FIN4414 Financial Management Fall 2017

Written by Sehoon Kim

Homework 3
(Due Oct 25th)

For each question, find one answer. This is not a group assignment. You are allowed to work in groups,
but ALL HOMEWORKS ARE TO BE SUBMITTED IN-CLASS INDIVIDUALLY.

1. The optimal capital structure has been achieved when the:

(a) Weight of equity is equal to the weight of debt.

(b) Debt-equity ratio is such that the cost of debt exceeds the cost of equity.

(c) Debt-equity ratio results in the lowest possible weighted average cost of capital.

(d) Value of the levered firm does not exceed the value of the firm if it were unlevered.

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

(a) The cost of equity declines as leverage rises

(b) The debt-equity ratio of a firm is completely irrelevant

(c) 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

(d) Homemade leverage is irrelevant

3. 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. The risk of a firm’s equity is determined by the debt-equity ratio.
III. A firm’s cost of equity is a linear function with a slope equal to (𝑟 – 𝑟 ).
IV. The cost of equity declines when the amount of leverage used by a firm rises.

(a) I and II only

(b) I and III only

(c) I, II, and III only

(d) II, III, and IV only

4. M & M Proposition I with tax supports the theory that:

(a) A firm's weighted average cost of capital stays constant as the firm's debt-equity ratio increases.

(b) The value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax
shield.

(c) The capital structure of a firm does not matter because investors can use homemade leverage.

(d) The value of a firm increases as the firm's debt increases because of the interest tax shield.

5. M & M Proposition II with taxes:

(a) Has the same general implications as M & M Proposition II without taxes.

(b) Supports the argument that the cost of equity decreases as the debt-equity ratio increases.

(c) Says that the weighted average cost of capital increases as the debt-equity ratio increases.

(d) Says that the weighted average cost of capital is equal to 𝑟 × (1 − 𝑇 ).

6. Which one of the following is a direct bankruptcy cost?

(a) Company CEO’s time spent in bankruptcy court

(b) Losing a key company employee

(c) Paying an outside accountant fees to prepare bankruptcy reports

(d) Customers shifting demand to competitor’s products

7. Which one of the following has the greatest tendency to increase the percentage of debt included in the
optimal capital structure of a firm?

(a) Exceptionally high depreciation expenses

(b) Low probabilities of financial distress

(c) Very low marginal tax rate

(d) Minimal taxable income

8. The static tradeoff theory of capital structure advocates that the optimal capital structure for a firm:

(a) Remains fixed over time

(b) Is independent of the firm's weighted average cost of capital

(c) Equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to
that additional dollar of debt

(d) Depends on the benefits of debt in mitigating managerial entrenchment and the agency costs arising
from conflicts of interests between debtholders and shareholders
9. Which of the following are correct according to pecking-order theory?

I. Firms stockpile internally-generated cash.

II. There is an inverse relationship between a firm's profit level and its debt level.
III. Firms avoid external debt at all costs.
IV. A firm's capital structure is dictated by its need for external financing.

(a) I and III only

(b) II and IV only

(c) I, II, and IV only

(d) I, II, III, and IV

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

(a) 0.26

(b) 0.33

(c) 0.37

(d) 0.43

11. 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% and the tax rate is 34%. The firm is
considering adding $1.2 million of debt with a coupon rate of 8% to its capital structure. The debt will be
sold at par value. What is the levered value of the equity?

(a) $5.209 million

(b) $5.288 million

(c) $6.512 million

(d) $6.708 million

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

(a) 0.24

(b) 0.29

(c) 0.36

(d) 0.52

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

(a) 22.46%

(b) 22.87%

(c) 23.20%

(d) 25.14%

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

(a) 10.72%

(b) 11.85%

(c) 14.29%

(d) 15.08%
15. The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5% coupon, pay interest
semiannually, and have a current market price equal to 98.6% of face value. The tax rate is 39%. What is
the amount of the annual interest tax shield?

(a) $4,112.60

(b) $5,311.22

(c) $7,897.50

(d) $8,225.20

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

(a) $504

(b) $644

(c) $6,200

(d) $6,720

17. Young's Home Supply has a debt-equity ratio of 0.80. The cost of equity is 14.5% and the after-tax
cost of debt is 4.9%. What will the firm's cost of equity be if the debt-equity ratio is revised to 0.70?

(a) 10.89%

(b) 11.47%

(c) 11.70%

(d) 13.97%
18. Percy's Wholesale Supply has earnings before interest and taxes of $106,000. Both the book and the
market value of debt is $170,000. The unlevered cost of equity is 15.5% while the pre-tax cost of debt is
8.6%. The tax rate is 38%. What is the firm's weighted average cost of capital?

(a) 11.94%

(b) 12.65%

(c) 13.45%

(d) 14.37%

19. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all
equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth
$240,000 and the interest rate on its debt is 9%. Both firms expect EBIT to be $58,400. Ignore taxes. The
cost of equity for ABC is _____, and for XYZ it is ______.

(a) 12.17%; 13.33%

(b) 12.17%; 15.33%

(c) 12.29%; 12.68%

(d) 12.29%; 13.33%

20. W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10%, and its cost of debt is 9%. The
corporate tax rate is 33%. What is the firm's unlevered cost of equity capital?

(a) 12.38%

(b) 13.68%

(c) 14.10%

(d) 14.45%