost of equity = 12.3% + (12.3% - 7.2%) * (60,000 / 40,000) * (1 - 25%)= 12.3% + 3.075%= 13.78%

Question 10

Roy's Welding has a cost of equity of 14.1 percent and a pretax cost of debt of 7.7 percent. The required return on the assets is 13.2 percent. What is the debt-equity ratio based on M&M II with no taxes?

Accepted Answer

The answer of Roy's Welding has a cost of equity...

Question 11

L.A. Clothing has expected earnings before interest and taxes of $63,300, an unlevered cost of capital of 14.7 percent, and a combined tax rate of 23 percent. The company also has $11,000 of debt that carries a coupon rate of 7 percent. The debt is selling at par value. What is the value of this company?

Accepted Answer

The answer of L.A. Clothing has expected earnings before interest...

Question 12

Key Motors has a cost of equity of 14.26 percent and an unlevered cost of capital of 11.34 percent. The company has $35,000 in debt that is selling at par value. The levered value of the company is $79,000 and the tax rate is 21 percent. What is the pretax cost of debt?

Accepted Answer

The answer of Key Motors has a cost of equity...

Question 13

Hanover Tech is currently an all-equity company that has 145,000 shares of stock outstanding with a market price of $22 a share. The current cost of equity is 13.9 percent and the tax rate is 21 percent. The company is considering adding $1.5 million of debt with a coupon rate of 7.5 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

Accepted Answer

The answer of Hanover Tech is currently an all-equity company...

Question 14

Eastern Markets has no debt outstanding and a total market value of $346,500. Earnings before interest and taxes, EBIT, are projected to be $14,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 13 percent higher. If there is a recession, then EBIT will be 32 percent lower. The firm is considering a debt issue of $16,000 with an interest rate of 6.8 percent. The proceeds will be used to repurchase shares of stock. There are currently 4,500 shares outstanding. Ignore taxes. What will be the percentage change in EPS if the economy enters a recessionary period?

Accepted Answer

The correct answer is A.The percentage change in EPS if the economy enters a recessionary period is -35%. This is calculated as follows:EPS without debt = EBIT / Number of shares outstanding= $14,000 / 4,500= $3.11EPS with debt = (EBIT - Interest expense) / (Number of shares outstanding - Shares repurchased)= ($14,000 - $16,000 * 0.068) / (4,500 - 16,000 / $3.11)= $2.02Percentage change in EPS = (EPS with debt - EPS without debt) / EPS without debt= ($2.02 - $3.11) / $3.11= -35%

Question 15

Lamont Corp. is debt-free and has a weighted average cost of capital of 12.7 percent. The current market value of the equity is $2.3 million and there are no taxes. According to M&M Proposition I, what will be the value of the company if it changes to a debt-equity ratio of .85?

Accepted Answer

According to Modigliani and Miller Proposition I (with no taxes), the total value of a leveraged firm is equal to the value of an unleveraged firm. This means that the capital structure changes (introduction of debt) do not affect the total value of the firm. Therefore, if Lamont Corp. is initially worth $2.3 million when it is debt-free, its value will remain $2.3 million regardless of the change in its debt-equity ratio.

Question 16

Winter's Toyland has a debt-equity ratio of .57. The pretax cost of debt is 8.2 percent and the required return on assets is 14.7 percent. What is the company's cost of equity if you ignore taxes?

Accepted Answer

First, we need to find the debt and equity proportions in the capital structure. Given debt-equity ratio of .57, the debt proportion is 0.57/(1+0.57) = 0.36 and the equity proportion is 1 - 0.36 = 0.64.

Next, we can use the following formula to calculate the cost of equity:
Cost of Equity = Required Return on Assets - (Debt/Equity) x (Required Return on Assets - Pretax Cost of Debt)

Cost of Equity = 14.7% - 0.36 x (14.7% - 8.2%) 
Cost of Equity = 18.41%

Therefore, the answer is E.

Question 17

Noelle owns 12 percent of The Toy Factory. She has decided to retire and wants to sell all of her shares in this closely held, all-equity firm. The other shareholders have agreed to have the company borrow the $248,000 needed to repurchase her shares of stock. What is the total market value of the company? Ignore taxes.

Accepted Answer

The total market value of the company is $2,066,667. This is because Noelle owns 12% of the company, and her shares are worth $248,000. Therefore, the total market value of the company is $248,000 / 0.12 = $2,066,667.

Question 18

North Side Inc. has no debt outstanding and a total market value of $168,000. Earnings before interest and taxes, EBIT, are projected to be $18,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 22 percent higher. If there is a recession, then EBIT will be 35 percent lower. The company is considering a $50,000 debt issue with an interest rate of 7.4 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,000 shares outstanding and the tax rate is 21 percent. What will be the percentage change in EPS if the economy has a strong expansion?

Accepted Answer

First, calculate the EBIT under strong expansion: $18,000 * 1.22 = $21,960. Then, calculate the interest expense: $50,000 * 0.074 = $3,700. The net income under expansion with debt is then: ($21,960 - $3,700) * (1 - 0.21) = $14,425.8. Without debt, net income under expansion is: $21,960 * (1 - 0.21) = $17,348.4. The number of shares repurchased with $50,000 is $50,000 / ($168,000 / 5,000) = 1,488.1 shares, leaving 3,511.9 shares. The EPS with debt is $14,425.8 / 3,511.9 = $4.11, and without debt, it's $17,348.4 / 5,000 = $3.47. The percentage change in EPS is (($4.11 - $3.47) / $3.47) * 100 = 18.44%. However, given the choices provided do not match the calculated result, it suggests a need to reevaluate the calculation or assumptions made. The correct approach involves comparing the EPS before and after the debt issue under the scenario of a strong expansion, taking into account the interest expense, tax savings from the debt, and the reduced number of shares outstanding after repurchase.

Question 19

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 112,000 shares of stock outstanding. Under Plan II, there would be 75,000 shares of stock outstanding and $600,000 in debt. The interest rate on the debt is 6.7 percent and there are no taxes. What is the break-even EBIT?

Accepted Answer

The answer of Galaxy Products is comparing two different capital...

Question 20

The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.8 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?

Accepted Answer

According to M&M Proposition II with no taxes, the cost of equity and the cost of capital are related as:

Cost of capital = Cost of equity + (Cost of equity - Cost of debt) x (Debt/Equity)

0.135 = 0.158 + (0.158 - Cost of debt) x (0.53/0.47)

Solving for the cost of debt gives:

Cost of debt = 0.0916 or 9.16%

Quiz 16: Financial Leverage and Capital Structure Policy