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Chapter 12—Capital Structure

MULTIPLE CHOICE

1. The uncertainty caused by the variability of a firm’s cash flows is called . . .


a. financial risk
b. business risk
c. financial leverage
d. none of the above
ANS: B DIF: E
REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

2. Which of the following is considered an indirect cost of bankruptcy?


a. document printing expenses
b. professional fees paid to lawyers
c. loss of key employees
d. none of the above
ANS: C DIF: E
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

3. Which of the following is considered a direct cost of bankruptcy?


a. diversion of management’s time
b. constrained capital investment spending
c. lost sales
d. none of the above
ANS: D DIF: E
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

4. A situation where shareholders refuse financing a “good” investment, because they think that only the
bondholders will benefit will lead to . . .
a. asset substitution
b. underinvestment
c. overinvestment
d. none of the above
ANS: B DIF: E
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

5. The proposition that the market value of the firm is independent of its capital structure is called . . .
a. M&M proposition I
b. M&M proposition II
c. the capital asset pricing model
d. none of the above
ANS: A DIF: E
REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

NARRBEGIN: Bavarian Brew


Bavarian Brew
Bavarian Brew, an unlevered firm, has an expected EBIT of $500,000. The required return on assets
for the firm’s assets is 10%. The company has 250,000 shares outstanding. The company is
considering raising $1 million in debt with a required return of 6% and would use the proceeds to
repurchase outstanding stock.
NARREND

6. What is the value of Bavarian Brew before restructuring? Assume no corporate taxes.
a. $500,000
b. $5,000,000
c. $1,000,000
d. $3,300,000
ANS: B
$500,000/.10 = $5,000,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew

7. What is the value of Bavarian Brew before restructuring? Assume a corporate tax rate of 34%.
a. $5,000,000
b. $500,000
c. $3,300,000
d. $1,000,000
ANS: C
5000,000(1-.34)/.10 = $3,300,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew

8. What is the value of Bavarian Brew after restructuring. Assume no corporate taxes.
a. $3,300,000
b. $5,000,000
c. $500,000
d. $1,000,000
ANS: B
500,000/.10 + 0 = $5,000,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew

9. What is the value of Bavarian Brew after restructuring? Assume corporate taxes of 34%.
a. $5,000,000
b. $5,340,000
c. $3,300,000
d. $1,000,000
ANS: B
500,000/.10 + 1,000,000(.34) = $5,340,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew
10. What is the present value of Bavarian Brew’s debt tax shield after the restructuring? Assume corporate
taxes of 34%.
a. $340,000
b. $1,000,000
c. $660,000
d. $0
ANS: A
1,000,000(.34) = $340,000

DIF: E REF: The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Bavarian Brew

11. What is Bavarian Brew’s required return on equity before the restructuring. Assume no corporate
taxes.
a. 10%
b. 6%
c. 11%
d. 12%
ANS: A
.10 + (.10-.06)(0/5,000,000) = .10

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew

12. What is the Bavarian Brew’s required return on levered equity after the restructuring?
a. 10.25%
b. 10.92%
c. 6.00%
d. 12.75%
ANS: B
.10 + (.10-.06)(1,000,000/4,340,000) = .1092

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
NAR: Bavarian Brew

13. What is the value of Bavarian Brew after the restructuring, if the PV of bankruptcy cost is $750,000?
Assume a corporate tax rate of 34%.
a. $5,000,000
b. $5,340,000
c. $4,590,000
d. $4,250,000
ANS: C
500,000/.10 + 1,000,000(.34) - $750,000 = $4,590,000

DIF: E
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage
NAR: Bavarian Brew

14. Refer to Bavarian Brew. What is the PV of bankruptcy costs for which the company is indifferent
about the proposed change in capital structure?
a. $450,000
b. $750,000
c. $340,000
d. $275,000
ANS: C
there are indifferent when the debt tax shield = PV of bankruptcy costs
1,000,000(.34) = $340,000

DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage
NAR: Bavarian Brew

15. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition the
personal tax rate on dividends for investors is 15% and the personal income tax on interest income
equals 40%.
a. $340,000
b. $65,000
c. $150,000
d. $400,000
ANS: B
1-{(1-.034)(1-.15)/(1-.4)}(1,000,000) = 65,000

