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QUIZ#5 – 25 PTS NAME_______________________________________

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.

1. 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

2. 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

3. 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

4. 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

5. 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

6. What is Bavarian Brew’s required return on equity before the restructuring. Assume no corporate taxes.
a. 10%
b. 6%
c. 11%
d. 12%

7. 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%
8. 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

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%.

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


a. $15,000
b. $125,000
c. $25,000
d. $75,000

10. 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

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.

11. 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

12. 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

13. 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

14. 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
15. 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

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%.

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


a. $15,000
b. $125,000
c. $25,000
d. $75,000

17. 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

18. 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 occurring,
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

19. 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
20. 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

21. 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 surprisingly announces that firms 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
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.

22. 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

23. 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

24. 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

25. 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.