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Exam 16: Financial Leverage and Capital Structure Policy

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Question 41

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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?

A) .24
B) .29
C) .36
D) .52
E) .71

F) A) and E)
G) C) and E)

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Question 42

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M & M Proposition II with taxes:

A) has the same general implications as M & M Proposition II without taxes.
B) states that a firm's capital structure is irrelevant.
C) supports the argument that business risk is determined by the capital structure decision.
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E) concludes that the capital structure decision is irrelevant to the value of a firm.

F) A) and B)
G) A) and C)

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Question 43

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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?

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.

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.

Which one of the following is a direct bankruptcy cost?

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

Homemade leverage is:

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.

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?

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?

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:

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.

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?

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?

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?

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

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?

The concept of homemade leverage is most associated with:

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?