DIF: E
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Bavarian Brew

16. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition,
assume that the personal tax rate on interest income equals 40% and that there is no tax on dividend
income.
a. -$100,000
b. $100,000
c. $340,000
d. -$340,000
ANS: A
{1-(1-.34)(1-0)/(1-.4)}(1,000,000) = -$100,000

DIF: M
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Bavarian Brew

17. Refer to Bavarian Brew. If the corporate tax rate equals 34% and dividend income is tax free, at which
personal tax rate on interest income is there no gain from leverage?
a. 34%
b. 40%
c. 15%
d. 0%
ANS: A
1-(1-.34)(1-0)/(1-t) = 0
t = .34

DIF: M
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Bavarian Brew

18. Refer to Bavarian Brew. If the corporate tax rate equals 34% and the personal tax rate on interest
income equals 40%, for which tax rate on dividend income is the gain from leverage equal to zero?
a. 15.2%
b. 9.1%
c. 12.6%
d. 6.6%
ANS: B
1-(1-.34)(1-t)/(1-.4) = 0
t = .0909

DIF: H
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Bavarian Brew

NARRBEGIN: Bavarian Brew EPS


Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets
for the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share.
The company is considering raising $1 million in debt with a required return of 6% and would use the
proceeds to repurchase 50,000 shares of outstanding stock.
NARREND

19. Calculate Bavarian Brew’s earnings per share after the restructuring. Assume no corporate taxes.
a. $2.20
b. $2.50
c. $2.00
d. $2.25
ANS: A
500,000 - (1,000,000)(.06)/200,000 = 2.20

DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?
NAR: Bavarian Brew EPS

20. What are Bavarian Brew’s earnings per share before the restructuring Assume corporate taxes of 34%
a. $1.32
b. $1.35
c. $1.42
d. $1.45
ANS: A
500,000(1-.34)/250,000 = 1.32

DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?
NAR: Bavarian Brew EPS

21. What are Bavarian Brew’s earnings per share before the restructuring? Assume no corporate taxes.
a. $2.50
b. $2.25
c. $2.00
d. $1.75
ANS: C
500,000/250,000 = 2.00

DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?
NAR: Bavarian Brew EPS

22. What are Bavarian Brew’s earnings per share after the restructuring? Assume corporate taxes of 34%.
a. $1.32
b. $1.35
c. $1.42
d. $1.45
ANS: D
[(500,000-60,000)(1-.34)]/200,000 = 1.45

DIF: M REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?
NAR: Bavarian Brew EPS

23. If a company issues $25,000 worth of debt and has a corporate tax rate of 40%, what is the PV of the
debt tax shield?
a. $25,000
b. $10,000
c. $15,000
d. $20,000
ANS: B
25,000(.4) = 10,000

DIF: E
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes

NARRBEGIN: Miller’s Drugstore


Miller’s Drugstore
Miller’s drugstore has an EBIT of $15,000, debt with a market value of $25,000 and a required return
on assets of 12%.
NARREND

24. Assuming no taxes, what is Miller’s Drugstore’s value?


a. $15,000
b. $125,000
c. $25,000
d. $75,000
ANS: B
15,000(1-0)/.12 + 25,000(0) = $125,000

DIF: E
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Miller’s Drugstore

25. Assuming a corporate tax rate of 35%, what is Miller’s Drugstore’s value?
a. $125,000
b. $25,000
c. $133,750
d. $75,000
ANS: C
15,000/.12 + 25,000(.35) = 133,750

DIF: E
REF: 12.3 The M&M Capital Structure Model with Corporate and Personal Taxes
NAR: Miller’s Drugstore

26. State Company had determined its earnings before interest and taxes (EBIT) in four possible states of
the world. In the Great State, EBIT will be $3,000,000 and in the Good, Normal and Poor States EBIT
will be $2,000,000, $1,500,000, and $1,000,000 in that order. If each state has an equal probability of
occuring, then what is State Company’s expected EBIT?
a. $3,000,000
b. $2,500,000
c. $1,875,000
d. none of the above
ANS: C
.25(3,000,000 + 2,000,000 + 1,500,000 + 1,000,000) = 1,875,000

DIF: E REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?

27. If a firm increases its use of financial leverage, then what would we generally expect for the effect of
that increased leverage to have on the dispersion of the firm’s Net Income distribution?
a. less dispersion
b. no effect on dispersion
c. greater dispersion
d. there is not enough information to determine
ANS: C DIF: E
REF: 12.1 What is Financial Leverage, and Why Do Firms Use It?

