Chapter 12—Capital Structure
MULTIPLE CHOICE
1. The uncertainty caused by the variability of a firm’s cash flows is called . . .
a.
financial risk
b.
business risk
c.
financial leverage
d.
none of the above
2. Which of the following is considered an indirect cost of bankruptcy?
a.
document printing expenses
b.
professional fees paid to lawyers
c.
loss of key employees
d.
none of the above
3. Which of the following is considered a direct cost of bankruptcy?
a.
diversion of management’s time
b.
constrained capital investment spending
c.
lost sales
d.
none of the above
4. A situation where shareholders refuse financing a “good” investment, because they think that only the
bondholders will benefit will lead to . . .
a.
asset substitution
b.
underinvestment
c.
overinvestment
d.
none of the above
5. The proposition that the market value of the firm is independent of its capital structure is called . . .
a.
M&M proposition I
b.
M&M proposition II
c.
the capital asset pricing model
d.
none of the above
6. What is the value of Bavarian Brew before restructuring? Assume no corporate taxes.
a.
$500,000
b.
$5,000,000
c.
$1,000,000
d.
$3,300,000
7. What is the value of Bavarian Brew before restructuring? Assume a corporate tax rate of 34%.
a.
$5,000,000
b.
$500,000
c.
$3,300,000
d.
$1,000,000
8. What is the value of Bavarian Brew after restructuring. Assume no corporate taxes.
a.
$3,300,000
b.
$5,000,000
c.
$500,000
d.
$1,000,000
9. What is the value of Bavarian Brew after restructuring? Assume corporate taxes of 34%.
a.
$5,000,000
b.
$5,340,000
c.
$3,300,000
d.
$1,000,000
10. What is the present value of Bavarian Brew’s debt tax shield after the restructuring? Assume corporate
taxes of 34%.
a.
$340,000
b.
$1,000,000
c.
$660,000
d.
$0
11. What is Bavarian Brew’s required return on equity before the restructuring. Assume no corporate
taxes.
a.
10%
b.
6%
c.
11%
d.
12%
12. What is the Bavarian Brew’s required return on levered equity after the restructuring?
a.
10.25%
b.
10.92%
c.
6.00%
d.
12.75%
13. What is the value of Bavarian Brew after the restructuring, if the PV of bankruptcy cost is $750,000?
Assume a corporate tax rate of 34%.
a.
$5,000,000
b.
$5,340,000
c.
$4,590,000
d.
$4,250,000
14. Refer to Bavarian Brew. What is the PV of bankruptcy costs for which the company is indifferent
about the proposed change in capital structure?
a.
$450,000
b.
$750,000
c.
$340,000
d.
$275,000
15. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition the
personal tax rate on dividends for investors is 15% and the personal income tax on interest income
equals 40%.
a.
$340,000
b.
$65,000
c.
$150,000
d.
$400,000
16. What is the gain from leverage for Bavarian Brew if the corporate tax rate equals 34%. In addition,
assume that the personal tax rate on interest income equals 40% and that there is no tax on dividend
income.
a.
-$100,000
b.
$100,000
c.
$340,000
d.
-$340,000
17. Refer to Bavarian Brew. If the corporate tax rate equals 34% and dividend income is tax free, at which
personal tax rate on interest income is there no gain from leverage?
a.
34%
b.
40%
c.
15%
d.
0%
18. Refer to Bavarian Brew. If the corporate tax rate equals 34% and the personal tax rate on interest
income equals 40%, for which tax rate on dividend income is the gain from leverage equal to zero?
a.
15.2%
b.
9.1%
c.
12.6%
d.
6.6%
NARRBEGIN: Bavarian Brew EPS
Bavarian Brew EPS
Bavarian Brew, an unlevered firm, has a perpetual EBIT of $500,000. The required return on assets for
the firm’s assets is 10%. The company has 250,000 shares outstanding, trading at $20 per share. The
company is considering raising $1 million in debt with a required return of 6% and would use the
proceeds to repurchase 50,000 shares of outstanding stock.
