Chapter 16 - Financial Leverage and Capital Structure Policy

Chapter 16 - Financial Leverage and Capital Structure Policy
Chapter 16
Financial Leverage and Capital Structure Policy
True / False Questions
1. All else equal, higher financial leverage decreases a firm's break-even EBIT.
2. Business risk declines as the systematic risk of a firm's assets increases.
3. Business risk is a positive function of the systematic risk of a firm's assets.
4. Ignoring financial distress costs, borrowing money decreases the value of the firm by
increasing the firm's tax liability.
5. Suppose we wish to draw a graph illustrating M&M Proposition II. Let the vertical
axisrepresent the cost of capital and the firm's debt-to-equity ratio represents the horizontal
axis. If the line representing the firm's WACC has a negative slope, we must be incorporating
taxes into the analysis.
6. Direct bankruptcy costs are those costs that are directly associated with bankruptcy, such as
legal and administrative costs.
7. Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a
financially distressed firm.
8. It has been observed that, when firms get into financial trouble, they often find it difficult to
attract and retain high-quality employees. The additional costs incurred in this situation would
be considered direct bankruptcy costs.
9. When a firm files for bankruptcy, the firm often must hire appraisers to determine the fair
value of the firm's assets. This is an example of a direct cost of bankruptcy.
10. According to the static theory of capital structure, value-maximizing financial managers
will borrow to the point where the firm's business risk is just equal to its financial risk.
11. If the static theory of capital structure is true, then the optimal level of debt for a given
firm increases as its marginal tax rate increases and decreases as the costs of financial distress
increase.
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12. In order to avoid bankruptcy, management sometimes seeks to work with creditors. One
method of restructuring debt involves composition, which involves a reduction in the amount
of the payment to be made.
Multiple Choice Questions
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13. The use of personal borrowing to change the overall amount of financial leverage to
which the individual is exposed is called:
A. Homemade leverage.
B. Dividend recapture.
C. The weighted average cost of capital.
D. Private debt placement.
E. A privileged subscription offer.
14. The proposition that the value of the firm is independent of its capital structure is called:
A. The Capital Asset Pricing Model.
B. M&M Proposition I (without taxes).
C. M&M Proposition II.
D. The Law of One Price.
E. The Efficient Markets Hypothesis.
15. The proposition that the cost of equity is a positive linear function of capital structure is
called:
A. The Capital Asset Pricing Model.
B. M&M Proposition I.
D. The Law of One Price.
E. The Efficient Markets Hypothesis.
16. The equity risk derived from the firm's operating activities is called ____________ risk.
A. market
B. systematic
C. extrinsic
D. business
E. financial
17. The equity risk derived from the firm's capital structure policy is called ___________
risk.
A. market
B. systematic
C. extrinsic
D. business
E. financial
18. The tax savings of the firm derived from the deductibility of interest expense is called
the:
A. Interest tax shield.
B. Depreciable basis.
C. Financing umbrella.
D. Current yield.
E. Tax-loss carry-forward savings.
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19. The unlevered cost of capital is _________________.
A. the cost of capital for a firm with no equity in its capital structure
B. the cost of capital for a firm with no debt in its capital structure
C. the interest tax shield times pretax net income
D. the cost of preferred stock for a firm with equal parts debt and common stock in its capital
structure
E. equal to the profit margin for a firm with some debt in its capital structure
20. The explicit costs associated with corporate default, such as legal expenses, are the
________ of the firm.
A. flotation costs
B. default beta coefficients
C. direct bankruptcy costs
D. indirect bankruptcy costs
E. default risk premium
21. The implicit costs associated with corporate default, such as lost sales, are the
__________ of the firm.
A. flotation costs
E. default risk premium
22. The explicit and implicit costs associated with corporate default are the ___________ of
the firm.
A. flotation costs
E. financial distress costs
23. 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:
A. Static Theory of Capital Structure.
B. M&M Proposition I.
D. Capital Asset Pricing Model.
E. Open Markets Theorem.
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28. A capital restructuring occurs when a firm:
A. Increases its debt-equity ratio while maintaining a constant debt-to-asset ratio.
B. Changes its debt-equity ratio without changing its total assets.
C. Reduces both its debt and its equity while maintaining a constant debt-equity ratio.
D. Changes its level of debt without changing its total equity.
E. Refinances its debt at a lower rate of interest.
29. The extent to which a firm relies on debt is referred to as:

B. The target ratio.
C. Business leverage.
D. Proposition I.
E. Financial leverage.
30. The weighted average cost of capital can also be defined as the:
A. Market weighted cost of equity financing.
B. Rate of return based on net book value.
C. Adjusted homemade leverage rate of return.
D. Required return on a firm's overall assets.
E. Basis of M&M Proposition
31. The cost of equity capital, based on M&M Proposition II, can be defined as:
A. RE = RD + (RA - RD) (D/E).
B. RE = RA + (RA - RD) (E/D).
C. RE = RA + (RA - RD) (D/E).
D. RE = RA + (RD - RA) (E/D).
E. RE = RD - (RD - RA) (D/E).
32. The theory that a change in the capital structure weights is exactly offset by the change in
the cost of equity is known as:
B. Financial leverage.
C. The targeted capital structure theory.
D. M&M Proposition I.
E. M&M Proposition II.
33. The fact that individual investors can alter the amount of financial leverage to which they
are exposed is referred to as:
A. Capital structure targeting.
B. Adjusting the business risk.
C. The static theory of capital structure.
D. Homemade leverage.
E. M&M Proposition II.
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34. The static theory of capital structure states that firms borrow up to the point where the tax
benefit of one additional dollar of debt is equal to the marginal cost of:
A. Sales.
B. Equity.
C. Financial distress.
D. Leverage.
E. Financial capital.
35. The option of keeping a financially distressed firm as an operating concern is called a(n):
A. Liquidation.
B. Reorganization.
C. Acquisition.
D. Merger.
E. Technical solvency.
36. The procedure for liquidating a corporation is outlined in:

A. The Bankruptcy and Insolvency Act.
B. The BNA Act.
C. The Canadian Constitution.
D. The Corporation Liquidation Act.
E. The Small Business Reform Act.
37. The absolute priority rule establishes the order in which:

A. Claims are paid in a bankruptcy proceeding.
B. Firms are liquidated by the bankruptcy courts.
C. Reorganization events must occur.
D. Bankruptcy cases are heard by the courts.
E. Judges are assigned to bankruptcy cases
38. Which of the following is true about the WACC?

A. The WACC is the appropriate discount rate for all new projects of the firm.
B. The optimal capital structure is the one that maximizes the WACC.
C. The value of the firm will be maximized when the WACC is minimized.
D. The WACC is virtually impossible to calculate for a firm with multiple divisions.
E. Since discount rates and firm value move in the same direction, minimizing the WACC will
minimize the value of the firm.39. When choosing a capital structure, the objective of the firm
should be to:
A. Choose the one that maximizes the current value of the firm's bonds.
B. Choose the one that minimizes the value of the firm.
C. Choose the one that minimizes the firm's WACC.
D. Choose the one that results in the largest interest tax shield.
E. Choose any capital structure since it is always irrelevant.
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40. The optimal capital structure is the mixture of debt and equity which:
I. Maximizes the value of the firm.

II. Minimizes the firm's weighted average cost of capital.
III. Maximizes the market price of the firm's bonds.
A. I only
B. III only
C. I and II only
D. I and III only
E. I, II, and III
41. Which of the following is NOT accurate regarding financial leverage?

