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Exam 16: Financial Leverage and Capital Structure Policy

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Question 1

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A firm has debt of $12,000,a leveraged value of $26,400,a pre-tax cost of debt of 9.20 percent,a cost of equity of 17.6 percent,and a tax rate of 37 percent.What is the firm's weighted average cost of capital?

A) 11.47 percent
B) 11.52 percent
C) 11.69 percent
D) 12.23 percent
E) 12.48 percent

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Question 2

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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:

A) the static theory of capital structure.
B) M & M Proposition I.
C) M & M Proposition II.
D) the capital asset pricing model.
E) the open markets theorem.

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Question 3

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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?

You have computed the break-even point between a levered and an unlevered capital structure.Assume there are no taxes.At the break-even level,the:

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized?

The concept of homemade leverage is most associated with:

Galaxy Products is comparing two different capital structures,an all-equity plan (Plan I) and a levered plan (Plan II) .Under Plan I,Galaxy would have 178,500 shares of stock outstanding.Under Plan II,there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding.The interest rate on the debt is 10 percent and there are no taxes.What is the breakeven EBIT?

Douglass & Frank has a debt-equity ratio of 0.35.The pre-tax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent.What is the cost of equity if the tax rate is 39 percent?

By definition,which of the following costs are included in the term "financial distress costs"? I.direct bankruptcy costs II.indirect bankruptcy costs III.direct costs related to being financially distressed,but not bankrupt IV.indirect costs related to being financially distressed,but not bankrupt

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:

New Schools,Inc.expects an EBIT of $7,000 every year forever.The firm currently has no debt,and its cost of equity is 15 percent.The firm can borrow at 8 percent and the corporate tax rate is 34 percent.What will the value of the firm be if it converts to 50 percent debt?

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?

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?

The absolute priority rule determines:

Jessica invested in Quantro stock when the firm was unlevered.Since then,Quantro has changed its capital structure and now has a debt-equity ratio of 0.30.To unlever her position,Jessica needs to:

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Draw the following two graphs,one above the other: In the top graph,plot firm value on the vertical axis and total debt on the horizontal axis.Use this 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 this second 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 reveal about firm value and its cost of capital under the three different theories.

Exports Unlimited is an unlevered firm with an aftertax net income of $52,300.The unlevered cost of capital is 14.1 percent and the tax rate is 36 percent.What is the value of this firm?

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share.The current cost of equity is 15.4 percent and the tax rate is 34 percent.The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure.The debt will be sold at par value.What is the levered value of the equity?

Pete is the CFO of Dexter International.He would like to increase the debt-equity ratio of the firm but is concerned that the firm's shareholders may not be willing to accept additional financial leverage.Pete has come to you for advice.What is your recommendation?