Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1)
Which of the following statements is false?
1)
A)
Because the cash flows of the levered firm are equal to the sum of the cash flows from the
unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for
the present values of these cash flows.
B)
By increasing the amount paid to debt holders through interest payments, the amount of the
pretax cash flows that must be paid as taxes increases.
C)
To determine the benefit of leverage for the value of the firm, we must compute the present
value of the stream of future interest tax shields the firm will receive.
D)
When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Year 2006 2005 2004
Total Sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1,265 1,256 1,209
Operating Income 2,035 847 1,370
Other Income 0 0 0
EBIT 2,035 847 1,370
Interest expense 510 557 604
Earnings before tax 1,525 290 766
Taxes (35%) 534 102 268
Net Income 991 189 498
2)
The total amount available to payout to all the investors in Kroger in 2005 is closest to:
2)
A)
$745 million
B)
$190 million
C)
$290 million
D)
$847 million
3)
Which of the following statements is false?
3)
A)
Equity investors must pay taxes on dividends but not capital gains.
B)
The value of a firm is equal to the amount of money the firm can raise by issuing securities.
C)
By reducing a firm’s corporate tax liability, debt allows the firm to pay more of its cash flows
to investors.
D)
For individuals, interest payments received from debt are taxed as income.
4)
Which of the following statements is false?
4)
A)
From a tax perspective, the firm’s optimal level of debt is proportional to its current earnings.
B)
The optimal proportion of debt in the firm’s capital structure will be higher, the higher the
firm’s growth rate.
C)
If there is uncertainty regarding EBIT, then with a higher interest expense there is a greater
risk that interest will exceed EBIT.
D)
Even for a firm with positive earnings, growth will affect the optimal leverage ratio.
Use the information for the question(s) below.
Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to
grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in
the 35% corporate tax bracket.
5)
If Flagstaff currently maintains a .5 debt to equity ratio, then the value of Flagstaff’s interest tax
shield is closest to:
5)
A)
$18 million
B)
$11 million
C)
$24 million
D)
$10 million
6)
If Flagstaff currently maintains a debt to equity ratio of 1, then the value of Flagstaff as a levered
firm is closest to:
6)
A)
$111 million
B)
$140 million
C)
$114 million
D)
$100 million
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Year 2006 2005 2004
Total Sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1,265 1,256 1,209
Operating Income 2,035 847 1,370
Other Income 0 0 0
EBIT 2,035 847 1,370
Interest expense 510 557 604
Earnings before tax 1,525 290 766
Taxes (35%) 534 102 268
Net Income 991 189 498
7)
The income that would be available to equity holders in 2005 if Kroger was not levered is closest
to:
7)
A)
$847 million
B)
$290 million
C)
$550 million
D)
$745 million
Use the information for the question(s) below.
Fly by Night Aviation (FBNA) expects to have net income next year of $24 million and Free Cash Flow of $27 million.
FBNA’s marginal corporate tax rate is 40%.
8)
IF FBNA increases leverage so that its interest expense rises by $1 million, then the amount its Free
Cash flow will change is closest to:
8)
A)
–$600,000
B)
$400,000
C)
$600,000
D)
–$400,000
9)
Consider the following formula:
VL= VU+
cDrD
rD
The term
cDrD
rDrepresents
9)
A)
the interest tax shield each year.
B)
the value of firm with leverage.
C)
the present value of the interest tax shield.
D)
the preset value of the future interest payments.
Use the information for the question(s) below.
KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently
stable earnings, and pays a 35% tax rate. Management plans to borrow $200 million on a permanent basis through a
leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.
10)
The value of KD’s unlevered equity is closest to:
10)
A)
$400 million
B)
$390 million
C)
$470 million
D)
$600 million
11)
Consider the following formula:
* =
(1 –i) – (1 –c)(1 –e)
(1 –i)
The term e is
11)
A)
the effective personal tax rate on interest income.