28. If a firm increases its financial leverage, then what would we generally expect for the effect of that
increased leverage on EPS to be if the firm’s EPS is already quite high?
a. EPS would be lower with financial leverage
b. EPS would always be the same with financial leverage
c. EPS would be higher with financial leverage
d. it is not possible to determine
ANS: C DIF: E REF: 12.1 What is Financial Leverage?

29. If a firm increases its use of financial leverage, then what would we generally expect for the effect of
that increased leverage to have on an EPS that is already very low?
a. EPS would be lower with financial leverage
b. EPS would always be the same with financial leverage
c. EPS would be higher with financial leverage
d. it is not possible to determine
ANS: A DIF: E REF: 12.1 What is Financial Leverage?

30. If a firm increases its use of financial leverage, then what would we generally expect for the
shareholders of that firm to
a. lower their demand for return on their investment.
b. remain indifferent with respect to their return on investment.
c. increase their demand for return on their investment.
d. it is not possible to tell what will happen.
ANS: C DIF: M REF: 12.1 What is Financial Leverage?

31. Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase
equity. If you assume that the Modigliani and Miller assumptions hold then the effect of this
increasing financial leverage transaction should
a. increase the market value of Firm X’s shares.
b. have no effect on the market value of Firm X’s shares.
c. decrease the market value of Firm X’s shares.
d. it is not possible to tell what will happen.
ANS: B DIF: M REF: 12.1 What is Financial Leverage?

32. Perfect capital markets describe markets without frictions such as


a. taxes.
b. trading costs.
c. problems transferring information between managers and investors.
d. all of the above.
ANS: D DIF: E
REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

33. In a world without taxes, distress costs, or agency problems, calculate the value of Lever Co. if its
perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s
cost of debt is 5% and its required return on firm’s assets is 10%.
a. $19,800,000
b. $10,000,000
c. $9,900,000
d. none of the above
ANS: B
1,000,000 / .1= 10,000,000

DIF: M REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

34. Roy’s Toy, Inc. currently has no debt outstanding. Its current cost of equity is 12% and the current
value of the company is $20,000,000. Roy is proposing to finance 1/4 of its assets with debt at a cost
of 8% per annum. What will be Roy’s cost of levered equity if things go as planned? Ignore any tax
effects.
a. 12.00%
b. 13.00%
c. 13.33%
d. none of the above
ANS: C
Current cost of equity = return on assets

rl = r + (r - rd)(D/E) ====> rl = .12 + (.12 - .08)(5,000,000 / 15,000,000) = .1333

DIF: H REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

35. Nuclear Widgets has a current cost of levered equity equal to 13%. Its’ return on assets is 12% and its
cost of debt is 8%. Nuclear widgets has borrowed a total of $5,000,000. What is the current value of
Nucler Widgets equity? Ignore the effect of taxes.
a. $1,250,000
b. $20,000,000
c. the problem yields a negative number which means the problem is not realistic
d. not enough information is given
ANS: B
rl = r + (r - rd)(D/E) ====> .13= .12 + (.12 - .08)(5,000,000 / E) =

=====> E = 20,000,000

DIF: H REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

36. A newly appointed CFO of a company tells you that he needs to determine the required return on
unlevered equity should his firm completely delever. He further tells you that the required return on
assets is 10% and that his cost of debt is 3% based upon a current borrowed amount of $50,000,000
but he doesn’t know the market value of his equity. What is the required retun on equity should his
firm eliminate all of its debt?
a. 10.0%
b. 11.5%
c. 13.0%
d. it is impossible to tell
ANS: A
rl = r + (r - rd)(D/E) ====> rl= .10+ (.10 - .03)(0 / E) = .1

DIF: M REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

37. In a world without distress costs or agency problems, calculate the value of Bilever Co. if its perpetual
EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s cost of debt
is 5% and its required return on firm’s assets is 10%. Assume that Bilever is in the 30% marginal tax
rate
a. $14,000,000
b. $7,000,000
c. $5,600,000
d. none of the above
ANS: B
(1,000,000  .7) / .1 = 7,000,000

DIF: M REF: 12.3 Capital Structure with Corporate and Personal Taxes

38. Big Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Big can issue the debt to
yield 8% per year, then what is the increase in value to Big if it issues the debt and is subject to a 34%
marginal tax rate?
a. $136,000
b. $400,000
c. $1,700,000
d. none of the above
ANS: C
5,000,000  .34 = 1,700,000

