CHAPTER 21—DYNAMIC CAPITAL STRUCTURES
TRUE/FALSE
1. In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value.
However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its
value rises as its debt is increased.
2. According to MM, in a world without taxes the optimal capital structure for a firm is approximately
100% debt financing.
3. MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.
4. MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.
5. The Miller model begins with the MM model with taxes and then adds personal taxes.
6. The Miller model begins with the MM model without corporate taxes and then adds personal taxes.
7. Other things held constant, an increase in financial leverage will increase a firm’s market (or
systematic) risk as measured by its beta coefficient.
8. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.
9. The MM model is the same as the Miller model, but with zero corporate taxes.
10. In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost
of equity.
11. In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.
12. In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost
of debt.
13. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an
exercise price equal to the face value of the debt.
14. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an
exercise price equal to the face value of the equity.
MULTIPLE CHOICE
15. The major contribution of the Miller model is that it demonstrates that
a.
personal taxes decrease the value of using corporate debt.
b.
financial distress and agency costs reduce the value of using corporate debt.
c.
equity costs increase with financial leverage.
d.
debt costs increase with financial leverage.
e.
personal taxes increase the value of using corporate debt.
16. Which of the following statements concerning capital structure theory is NOT CORRECT?
a.
Under MM with zero taxes, financial leverage has no effect on a firm’s value.
b.
Under MM with corporate taxes, the value of a levered firm exceeds the value of the
unlevered firm by the product of the tax rate times the market value dollar amount of debt.
c.
Under MM with corporate taxes, rs increases with leverage, and this increase exactly
offsets the tax benefits of debt financing.
d.
Under MM with corporate taxes, the effect of business risk is automatically incorporated
because rsL is a function of rsU.
e.
The major contribution of Miller’s theory is that it demonstrates that personal taxes
decrease the value of using corporate debt.
17. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a.
The value of a growing tax shield is greater than the value of a constant tax shield.
b.
For a given D/S, the levered cost of equity is greater than the levered cost of equity under
MM’s original (with tax) assumptions.
c.
For a given D/S, the WACC is less than the WACC under MM’s original (with tax)
assumptions.
d.
The total value of the firm increases with the amount of debt.
e.
The tax shields should be discounted at the unlevered cost of equity.
18. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a.
The value of a growing tax shield is greater than the value of a constant tax shield.
b.
For a given D/S, the levered cost of equity is greater than the levered cost of equity under
MM’s original (with tax) assumptions.
c.
For a given D/S, the WACC is greater than the WACC under MM’s original (with tax)
assumptions.
d.
The total value of the firm increases with the amount of debt.
e.
The tax shields should be discounted at the cost of debt.
19. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a.
The value of a growing tax shield is greater than the value of a constant tax shield.
b.
For a given D/S, the levered cost of equity is greater than the levered cost of equity under
MM’s original (with tax) assumptions.
c.
For a given D/S, the WACC is greater than the WACC under MM’s original (with tax)
assumptions.
d.
The total value of the firm is independent of the amount of debt it uses.
e.
The tax shields should be discounted at the unlevered cost of equity.
20. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value
of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no
debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L’s cost of
equity?
a.
11.4%
b.
12.0%
c.
12.6%
d.
13.3%
e.
14.0%
21. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value
of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt
has a cost of equity of 12%. Under the MM extension with growth, what would Firm L’s total value be
if it had no debt?
a.
$358,421
b.
$377,286
c.
$397,143
d.
$417,000
e.
$437,850
22. A local firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at
a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the
MM extension with growth, what is the value of your firm’s tax shield, i.e., how much value does the
use of debt add?
a.
$92,571
b.
$102,857
c.
$113,143
d.
$124,457
e.
$136,903
23. Refer to Exhibit 21.1. What is the value of the firm according to MM with corporate taxes?
a.
$475,875
b.
$528,750
c.
$587,500
d.
$646,250
e.
$710,875
24. Refer to Exhibit 21.1. What is the firm’s cost of equity?
a.
21.0%
b.
23.3%
c.
25.9%
d.
28.8%
e.
32.0%
25. Refer to Exhibit 21.1. Assume that the firm’s gain from leverage according to the Miller model is
$126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal
tax rate on debt income?
a.
16.4%
b.
18.2%
c.
20.2%
d.
22.5%
e.
25.0%
26. Refer to Exhibit 21.2. According to the MM extension with growth, what is the value of Kitto’s tax
shield?
a.
$156,385
b.
$164,616
c.
$173,280
d.
$182,400
e.
$192,000
27. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s unlevered value?
a.
$1,296,000
b.
$1,440,000
c.
$1,600,000
d.
$1,760,000
e.
$1,936,000
28. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s value of equity?
a.
$1,492,000
b.
$1,529,300
c.
$1,567,533
d.
$1,606,721
e.
$1,646,889
29. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s equity if it is viewed as an
option?
a.
$228.77
b.
$254.19
c.
$282.43
d.
$313.81
e.
$345.19
30. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s debt if its equity is viewed as
an option?
a.
$167.57
b.
$186.19
c.
$204.81
d.
$225.29
e.
$247.82
31. Refer to Exhibit 21.3. What is the yield on Wilson Dover’s debt?
a.
6.04%
b.
6.36%
c.
6.70%
d.
7.05%
e.
7.42%