B)
the effective tax advantage of debt.
C)
the effective personal tax rate on equity.
D)
the effective corporate tax rate on income.
12)
Which of the following statements is false?
12)
A)
Investors with accrued losses that they can use to offset gains face a zero effective capital
gains tax rate.
B)
Deferring the payment of capital gains taxes lowers the present value of the taxes, which can
be interpreted as a lower effective capital gains tax rate.
C)
Unlike taxes on capital gains or interest income, which are paid annually, taxes on dividends
are paid only at the time the investor sells the stock.
D)
Investors with longer holding periods or with accrued losses face a lower tax rate on equity
income, decreasing the effective tax advantage of debt.
13)
Consider the following formula:
VL= VU+cD
The term cD represents
13)
A)
the value of firm with leverage.
B)
the preset value of the future interest payments.
C)
the interest tax shield each year.
D)
the present value of the interest tax shield.
Use the information for the question(s) below.
KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently
stable earnings, and pays a 35% tax rate. Management plans to borrow $200 million on a permanent basis through a
leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.
14)
After the recapitalization, the total value of KD as a levered firm is closest to:
14)
A)
$530 million
B)
$730 million
C)
$670 million
D)
$470 million
15)
The preset value of KD’s interest tax shield is closest to:
15)
A)
$70 million
B)
$200 million
C)
$400 million
D)
$130 million
16)
Which of the following statements is false?
16)
A)
Capital expenditures greatly exceed firms’ external financing, implying that most investment
and growth is supported by internally generated funds, such as retained earnings.
B)
The data show a clear preference for equity as a source of external financing for the total
population of U.S. firms.
C)
Debt as a fraction of firm value has varied in a range from 30–45% for the average firm.
D)
Firms in growth industries like biotechnology or high technology carry very little debt,
whereas airlines, auto makers, utilities, and financial firms have high leverage ratios.
Use the information for the question(s) below.
KD Industries has 30 million shares outstanding with a market price of $20 per share and no debt. KD has had consistently
stable earnings, and pays a 35% tax rate. Management plans to borrow $200 million on a permanent basis through a
leveraged recapitalization in which they would use the borrowed funds to repurchase outstanding shares.
17)
After the recapitalization, the value of KD‘s levered equity is closest to:
17)
A)
$670 million
B)
$330 million
C)
$400 million
D)
$470 million
18)
Which of the following statements is false?
18)
A)
In Modigliani and Miller’s setting of perfect capital markets, firms could use any combination
of debt and equity to finance their investments without changing the value of the firm.
B)
Even after adjusting for personal taxes, the value of an unlevered firm exceeds the value of a
levered firm, and there is a tax advantage to using debt financing.
C)
When firms raise new capital from investors, they do so primarily by issuing debt.
D)
In most years aggregate equity issues are negative, meaning that firms are reducing the
amount of equity outstanding by buying shares.
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Year 2006 2005 2004
Total Sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1,265 1,256 1,209
Operating Income 2,035 847 1,370
Other Income 0 0 0
EBIT 2,035 847 1,370
Interest expense 510 557 604
Earnings before tax 1,525 290 766
Taxes (35%) 534 102 268
Net Income 991 189 498
19)
The income that would be available to equity holders in 2006 if Kroger was not levered is closest
to:
19)
A)
$1,500 million
B)
$1,325 million
C)
$2,035 million
D)
$1,525 million
Use the information for the question(s) below.
Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%.
20)
Rosewood’s net income is closest to:
20)
A)
$450 million
B)
$95 million
C)
$180 million
D)
$290 million
Use the information for the question(s) below.
Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to
grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in
the 35% corporate tax bracket.
21)
If Flagstaff currently maintains a debt to equity ratio of 1, then Flagstaff’s after–tax WACC is closest
to:
21)
A)
8.75%
B)
10.00%
C)
9.50%
D)
10.25%
22)
Which of the following statements is false?
