Question 1

East Side, Inc. has no debt outstanding and a total market value of $136,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

A)  -70.97 percent
B)  -63.15 percent
C)  -58.08 percent
D)  -42.29 percent
E)  -38.87 percentF) A) and B)
G) A) and C)

Question 2

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

A)  0.72
B)  0.76
C)  0.79
D)  0.82
E)  0.87F) A) and D)
G) D) and E)

Question 3

Based on M&M Proposition II with taxes, the weighted average cost of capital:

Accepted Answer

A)  is equal to the aftertax cost of debt.
B)  has a linear relationship with the cost of equity capital.
C)  is unaffected by the tax rate.
D)  decreases as the debt-equity ratio increases.
E)  is equal to RU * (1 - T
C)  .F) B) and E)
G) None of the above

Question 4

Georga's Restaurants has 4,500 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

A)  $137,362.50
B)  $162,411.90
C)  $187,750.00
D)  $210,420.00
E)  $233,887.50F) B) and D)
G) C) and D)

Question 5

Which one of the following makes the capital structure of a firm irrelevant?

Accepted Answer

A)  taxes
B)  interest tax shield
C)  100 percent dividend payout ratio
D)  debt-equity ratio that is greater than 0 but less than 1
E)  homemade leverageF) All of the above
G) B) and E)

Question 6

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Accepted Answer

A)  flotation
B)  direct bankruptcy
C)  indirect bankruptcy
D)  financial solvency
E)  capital structureF) A) and B)
G) C) and D)

Question 7

The Corner Bakery has a debt-equity ratio of 0.54. 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

A)  7.10 percent
B)  8.79 percent
C)  10.68 percent
D)  17.56 percent
E)  18.40 percentF) A) and B)
G) B) and E)

Question 8

The interest tax shield is a key reason why:

Accepted Answer

A)  the required rate of return on assets rises when debt is added to the capital structure.
B)  the value of an unlevered firm is equal to the value of a levered firm.
C)  the net cost of debt to a firm is generally less than the cost of equity.
D)  the cost of debt is equal to the cost of equity for a levered firm.
E)  firms prefer equity financing over debt financing.F) B) and C)
G) A) and B)

Question 9

The capital structure that maximizes the value of a firm also:

Accepted Answer

A)  minimizes financial distress costs.
B)  minimizes the cost of capital.
C)  maximizes the present value of the tax shield on debt.
D)  maximizes the value of the debt.
E)  maximizes the value of the unlevered firm.F) B) and C)
G) D) and E)

Question 10

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

A)  11.47 percent
B)  11.52 percent
C)  11.69 percent
D)  12.23 percent
E)  12.48 percentF) B) and E)
G) None of the above

Question 11

M&M Proposition I with no tax supports the argument that:

Accepted Answer

A)  business risk determines the return on assets.
B)  the cost of equity rises as leverage rises.
C)  the debt-equity ratio of a firm is completely irrelevant.
D)  a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
E)  homemade leverage is irrelevant.F) B) and D)
G) C) and E)

Question 12

In general, the capital structures used by U.S. firms:

Accepted Answer

A)  tend to overweigh debt in relation to equity.
B)  generally result in debt-equity ratios between 0.45 and 0.60.
C)  are fairly standard for all SIC codes.
D)  tend to be those which maximize the use of the firm's available tax shelters.
E)  vary significantly across industries.F) B) and D)
G) All of the above

Question 13

Which of the following statements are correct in relation to M&M Proposition II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.

Accepted Answer

A)  I and III only
B)  II and IV only
C)  I and II only
D)  III and IV only
E)  I and IV onlyF) A) and E)
G) A) and B)

Question 14

Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

Accepted Answer

A)  $42,208
B)  $44,141
C)  $46,333
D)  $49,667
E)  $52,267F) B) and E)
G) D) and E)

Question 15

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

A)  $3,948.75
B)  $4,112.60
C)  $5,311.22
D)  $7,897.50
E)  $8,225.20F) C) and E)
G) A) and E)

Question 16

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Accepted Answer

A)  $2.5 million
B)  $4.0 million
C)  $5.0 million
D)  $5.5 million
E)  $6.0 millionF) A) and E)
G) A) and D)

Question 17

The interest tax shield has no value when a firm has a:
I. tax rate of zero.
II. debt-equity ratio of 1.
III. zero debt.
IV. zero leverage.

Accepted Answer

A)  I and III only
B)  II and IV only
C)  I, III, and IV only
D)  II, III, and IV only
E)  I, II, and IV onlyF) B) and D)
G) All of the above

Question 18

A business firm ceases to exist as a going concern as a result of which one of the following?

Accepted Answer

A)  divestiture
B)  share repurchase
C)  liquidation
D)  reorganization
E)  capital restructuringF) A) and B)
G) All of the above

Question 19

A firm should select the capital structure that:

Accepted Answer

A)  produces the highest cost of capital.
B)  maximizes the value of the firm.
C)  minimizes taxes.
D)  is fully unlevered.
E)  equates the value of debt with the value of equity.F) A) and C)
G) B) and D)

Question 20

North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

A)  38.80 percent
B)  45.26 percent
C)  50.45 percent
D)  53.92 percent
E)  61.07 percentF) A) and B)
G) A) and C)

Exam 16: Financial Leverage and Capital Structure Policy

The Corner Bakery has a debt-equity ratio of 0.54. 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?

Correct Answer
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Which one of the following makes the capital structure of a firm irrelevant?

Correct Answer
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The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

Correct Answer
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In general, the capital structures used by U.S. firms:

Correct Answer
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A business firm ceases to exist as a going concern as a result of which one of the following?

Correct Answer
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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?

Correct Answer
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Based on M&M Proposition II with taxes, the weighted average cost of capital:

Correct Answer
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Correct Answer
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Correct Answer
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Georga's Restaurants has 4,500 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?

Correct Answer
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Correct Answer
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M&M Proposition I with no tax supports the argument that:

Correct Answer
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Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Correct Answer
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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?

Correct Answer
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The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Correct Answer
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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?

Correct Answer
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The interest tax shield is a key reason why:

Correct Answer
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The capital structure that maximizes the value of a firm also:

Correct Answer
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Correct Answer
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A firm should select the capital structure that:

Correct Answer
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Exam 16: Financial Leverage and Capital Structure Policy

The Corner Bakery has a debt-equity ratio of 0.54. 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?

Correct AnswerverifiedShow Answer

Which one of the following makes the capital structure of a firm irrelevant?

Correct AnswerverifiedShow Answer

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

Correct AnswerverifiedShow Answer

In general, the capital structures used by U.S. firms:

Correct AnswerverifiedShow Answer

A business firm ceases to exist as a going concern as a result of which one of the following?

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

Based on M&M Proposition II with taxes, the weighted average cost of capital:

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Georga's Restaurants has 4,500 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?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

M&M Proposition I with no tax supports the argument that:

Correct AnswerverifiedShow Answer

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Correct AnswerverifiedShow Answer

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?

Correct AnswerverifiedShow Answer

The interest tax shield is a key reason why:

Correct AnswerverifiedShow Answer

The capital structure that maximizes the value of a firm also:

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

A firm should select the capital structure that:

Correct AnswerverifiedShow Answer

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