DIF: M REF: 12.3 Capital Structure with Corporate and Personal Taxes
39. Large Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Large can issue the debt to
yield 8% per year, then what is the single year increase in cash flow to Large if it issues the debt and is
subject to a 34% marginal tax rate?
a. $136,000
b. $400,000
c. $2,720,000
d. none of the above
ANS: A
5,000,000  .08  .34 = 136,000

DIF: M REF: 12.3 Capital Structure with Corporate and Personal Taxes

40. If we start with the M&M perfect capital markets assumption and then relax the no tax assumption on
corporations, then we would expect for firms that go from no leverage to some leverage to
a. have the levered version of the firm at least as valuable as the no-leverage firm.
b. have the no-leverage version of the firm at least as valuable as the levered firm.
c. change in value depending upon the level of personal taxes.
d. none of the above.
ANS: A DIF: M
REF: 12.3 Capital Structure with Corporate and Personal Taxes

41. You need to calculate the gains from using $1,000,000 of additional leverage on the average company
in the U.S. economy. You are told that the average investors personal tax rate on income from stock is
15% and that investors can generally avoid personal taxes on income from debt. You are also told that
the average corporation is subject to the 35% marginal corporate tax rate. What is the benefit to firm
value for this additonal debt load?
a. $650,000
b. $447,500
c. $350,000
d. none of the above
ANS: B
GL = [ 1- {(1-Tc)(1-Tps)/(1-Tpd)}]  D = [ 1- {(1-.35)(1-.15)/(1-0)}]  1,000,000 = 447,500

DIF: H REF: 12.3 Capital Structure with Corporate and Personal Taxes

42. On-the-Fence Co. (OTF) is considering issuing an additional $5,000,000 perpetual debt. It is subject
to a 35% marginal corporate tax rate but is being told that the costs of financial distress on that
additional debt is $1,000,000. What should OTF do?
a. Do not issue the debt
b. Issue the debt
c. It doesn’t matter what it does as M&M with perfect markets holds
d. none of the above
ANS: B
PV of Tax shield: 5,000,000  .35 = 1,750,000

Less costs of financial disress = 1,000,000

equals the additional value = 750,000 ====> issue the debt

DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage
43. Costs associated with the requirement that management divert its attention away from strategically
managing a corporation in favor of spending time with financial attorneys could be best described as
a. direct bankruptcy costs.
b. indirect bankruptcy costs.
c. mangerial-shareholder related agency costs.
d. none of the above.
ANS: B DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

44. Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget
manufacturing plant. Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas.
Which of the following best describes the general problem that Y’s investors must deal with?
a. The Underinvestment Problem
b. The Overinvestment Problem
c. The Asset Substitution Problem
d. The Enron Problem
ANS: C DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

45. Lord Brack has recently sold 90% of his company to the general public but he remains the CEO of the
firm. Unfortunately, the Lord prefers to each $1,000 lunches in the corporate dining room (for which
he does not reimburse the company). What is Lord Brack’s cost of these lunches?
a. $1,000
b. $900
c. $100
d. none of the above
ANS: C DIF: H
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

46. Molotov Cranberry Cocktail Corp finds that the value of the firm is equal to $100,000,000 with no
debt. It knows that if it issues new debt, the value of the tax shield will be $3,000,000 while the value
of the bankruptcy costs, outside agency costs and inside agency costs will be $1,000,000, $2,000,000,
and $4,000,000 in that order. What will the value of Molotov be if it issues the debt?
a. $0
b. $96,000,000
c. $100,000,000
d. none of the above
ANS: C
100MM + 3MM -1MM + 2MM - 4MM= 100MM

DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

47. Fidget Inc. is currently worth $10,000,000. It is told that if it issues $1,000,000 of perpetual debt (and
uses the proceeds to repurchase equity) the value of the firm will increase by $290,000. If the total
bankruptcy costs and agency costs combine to be a cost of $20,000, what is Fidget’s marginal
corporate tax rate? Ignore personal taxes.
a. 29%
b. 30%
c. 31%
d. none of the above
ANS: C
290,000 = (1,000,000  Tc) - 20,000

Tc = .31

DIF: M
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

48. You are evaluating a company and have found a new way to calculate the present value of bankruptcy
costs, agency costs of outside equity as well as debt. You find that the agency costs of outside equity
is $100 while the agency cost of outside debt is $1,000,000. The costs of bankruptcy are also
$1,000,000. What type of firm does most likely describe?
a. a firm with too little leverage
b. a firm with too much leverage
c. a firm with too much equity
d. a firm that should disregard its agency costs
ANS: B DIF: H
REF: 12.4 The Agency Cost/Tax Shield Trade-Off Model of Corporate Leverage

