Question 1

Outflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure. M&M Proposition 2: Suppose revenues fall by $300. What is the per cent change in profit with and without the debt? Assume that the total variable productions costs remain the same.
A) 64.5%, 60%
B) 60%, 64.5%
C) 59.2%, 40.8%
D) 40.8%, 59.2%

Accepted Answer

Without debt, the profit change is calculated by the change in revenue minus the change in COGS and SG&A. With debt, the interest expense affects the profit change. The calculations show a 60% change without debt and a 64.5% change with debt.

Question 2

The benefits of debt: Packman Company has a reported EBIT of $500, which is expected to remain constant in perpetuity. If the company borrows $2,000, its YTM will be 6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?
A) $238
B) $272
C) $259
D) None of the above.

Accepted Answer

By taking on debt, Packman Company is able to lower its cost of capital, as the interest payments on the debt are tax deductible. The after-tax cost of debt is calculated as follows:
After-tax cost of debt = YTM x (1 - marginal tax rate)
After-tax cost of debt = 6.5% x (1 - 30%)
After-tax cost of debt = 4.55%
The interest payments on the debt are then calculated as:
Interest payments = Total debt x coupon rate
Interest payments = $2,000 x 8%
Interest payments = $160
The tax savings from the interest payments are calculated as:
Tax savings = Interest payments x marginal tax rate
Tax savings = $160 x 30%
Tax savings = $48
Therefore, the after-tax earnings are calculated as:
After-tax earnings = EBIT - Interest payments + Tax savings
After-tax earnings = $500 - $160 + $48
After-tax earnings = $388
However, this is the after-tax earnings assuming the company does not have any debt. To calculate the after-tax earnings with the debt, we need to subtract the after-tax cost of debt:
After-tax earnings with debt = After-tax earnings - (Total debt x After-tax cost of debt)
After-tax earnings with debt = $388 - ($2,000 x 4.55%)
After-tax earnings with debt = $238
Therefore, the answer is (A) $238.

Question 3

M&M Proposition 2: Bellamee Ltd has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?
A) 12.15%
B) 13.15%
C) 14.15%
D) 10.4%

Accepted Answer

According to M&M Proposition 2, the required rate of return on equity (Re) is given by the formula: 
Re = R0 + (R0 - Rd) × (D/E)
where, R0 = Required rate of return on assets, Rd = Cost of debt, and (D/E) = Debt-to-equity ratio.
Substituting the given values, we get: 
Re = 12% + (12% - 6.25%) × (1/5) 
Re = 13.15%
Hence, the required rate of return on equity is 13.15%.

Question 4

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What will the equity value of USB be in one-year without shareholders taking on the project?
A) $100m
B) $80m
C) $20m
D) $8m

Accepted Answer

Without taking on the project, USB Corp will receive $108m from the risk-free bonds ($100m principal + $8m interest). After paying off the $80m debt, the equity value will be $28m.

Question 5

The benefits of debt: A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the company's annual tax liability?
A) $13,500
B) $22,500
C) $32,500
D) None of the above.

Accepted Answer

The annual interest expense on the debt can be calculated as:
Annual interest expense = $1,000,000 * 9% = $90,000
The tax shield generated by the interest expense can be calculated as:
Tax shield = $90,000 * 25% = $22,500
Since the debt reduces the company's taxable income, we need to calculate the tax savings at the marginal tax rate of 25%. Thus, the debt issuance will reduce the company's annual tax liability by $22,500. Therefore, the correct answer is B.

Question 6

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What is the expected value of the equity if the shareholders sell the debt?
A) $175m
B) $97.5m
C) $51m
D) None of the above.

Accepted Answer

The answer of Suppose that USB Corp has $100m invested...

Question 7

Which of the following supports the trade-off theory of capital structure?
A) Companies use cash on hand first, since issuing equity and debt is expensive.
B) A company's capital structure is the result of past equity and debt issuance decisions.
C) Companies have a target capital structure.
D) a and b.

Accepted Answer

The trade-off theory states that companies have a target capital structure, which balances the costs and benefits of debt and equity financing. Choice A supports the pecking order theory, which suggests that companies prioritize financing through internal funds before resorting to external financing. Choice B suggests that a company's capital structure is a historical outcome rather than a deliberate choice, which is not consistent with the trade-off theory. Therefore, the best choice is C.

Question 8

Outflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure. M&M Proposition 2: What per cent of the company's costs are fixed, and what per cent are variable with the debt and without the change in leverage?
A) 27.9%, 72.1%
B) 72.1%, 27.9%
C) 25.23, 74.77%
D) 74.77%, 25.23%

Accepted Answer

The COGS of $400 is variable, as it includes only the marginal costs. SG&A of $100 is fixed. Without the debt, the total costs are $500, with $100 fixed (20%) and $400 variable (80%). With the debt, the interest cost is $700 * 5% = $35, making total costs $535, with $135 fixed (25.23%) and $400 variable (74.77%).

Question 9

The pecking order theory: A company wishes to undertake a project that costs $150mm. It currently has $10mm in cash on hand and believes that it can raise $75mm in debt and $100mm in equity if needed. According to the pecking order theory of the capital structure, what per cent of the project will be financed by debt?
A) 0%
B) 26.67%
C) 50%
D) None of the above

Accepted Answer

The answer of The pecking order theory: A company wishes...

Question 10

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the company issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders. The cost of equity: What is its value without debt in the capital structure?
A) $350
B) $650
C) $2,917
D) $5,417

Accepted Answer

The answer of Millennium Motors has current pretax annual cash...

Question 11

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the company issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to shareholders. The cost of equity: What is Millennium's value after the debt issuance?
A) $5,417
B) $5,942
C) $6,392
D) None of the above.

Accepted Answer

Firstly, we need to calculate the cost of equity:

Cost of equity = (1,000 / (1 - 0.35)) / Value + 0.12

Cost of equity = 1,538.46 / Value + 0.12

We know that the bond issuance raises $1,500 which is paid out to shareholders. This will increase the value of equity by $1,500. Therefore:

Value after bond issuance = (1,000 + 1,500) / (0.12 - 0.35) = $5,942.31

Hence, the answer is B.

Question 12

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: What is the expected value of the bonds if the shareholders sell the debt?
A) $100m
B) $88.8m
C) $48.8m
D) None of the above.

Accepted Answer

The expected value of the project is (0.6 * $200m) + (0.4 * $2m) = $120.8m. After paying off the $80m debt, $40.8m remains for bondholders, which is less than the $100m they would have received from the risk-free bonds.

Question 13

The benefits of debt. A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?
A) $11,025
B) $20,475
C) $350,000
D) $227,500

Accepted Answer

The answer of The benefits of debt. A company plans...

Question 14

One of the conditions that the M&M Propositions required was for there to be no tax. Briefly discuss whether the introduction of tax decreases or increases the value of the company.

Accepted Answer

The answer of One of the conditions that the M&M...

Question 15

Suppose that USB Corp has $100m invested in 8% risk-free bonds that mature in one-year. The company also has $80m in debt outstanding that will also mature in a year. USB shareholders are considering selling the $100m in debt and investing in a project that has a 60% chance of returning $200m and a 40% chance of returning $2m. Agency costs: Given the pay-offs of the project, what does the per cent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?
A) 1/3
B) 1/4
C) 1/5
D) 1/6

Accepted Answer

To calculate the expected value of equity without the project, we need to subtract the debt from the assets and divide the sum by the number of outstanding shares. Therefore, the expected value of equity without the project is:

Equity without project = ($100m x 1.08 - $80m) / 1 = $28m

To calculate the expected value of equity with the project, we need to consider the payoffs of the project and the probability of success. Therefore, the expected value of equity with the project is:

Equity with project = ($200m x 0.6 + $2m x 0.4) / 1 = $120m

Now, we need to find the probability of success that makes the expected value of equity with the project equal to the expected value of equity without the project. Mathematically, we can express this as:

Equity with project = Equity without project
$120m = $28m
($200m x p + $2m x (1 - p)) = $28m
p = 0.167 or 1/6

Therefore, the per cent chance of success that makes the expected value of equity with the project equal to the expected value of equity without the project is 1/6 or 16.7%, which corresponds to answer D.

Question 16

M&M Proposition 2: Bellamee Ltd has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on their debt to 7%?
A) 14%
B) 14.25%
C) 14.50%
D) 15%

Accepted Answer

The correct answer is A because the required return on equity increases when the debt-to-equity ratio increases and the cost of debt increases.

Question 17

The pecking order theory of capital structure suggests that managers will choose to utilise retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities?

Accepted Answer

The answer of The pecking order theory of capital structure...

Question 18

Ouflung Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only includes the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its capital structure M&M Proposition 2: What is the profit of Outflung without and with the debt?
A) $500, $484.20
B) $484.20, $500
C) $500, $465
D) $490, $500

Accepted Answer

The answer of Ouflung Computers has $1,000 in revenue this...

Question 19

Briefly explain how an increase in the amount of debt that a company has outstanding may actually decrease the agency costs caused by the conflict between managers and shareholders.

Accepted Answer

The answer of Briefly explain how an increase in the...

Quiz 16: Capital Structure Policy

M&M Proposition 2: Bellamee Ltd has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?

The benefits of debt: A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will this debt issuance reduce the company's annual tax liability?

Which of the following supports the trade-off theory of capital structure?

The benefits of debt. A company plans to issue $1 million worth of debt at a YTM of 9%. The debt is trading at par. The company's marginal corporate tax rate is 35%. What is the present value of the tax savings in perpetuity?

One of the conditions that the M&M Propositions required was for there to be no tax. Briefly discuss whether the introduction of tax decreases or increases the value of the company.

The pecking order theory of capital structure suggests that managers will choose to utilise retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities?

Briefly explain how an increase in the amount of debt that a company has outstanding may actually decrease the agency costs caused by the conflict between managers and shareholders.