Question 1

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share.The current cost of equity is 15.4 percent and the tax rate is 34 percent.The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure.The debt will be sold at par value.What is the levered value of the equity?

Accepted Answer

V_L = (320,000 × $19) + (0.34 × $1.2m) = $6.488mV_E = $6.488m - $1.2m = $5.288m

Question 2

Jemisen's has expected earnings before interest and taxes of $6,200.Its unlevered cost of capital is 14 percent and its tax rate is 34 percent.The firm has debt with both a book and a face value of $2,500.This debt has a 9 percent coupon and pays interest annually.What is the firm's weighted average cost of capital?

Accepted Answer

V_U = [$6,200 × (1 - 0.34)]/0.14 = $29,228.57V_L = $29,228.57 + (0.34 × $2,500) = $30,078.57V_E = $30,078.57 - $2,500 = $27,578.57R_E = 0.14 + (0.14 - 0.09) × ($2,500/$27,578.57) × (1 - 0.34) = 0.142991WACC = [($27,578.57/$30,078.57) × 0. 142991] + [($2,500/$30,078.57) × 0.09 × (1 - 0.34)] = 13.60 percent

Question 3

The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent.The company has $22,000 in debt that is selling at par value.The levered value of the firm is $41,000 and the tax rate is 34 percent.What is the pre-tax cost of debt?

Accepted Answer

R_E = 0.153 = 0.118 + (0.118 - R_D) × [$22,000/($41,000 - $22,000)] × (1 - 0.34);R_D = 7.22 percent

Question 4

Douglass & Frank has a debt-equity ratio of 0.35.The pre-tax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent.What is the cost of equity if the tax rate is 39 percent?

Accepted Answer

R_E = 0.133 + (0.133 - 0.082) × 0.35 × (1 - 0.39) = 14.39 percent

Question 5

Winter's Toyland has a debt-equity ratio of 0.65.The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent.What is the cost of equity if you ignore taxes?

Accepted Answer

R_E = 0.161 + (0.161 - 0.087) × 0.65 = 20.91 percent

Question 6

Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent.The required return on the assets is 13.2 percent.What is the firm's debt-equity ratio based on M & M II with no taxes?

Accepted Answer

R_E = 0.146 = 0.132 + (0.132 - 0.078) × D/E; D/E = 0.26

Question 7

The Green Paddle has a cost of equity of 12.1 percent and a pre-tax cost of debt of 7.6 percent.The debt-equity ratio is 0.65 and the tax rate is 32 percent.What is Green Paddle's unlevered cost of capital?

Accepted Answer

First, we need to calculate the weighted average cost of capital (WACC) using the formula:
WACC = E/(E+D) x Re + D/(E+D) x Rd x (1-T)
where,
E = market value of equity
D = market value of debt
Re = cost of equity
Rd = cost of debt
T = tax rate

Let's assume the market value of equity and debt for Green Paddle are both $100.

Then, we can calculate:
E = $100
D = $100 x 0.65 = $65
Re = 12.1%
Rd = 7.6%
T = 32%

WACC = (100/(100+65)) x 12.1% + (65/(100+65)) x 7.6% x (1-0.32) = 10.72%
This is the unlevered cost of capital, which reflects the cost of capital for Green Paddle if it had no debt.

Question 8

A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent.What is the firm's weighted average cost of capital?

Accepted Answer

WACC = {[($26,400 - $12,000)/$26,400] × 0.176} + [($12,000/$26,400) × 0.092 × (1 - 0.37)] = 12.23 percent

Question 9

Exports Unlimited is an unlevered firm with an aftertax net income of $52,300.The unlevered cost of capital is 14.1 percent and the tax rate is 36 percent.What is the value of this firm?

Accepted Answer

The value of the firm can be calculated using the formula: 
Value of unlevered firm = After-tax net income / Unlevered cost of capital
Substituting the given values, we get:
Value of unlevered firm = $52,300 / 0.141
Value of unlevered firm = $370,921.99
Therefore, the value of the firm is $370,922, which is closest to option C.

Question 10

Johnson Tire Distributors has debt with both a face and a market value of $12,000.This debt has a coupon rate of 6 percent and pays interest annually.The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent.What is the firm's cost of equity?

Accepted Answer

V_U = [$2,100 × (1 - 0.30)]/0.117 = $12,564.10V_L = $12,564.10 + (0.30 × $12,000) = $16,164.10V_E = $16,164.10 - $12,000 = $4,164.10R_E = 0.117 + [(0.117 - 0.06) × ($12,000/$4,164.10) × (1 - 0.30)] = 23.20 percent

Question 11

D.L.Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent.The tax rate is 32 percent.What is the present value of the tax shield?

Accepted Answer

Present value of the tax shield = 0.32 × $21,000 = $6,720

Question 12

The June Bug has a $270,000 bond issue outstanding.These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value.The tax rate is 39 percent.What is the amount of the annual interest tax shield?

Accepted Answer

Annual interest tax shield = $270,000 × 0.075 × 0.39 = $7,897.50

Question 13

Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700.The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually.The bonds are selling at par value.What is the cost of equity?

Accepted Answer

V_U = [$15,700 × (1 - 0.38)]/0.12 = $81,116.67V_L = $81,116.67 + (0.38 × $12,000) = $85,676.67V_E = $85,676.67 - $12,000 = $73,676.67R_E = 0.12 + [(0.12 - 0.06) × ($12,000/$73,676.67) × (1 - 0.38)] = 12.61 percent

Question 14

The Corner Bakery has a debt-equity ratio of 0.62.The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent.What is the pre-tax cost of debt based on M & M Proposition II with no taxes?

Accepted Answer

According to M&M Proposition II without taxes, the cost of equity (Ke) is equal to the required return on assets (Ko) plus the debt-equity ratio (D/E) multiplied by the difference between the return on assets (Ko) and the pre-tax cost of debt (Kd), i.e.
Ke = Ko + (D/E)(Ko-Kd)
Rearranging the above equation:
Kd = (D/E)(Ko - Ke) + Ko
Plugging in the given values, we get
Kd = (0.62/1)(14.2% - 16.1%) + 14.2%
Kd = 11.14%
Therefore, the correct answer is (C) 11.14 percent.

Question 15

Georga's Restaurants has 5,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent.The interest is paid semi-annually.What is the amount of the annual interest tax shield if the tax rate is 37 percent?

Accepted Answer

Annual interest tax shield = 5,000 × $1,000 × 0.0825 × 0.37 = $152,625.00

Question 16

L.A.Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent.The company also has $8,000 of debt that carries a 7 percent coupon.The debt is selling at par value.What is the value of this firm?

Accepted Answer

V_U = [$48,900 × (1 - 0.34)]/0.145 = $222,579.31V_L = $222,579.31 + 0.34 ($8,000) = $225,299.31

Question 17

Down Bedding has an unlevered cost of capital of 14 percent, a cost of debt of 7.8 percent, and a tax rate of 32 percent.What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent?

Accepted Answer

R_E = 0.1551 = 0.14 + (0.14 - 0.078) × D/E × (1 - 0.32); D/E = 0.358

Question 18

An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500.A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon.The applicable tax rate is 38 percent.What is the value of the levered firm?

Accepted Answer

V_U = [$327,500 × (1 - 0.38)]/0.175 = $1,160,285.71V_L = $1,160,285.71 + 0.38($650k) = $1,407,286

Question 19

Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent.The firm's tax rate is 37 percent and the cost of equity is 18 percent.What is the firm's debt-equity ratio?

Accepted Answer

R_E = 0.18 = 0.146 + (0.146 - 0.084) × D/E × (1 - 0.37); D/E = 0.87

Question 20

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000.The debt has an 8.5 percent coupon.The tax rate is 34 percent.What is the value of the firm?

Accepted Answer

1) Calculate the weighted average cost of capital (WACC):

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

where: 
E = value of equity = unknown 
D = value of debt = $25,000 
V = total value of the firm = E + D 
Re = cost of equity = unlevered cost of capital = 13.2% 
Rd = cost of debt = coupon rate = 8.5% 
Tc = corporate tax rate = 34%

We have one equation and one unknown (E), so let's solve for E:

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

E = [(0.132 x (E + 25000)) - (0.085 x 25000 x 0.66)] / 0.132

E = 1.125 x (E + 25000) - 1223.5

E = 1.125E + 28125

E - 1.125E = 28125

0.875E = 28125

E = 32142.86

2) Calculate the value of the firm:

V = E + D = 32142.86 + 25000 = $57142.86

The value of the firm is closest to $251,500, which is answer choice C.

Quiz 16: Dividends and Payout Policy