49. If you were to look at leverage for companies in a country where the there is a very high cost of
attorneys and accountants, all other things being equal you would expect
a. that firms in those countries would utilized less leverage than in other countries.
b. that firms in those countries would utilized more leverage than in other countries.
c. that firms in those coutnries would utilize no leverage.
d. that firms in those countries would utilize as much leverage as is mathematically possible.
ANS: A DIF: H
REF: 12.5 Patterns Observed in Corporate Capital Structures

50. DebtCo. has $100,000,000 of perpetual debt outstanding with a cost of 9%. DebtCo. is currently
subject to a 30% marginal tax rate. If a new president is elected who suprisingly announces that firm’s
like DebtCo. will now be subject to a 35% marginal tax rate, what should be the effect of the
immediate value change on DebtCo.?
a. -$35,000,000
b. -$5,000,000
c. $5,000,000
d. $35,000,000
ANS: C
Old value: 100,000,000  .3 = 30,000,000

New value: 100,000,000  .35 = 35,000,000

Change in value: 5,000,000

DIF: M REF: 12.5 Patterns Observed in Corporate Capital Structures

NARRBEGIN: Kennesaw Steel Corp.


Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC), you are considering a
recapitalization plan that would convert KSC from its current all-equity capital structure to one
including substantial financial leverage. KSC now has 100,000 shares of common stock outstanding,
which are selling for $50.00 each, and the recapitalization proposal is to issue $2,000,000 worth of
long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of
common stock.
NARREND

51. Refer to Kennesaw Steel Corporation. What is the new debt-to-equity ratio if the recapitalization is
completed? (assume that the stock can be repurchased at $50 per share)
a. 1.50
b. 1.00
c. 0.67
d. 0.33
ANS: C
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000

D/E = $2,000,000/$3,000,000 = 0.67

DIF: E REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

52. Refer to Kennesaw Steel Corporation. How many shares will be left outstanding after the re-
capitalization? (assume that the stock can be repurchased at $50 per share)
a. 60,000
b. 50,000
c. 45,000
d. 40,000
ANS: A
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000

# of shares = $3,000,000 / $50 = 60,000

DIF: M REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

53. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What level of EBIT will earnings per share
equal zero for shareholders under the new capital structure? (assume that the stock can be repurchased
at $50 per share)
a. $0
b. $60,000
c. $120,000
d. $160,000
ANS: D
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000)

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000

# of shares = $3,000,000 / $50 = 60,000

EPS = $0 = ($X - $160,000) * (1-.40) = $0 ; X=$160,000

DIF: M REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

54. Refer to Kennesaw Steel Corporation. The tax rate is 40%. At what level of EBIT will earnings per
share be equal for shareholders under each capital structure? (assume that the stock can be repurchased
at $50 per share)
a. $350,000
b. $400,000
c. $450,000
d. $500,000
ANS: B
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000)

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000

# of shares = $3,000,000 / $50 = 60,000

BREAKEVEN = ($X - $0)* (1-.4) / 100,000 = ($X - $160,000)* (1-.4) / 75,000


X = $400,000

DIF: M REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

55. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What is the earnings per share under the
new plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per
share)
a. $4.40
b. $4.20
c. $4.00
d. $3.80
ANS: A
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000)

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000

# of shares = $3,000,000 / $50 = 60,000


NI: ($600,000 - $160,000)*(1-.40) = $264,000
EPS = $264,000 / 60,000 = $4.40

DIF: M REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

56. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What is the return on equity under the new
plan if EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share)
a. 7.4%
b. 8.1%
c. 8.8%
d. 9.5%
ANS: C
Before re-capitalization:
Equity = $50 * 100,000 = $5,000,000 (# of shares = 100,000)

After:
Equity = $5,000,000 - $2,000,000 = $3,000,000
Debt = $2,000,000; Interest Paid = $2,000,000*.08 = $160,000

# of shares = $3,000,000 / $50 = 60,000

NI: ($600,000 - $160,000)*(1-.40) = $264,000


Shareholder equity = 60,000 * $50 = $3,000,000
ROE = 8.8%

DIF: M REF: 12.1 What is Financial Leverage? NAR: Kennesaw Steel Corp.

