11) Fuji Inc. is registered as a business in the film-making industry and has a required return on
its assets of 10%. It can borrow in the debt market at 5%. If there are no taxes and M&M’s
proposition II holds, what is the cost of equity if there is 100% equity financing?
A) 10%
B) 11%
C) 12%
D) 13%
12) Ace Pharmacy Inc. is a business dealing in pain reduction medication. It has a required return
on its assets of 15%. It can borrow in the debt market at 8%. If there are no taxes and M&M’s
proposition II holds, what is the cost of equity if there is 50% equity financing and 50% debt
financing?
A) 18%
B) 22%
C) 26%
D) None of these
13) APM Inc. is in the property management business and has a required return on its assets of
14%. It can borrow in the debt market at 7%. If there are no taxes and M&M’s proposition II
holds, what is the cost of equity if there is 30% equity financing and 70% debt financing?
A) 55%
B) 40%
C) 30%
D) 16%
14) Modigliani and Miller followed up their initial work with a new model that incorporated a
world with corporate taxes. Which of the statements below results from this model?
A) A new Proposition I with taxes and it states: All debt financing is optimal.
B) A new Proposition II with taxes and it states: The WACC of the firm falls as more debt is
added.
C) The more debt sold, the greater the tax shield and the smaller the government’s share of the
firm.
D) All of these
15) Consider the M&M world of corporate taxes. The interest expense is $5 million, the
corporate tax rate is 20%, and the discount rate on the tax shield is 8%. What is the gain to
leverage or the value added from issuing debt?
A) $7.5 million
B) $12.5 million
C) $15 million
D) $18.5 million
16) Consider the Modigliani and Miller world of corporate taxes. An unleveraged (all-equity)
firm value is $80 million. By adding debt, the annual interest expense is $10 million, the
corporate tax rate is 20%, and the discount rate on the tax shield is 8.0%. What is the value of the
firm after adding debt?
A) $80 million
B) $92 million
C) $105 million
D) $125 million
17) Consider the Modigliani and Miller world of corporate taxes. An unlevered (all-equity) firm
value is $400 million. By adding debt, the annual interest expense is $150 million, the corporate
tax rate is 20%, and the discount rate on the tax shield is 8%. What is the value of the firm after
adding debt?
A) $400 million
B) $775 million
C) $875 million
D) $1,000 million
18) TransPacific Inc. is an import-export company specializing in products from Asia and the
West Coast. It can borrow in the debt market at 9%. Its cost of equity with 40% D/V ratio is
13%. Its corporate tax rate is 20%. If the M&M world of taxes holds true, what is the WACC for
TransPacific Inc. with a 40% D/V financing?
A) 7.80%
B) 8.00%
C) 9.44%
D) 10.68%
19) Fuji Inc. is registered as a business in the film-making industry. It can borrow in the debt
market at 7%. Its cost of equity with 50% debt is 14%. Its corporate tax rate is 20%. If the M&M
world of taxes holds, what is the WACC for Fuji with 50% debt financing?
A) 8.75%
B) 8.90%
C) 9.15%
D) 9.80%
20) Consider the Modigliani and Miller world of corporate taxes. An unlevered (all-equity) firm
value is $300 million. By adding debt, the annual interest expense is $30 million, the corporate
tax rate is 30%, and the discount rate on the tax shield is 7%. What is the value of the firm after
adding debt?
A) $366.67 million
B) $428.57 million
C) $433.33 million
D) $467.53 million
21) Worldwide Inc. is an import-export company specializing in products from Canada,
Australia, and the West Coast. It can borrow in the debt market at 8%. Its cost of equity with
30% D/V ratio is 13%. Its corporate tax rate is 30%. If the M&M world of taxes holds true, what
is the WACC for the firm with a 30% D/V financing?
A) 11.90%
B) 11.05%
C) 10.78%
D) 9.44%
22) Fuji Inc. is registered as a business in the film-making industry. It can borrow in the debt
market at 5%. Its cost of equity with 50% debt is 10%. Its corporate tax rate is 20%. If the M&M
world of taxes holds, what is the WACC for Fuji with 50% debt financing?
A) 9.70%
B) 9.00%
C) 8.15%
D) 7.00%
23) In the Modigliani & Miller model of capital structure, with no corporate taxes, as a firm
increases the D/V ratio, the cost of equity also increases.
24) The Modigliani-Miller model of capital structure begins with the simple assumption that the
investing decision and financing decision of a firm are inseparable.
25) A simple way of stating the original M&M proposition 1 is that it doesn’t matter how you
slice the pie—the size of the pie is still the same.
26) The original Modigliani and Miller proposition I states that the value of a firm depends on its
capital structure.
27) The Modigliani and Miller original proposition II states that the value of the firm depends on
three things: the required rate of return on the firm’s assets, the firm’s cost of debt, and the firm’s
debt-to-equity ratio.
28) In the original Modigliani/Miller world, the value of the firm is sensitive to the funding
choice between debt and equity.
29) In their later proposition II with taxes, Modigliani and Miller concluded that as more debt is
added, the WACC of the firm falls, and the firm’s overall value increases for the equity holder.
30) Summarize the Modigliani and Miller contribution to the debate on the optimal capital
structure.
1) The indirect costs of bankruptcy can include which of the following?
A) Setting aside projects with good NPVs
B) Lost sales
C) Loss of confidence in the firm’s products and services
D) All of the above
2) ________ is the point at which the equity value of the firm is zero.
A) The optimal capital structure
B) Bankruptcy
C) The optimal tax structure
D) None of the above
3) When bankruptcy is added to the M&M world of capital structure, which of the following
statements is TRUE as more debt is added to the financing mix of the company?
A) The interest tax shield is a benefit to equity holders, although they bear increasing risk.
B) The advantage of the tax shield starts to be offset by financial distress costs.
C) The WACC of the company starts to increase past a certain level of debt.
D) All of the above
4) A rising WACC ________ the values of the firm’s future cash flows.
A) increases
B) reduces
C) keeps constant
D) has no effect on
5) At the optimal debt-to-equity ratio, the cost of capital (WACC) is ________ for the firm. This
point reflects the maximum benefit of leverage.
A) the lowest
B) the highest
C) at the midpoint
D) irrelevant
6) Bankruptcy is the point at which the equity value of the firm is zero. That is, the value of the
assets is equal to or less than the value of the liabilities of the firm.
7) Although the work of Modigliani and Miller produced a near-100% debt mix for firms in a
world of taxes, the actual debt-to-equity ratio for most firms falls far short of 100% debt
financing.
8) The work of Modigliani and Miller produced a near 100% debt/value mix for firms in a world
of taxes. As it turns out, the theoretical and the actual debt/value ratio for most firms are almost
identical at just about 100%.
9) The optimal capital structure of a firm is that combination of debt and equity that provides the
highest overall cost of capital, or the highest WACC.
10) Describe in detail the costs of bankruptcy. In your answer discuss both the direct and indirect
costs.
11) Describe the Static Theory of Capital Structure.