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Exam 16: Financial Leverage and Capital Structure Policy

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Question 191

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Which of the following is the best definition of financial risk?

A) A legal proceeding for liquidating or reorganizing a business. Also, the transfer of some or all of a firm's assets to its creditors.
B) The direct and indirect costs associated with going bankrupt or experiencing financial distress.
C) The equity risk that comes from the financial policy (i.e., capital structure) of the firm.
D) The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed.
E) The difficulties of running a business that is experiencing financial distress.

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Question 192

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In relation to M&M Proposition II with no taxes, financial risk determines the return on assets.

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Question 193

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The equity beta of a firm depends on the firm's business risk and its financial policy.

Jageman Athletic Apparel has a debt-equity ratio of .4 and earnings before interest and taxes (EBIT) of $265,000. The break-even level of EBIT is $338,000. Based on this information, you know the:

Draw the following two graphs, one above the In the top graph, plot firm value on the vertical axis and total debt on the horizontal. Use the graph to illustrate the value of a firm under M&M without taxes, M&M with taxes, and the static theory of capital structure. On the lower graph, plot the WACC on the vertical axis and the debt/equity ratio on the horizontal axis. Use the graph to illustrate the value of the firm's WACC under M&M without taxes, M&M with taxes, and the static theory. Briefly explain what the two graphs tell us about firm value and its cost of capital under the three different theories.

The Coffee Shop has expected earnings before interest and taxes of $14,600, an unlevered cost of capital of 12%, and debt with both a book and face value of $18,000. The debt has an annual 8.25% Coupon. The tax rate is 35%. What is the value of the firm?

Jemison Foods has 6,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax Rate is 35%?

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called the:

Provide a definition of direct bankruptcy costs.

The actual value of a firm with debt is generally greater than the value of a firm without debt.

A large depreciation tax deduction will tend to diminish the benefit of the interest tax shield.

You have computed the break-even point between a capital structure that has no debt and one that has debt. Assume there are no taxes. At the break-even level, the:

Abcois an all equity firm with 32,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $92,000. Abco has decided to add leverage To its financial operations by issuing $220,000 of debt at a 9% rate of interest. The debt will be used To repurchase shares of stock. You own 600 shares of Abco stock. You also lend out funds at a 9% Rate of interest. How many shares of Abco stock must you sell to offset the leverage that Abco is Assuming? Assume you lend out all of the funds you receive from the sale of stock.

The capital structure chosen by a firm doesn't really matter because of:

A sizeable increase in taxable income will tend to diminish the benefit of the interest tax shield.

The extent to which a firm relies on debt is referred to as:

Your firm has a debt-equity ratio of .60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and Equity?

The unlevered cost of capital for Red Ryder, Inc. is 12%. Pretax debt costs are 8%. Assuming a debt equity ratio of 0.33, what is the cost of equity? The tax rate is 34%.

Provide a definition of reorganization.

A capital restructuring occurs when a firm: