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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,

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

II. The required return on assets is equal to the weighted average cost of capital. . III. (b) Supports the argument that the cost of equity decreases as the debt-equity ratio increases. Which of the following statements are correct in relation to M & M Proposition II with no taxes? I. (c) Says that the weighted average cost of capital increases as the debt-equity ratio increases.3. and III only (d) II. IV. A firm’s cost of equity is a linear function with a slope equal to (𝑟 – 𝑟 ). and IV only 4. (a) I and II only (b) I and III only (c) I. (d) Says that the weighted average cost of capital is equal to 𝑟 × (1 − 𝑇 ). 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. The risk of a firm’s equity is determined by the debt-equity ratio. (c) The capital structure of a firm does not matter because investors can use homemade leverage. M & M Proposition II with taxes: (a) Has the same general implications as M & M Proposition II without taxes. II. III. (b) The value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. 5. The cost of equity declines when the amount of leverage used by a firm rises. (d) The value of a firm increases as the firm's debt increases because of the interest tax shield.

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 . 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 8.6. 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.

II.6% and a pre-tax cost of debt of 7.4% and the tax rate is 34%.8%.708 million .33 (c) 0. II. The required return on the assets is 13. and IV 10. Firms avoid external debt at all costs. Firms stockpile internally-generated cash. III. The current cost of equity is 15.9.209 million (b) $5. Jefferson & Daughter has a cost of equity of 14. Which of the following are correct according to pecking-order theory? I. What is the firm's debt-equity ratio based on M & M II with no taxes? (a) 0. II.512 million (d) $6. A firm's capital structure is dictated by its need for external financing. The debt will be sold at par value.2%. The firm is considering adding $1.26 (b) 0.37 (d) 0.000 shares of stock outstanding with a market price of $19 a share. What is the levered value of the equity? (a) $5. IV.43 11. There is an inverse relationship between a firm's profit level and its debt level.288 million (c) $6. and IV only (d) I.2 million of debt with a coupon rate of 8% to its capital structure. Hanover Tech is currently an all equity firm that has 320. (a) I and III only (b) II and IV only (c) I. III.

100. What is the target debt-equity ratio if the targeted cost of equity is 15.87% (c) 23.46% (b) 22.52 13. The expected earnings before interest and taxes are $2. the tax rate is 30%.51%? (a) 0.24 (b) 0. The Green Paddle has a cost of equity of 12. What is Green Paddle's unlevered cost of capital? (a) 10.36 (d) 0.8%. Down Bedding has an unlevered cost of capital of 14%.000. What is the firm's cost of equity? (a) 22.14% 14.08% .72% (b) 11. a cost of debt of 7.12. and a tax rate of 32%. The debt-equity ratio is 0.29% (d) 15. and the unlevered cost of capital is 11.29 (c) 0.7%. Johnson Tire Distributors has debt with both a face and a market value of $12. This debt has a coupon rate of 6% and pays interest annually.65 and the tax rate is 32%.6%.1% and a pre-tax cost of debt of 7.85% (c) 14.20% (d) 25.

What is the amount of the annual interest tax shield? (a) $4.50 (d) $8. The cost of equity is 14.000 bond issue outstanding.897. What will the firm's cost of equity be if the debt-equity ratio is revised to 0. Young's Home Supply has a debt-equity ratio of 0. These bonds have a 7. and have a current market price equal to 98.47% (c) 11.5% coupon. What is the present value of the tax shield? (a) $504 (b) $644 (c) $6. The tax rate is 39%.5%.112. The June Bug has a $270.70? (a) 10.70% (d) 13.97% .89% (b) 11.311. Tuckers has $21. The tax rate is 32%.000 of debt outstanding that is selling at par and has a coupon rate of 7.80.6% of face value. pay interest semiannually.22 (c) $7.60 (b) $5. D.720 17.200 (d) $6.5% and the after-tax cost of debt is 4.9%.20 16.15. L.225.

and for XYZ it is ______. W.29%.33% (b) 12.000 in stock.V.400. its stock is worth $240. Trees. ABC is all equity financed with $480. Its WACC is 10%.18. are identical firms in all respects except for their capital structure. What is the firm's weighted average cost of capital? (a) 11.38% (b) 13.45% (d) 14. Both the book and the market value of debt is $170. 12.68% (d) 12.33% (c) 12. The corporate tax rate is 33%. 13.17%. Percy's Wholesale Supply has earnings before interest and taxes of $106.33% 20. The unlevered cost of equity is 15. 15. and its cost of debt is 9%.6%.37% 19.17%. and XYZ Co.4. The tax rate is 38%. (a) 12.45% . Both firms expect EBIT to be $58. has a debt-equity ratio of 1. 13.000.5% while the pre-tax cost of debt is 8.000. Ignore taxes. Inc.65% (c) 13. What is the firm's unlevered cost of equity capital? (a) 12.68% (c) 14. XYZ uses both stock and perpetual debt.29%.10% (d) 14.000 and the interest rate on its debt is 9%.94% (b) 12. ABC Co. The cost of equity for ABC is _____.