NARREND
19. Calculate Bavarian Brew’s earnings per share after the restructuring. Assume no corporate taxes.
a.
$2.20
b.
$2.50
c.
$2.00
d.
$2.25
20. What are Bavarian Brew’s earnings per share before the restructuring Assume corporate taxes of 34%
a.
$1.32
b.
$1.35
c.
$1.42
d.
$1.45
21. What are Bavarian Brew’s earnings per share before the restructuring? Assume no corporate taxes.
a.
$2.50
b.
$2.25
c.
$2.00
d.
$1.75
22. What are Bavarian Brew’s earnings per share after the restructuring? Assume corporate taxes of 34%.
a.
$1.32
b.
$1.35
c.
$1.42
d.
$1.45
23. If a company issues $25,000 worth of debt and has a corporate tax rate of 40%, what is the PV of the
debt tax shield?
a.
$25,000
b.
$10,000
c.
$15,000
d.
$20,000
NARRBEGIN: Miller’s Drugstore
Miller’s Drugstore
Miller’s drugstore has an EBIT of $15,000, debt with a market value of $25,000 and a required return
on assets of 12%.
NARREND
24. Assuming no taxes, what is Miller’s Drugstore’s value?
a.
$15,000
b.
$125,000
c.
$25,000
d.
$75,000
25. Assuming a corporate tax rate of 35%, what is Miller’s Drugstore’s value?
a.
$125,000
b.
$25,000
c.
$133,750
d.
$75,000
26. State Company had determined its earnings before interest and taxes (EBIT) in four possible states of
the world. In the Great State, EBIT will be $3,000,000 and in the Good, Normal and Poor States EBIT
will be $2,000,000, $1,500,000, and $1,000,000 in that order. If each state has an equal probability of
occurring, then what is State Company’s expected EBIT?
a.
$3,000,000
b.
$2,500,000
c.
$1,875,000
d.
none of the above
27. If a firm increases its use of financial leverage, then what would we generally expect for the effect of
that increased leverage to have on the dispersion of the firm’s Net Income distribution?
a.
less dispersion
b.
no effect on dispersion
c.
greater dispersion
d.
there is not enough information to determine
28. If a firm increases its financial leverage, then what would we generally expect for the effect of that
increased leverage on EPS to be if the firm’s EPS is already quite high?
a.
EPS would be lower with financial leverage
b.
EPS would always be the same with financial leverage
c.
EPS would be higher with financial leverage
d.
it is not possible to determine
29. If a firm increases its use of financial leverage, then what would we generally expect for the effect of
that increased leverage to have on an EPS that is already very low?
a.
EPS would be lower with financial leverage
b.
EPS would always be the same with financial leverage
c.
EPS would be higher with financial leverage
d.
it is not possible to determine
30. If a firm increases its use of financial leverage, then what would we generally expect for the
shareholders of that firm to
a.
lower their demand for return on their investment.
b.
remain indifferent with respect to their return on investment.
c.
increase their demand for return on their investment.
d.
it is not possible to tell what will happen.
31. Firm X plans to increase its financial leverage by issuing debt and using the proceeds to repurchase
equity. If you assume that the Modigliani and Miller assumptions hold, then the effect of this
increasing financial leverage transaction should
a.
increase the market value of Firm X’s shares.
b.
have no effect on the market value of Firm X’s shares.
c.
decrease the market value of Firm X’s shares.
d.
it is not possible to tell what will happen.
32. Perfect capital markets describe markets without frictions such as
a.
taxes.
b.
trading costs.
c.
problems transferring information between managers and investors.
d.
all of the above.
33. In a world without taxes, distress costs, or agency problems, calculate the value of Lever Co. if its
perpetual EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s
cost of debt is 5% and its required return on firm’s assets is 10%.
a.
$19,800,000
b.