22)
A)
Even though firms have not issued new equity, the market value of equity has risen over time
as firms have grown.
B)
To receive the full tax benefits of leverage a firm needs to use 100% debt financing.
C)
If bankruptcy is costly, these costs might offset the tax advantages of debt financing.
D)
While firms seem to prefer debt when raising external funds, not all investment is externally
funded.
23)
Which of the following statements is false?
23)
A)
Aside from taxes, another important difference between debt and equity financing is that debt
payments must be made to avoid bankruptcy, whereas firms have no similar obligation to
pay dividends or realize capital gains.
B)
To the extent that a firm has other tax shields, its taxable earnings will be increased and it will
rely more heavily on the interest tax shield.
C)
A firm receives a tax benefit only if it is paying taxes in the first place.
D)
Increasing the level of debt increases the probability of bankruptcy.
Use the information for the question(s) below.
Shepard Industries expects free cash flow of $10 million each year. Shepard’s corporate tax rate is 35%, and its unlevered cost
of equity is 10%. The firm also has outstanding debt of $40 million and it expects to maintain amount of debt permanently.
24)
The value of Shepard Industries with leverage is closest to:
24)
A)
$135 million
B)
$114 million
C)
$64 million
D)
$100 million
Use the information for the question(s) below.
Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to
grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in
the 35% corporate tax bracket.
25)
If Flagstaff maintains a .5 debt to equity ratio, then Flagstaff‘s pre–tax WACC is closest to:
25)
A)
9.0%
B)
10.5%
C)
11.0%
D)
10.0%
Use the information for the question(s) below.
Rosewood Industries has EBIT of $450 million, interest expense of $175 million, and a corporate tax rate of 35%.
26)
If Rosewood had no interest expense, its net income would be closest to:
26)
A)
$290 million
B)
$405 million
C)
$160 million
D)
$450 million
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Year 2006 2005 2004
Total Sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1,265 1,256 1,209
Operating Income 2,035 847 1,370
Other Income 0 0 0
EBIT 2,035 847 1,370
Interest expense 510 557 604
Earnings before tax 1,525 290 766
Taxes (35%) 534 102 268
Net Income 991 189 498
27)
The interest rate tax shield for Kroger in 2004 is closest to:
27)
A)
$393 million
B)
$211 million
C)
$268 million
D)
$94 million
Use the information for the question(s) below.
LCMS Industries has $70 million in debt outstanding. The firm will pay only interest on this debt (the debt is perpetual).
LCMS’ marginal tax rate is 35% and the firm pays a rate of 8% interest on its debt.
28)
LCMS’ annual interest tax shield is closest to:
28)
A)
$5.6 million
B)
$2.0 million
C)
$3.6 million
D)
$2.8 million
29)
Assuming that the risk of the tax shield is only 6% even though the loan pays 8%, then the present
value of LCMS’ interest tax shield is closest to:
29)
A)
$18 million
B)
$20.0 million
C)
$33.0 million
D)
$24.5 million
30)
Consider the following formula:
* =
(1 –i) – (1 –c)(1 –e)
(1 –i)
The term i is
30)
A)
the effective tax advantage of debt.
B)
the effective corporate tax rate on income.
C)
the effective personal tax rate on interest income.
D)
the effective personal tax rate on equity.
31)
Which of the following statements regarding recapitializations is false?
31)
A)
The share price rises after the completion of the recapitalization.
B)
When a firm makes a significant change to its capital structure, the transaction is called a
recapitalization.
C)
With a recapitalization, even though leverage reduces the total value of equity, shareholders
capture the benefits of the interest tax shield up front.
D)
Leveraged recaps were especially popular in the mid– to late–1980s, when many firms found
that these transactions could reduce their tax payments.
32)
Which of the following statements is false?
32)
A)
Given a 35% corporate tax rate, for every $1 in new permanent debt that the firm issues, the
value of the firm increases by $0.65.