57. Which statement is TRUE regarding a firm that increases financial leverage?
a. Average earnings per share increases, while shareholder risk increases.
b. Average earnings per share increases, while shareholder risk decreases.
c. Average earnings per share decreases, while shareholder risk decreases.
d. Average earnings per share decreases, while shareholder risk increases.
ANS: A DIF: E REF: 12.1 What is Financial Leverage?

58. The Globe Incorporated has EBIT of $20 million for the current year. On the firm balance sheet, there
is $80 million of debt outstanding that carries a coupon rate of 8 percent. Investors seek a return of 12
percent on the firm, and the firm has a corporate tax rate of 40%. What is the value of the firm?
a. $124,000,000
b. $128,000,000
c. $132,000,000
d. $136,000,000
ANS: C
LEVERED UNLEVERED
EBIT $20,000,000 $20,000,000
INT $80*8% $ 6,400,000 $ 0
EBT $13,600,000 $20,000,000
Taxes at 40% $ 5,440,000 $ 8,000,000
NI $ 8,160,000 $12,000,000
+ Interest $ 6,400,000 $ 0
Available to $14,560,000 $12,000,000
Investors
PV of Tax Shield = $80,000,000*0.40 = $32,000,000
Value of Unlevered Firm = $12,000,000/.12 = $100,000,000
Value of Levered Firm = $100,000,000+$32,000,000

DIF: H REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

59. The Globe Incorporated has EBIT of $30 million for the current year. On the firm balance sheet, there
is $90 million of debt outstanding that carries a coupon rate of 9 percent. Investors seek a return of 12
percent on the firm, and the firm has a corporate tax rate of 40%. What is the value of the firm?
a. $152,000,000
b. $160,000,000
c. $174,000,000
d. $186,000,000
ANS: D
LEVERED UNLEVERED
EBIT $30,000,000 $30,000,000
INT $80*8% $ 8,100,000 $ 0
EBT $21,900,000 $30,000,000
Taxes at 40% $ 8,760,000 $12,000,000
NI $13,140,000 $18,000,000
+ Interest $ 8,100,000 $ 0
Available to $21,240,000 $18,000,000
Investors

PV of Tax Shield = $90,000,000*0.40 = $36,000,000


Value of Unlevered Firm = $18,000,000/.12 = $150,000,000
Value of Levered Firm = $150,000,000+$36,000,000

DIF: H REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

60. The Globe Incorporated has EBIT of $20 million for the current year. On the firm balance sheet, there
is $80 million of debt outstanding that carries a coupon rate of 8 percent. Investors seek a return of 12
percent on the firm, and the firm has a corporate tax rate of 40%. What is the present value of the
firm’s tax shields?
a. $32,000,000
b. $30,000,000
c. $24,000,000
d. $6,400,000
ANS: A
PV of Tax Shield = $80,000,000*0.40 = $32,000,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

61. TransMetro Incorporated has EBIT of $1 million for the current year. On the firm balance sheet, there
is $6 million of debt outstanding that carries a coupon rate of 15 percent. Investors seek a return of 20
percent on the firm, and the firm has a corporate tax rate of 40%. What is the present value of the
firm’s tax shields?
a. $2,000,000
b. $2,200,000
c. $2,400,000
d. $2,700,000
ANS: C
PV of Tax Shield = $6,000,000*0.40 = $2,400,000

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

62. Which statement correctly describes proposition I of Modigliani and Miller?


a. The value of the firm is independent of its capital structure.
b. If there is no default risk, firms should exclusively use debt to finance projects.
c. If there is no default risk, firms should exclusively use equity to finance projects.
d. The value of the firm’s tax shields depends solely on the amount of debt issued.
ANS: A DIF: E
REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

63. Lightyear Technology Corporation finances its operations with $75 million in stock with a required
return of 12 percent and $45 million in bonds with a required return of 8 percent. Suppose the firm
issues $15 million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of
equity. What will be the firm’s new debt to equity ratio? (Assume zero taxes and perfect capital
markets)
a. 0.75
b. 0.90
c. 1.00
d. 1.10
ANS: C
Debt Total = $45+$15=$60
Equity = $75-$15 = $60