$10,000,000
c.
$9,900,000
d.
none of the above
34. Roy’s Toy, Inc. currently has no debt outstanding. Its current cost of equity is 12% and the current
value of the company is $20,000,000. Roy is proposing to finance 1/4 of its assets with debt at a cost
of 8% per annum. What will be Roy’s cost of levered equity if things go as planned? Ignore any tax
effects.
a.
12.00%
b.
13.00%
c.
13.33%
d.
none of the above
35. Nuclear Widgets has a current cost of levered equity equal to 13%. Its return on assets is 12% and its
cost of debt is 8%. Nuclear Widgets has borrowed a total of $5,000,000. What is the current value of
Nuclear Widgets’ equity? Ignore the effect of taxes.
a.
$1,250,000
b.
$20,000,000
c.
the problem yields a negative number which means the problem is not realistic
d.
not enough information is given
36. A newly appointed CFO of a company tells you that he needs to determine the required return on
unlevered equity should his firm completely deliver. He further tells you that the required return on
assets is 10% and that his cost of debt is 3% based upon a current borrowed amount of $50,000,000
but he doesn’t know the market value of his equity. What is the required return on equity should his
firm eliminate all of its debt?
a.
10.0%
b.
11.5%
c.
13.0%
d.
it is impossible to tell
37. In a world without distress costs or agency problems, calculate the value of Bilever Co. if its perpetual
EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm’s cost of debt
is 5% and its required return on firm’s assets is 10%. Assume that Bilever is in the 30% marginal tax
rate.
a.
$14,000,000
b.
$7,000,000
c.
$5,600,000
d.
none of the above
38. Big Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Big can issue the debt to yield
8% per year, then what is the increase in value to Big if it issues the debt and is subject to a 34%
marginal tax rate?
a.
$136,000
b.
$400,000
c.
$1,700,000
d.
none of the above
39. Large Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Large can issue the debt to
yield 8% per year, then what is the single year increase in cash flow to Large if it issues the debt and is
subject to a 34% marginal tax rate?
a.
$136,000
b.
$400,000
c.
$2,720,000
d.
none of the above
40. If we start with the M&M perfect capital markets assumption and then relax the no tax assumption on
corporations, then we would expect for firms that go from no leverage to some leverage to
a.
have the levered version of the firm at least as valuable as the no-leverage firm.
b.
have the no-leverage version of the firm at least as valuable as the levered firm.
c.
change in value depending upon the level of personal taxes.
d.
none of the above.
41. You need to calculate the gains from using $1,000,000 of additional leverage on the average company
in the U.S. economy. You are told that the average investor’s personal tax rate on income from stock is
15% and that investors can generally avoid personal taxes on income from debt. You are also told that
the average corporation is subject to the 35% marginal corporate tax rate. What is the benefit to firm
value for this additional debt load?
a.
$650,000
b.
$447,500
c.
$350,000
d.
none of the above
42. On–the-Fence Co. (OTF) is considering issuing an additional $5,000,000 perpetual debt. It is subject to
a 35% marginal corporate tax rate but is being told that the costs of financial distress on that additional
debt is $1,000,000. What should OTF do?
a.
Do not issue the debt
b.
Issue the debt
c.
It doesn’t matter what it does as M&M with perfect markets holds
d.
none of the above
43. Costs associated with the requirement that management divert its attention away from strategically
managing a corporation in favor of spending time with financial attorneys could be best described as
a.
direct bankruptcy costs.
b.
indirect bankruptcy costs.
c.
managerial-shareholder related agency costs.
d.
none of the above.
44. Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget
manufacturing plant. Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas.
Which of the following best describes the general problem that Y’s investors must deal with?
a.
The Underinvestment Problem
b.
The Overinvestment Problem
c.
The Asset Substitution Problem
d.
The Enron Problem
45. Lord Brack has recently sold 90% of his company to the general public but he remains the CEO of the
firm. Unfortunately, the Lord prefers to eat $1,000 lunches in the corporate dining room (for which he
does not reimburse the company). What is Lord Brack’s cost of these lunches?
a.