B)
Typically, the level of future interest payments varies due to changes the firm makes in the
amount of debt outstanding, changes in the interest rate on that debt, and the risk that the
firm may default and fail to make an interest payment.
C)
The firm’s marginal tax rate may fluctuate due to changes in the tax code and changes in the
firm’s income bracket.
D)
Many large firms have a policy of maintaining a certain amount of debt on their balance
sheets.
33)
Which of the following statements is false?
33)
A)
When a firm uses debt financing, the cost of the interest it must pay is offset to some extent by
the tax savings from the interest tax shield.
B)
The tax deductibility of interest lowers the effective cost of debt financing for the firm.
C)
With tax–deductible interest, the effective after–tax borrowing rate is r(C).
D)
The WACC represents the cost of capital for the free cash flow generated by the firm’s assets.
With tax–deductible interest, the effective after–tax borrowing rate is r(1 –C).
Use the information for the question(s) below.
Flagstaff Enterprises expected to have free cash flow in the coming year of $8 million, and this free cash flow is expected to
grow at a rate of 3% per year thereafter. Flagstaff has an equity cost of capital of 13%, a debt cost of capital of 7%, and it is in
the 35% corporate tax bracket.
34)
If Flagstaff currently maintains a debt to equity ratio of 1, then the value of Flagstaff as an all equity
firm would be closest to:
34)
A)
$100 million
B)
$73 million
C)
$115 million
D)
$80 million
35)
Which of the following equations is incorrect?
35)
A)
VL= VU+
cDrD
rD
B)
VL= VU+cD
C)
rwacc =E
E + D rE+D
E + D rD(1 +c)
D)
rwacc =E
E + D rE+D
E + D rD–D
E + D rDc
36)
Which of the following statements is false?
36)
A)
Given a forecast of future interest payments, we can determine the interest tax shield and
compute its present value by discounting it at a rate that corresponds to its risk.
B)
There is an important tax advantage to the use of debt financing.
C)
To compute the increase in the firm’s total value associated with the interest tax shield, we
need to forecast how a firm’s debt–and therefore its interest payments.
D)
The total value of the unlevered firm exceeds the value of the firm with leverage due to the
present value of the tax savings from debt.
D
Use the information for the question(s) below.
Fly by Night Aviation (FBNA) expects to have net income next year of $24 million and Free Cash Flow of $27 million.
FBNA’s marginal corporate tax rate is 40%.
37)
IF FBNA increases leverage so that its interest expense rises by $1 million, then the amount its net
income will change is closest to:
37)
A)
–$400,000
B)
$600,000
C)
–$600,000
D)
$400,000
C
C
Use the table for the question(s) below.
Consider the following income statement for Kroger Inc. (all figures in $ Millions):
Year 2006 2005 2004
Total Sales 60,553 56,434 53,791
Cost of goods sold 45,565 42,140 39,637
Selling, general & admin expenses 11,688 12,191 11,575
Depreciation 1,265 1,256 1,209
Operating Income 2,035 847 1,370
Other Income 0 0 0
EBIT 2,035 847 1,370
Interest expense 510 557 604
Earnings before tax 1,525 290 766
Taxes (35%) 534 102 268
Net Income 991 189 498
38)
The interest rate tax shield for Kroger in 2005 is closest to:
38)
A)
$195 million
B)
$36 million
C)
$362 million
D)
$102 million
39)
The interest rate tax shield for Kroger in 2006 is closest to:
39)
A)
$187 million
B)
$179 million
C)
$332 million
D)
$534 million
Use the table for the question(s) below.
Consider the following top federal tax rates in the United States:
Personal Tax Rates
Year
Corporate
Tax Rate
Interest
Income Dividends
Capital
Gains
2000 35% 40% 40% 20%
2005 35% 35% 15% 15%
40)
In 2000, the effective tax rate for debt holders was closest to:
40)
A)
61%
B)
40%
C)
52%
D)
64%