D/E = 1

DIF: E REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

64. Burdell Scientific Incorporated finances its operations with $40 million in stock with a required return
of 12 percent and $10 million in bonds with a required return of 6 percent. Suppose the firm issues $15
million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of equity. If the
WACC remains the same, what will be the firm’s new cost of equity? (Assume zero taxes and perfect
capital markets)
a. 15.60%
b. 15.00%
c. 14.40%
d. 13.80%
ANS: C
Old WACC:
Rs = R + (R - Rd) * D/E = .12 = R + (R - .06) * $10/$40
.12 = R + .25 R - .015
R = (.12+.015)/1.25 = .1080

New Rs:
Rd = $10/$25*.06+$15/$25*.08=.072
Rs = R + (R - Rd) * D/E
Rs = .1080 + (.1080 - .072) * $25/$25 = .1080 + .036 = .144

DIF: M REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions
65. Bulldog Electronics Corporation finances its operations with $75 million in stock with a required
return of 12 percent and $45 million in bonds with a required return of 8 percent. Suppose the firm
issues $15 million in additional bonds at 8 percent, using the proceeds to retire $15 million worth of
equity. If the WACC remains the same, what will be the firm’s new cost of equity? (Assume zero
taxes and perfect capital markets)
a. 12.50%
b. 13.00%
c. 14.00%
d. 14.40%
ANS: B
Old WACC:
Rs = R + (R - Rd) * D/E = .12 = R + (R - .08) * $45/$75
.12 = R + .6 R - .048
R = (.12+.048)/1.6 = .1050

New Rs:
Rs = R + (R - Rd) * D/E
Rs = .1050 + (.1050 - .08) * $60/$60 = .1050 + .025 = .13

DIF: M REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

66. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million
of debt outstanding with a required rate of return of 7 percent; the required rate of return on the
industry is 11 percent; and the corporate tax rate is 40 percent. What is the gain from leverage if the
personal tax rate on stock income is 20 percent and the personal tax rate on debt income is 30 percent?
a. $22.34 million
b. $23.77 million
c. $24.63 million
d. $25.14 million
ANS: D
PV of tax shield = $80*.40=$32 million
Value of unlevered firm = NI/r = $10 million * (1-.40) / .11 = $6/.11 = $54.55 million
Value of levered firm = $54.55 + $32 = $86.55 million

Gain from leverage = (1 - ((1-.4)*(1-.2)/(1-.3)))*$80 = $25.14 million

DIF: M REF: 12.3 The M&M Model with Personal and Corporate Taxes

67. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million
of debt outstanding with a required rate of return of 7 percent; the required rate of return on the
industry is 12 percent; and the corporate tax rate is 35 percent. What is the gain from leverage if the
personal tax rate on stock income is 15 percent and the personal tax rate on debt income is 30 percent?
a. $22.34 million
b. $19.41 million
c. $16.86 million
d. $12.19 million
ANS: C
PV of tax shield = $80*.35=$28 million
Value of unlevered firm = NI/r = $10 million * (1-.35) / .12 = $6.5/.12 = $54.17 million
Value of levered firm = $54.17 + $28 = $82.17 million

Gain from leverage = (1 - ((1-.35)*(1-.15)/(1-.3)))*$80 = $16.86 million


DIF: M REF: 12.3 The M&M Model with Personal and Corporate Taxes

68. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million
of debt outstanding with a required rate of return of 7 percent; the required rate of return on the
industry is 11 percent; and the corporate tax rate is 40 percent. What is the value of the Oak Barrel
Company?
a. $86.55 million
b. $83.77 million
c. $81.46 million
d. $72.28 million
ANS: A
PV of tax shield = $80*.40=$32 million
Value of unlevered firm = NI/r = $10 million * (1-.40) / .11 = $6/.11 = $54.55 million
Value of levered firm = $54.55 + $32 = $86.55 million

DIF: M REF: 12.3 The M&M Model with Personal and Corporate Taxes

69. Which statement is FALSE regarding empirical evidence of capital structures?


a. Capital structures show strong industry patterns.
b. Economy wide leverage ratios are consistent across countries.
c. Leverage ratios are negatively related to the cost of financial distress.
d. Within industries, the most profitable companies borrow the least.
ANS: B DIF: H
REF: 12.3 The M&M Model with Personal and Corporate Taxes

70. In a world with only company-level taxation of operating profits, no costs of bankruptcy, and tax-
deductible interest payments, what is the optimal corporate strategy?
a. The firm should use all equity to maximize firm value.
b. The firm should use all debt to maximize its value.
c. The firm’s value is independent of the way it is financed.
d. The firm should maximize the use of preferred stock to create value.
ANS: B DIF: E
REF: 12.2 The Modigliani & Miller Capital Structure Irrelevance Propositions

NARRBEGIN: ABC Corporation


ABC Corporation
ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity.
The debt has a coupon rate of 10%, while the industry return on equity is 15%. ABC Corporation is
unsure of the state of the economy in the next year. The tax rate facing the company is 40%.

State of the Economy BAD GOOD GREAT


EBIT $2,000,000 $5,000,000 $10,000,000
Probability 0.40 0.40 0.20

NARREND

71. Refer to ABC Corporation. Given the information in the table, what is the expected earnings per share
if the company has 1 million shares outstanding?
a. $1.44
b. $1.56
c. $1.68
d. $1.78
ANS: C
Interest payment = $20*.10 = $2 million
NI (bad) = ($2-$2)*(1-.4) = $0
NI (good) = ($5-$2)*(1-.4) = $1.8 million
NI (great) = ($10 - $2)*(1-.4) = $4.8 million

Expected EPS = ($0*.4+$1.8*.4+$4.8*.2)/1 = $1.68

DIF: M REF: 12.1 What is Financial Leverage? NAR: ABC Corporation

72. Refer to ABC Corporation. The company is considering the issue of $10 million in new debt at a rate
of 10%. The funds from the new debt will be used to retire $10 million in equity. Currently, there are
1 million shares outstanding trading at $40 per share. Assuming the stock price will remain the same,
what is the expected earnings per share in the next year if the company goes through with the re-
capitalization?
a. $1.32
b. $1.56
c. $1.68
d. $1.76
ANS: D
Re-capitalize:
Total Debt = $20 + $10 = $30
# of shares = $30 million / $40 per share = 750,000

Interest payment = $30*.10 = $3 million


NI (bad) = ($3-$3)*(1-.4) = $0
NI (good) = ($5-$3)*(1-.4) = $1.2 million
NI (great) = ($10 - $3)*(1-.4) = $4.2 million

Expected EPS = ($0*.4+$1.2*.4+$4.2*.2)/.75 = $1.76

DIF: H REF: 12.1 What is Financial Leverage? NAR: ABC Corporation

73. Which statement is FALSE concerning capital structure?


a. Firms with large amounts of tangible assets tend to use a lot of debt in their capital
structures.
b. When corporate profits are taxed at the corporate and personal level, the benefits of
leverage are greatly reduced.
c. Modern trade off theory predicts that a firm’s optimal debt level is set by trading off the
tax benefits of leverage against the agency costs of increased debt.
d. Debt is used more frequently abroad (such as Germany and England) as international laws
tend to favor debtors.
ANS: D DIF: M
REF: 12.3 The M&M Model with Personal and Corporate Taxes

NARRBEGIN: Exhibit 12-1


Exhibit 12-1
An all-equity firm has 80,000 shares outstanding worth $20 each. The firm is considering a project
requiring an investment of $500,000 and has an NPV of $30,000. The company is also considering
financing this project with a new issue of equity.
NARREND

74. Refer to Exhibit 12-1. What is the price at which the firm needs to issue the new shares so that the
existing shareholders are indifferent to whether the firm takes on the project with this equity financing
or does not take on the project?
a. $18.44
b. $18.87
c. $19.71
d. $20.00
ANS: B
Old firm value = $20*80,000 = $1,600,000
New value of the firm = Old firm value + new assets + NPV of project
=$1,600,000 + $500,000 + $30,000 = $2,130,000
=2,130,000 = 1,600,000 + $20 * X
X = 26,500 shares

$500,000 needed / 26,500 shares = $18.87

DIF: H REF: 12.4 Costs of Bankruptcy and Financial Distress


NAR: Exhibit 12-1

75. Refer to Exhibit 12-1. What is the price at which the firm needs to issue the new shares so that the
existing shareholders capture the full benefit associated with the new project?
a. $20.48
b. $20.38
c. $20.15
d. $20.07
ANS: B
Old firm value = $20*80,000 = $1,600,000
New value of the firm = Old firm value + new assets + NPV of project
=$1,600,000 + $500,000 + $30,000 = $2,130,000
$30,000 in NPV means shareholders capture $30,000/80,000 = $.375 per shareholder

Issue at $20.375

DIF: H REF: 12.4 Costs of Bankruptcy and Financial Distress


NAR: Exhibit 12-1