Ch16 – Financial Leverage And Capital + Test Bank + Answers

1.

Homemade leverage is: 
 

2.

Which one of the following states that the value of a firm is unrelated to the firm's capital structure? 
 

3.

Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure? 
 

4.

Which one of the following is the equity risk that is most related to the daily operations of a firm? 
 

5.

Which one of the following is the equity risk related to a firm's capital structure policy? 
 

6.

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? 
 

7.

The unlevered cost of capital refers to the cost of capital for a(n): 
 

8.

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs. 
 

9.

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

10.

By definition, which of the following costs are included in the term "financial distress costs"?

I. direct bankruptcy costs
II. indirect bankruptcy costs
III. direct costs related to being financially distressed, but not bankrupt
IV. indirect costs related to being financially distressed, but not bankrupt 
 

11.

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: 
 

12.

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? 
 

13.

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

14.

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a: 
 

15.

The absolute priority rule determines: 
 

16.

A firm should select the capital structure that: 
 

17.

The value of a firm is maximized when the: 
 

18.

The optimal capital structure has been achieved when the: 
 

19.

AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes. 
 

20.

You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the: 
 

21.

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. 
 

22.

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to: 
 

23.

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

24.

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

25.

The concept of homemade leverage is most associated with: 
 

26.

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. 
 

27.

M & M Proposition II is the proposition that: 
 

28.

The business risk of a firm: 
 

29.

Which of the following statements related to financial risk are correct?

I. Financial risk is the risk associated with the use of debt financing.
II. As financial risk increases so too does the cost of equity.
III. Financial risk is wholly dependent upon the financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's operations. 
 

30.

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

31.

M & M Proposition I with taxes is based on the concept that: 
 

32.

M & M Proposition II with taxes: 
 

33.

The present value of the interest tax shield is expressed as: 
 

34.

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. 
 

35.

The interest tax shield is a key reason why: 
 

36.

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

37.

Bankruptcy: 
 

38.

Which one of the following is a direct bankruptcy cost? 
 

39.

If a firm has the optimal amount of debt, then the: 
 

40.

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

41.

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

42.

The optimal capital structure: 
 

43.

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

44.

The basic lesson of M & M Theory is that the value of a firm is dependent upon: 
 

45.

Which form of financing do firms prefer to use first according to the pecking-order theory? 
 

46.

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. 
 

47.

Corporations in the U.S. tend to: 
 

48.

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

49.

A firm is technically insolvent when: 
 

50.

Which one of the following statements related to Chapter 7 bankruptcy is correct? 
 

51.

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding? 
 

52.

A firm may file for Chapter 11 bankruptcy:

I. in an attempt to gain a competitive advantage.
II. using a prepack.
III. while allowing the current management to continue running the firm.
IV. only after the firm becomes insolvent. 
 

53.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: 
 

54.

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. 
 

55.

Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $45 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes. 
 

56.

Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes. 
 

57.

Miller's Dry Goods is an all equity firm with 48,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes. 
 

58.

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest? 
 

59.

Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $102,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes. 
 

60.

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? 
 

61.

The Jean Outlet is an all equity firm that has 146,000 shares of stock outstanding. The company has decided to borrow the $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes? 
 

62.

Stacy owns 38 percent of The Town Centre. She has decided to retire and wants to sell all of her shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock. What is the total market value of The Town Centre? Ignore taxes. 
 

63.

Winter's Toyland has a debt-equity ratio of 0.65. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes? 
 

64.

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

65.

The Corner Bakery has a debt-equity ratio of 0.62. 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? 
 

66.

L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm? 
 

67.

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

68.

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm? 
 

69.

Exports Unlimited is an unlevered firm with an aftertax net income of $52,300. The unlevered cost of capital is 14.1 percent and the tax rate is 36 percent. What is the value of this firm? 
 

70.

An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500. A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon. The applicable tax rate is 38 percent. What is the value of the levered firm? 
 

71.

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

72.

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

73.

Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity? 
 

74.

The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $41,000 and the tax rate is 34 percent. What is the pre-tax cost of debt? 
 

75.

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

76.

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? 
 

77.

Douglass & Frank has a debt-equity ratio of 0.35. The pre-tax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent? 
 

78.

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? 
 

79.

Georga's Restaurants has 5,000 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? 
 

80.

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

81.

Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital? 
 

82.

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? 
 

83.

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

84.

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 percent while the pre-tax cost of debt is 8.6 percent. The tax rate is 38 percent. What is the firm's weighted average cost of capital? 
 

85.

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. 
 

86.

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 30 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. 
 

87.

Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Galaxy would have 178,500 shares of stock outstanding. Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. What is the breakeven EBIT? 
 

88.

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 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent. 
 

89.

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT? 
 

90.

The SLG Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $31 million and the corporate tax rate is 34 percent. What is EBIT? 
 

91.

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

92.

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 10 percent. Bruce currently has no debt, and its cost of equity is 20 percent. The tax rate is 34 percent. What will the value of Bruce & Co. be if the firm borrows $54,000 and uses the loan proceeds to repurchase shares? 
 

93.

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization? 
 

94.

New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt? 
 

95.

Draw the following two graphs, one above the other: In the top graph, plot firm value on the vertical axis and total debt on the horizontal axis. Use this graph to illustrate the value of a firm under M & M without taxes, M & M with taxes, and the static theory of capital structure. On the lower graph, plot the WACC on the vertical axis and the debt-equity ratio on the horizontal axis. Use this second graph to illustrate the value of the firm's WACC under M & M without taxes, M & M with taxes, and the static theory. Briefly explain what the two graphs reveal about firm value and its cost of capital under the three different theories. 
 

96.

Based on the M & M propositions with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory? 
 

97.

Pete is the CFO of Dexter International. He would like to increase the debt-equity ratio of the firm but is concerned that the firm's shareholders may not be willing to accept additional financial leverage. Pete has come to you for advice. What is your recommendation? 
 

98.

In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm? 
 

99.

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.