$1,000
b.
$900
c.
$100
d.
none of the above
46. Molotov Cranberry Cocktail Corp finds that the value of the firm is equal to $100,000,000 with no
debt. It knows that if it issues new debt, the value of the tax shield will be $3,000,000 while the value
of the bankruptcy costs, outside agency costs and inside agency costs will be $1,000,000, $2,000,000,
and $4,000,000 in that order. What will the value of Molotov be if it issues the debt?
a.
$0
b.
$96,000,000
c.
$100,000,000
d.
none of the above
47. Fidget Inc. is currently worth $10,000,000. It is told that if it issues $1,000,000 of perpetual debt (and
uses the proceeds to repurchase equity) the value of the firm will increase by $290,000. If the total
bankruptcy costs and agency costs combine to be a cost of $20,000, what is Fidget’s marginal
corporate tax rate? Ignore personal taxes.
a.
29%
b.
30%
c.
31%
d.
none of the above
48. You are evaluating a company and have found a new way to calculate the present value of bankruptcy
costs, agency costs of outside equity as well as debt. You find that the agency costs of outside equity is
$100 while the agency cost of outside debt is $1,000,000. The costs of bankruptcy are also $1,000,000.
What type of firm does most likely describe?
a.
a firm with too little leverage
b.
a firm with too much leverage
c.
a firm with too much equity
d.
a firm that should disregard its agency costs
49. If you were to look at leverage for companies in a country where there is a very high cost of attorneys
and accountants, all other things being equal you would expect
a.
that firms in those countries would utilized less leverage than in other countries.
b.
that firms in those countries would utilized more leverage than in other countries.
c.
that firms in those countries would utilize no leverage.
d.
that firms in those countries would utilize as much leverage as is mathematically possible.
50. DebtCo. has $100,000,000 of perpetual debt outstanding with a cost of 9%. DebtCo. is currently
subject to a 30% marginal tax rate. If a new president is elected who surprisingly announces that firms
like DebtCo. will now be subject to a 35% marginal tax rate, what should be the effect of the
immediate value change on DebtCo.?
a.
-$35,000,000
b.
-$5,000,000
c.
$5,000,000
d.
$35,000,000
NARRBEGIN: Kennesaw Steel Corp.
Kennesaw Steel Corporation
As Chief Financial Officer of the Kennesaw Steel Corporation (KSC), you are considering a
recapitalization plan that would convert KSC from its current all-equity capital structure to one
including substantial financial leverage. KSC now has 100,000 shares of common stock outstanding,
which are selling for $50.00 each, and the recapitalization proposal is to issue $2,000,000 worth of
long-term debt at an interest rate of 8.0 percent and use the proceeds to repurchase $2,000,000 of
common stock.
NARREND
51. Refer to Kennesaw Steel Corporation. What is the new debt-to-equity ratio if the recapitalization is
completed? (assume that the stock can be repurchased at $50 per share)
a.
1.50
b.
1.00
c.
0.67
d.
0.33
52. Refer to Kennesaw Steel Corporation. How many shares will be left outstanding after the
re-capitalization? (assume that the stock can be repurchased at $50 per share)
a.
60,000
b.
50,000
c.
45,000
d.
40,000
53. Refer to Kennesaw Steel Corporation. The tax rate is 40%. What level of EBIT will earnings per share
equal zero for shareholders under the new capital structure? (assume that the stock can be repurchased
at $50 per share)
a.
$0
b.
$60,000
c.
$120,000
d.
$160,000
54. Refer to Kennesaw Steel Corporation. The tax rate is 40%. At what level of EBIT will earnings per
share be equal for shareholders under each capital structure? (assume that the stock can be repurchased
at $50 per share)
a.
$350,000
b.
$400,000
c.
$450,000
d.
$500,000