A. Whenever a firm's debt increases faster than its equity, financial leverage increases.
B. Leverage is most beneficial when EBIT is relatively high.
C. Investors can undo the effects of the firm's capital structure by using homemade leverage.
D. Increasing financial leverage will always increase the EPS for stockholders.
E. The level of financial leverage that produces the highest firm value is the one most
beneficial to stockholders.
42. All else the same, the financial leverage of a firm will _________________.
A. decrease as the debt/equity ratio increases
B. decrease as the firm's retained earnings account grows
C. increase by the amount of equity it issues in a given year
D. decrease if the firm has negative net income
E. decrease as the firm uses debt to fund expansion projects
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43. Suppose you work for the CFO of Danforth, Inc. He believes sales and operating income
will be sharply higher each year for the foreseeable future. If he seeks to maximize earnings
per share, he should _____________. (Assume there are no taxes.)
A. increase the firm's debt to equity ratio
B. increase the firm's debt to equity ratio if the firm's EBIT will remain below the break-even
(comparing levered to unlevered) level of EBIT
C. decrease the firm's debt to equity ratio
D. not change the firm's debt to equity ratio
E. decrease the firm's debt to equity ratio if the firm's EBIT will remain below the break-even
(comparing levered to unlevered) level of EBIT
44. Which of the following statements is/are true regarding corporate borrowing when EBIT
is positive?
I. Increasing financial leverage increases the sensitivity of EPS and ROE to changes in EBIT
II. The effect of financial leverage depends on the company's EBIT, that is, leverage is
unfavourable when EBIT is relatively high, and leverage is favourable when EBIT is
relatively low
III. High leverage decreases the returns to shareholders (as measured by ROE)
A. I only
B. II only
C. III only
D. I and II only
E. I, II, and III
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45. Which of the following statements regarding leverage is false?

A. The ultimate effect of leverage depends on the firm's EBIT.
B. If things go poorly for the firm, increased leverage provides greater returns to shareholders
(as measured by ROE and EPS).
C. As a firm levers up, shareholders are exposed to greater risk.
D. The benefits of leverage will not be as great in a firm with substantial accumulated losses
or other types of tax shields compared to a firm without many tax shields.
E. Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.
46. Below the break-even EBIT, increased financial leverage will _______ EPS, all else the
same. Assume there are no taxes.
A. increase
B. decrease
C. not affect
D. either increase or decrease
E. increase EBIT but decrease
47. All else the same, which of the following claims on the cash flows of the firm will tend to
increase with decreases in the debt/equity ratio?
I. Taxes
II. Bankruptcy costs
III. Stockholder claims
IV. Bondholder claims
A. I and III only
B. I and IV only
C. II and IV only
D. I, II, and III only
E. I, II, and IV only
48. Which of the following statements is correct?

A. Decisions regarding a firm's debt and equity can be called capital budgeting decisions
B. The asset beta is a measure of the unsystematic risk of a firm's assets
C. In a purely capital restructuring, the composition of the assets of the firm will change
D. The value of the overall firm will not change as a result of a capital restructuring unless the
NPV of the restructuring is negative
E. The use of personal leverage by an investor to alter the degree of financial leverage of a
firm is called homemade leverage
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49. According to _________, the value of the firm is independent of its capital structure.
A. M&M Proposition I without taxes
B. M&M Proposition I with taxes
C. the static theory of capital structure
D. M&M Proposition II without taxes
E. M&M Proposition II with taxes
50. The cost of debt is generally lower than the cost of equity; however, according to
__________, replacing equity with debt will not change the value of the firm because the
savings attributable to the lower cost of debt financing will be offset by the higher required
return on the remaining equity.
A. M&M Proposition I with taxes
B. M&M Proposition I without taxes
51. _____________ implies that the firm should issue as much debt as possible.
52. According to M&M Proposition II without taxes, a firm's cost of equity is a function of
which of the following factors?
I. The required rate of return on the firm's assets

II. The firm's debt/equity ratio
III. The firm's cost of debt
A. II only
B. I and II only
C. I and III only
D. II and III only
E. I, II, and III
53. Assume there are no corporate or personal taxes. According to M&M Proposition:
A. I, the total value of the firm depends on how cash flows are divided up between
stockholders and bondholders.
B. I, a firm's capital structure is relevant.
C. II, the cost of equity rises as the firm increases its use of debt financing.
D. II, the cost of equity depends on the firm's business risk but not its financial risk.
E. I and II, as debt increases, the increase in the cost of equity is more than offset by the lower
cost of debt and the WACC falls.
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54. Assume there are no personal or corporate income taxes and that the firm's WACC is
unaffected by its capital structure. Which of the following is true?
I. A firm's cost of equity depends on the firm's business and financial risks.
II. The value of the firm is dependent on its capital structure.
III. The cost of equity increases as the firm's leverage decreases.
A. I only
B. II only
C. III only
D. I and III only
E. II and III only
55. Which of the following is true concerning the rate of return earned on shares of a levered
firm in terms of the possible range of earnings? There are no taxes.
A. The returns do not differ from those of an unlevered firm.
B. The returns are greater than for an unlevered firm on the upside and equal on the downside.
C. The returns are the same as for an unlevered firm on the upside and lower on the downside.
D. The returns are greater than for an unlevered firm on the upside and lower on the
downside.
E. The returns are the same as for an unlevered firm on the upside and greater on the
downside.
56. The equity beta of a firm depends on which of the following?
I. The firm's business risk.

II. The firm's financial policy.
III. The firm's advertising policy.
A. I and II only
B. III only
C. I and III only
D. II and III only
E. I, II, and III
57. A firm's systematic risk will ____________ as its debt/equity ratio __________.
A. increase; increases
B. decrease; increases
C. remain unchanged; decreases
D. remain unchanged; increases
E. first increase, and then decrease; increases
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58. __________ arises from decisions that affect the left-hand side of the statement of
financial position, while ________________ arises from decisions that affect the right-hand
side of the statement of financial position.
A. Systematic risk; financial risk
B. Business risk; financial risk
C. Unsystematic risk; systematic risk
D. Business risk; diversifiable risk
E. Systematic risk; unsystematic risk
59. Which of the following correctly completes this sentence: All else the same,
_____________.
A. the business risk of a firm increases when it takes on a risky project
B. the business risk of a firm increases when it takes on more debt
C. the financial risk of a firm decreases when it takes on a risky project
D. the financial risk of a firm increases when it takes on more equity
E. the higher the business risk for a firm, the higher the financial risk as well
60. All else the same, which of the following is true about the interest tax shield of a firm with
positive EBIT?
A. The higher the corporate tax rate, the less valuable the interest tax shield.
B. If the firm dramatically increases its depreciation expense, it may have more of a need for
an interest tax shield.
C. The interest tax shield becomes more valuable as the size of the debt load increases.
D. The interest tax shield increases as a firm reduces its level of outstanding debt.
E. Since the interest tax shield is valuable, the firm would rather pay a high coupon rate on its
bonds than a low coupon rate.
61. According to ___________, a firm's cost of equity increases with greater debt financing,
but the WACC remains unchanged.
62. According to ___________, a firm's cost of equity increases with greater debt financing,
and the WACC decreases.
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63. Which of the following correctly completes the following: M&M I with taxes shows
___________________.
A. the value of an unlevered firm exceeds the value of a levered firm by the present value of
the interest tax shield
B. a levered firm can increase its value by reducing debt
C. the optimal amount of leverage for a firm is not possible to determine
D. the value of a levered firm is equal to its after-tax EBIT discounted by the unlevered cost
of capital
E. there is a linear relationship between the amount of debt in a levered firm and its value
64. A firm that is approaching bankruptcy will find that

A. stockholders will try to push the firm into bankruptcy as rapidly as possible
B. bondholders will attempt to push the firm into bankruptcy to prevent their position from
deteriorating
C. stockholders will seek to protect the value of the assets of the firm as much as possible
D. direct bankruptcy costs such as filing fees will tend to diminish
E. indirect bankruptcy costs such as opportunity costs will tend to decrease
65. Which of the following is NOT true about bankruptcy and its costs?
A. As the debt/equity ratio falls, the probability that a firm will be able to meet the promised
payments on bonds decreases.
B. If a firm is economically bankrupt, then an ensuing legal bankruptcy will likely result in
the bondholders receiving less than what they are owed.
C. The amount of debt a firm can raise decreases as the probability of bankruptcy increases.
D. A firm is economically bankrupt when the value of its assets is less than the value of its
debt.
E. Direct bankruptcy costs are a disincentive to debt financing.
66. Which of the following would be considered an indirect bankruptcy cost?

A. The cost of the extra insurance the bankruptcy court requires the firm to carry on its assets.
B. The cost the firm must pay to the court when filing its bankruptcy petition.
C. The cost of the appraisals a firm must obtain on its assets by order of the bankruptcy court.
D. The fee the firm pays its lawyer to draw up the bankruptcy petition.
E. The cost to the firm of projects in-progress terminated in order to preserve cash.
67. When the value of a firm's assets exactly equals the value of its debt, the firm:
A. Is economically bankrupt.
B. Is technically insolvent.
C. Is legally bankrupt.
D. Is in liquidation.
E. Is in default.
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68. According to __________, a firm's cost of equity increases with greater debt financing,
while the WACC first decreases and then increases.
69. According to the static theory of capital structure, ____________________.

A. a firm's choice of assets and operations is fixed for all time
B. a firm will borrow up to the point where the benefit from an extra dollar of debt is just
equal to the tax benefit associated with that debt
C. the value of the firm will differ from the M&M value without taxes by the gain from
leverage
D. the optimal WACC is the same as it is in M&M with taxes
E. the value of the firm in M&M with taxes is overstated by the amount of financial distress
costs
70. Of the following, all are conclusions that can be drawn from the capital structure puzzle
EXCEPT:
A. In the framework of the static theory of capital structure, a firm can precisely identify its
optimal capital structure.
B. Firms with tax shields from other sources such as depreciation will benefit less from
leverage.
C. Firms in lower tax brackets will tend to benefit less from increases in financial leverage.
D. The financial structure that minimizes WACC is the one that will maximize the value of
the firm.
E. All else the same, firms with tangible, liquid assets will have an incentive to borrow more.
71. Which of the following individuals has NOT acquired a marketed claim against RDJ,
Inc.?
A. John purchased 250 shares of RDJ common stock.
B. Tom acquired rights allowing him to purchase 50 shares of RDJ common stock.
C. First State Bank wrote an unsecured loan to RDJ.
D. Susan purchased 200 shares of RDJ preferred stock.
E. Jim purchased a long-term bond issued by RDJ.
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72. Which of the following statements is/are true regarding observed capital structures?
I. There appears to be some connection between operating characteristics and capital structure
II. D/E ratios are significantly higher today than they were in the 1960s.
III. It appears that, for whatever reason, capital structures vary quite a bit across differing
industry groups
A. I only
B. III only
C. I and III only
D. I and II only
E. I, II, and III
73. In a(n) ______________ a business is liquidated, usually at a loss for the creditors.
A. violation of protective covenants
B. legal bankruptcy
C. technical insolvency
D. accounting insolvency
E. business failure
74. If a firm fails to make the required interest payments on its long-term bonds, it is said to
be in:
A. Business failure.
B. Accounting failure.
C. Accounting insolvency.
D. Technical insolvency.
E. Economic failure.
75. When a firm defaults on a legal obligation, ___________.

A. it is called a business failure
B. the firm is in legal bankruptcy
C. the firm is in technical insolvency
D. the firm is in accounting insolvency
E. the firm is in violation of protective covenants
76. Of the following, __________ does NOT necessarily indicate financial distress.
A. business failure
B. legal bankruptcy
C. technical insolvency
D. accounting insolvency
E. an involuntary bankruptcy petition
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77. You are a secured creditor in a bankruptcy liquidation. Listed below, in chronological
order, are the steps in the bankruptcy proceeding. Just prior to which step would you expect to
have to document the strength of your claim on the firm's assets?
A. The corporation files a bankruptcy petition
B. A trustee in bankruptcy is elected
C. Assets are liquidated and bankruptcy administration costs are paid
D. The proceeds are distributed among creditors
E. Residual payments are made to shareholders
78. Which of the following describes a correct priority of claims in a bankruptcy liquidation?
A. Wages, government tax claims, consumer claims, preferred stockholders
B. Government tax claims, bankruptcy expenses, unsecured creditors, preferred stockholders
C. Bankruptcy expenses, consumer claims, unsecured creditors, government tax claims
D. Government tax claims, unsecured creditors, preferred stockholders, bankruptcy expenses
E. Bankruptcy expenses, wages, unsecured creditors, preferred stockholders
79. Which of the following DOES not correctly rank the priority of claims of the parties to a
corporate bankruptcy? (Rank from strongest to weakest. )
A. Wages and salaries; consumer claims; unsecured creditors
B. Contributions to employee benefit plans; consumer claims; common stockholders
C. Government tax claims; preferred stockholders; unsecured creditors
D. Bankruptcy-related administrative expenses; wages and salaries; common stockholders
E. Wages and salaries; consumer claims; preferred stockholder
80. Which of the following is true regarding bankruptcy?

A. Liquidation frequently is converted into a reorganization.
B. In a prepack, creditors agree to a reorganization plan prior to the bankruptcy filing.
C. Firms cannot file bankruptcy to escape long-term leases on closed stores.
D. Creditors of the firm may not initiate bankruptcy proceedings.
E. A party other than the current firm management must take control of the firm before it
comes out of bankruptcy.
81. Which of the following are true when a firm is operating at its target capital structure
point?
I. The WACC is at its minimum point.

II. The debt-equity ratio is equal to 1.
III. Shareholder value is maximized.
IV. The total value of the firm is maximized.
A. I and IV only
B. II and III only
C. I and III only
D. I, III, and IV only
E. I, II, III, and IV
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82. The value of a restructuring is equal to the net present value of the:
A. Resulting change in the total value of the firm.
B. Additional debt incurred minus the additional interest expense.
C. Debt outstanding minus the market value of the equity.
D. Net change in the total debt outstanding.
E. Change in the shareholders' value minus the additional interest expense incurred.
83. Firm A has a debt-equity ratio of .5. Firm B has a debt-equity ratio of .8. All other features
of these firms are identical. The return on equity of Firm A is:
A. Equally as volatile as the return of equity of Firm B.
B. Less volatile than the return on equity of Firm B.
C. More volatile than the return on equity of Firm B.
D. Unaffected by the debt-equity ratio.
84. Which one of the following statements concerning financial leverage is correct in a world
without taxes?
A. Leverage is beneficial only when EBIT is relatively low.
B. EPS is decreased when leverage is used and the expected level of EBIT is achieved.
C. Financial leverage lowers the risk level of a firm.
D. The amount of financial leverage employed has a major effect on the value of the firm.
E. M&M Proposition I states that financial leverage is irrelevant to the value of a firm.
85. In a world without taxes, M&M Proposition I contends that:

A. The cost of equity is dependent upon the debt-ratio of the firm.
B. A firm's cost of equity varies with its cost of debt.
C. The total value of the firm remains constant regardless of the debt-equity mixture applied.
D. A firm's WACC also determines its cost of equity.
E. The cost of capital is a linear function with a positive slope.
86. Which of the following apply to levered firms but not to unlevered firms?
I. Financial risk
II. Systematic risk
III. Business risk
IV. Interest tax shield
A. I only
B. I and IV only
C. II and III only
D. II, III, and IV only
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87. M&M Proposition I with taxes states that the:
A. Debt-equity ratio does not affect the total value of a firm.
B. Cost of equity financing increases as the debt-equity ratio rises.
C. Value of a levered firm is equal to the present value of the interest tax shield plus the value
of an unlevered firm.
D. Required return on assets is determined by the level of financial risk.
E. Return on equity is dependent upon the marginal tax rate and the debt-equity ratio.
88. Which one of the following statements is true?

A. The total value of a firm decreases as debt is initially added to an all equity firm, if taxes
are considered.
B. The tax shield applies to both debt and equity financing.
C. The ideal capital structure minimizes the total tax liability.
D. Capital structure does matter when taxes are included.
E. The general conclusions of M&M Proposition II do not hold when taxes are considered.
89. Individual investors who lend out part of their personal funds are in fact:
A. Offsetting part of the financial leverage of their investments.
B. Eliminating the business risk of their investments.
C. Increasing their total financial leverage.
D. Increasing their benefits from the interest tax shield.
E. Leveraging their investments.
90. Firm A is levered. Firm B is unlevered. In all other aspects, Firms A and B are identical.
There is no depreciation expense. Considering taxes, Firm A will have _____ net income and
_____ cash flow from operations than will Firm B.
A. The same; the same
B. Lower; lower
C. Lower; higher
D. Higher; lower
E. Higher; higher
91. Which of the following are indirect costs of bankruptcy?
I. Loss of key employees

II. Foregone profitable projects due to debt restrictions
III. Loss created by sale of assets which was required to improve liquidity
IV. Accounting and legal fees incurred in the bankruptcy process
A. I and III only
B. I, II, and III only
C. I, III, and IV only
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92. Which one of the following groups is most apt to push a company towards filing
bankruptcy once the firm becomes financially distressed?
A. Executives
B. Employees
C. Stockholders
D. Secured bondholders
E. Suppliers
93. The cost of bankruptcy:

A. Includes only the direct costs associated with the actual bankruptcy filing.
B. At least partially offsets the benefits of the interest tax shield.
C. Is minimal due to the regulated processes that have been established under the Bankruptcy
and Insolvency Act.
D. Is not affected by the level of the debt-equity ratio.
E. Ignores all opportunity costs.
94. Shareholders generally prefer that a distressed firm:

A. Undergo reorganization under the Bankruptcy and Insolvency Act because the common
stock generally recoups its value.
B. Undergo liquidation under the Bankruptcy and Insolvency Act because they have first
priority over the firm's assets.
C. Undergo reconstitution under the Bankruptcy and Insolvency Act because that option
usually minimizes shareholder loss.
D. Not declare bankruptcy because they are generally required to convert their shares into
debt securities.
E. Not declare bankruptcy since the common shares are often rendered worthless.
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95. The optimal firm value is achieved when the:

A. Present value of the bankruptcy cost is minimized.
B. The interest tax shield on debt is maximized.
C. Weighted average cost of capital is minimized.
D. Debt-equity ratio is maximized.
E. Total net gain from leverage is equal to zero.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Type: Concepts
96. Which of the following statements concerning the actual value of a firm are correct?
I. The actual firm value is equal to the M&M Proposition I with tax value minus the financial
distress costs.
II. The actual value of a firm is equal to the value of the firm with no debt plus the present
value of the tax shield on debt minus the financial distress costs.
III. The actual value of a firm with debt is generally greater than the value of a firm without
debt.
IV. The maximum value of a firm is at the point where the additional gain from leverage is
just offset by the additional financial distress cost.
A. II and III only
B. II and IV only
C. I and IV only
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Type: Concepts
16-21
97. The interest tax shield has more value when the amount of debt is _____ and the tax rate
is _____.
A. Low; zero.
B. Low; high.
C. High; zero.
D. High; high.
E. Low; low.
Difficulty: Basic
Type: Concepts
98. Which of the following will affect the optimal level of debt for a firm?
I. Tax rate
II. Volatility of earnings
III. Nature of assets
IV. Accumulated tax losses
A. I and II only
B. I and IV only
C. I, II, and III only
D. I, III, and IV only
Type: Concepts
16-22
99. According to the absolute priority rule, which one of the following represents the correct
order of distributions in liquidation, starting with the highest priority first?
I. Employee wages
II. Government taxes
III. Administrative expenses of the bankruptcy
IV. Unsecured creditors
A. I, III, IV, II
B. II, III, I, IV
C. III, II, I, IV
D. III, I, II, IV
E. III, II, IV, I
Learning Objective: 16-03 The essentials of the bankruptcy process.
Type: Concepts
100. The financial management goal as it pertains to the capital structure of a firm is to
operate at the point where the debt-equity mix:
A. Creates the largest tax shield for the firm.
B. Maximizes the financial distress costs.
C. Maximizes the value of the firm
D. Minimizes the potential bankruptcy costs.
E. Minimizes the yield-to-maturity on debt.
Type: Concepts
101. The proposition that the value of the firm is independent of its capital structure is called:
A. the capital asset pricing model.
D. the law of one price.
E. the efficient markets hypothesis.
Difficulty: Basic
Type: Definitions
16-23
102. The equity risk derived from a firm's operating activities is called _____ risk.
A. market
B. systematic
C. extrinsic
D. business
E. financial
Difficulty: Basic
Type: Definitions
103. The equity risk derived from a firm's capital structure policy is called _____ risk.
A. market
B. systematic
C. extrinsic
D. business
E. financial
Difficulty: Basic
Type: Definitions
104. The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as
_____ costs.
A. flotation
B. direct bankruptcy
C. indirect bankruptcy
D. financial solvency
E. capital structure
Difficulty: Basic
Type: Definitions
16-24
105. The legal proceeding for liquidating or reorganizing a firm operating in default is called
a
A. tender offer.
B. bankruptcy.
C. merger.
D. takeover.
E. proxy fight.
Difficulty: Basic
Type: Definitions
106. A firm should select the capital structure which:

A. produces the highest cost of capital.
B. maximizes the value of the firm.
C. minimizes taxes.
D. is fully unlevered.
E. has no debt.
Difficulty: Basic
Type: Concepts
107. The value of a firm is maximized when the:

A. cost of equity is maximized.
B. tax rate is zero.
C. levered cost of capital is maximized.
D. weighted average cost of capital is minimized.
E. debt-equity ratio is minimized.
Difficulty: Basic
Type: Concepts
16-25
108. The optimal capital structure has been achieved when the:
A. debt-equity ratio is equal to 1.
B. weight of equity is equal to the weight of debt.
C. cost of equity is maximized given a pre-tax cost of debt.
D. debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E. debt-equity ratio selected results in the lowest possible weighed average cost of capital.
Difficulty: Basic
Type: Concepts
109. ABC, Inc. is comparing two capital structures to determine how to best finance the firm's
operations. The first option consists of 100% equity financing. The second option is based on
a debt-equity ratio of .40. What should ABC do if expected earnings before interest and taxes
(EBIT) are less than the break-even level? Assume there are no taxes.
A. select the leverage option because the debt-equity ratio is less than .50
B. select the leverage option since the expected EBIT is less than the break-even level
C. select the unlevered option since the debt-equity ratio is less than .50
D. select the unlevered option since the expected EBIT is less than the break-even level
E. cannot be determined from the information provided
Difficulty: Basic
Type: Concepts
110. 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:
A. firm is just earning enough to pay for the cost of the debt.
B. firm's earnings before interest and taxes are equal to zero.
C. earnings per share for the levered option are exactly double those of the unlevered option.
D. advantages of leverage exceed the disadvantages of leverage.
E. firm has a debt-equity ratio of .50.
Difficulty: Basic
Type: Concepts
16-26
111. Which one of the following statements is correct concerning the relationship between a
capital structure with debt and one without debt? Assume there are no taxes.
A. When a firm is operating at a point where the actual earnings before interest and taxes
(EBIT) exceed the break-even level, then adding debt to the capital structure will increase the
earnings per share (EPS).
B. The earnings per share will equal zero when EBIT is zero for a levered firm.
C. The advantages of leverage primarily occur when EBIT is just barely positive.
D. The firm's EPS will always be higher if the firm uses leverage.
E. EPS are more sensitive to changes in EBIT when a firm is unlevered.
Difficulty: Basic
Type: Concepts
112. Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The
firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:
A. borrow some money and purchase additional shares of Bryco stock.
B. maintain his current position as the debt of the firm did not affect his personal leverage
position.
C. sell some shares of Bryco stock and hold the proceeds in cash.
D. sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity
ratio equal to that of the firm.
E. create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of
the firm.
Difficulty: Basic
Type: Concepts
113. The capital structure chosen by a firm doesn't really matter because of:
A. taxes.
B. the interest tax shield.
C. the relationship between dividends and earnings per share.
D. the effects of leverage on the cost of equity.
E. homemade leverage.
Difficulty: Basic
Type: Concepts
16-27
114. M&M Proposition I with no tax supports the argument that:

A. business risk determines the return on assets.
B. the cost of equity rises as leverage rises.
C. it is completely irrelevant how a firm arranges its finances.
D. a firm should borrow money to the point where the tax benefit from debt is equal to the
cost of the increased probability of financial distress.
E. financial risk is determined by the debt-equity ratio.
Difficulty: Basic
Type: Concepts
115. The proposition that the value of a levered firm is equal to the value of an unlevered firm
is known as:
A. M&M Proposition I with no tax.
B. M&M Proposition II with no tax.
C. M&M Proposition I with tax.
D. M&M Proposition II with tax.
E. static theory proposition.
Difficulty: Basic
Type: Concepts
116. The concept of homemade leverage is most associated with:

B. M&M Proposition II with no tax.
C. M&M Proposition I with tax.
E. static theory proposition.
Difficulty: Basic
Type: Concepts
16-28
117. Which of the following statements are correct in relation to M&M Proposition II with no
taxes?
I. The return on assets is equal to the weighted average cost of capital.

II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I and IV only
Difficulty: Basic
Type: Concepts
118. M&M Proposition I with tax supports the theory that:

A. there is a positive linear relationship between the amount of debt in a levered firm and its
value.
B. the value of a firm is inversely related to the amount of leverage used by the firm.
C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the
interest tax shield.
D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the
firm.
E. a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises.
Difficulty: Basic
Type: Concepts
16-29
119. M&M Proposition I with taxes is based on the concept that:

A. the optimal capital structure is the one that is totally financed with equity.
B. the capital structure of the firm does not matter because investors can use homemade
leverage.
C. the firm is better off with debt based on the weighted average cost of capital.
D. the value of the firm increases as total debt increases because of the interest tax shield.
E. the cost of equity increases as the debt-equity ratio of a firm increases.
Difficulty: Basic
Type: Concepts
120. M&M Proposition II is the proposition that:

A. supports the argument that the capital structure of a firm is irrelevant to the value of the
firm.
B. the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.
C. a firm's cost of equity capital is a positive linear function of the firm's capital structure.
D. the cost of equity is equivalent to the required return on the total assets of a firm.
E. supports the argument that the size of the pie does not depend on how the pie is sliced.
Difficulty: Basic
Type: Concepts
121. The business risk of a firm:

A. depends on the level of unsystematic risk associated with the assets of the firm.
B. is inversely related to the required return on the firm's assets.
C. is dependent upon the relative weights of the debt and equity used to finance the firm.
D. has a positive relationship with the cost of equity for that firm.
E. has no relationship with the required return on a firm's assets according to M&M
Proposition II.
Difficulty: Basic
Type: Concepts
16-30
122. Which of the following statements concerning financial risk are correct?
I. Financial risk is the risk associated with the use of debt financing.
II. As financial risk increases so too does the cost of equity.
III. Financial risk is wholly dependent upon the financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's operations.
A. I and III only
B. II and IV only
C. II and III only
Difficulty: Basic
Type: Concepts
123. The present value of the interest tax shield is expressed as:
A. (TC  D) RA.
B. VU + (TC  D).
C. [EBIT  (TC  D)] RU.
D. [EBIT  (TC  D)] RA.
E. Tc  D.
Difficulty: Basic
Type: Concepts
16-31
124. The interest tax shield has no value for a firm when:
I. the tax rate is equal to zero.

II. the debt-equity ratio is exactly equal to 1.
III. the firm is unlevered.
IV. a firm elects 100% equity as its capital structure.
A. I and III only
B. II and IV only
Difficulty: Basic
Type: Concepts
125. The interest tax shield is a key reason why:

A. the required rate of return on assets rises when debt is added to the capital structure.
B. the value of an unlevered firm is equal to the value of a levered firm.
C. the net cost of debt to a firm is generally less than the cost of equity.
D. the cost of debt is equal to the cost of equity for a levered firm.
E. firms prefer equity financing over debt financing.
Difficulty: Basic
Type: Concepts
16-32
126. Which of the following will tend to diminish the benefit of the interest tax shield?
I. a reduction in tax rates

II. a large tax loss carry forward
III. a large depreciation tax deduction
IV. a sizeable increase in taxable income
A. I and II only
B. I and III only
C. II and III only
Type: Concepts
127. Which one of the following statements concerning bankruptcy is correct?

A. The administrative costs incurred in a bankruptcy are considered indirect bankruptcy costs.
B. Bondholders have a greater incentive than stockholders to keep a firm from filing for
bankruptcy.
C. Bankruptcy is sometimes used as a means to increase payroll costs.
D. The assets of a firm tend to increase in value when a firm is in financial distress.
E. An implicit cost of bankruptcy is the loss of key employees.
Difficulty: Basic
Type: Concepts
128. Indirect bankruptcy costs:

A. effectively limit the amount of equity a firm issues.
B. serve as an incentive to increase the financial leverage of a firm.
C. include direct costs such as legal and accounting fees.
D. tend to increase as the debt-equity ratio decreases.
E. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.
Difficulty: Basic
Type: Concepts
16-33
129. When a firm is operating with the optimal capital structure:
I. the debt-equity ratio will also be optimal.

II. the weighted average cost of capital will be at its minimal point.
III. the required return on assets will be at its maximum point.
IV. the increased benefit from additional debt is equal to the increased bankruptcy costs of
that debt.
A. I and IV only
B. II and III only
C. I and II only
Difficulty: Basic
Type: Concepts
130. The optimal capital structure will tend to include more debt for firms with:
A. the highest depreciation deductions.
B. the lowest marginal tax rate.
C. substantial tax shields from other sources.
D. lower probability of financial distress.
E. less taxable income.
Difficulty: Basic
Type: Concepts
131. The optimal capital structure of a firm _____ the marketed claims and _____ the
nonmarketed claims against the cash flows of the firm.
A. minimizes; minimizes
B. minimizes; maximizes
C. maximizes; minimizes
D. maximizes; maximizes
E. equates; (leave blank)
Difficulty: Basic
Type: Concepts
16-34
132. The optimal capital structure:

A. will be the same for all firms in the same industry.
B. will remain constant over time unless the firm does an acquisition.
C. of a firm will vary over time as taxes and market conditions change.
D. places more emphasis on the operations of a firm rather than the financing of a firm.
E. is unaffected by changes in the financial markets.
Difficulty: Basic
Type: Concepts
133. The basic lesson of M&M Theory is that the value of a firm is dependent upon the:
A. capital structure of the firm.
B. total cash flows of the firm.
C. percentage of a firm to which the bondholders have a claim.
D. tax claim placed on the firm by the government.
E. size of the stockholders claims on the firm.
Type: Concepts
134. In general, observed capital structures:

A. tend to overweigh debt in relation to equity.
B. are easily explained in terms of earnings volatility.
C. are easily explained by analyzing the types of assets owned by the various firms.
D. tend to be those which maximize the use of the firm's available tax shelters.
E. vary significantly across industries.
Difficulty: Basic
Type: Concepts
16-35
135. A firm is technically insolvent when:

A. it has a negative net worth on its statement of financial position.
B. the value of the firm's assets is less than the value of the firm's liabilities.
C. it is unable to meet its financial obligations.
D. it files the legal forms petitioning for bankruptcy protection.
E. the value of its stock declines by more than 50%.
Difficulty: Basic
Type: Concepts
136. The static theory of capital structure:

A. assumes that the firm's operations and assets are fixed.
B. assumes that the firm's operations are fixed but that its assets are increasing.
C. supports increasing the leverage employed by a firm when the probability of financial
distress becomes significant.
D. equates the benefits of equity financing to the costs associated with the probability of
financial distress.
E. states that a firm should operate at the point where the cost of capital is maximized.
Difficulty: Basic
Type: Concepts
137. The static theory of capital structure supports the theory that value-maximizing managers
will:
A. look to the asset side of the statement of financial position to increase firm value since the
mix of debt and equity selected is unlikely to affect firm value.
B. not concern themselves with the capital structure of the firm as it is an irrelevant issue.
C. select the capital structure for which the cost associated with the probability of financial
distress equals the benefit of the interest tax shield.
D. select an all equity capital structure to ensure the value of the firm is maximized.
E. select the capital structure which maximizes the interest tax shield.
Difficulty: Basic
Type: Concepts
16-36
138. The cost of capital for a firm which has no debt is called the _____ cost of capital.
A. levered
B. unlevered
C. direct
D. indirect
E. straight
Difficulty: Basic
Type: Definitions
139. A reorganization is defined as:

A. a situation where the senior management of a firm is replaced.
B. a change in the reporting structure of a firm's various divisions and departments.
C. the sale and total closure of a firm.
D. a merger which results in the total replacement of the target firm's managers.
E. a financial restructuring of a distressed firm in an attempt to keep the firm operating.
Difficulty: Basic
Type: Definitions
140. The capital structure of a firm refers to the firm's:

A. ratio of fixed assets to total assets.
B. mix of long-term assets including such things as office buildings, manufacturing facilities,
and equipment.
C. financing arrangements as evidenced by the firm's debt-equity ratio.
D. ability to generate sales by utilizing the fixed assets of the firm.
E. issuance of equity securities in the firm.
Difficulty: Basic
Type: Definitions
16-37
141. M&M Proposition II is the proposition that:

A. the value of a firm is independent of the firm's capital structure.
B. states the value of a firm is dependent upon the interest tax shield.
C. the levered value of a firm is equal to the unlevered value plus the interest tax shield.
D. a firm's cost of equity capital is a positive linear function of the firm's capital structure.
E. the levered value of a firm is equal to the unlevered value plus the present value of the
interest tax shield.
Difficulty: Basic
Type: Definitions
142. The ideal capital structure:

A. is that combination of debt and equity which results in a debt-equity ratio of 1.0.
B. is that combination of debt and equity which yields the highest level of sales growth.
C. is that of an unlevered firm.
D. produces the lowest weighted average cost of capital.
E. is generally unobtainable as it exists only in a firm financed solely with debt.
Difficulty: Basic
Type: Definitions
143. 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:
A. firm should increase its debt-equity ratio.
B. firm is operating at its optimal level.
C. firm has minimized its weighted average cost of capital.
D. firm would be more profitable if it lowered its level of output.
E. debt of the firm is a disadvantage.
Difficulty: Basic
Type: Concepts
16-38
144. The use of homemade leverage:

A. optimizes the profitability of a firm.
B. minimizes the weighted average cost of capital for a firm.
C. makes the capital structure of a firm irrelevant.
D. is effective only when investors own shares of all-equity firms.
E. increases the debt-equity ratio of a firm.
Difficulty: Basic
Type: Concepts
145. Homemade leverage makes which one of the following irrelevant?

A. cash flows from an investment
B. interest payments on a loan
C. dividends on a stock
D. a firm's capital structure
E. a firm's effective tax rate
Difficulty: Basic
Type: Concepts
146. The argument(s) that the value of a firm is independent of the firm's capital structure is
presented as:
B. M&M Proposition I with tax.
C. M&M Proposition II with no tax.
E. both M&M Proposition I and II with no tax.
Difficulty: Basic
Type: Concepts
16-39
147. M&M Proposition I with no tax argues that:

A. leverage increases the value of a firm.
B. the cost of equity decreases as the debt-equity ratio increases.
C. the value of a firm is unaffected by the debt-equity ratio the firm chooses.
D. the required return on a firm's assets is equal to the minimum weighted average cost of
capital.
E. the value of a firm varies directly with a firm's cost of capital.
Difficulty: Basic
Type: Concepts
148. M&M Proposition II with no tax states that a firm's cost of equity is dependent upon:
I. the firm's debt-equity ratio.

II. the required rate of return on the firm's assets.
III. the firm's interest tax shield.
IV. the firm's cost of debt financing.
A. I and III only
B. II and IV only
C. I, II, and III only
D. I, II, and IV only
E. II, III, and IV only
Difficulty: Basic
Type: Concepts
149. M&M Proposition I with tax states that the value of a levered firm increases as the:
A. level of debt decreases.
B. tax rate of the firm decreases.
C. debt-equity ratio increases.
D. unlevered value of the firm decreases.
E. inflation rate increases.
Difficulty: Basic
Type: Concepts
16-40
150. M&M Proposition II with tax supports the argument that a firm's:
A. cost of equity decreases as its weighted average cost of capital decreases.
B. cost of equity increases as the firm increases its debt-equity ratio.
C. cost of debt varies inversely with the debt-equity ratio.
D. use of debt decreases the value of the firm.
E. weighted average cost of the capital remains constant as the debt-equity ratio rises.
Difficulty: Basic
Type: Concepts
151. In general terms, M&M Proposition I deals with the firm's ____ while M&M Proposition
II deals with the firm's _____.
A. value; level of risk
B. optimal debt-equity ratio; value
C. value; cost of equity
D. cost of equity; cost of debt
E. cost of debt; value
Difficulty: Basic
Type: Concepts
152. Which of the following are the two component parts of a firm's cost of equity as
illustrated by M&M Proposition II?
A. financial risk and interest rate risk
B. inflation risk and interest rate risk
C. tax risk and interest rate risk
D. business risk and market risk
E. business risk and financial risk
Difficulty: Basic
Type: Concepts
16-41
153. As the debt-equity ratio of a firm rises, the:

A. cost of debt declines.
B. cost of equity declines.
C. weighted average cost of capital increases, at least initially.
D. equity risk also rises.
E. capital structure of the firm remains constant.
Difficulty: Basic
Type: Concepts
154. According to M&M Proposition I with taxes, the interest tax shield:
A. affects the net earnings, but not the value of a firm.
B. increases the pre-tax rate of return on debt.
C. increases the value of a firm.
D. lowers the firm's cost of equity.
E. increases the firm's weighted average cost of capital.
Difficulty: Basic
Type: Concepts
155. Debt financing in a world of taxes:
I. increases the value of a firm.

II. lowers a firm's cost of equity.
III. creates positive value in the form of an interest tax shield.
IV. lowers a firm's weighted average cost of capital.
A. I and III only
B. II and IV only
Difficulty: Basic
Type: Concepts
16-42
156. Which one of the following statements concerning bankruptcy is correct?

A. A firm is considered bankrupt when it becomes delinquent on a loan payment.
B. The administrative expenses of a bankruptcy are classified as indirect bankruptcy costs.
C. Bankruptcy costs may offset the tax-related gains from leverage.
D. The higher cost of capital which a firm pays in order to avoid excessive debt is considered
a direct cost of bankruptcy.
E. Bankruptcy is a relatively inexpensive process.
Difficulty: Basic
Type: Concepts
157. The static theory of capital structure states that the:

A. debt-equity ratio of a firm is permanently fixed.
B. optimal firm value is reached when the tax benefit from another dollar of debt is exactly
offset by the financial distress costs of that debt.
C. value of a firm rises in a linear fashion in response to the pre-tax cost of debt.
D. value of a firm rises every time the debt-equity ratio is increased.
E. financial distress costs of a firm are constant.
Difficulty: Basic
Type: Concepts
158. The optimal capital structure of a firm maximizes the value of the firm while:
A. maximizing the interest tax shield.
B. minimizing the firm's cost of capital.
C. equating the level of debt to the level of equity.
D. minimizing the debt-equity ratio.
E. minimizing the financial distress costs.
Difficulty: Basic
Type: Concepts
16-43
159. Which one of the following statements is correct?

A. The greater the volatility of EBIT, the more a firm should borrow.
B. Firms with a large percentage of assets invested in intangibles, should borrow more than a
comparable firm with a minimal investment in intangibles.
C. A firm with a high annual depreciation write-off benefits more from leverage than a
comparable firm with a low annual depreciation write-off.
D. The static model of capital structure identifies the precise debt-equity ratio that optimizes
the value of the firm.
E. Firms with high tax rates have a greater incentive to borrow than firms with low tax rates.
Difficulty: Basic
Type: Concepts
160. Which one of the following receives the highest priority in the distribution of assets
under a bankruptcy proceeding?
A. employee wages
B. government taxes
C. consumer claims
D. administrative expenses related to the bankruptcy
E. contributions to employee retirement plans
Difficulty: Basic
Type: Concepts
161. An unlevered firm with a market value of $1 million has 50,000 shares outstanding. The
firm restructures itself by issuing 200 new bonds with face value $1,000 and an 8% coupon.
The firm uses the proceeds to repurchase outstanding stock. In considering the newly levered
versus formerly unlevered firm, what is the break-even EBIT? Ignore taxes.
A. $25,000
B. $50,000
C. $75,000
D. $80,000
E. $95,000
Difficulty: Basic
Type: Problems
16-44
162. An investor owns 500 shares of stock in a Montreal firm with a debt/equity ratio = 1.0.
The investor prefers a debt/equity ratio = 1.5. If the stock price is $2 per share, what should
the investor do?
A. Borrow $500 and buy 250 new shares.
B. Borrow $1,500 and buy 750 new shares.
C. Borrow $2,500 and buy 1,250 new shares.
D. Sell 250 shares and lend $500.
E. Sell 25 shares and lend $50.
Difficulty: Basic
Type: Problems
163. An investor owns 500 shares of stock in a firm with a debt/equity ratio = 1.0. The
investor prefers an all-equity firm. If the stock price is $2 per share, what should the investor
do?
A. Borrow $500 and buy 250 new shares.
B. Borrow $1,500 and buy 750 new shares.
C. Borrow $2,500 and buy 1,250 new shares.
D. Sell 250 shares and lend $500.
E. Sell 25 shares and lend $50.
Difficulty: Basic
Type: Problems
164. The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000
paying an 8.5% annual coupon, and an unlevered cost of capital of 12%. If the tax rate is
34%, what is the value of the Brassy's equity?
A. $3,258
B. $3,685
C. $5,685
D. $6,325
E. $7,005
Difficulty: Basic
Type: Problems
16-45
165. What is the cost of equity for a firm where the required return on assets is 14%, the cost
of debt is 11%, and the target debt/equity ratio is 0.5? Ignore taxes.
A. 11.0%
B. 12.5%
C. 14.0%
D. 15.5%
E. 16.0%
Difficulty: Basic
Type: Problems
166. 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%.
A. 11.0%
B. 12.6%
C. 12.9%
D. 13.4%
E. 13.8%
Difficulty: Basic
Type: Problems
167. ABC, Inc. has a debt/equity ratio = 1.2. The firm has a cost of equity of 12% and a cost
of debt of 8%. What will the cost of equity be if the target debt/equity ratio increases to 2.0
and the cost of debt does not change? Ignore taxes.
A. 10.56%
B. 11.12%
C. 13.46%
D. 14.74%
E. 15.45%
Difficulty: Basic
Type: Problems
16-46
168. RDJ Inc. has an asset beta of 0.95. Its current capital structure is 60% debt, 40% equity.
What is the firm's equity beta? Ignore taxes.
A. 0.380
B. 1.243
C. 1.583
D. 1.875
E. 2.375
Difficulty: Basic
Type: Problems
169. Suppose a Vancouver firm issues perpetual debt with a face and market value of $5,000
and a coupon rate of 12%. If the firm is subject to a 40% tax rate and the appropriate discount
rate is 10%, what is the present value of the interest tax shield?
A. $1,667
B. $2,000
C. $2,400
D. $3,600
E. $6,000
Difficulty: Basic
Type: Problems
170. An unlevered firm has after-tax net income = $125,000. The unlevered cost of capital is
13% and the corporate tax rate is 34%. What is the value of this firm?
A. $594,102
B. $634,615
C. $729,654
D. $961,538
E. $1,051,591
Difficulty: Basic
Type: Problems
16-47
171. A Calgary firm with no debt has 200,000 shares outstanding valued at $20 each. Its cost
of equity is 12%. The firm is considering adding $1 million in debt to its capital structure. The
coupon rate would be 8% and the bonds would sell for par value. The firm's tax rate is 34%.
How much will the firm be worth after adding the debt?
A. $4.033 million
B. $4.180 million
C. $4.340 million
D. $4.660 million
E. $5.000 million
Difficulty: Basic
Type: Problems
172. An unlevered firm has an EBIT = $250,000, after-tax net income = $165,000, and a cost
of capital of 12%. A levered firm with the same assets and operations has $1.25 million in
face value debt paying an 8% annual coupon; the debt sells for par value in the marketplace.
What is the value of the levered firm? The tax rate is 34%.
A. $1,250,000
B. $1,375,000
C. $1,666,667
D. $1,800,000
E. $2,625,000
Difficulty: Basic
Type: Problems
16-48
173. The Wrangler Co. has expected EBIT = $9,250, debt with a face and market value of
$14,000 paying a 9% annual coupon, and an unlevered cost of capital of 12%. If the tax rate is
39%, what is the value of Wrangler's equity?
A. $38,481
B. $52,481
C. $55,635
D. $58,525
E. $65,600
Difficulty: Basic
Type: Problems
174. The Wrangler Co. has expected EBIT = $9,250, and debt with a face and market value of
$14,000 paying a 9% annual coupon. The market value of the firm is $58,525. If the tax rate
is 34%, what is Wranger's unlevered cost of capital?
A. 9.00%
B. 11.35%
C. 12.12%
D. 12.76%
E. 12.99%
Difficulty: Basic
Type: Problems
175. A firm has an unlevered cost of capital of 10%, a cost of debt of 9%, and a tax rate of
34%. If it desires a cost of equity of 14%, what is its target debt/equity ratio?
A. 2.49
B. 3.89
C. 4.68
D. 5.14
E. 6.06
Difficulty: Basic
Type: Problems
16-49
176. The Brassy Co. has expected EBIT = $910, an unlevered cost of capital of 12%, and debt
with a face and market value of $2,000 paying an 8.5% annual coupon. If the tax rate is 34%,
what is the WACC of Brassy Co.?
A. 10.56%
B. 11.12%
C. 13.25%
D. 13.64%
E. 14.45%
Difficulty: Basic
Type: Problems
177. Given the following, what is the WACC? EBIT = $2 million; tax rate = 34%; market
value and book value of debt = $4 million; unlevered cost of capital = 14%; cost of debt =
9%.
A. 11.4%
B. 11.9%
C. 12.2%
D. 12.6%
E. 13.1%
Difficulty: Basic
Type: Problems
16-50
There are no taxes. EBIT is expected to be $2.5 million, but could be as high as $3.5 million if
an economic expansion occurs, or as low as $2 million if a recession occurs. All values are
market values.
178. How many shares are outstanding under the proposed capital structure?
A. 100,000
B. 200,000
C. 300,000
D. 400,000
E. 500,000
Difficulty: Basic
Type: Problems
179. What is EPS under the current capital structure if there is a recession?
A. $3.33
B. $4.17
C. $5.00
D. $6.25
Difficulty: Basic
Type: Problems
16-51
180. What is EPS during an expansion for the proposed capital structure?
A. $4.17
B. $5.00
C. $5.83
D. $6.00
E. $7.55
Difficulty: Basic
Type: Problems
181. What is ROE for the proposed capital structure if the expected state occurs?
A. 11.7%
B. 16.7%
C. 20.0%
D. 22.4%
E. 23.3%
Difficulty: Basic
Type: Problems
182. What is the break-even EPS for these two capital structures?
A. $2.40
B. $3.28
C. $4.25
D. $5.00
E. $8.75
Difficulty: Basic
Type: Problems
UNLEV has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and
there are 20,000 shares of stock outstanding. The firm is considering issuing $8,800 in new
par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to
repurchase equity. The cost of debt = 10% and the tax rate = 34%. There are no flotation
costs.
16-52
183. Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. The
stockholder prefers a debt/equity ratio = 1.0. How could the stockholder use homemade
leverage to achieve the restructuring without the help of UNLEV? Assume there are no taxes.
A. The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B. The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C. The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D. The stockholder should lend $667 and sell 300 shares of UNLEV.
E. The stockholder should lend $1,337 and sell 667 shares of UNLEV.
Type: Problems
184. Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. Also
assume UNLEV's debt/equity ratio will be 0.493 after the restructuring. How could the
stockholder use homemade leverage to unlever her investment in the firm after the
restructuring? Assume there are no taxes.
A. The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B. The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C. The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D. The stockholder should lend $443 and sell 333 shares of UNLEV.
E. The stockholder should lend $1,337 and sell 667 shares of UNLEV.
Type: Problems
185. If there were no taxes, what would be the value of UNLEV before the restructuring?
A. $15,930
B. $17,600
C. $18,519
D. $26,667
E. $30,000
Type: Problems
16-53
186. Including the effect of taxes, what is the value of UNLEV before the restructuring?
A. $15,930
B. $17,600
C. $18,519
D. $26,667
E. $30,000
Type: Problems
187. What is the value of UNLEV after the restructuring?

A. $15,930
B. $17,600
C. $18,519
D. $20,592
E. $22,461
Type: Problems
188. What is the value of UNLEV's equity after the restructuring?

A. $11,792
B. $12,600
C. $12,819
D. $13,592
E. $16,461
Type: Problems
16-54
189. What is UNLEV's cost of equity after the restructuring?

A. 14.8%
B. 17.5%
C. 18.4%
D. 20.0%
E. 22.5%
Type: Problems
190. The projected EBIT of a firm is $300,000. The firm currently has 100,000 shares of
common stock outstanding at a value of $18 per share. The firm has no debt. By how much
will the ROE change if the firm borrows $600,000 at 8% interest and uses the funds to
repurchase shares of stock at the market price? Ignore taxes.
A. -2.67%
B. 1.67%
C. 2.33%
D. 4.33%
E. 5.67%
Type: Problems
191. ADA, Inc. currently has 20,000 shares of stock outstanding at a market value of $40 a
share. The firm is currently 100% financed with equity. ADA is considering a restructuring
which will include issuing $400,000 of bonds at par value with a coupon rate of 6%. What is
the break-even EBIT?
A. $12,000
B. $24,000
C. $36,000
D. $48,000
E. $60,000
Type: Problems
16-55
192. A firm has a tax rate of 35%, an unlevered rate of return of 14%, total debt of $1,000,
and an EBIT of $300.00. What is the unlevered value of the firm?
A. $27
B. $393
C. $1,027
D. $1,393
E. $2,143
Type: Problems
193. A firm has a 34% tax rate, EBIT of $400, total debt of $600, and an unlevered value of
$1,000. What is the value of the firm with debt?
A. $604
B. $816
C. $940
D. $1,136
E. $1,204
Type: Problems
194. A firm is worth $1,400, has a 35% tax rate, total debt of $600, an unlevered return of
15%, and a cost of debt of 9%. What is the cost of equity?
A. 12.07%
B. 16.67%
C. 17.93%
D. 18.75%
E. 20.20%
Type: Problems
16-56
195. A firm has $500 in debt at a cost of 7%, a 34% tax rate, a total firm value of $1,100, and
an unlevered return of 14%. What is the WACC?
A. 9.24%
B. 9.74%
C. 9.88%
D. 10.67%
E. 11.84%
Type: Problems
196. A firm has a debt-equity ratio of .40, a WACC of 16%, and a yield-to-maturity on its debt
of 13%. Ignoring taxes, what is the cost of equity?
A. 7.8%
B. 9.6%
C. 11.8%
D. 15.2%
E. 17.2%
Type: Problems
197. The Addopa Co. has a projected annual EBIT of $5,000. The company is currently 100%
equity financed with a cost of equity of 14%. The tax rate is 34% and the cost of debt is 10%.
What is the value of the firm if they borrow $12,000?
A. $23,571
B. $24,771
C. $26,009
D. $27,651
E. $29,229
Type: Problems
16-57
198. A firm has 30,000 shares of stock outstanding, $450,000 in debt at a 9% rate, an EBIT of
$112,000, and a tax rate of 0%. What is the EPS?
A. $2.38
B. $2.51
C. $2.87
D. $3.36
E. $3.73
Type: Problems
199. McMillin Industries is currently 100% equity financed, has 25,000 shares outstanding at
a price of $30 a share, and produces an annual EBIT of $150,000. The firm is considering
issuing $300,000 of debt and repurchasing shares. The cost of debt is 12%. Ignore taxes. By
how much will EPS change if the company issues the debt and EBIT remains constant?
A. $.72
B. $.76
C. $1.54
D. $1.60
E. $1.72
Type: Problems
16-58
200. Lance owns 200 shares of ABC stock with a current market value of $10 a share. ABC
has an annual EBIT of $400,000 and a cost of debt of 8%. Currently, ABC is 100% equity
financed with 100,000 shares outstanding. ABC is going to a 25% debt capital structure by
issuing debt and redeeming shares. Ignore taxes. What does Lance have to do to return his
capital structure position to approximately its original position?
A. Sell 69 shares and lend the money at 8%.
B. Sell 187 shares and lend the money at 8%.
C. Borrow $1,870 and buy an additional 187 shares.
D. Borrow $690 at 8% and buy an additional 69 shares.
E. Sell 50 shares and loan the money at 8%.
Type: Problems
201. A firm has total debt of $900 and total equity of $1,600. The cost of debt is 10% and the
unlevered rate of return is 13%. The tax rate is 34%. What is the cost of equity?
A. 12.29%
B. 12.69%
C. 13.88%
D. 14.11%
E. 14.69%
Type: Problems
202. Martha's Grapevines, Inc. has an EBIT of $46,000, no debt, a 34% tax rate, and a 15%
cost of capital. What will the value of the firm be if Martha's Grapevines issues $75,000 in
debt?
A. $202,400
B. $227,900
C. $267,300
D. $291,100
E. $330,000
Type: Problems
16-59
203. The Tee Company has total assets of $20,000 and total debt of $8,000. The yield-to-
maturity on its bonds is 9%. The cost of capital with no debt is 15%. The tax rate is 34%.
What is the WACC?
A. 8.64%
B. 10.58%
C. 10.88%
D. 11.39%
E. 12.96%
Type: Problems
204. BK Inc. has a cost of debt of 10% and a WACC of 15%. The debt-equity ratio is .6. The
tax rate is 35%. What is the cost of equity?
A. 19.33%
B. 19.88%
C. 20.10%
D. 20.54%
E. 20.67%
Type: Problems
205. LKP, Inc. has an unlevered cost of capital of 14%, a cost of debt of 9%, a 34% tax rate,
and an EBIT of $60,000. The company has $120,000 in total assets, no accounts payable, and
$70,000 in total equity. What is the value of LKP, Inc.?
A. $265,857
B. $271,009
C. $282,857
D. $291,009
E. $299,857
Type: Problems
16-60
206. A firm has earnings per share of $2.12 on 40,000 shares outstanding. The firm also has
$360,000 in debt at a cost of 9%. Ignore taxes. What is the EBIT?
A. $84,800
B. $91,600
C. $102,300
D. $117,200
E. $119,700
Type: Problems
207. A Winnipeg firm is considering two separate capital structures. The first is an all equity
plan consisting of 25,000 shares of stock. The second plan would consist of 10,000 shares of
stock and $90,000 in debt at a cost of 8%. Ignore taxes. What is the break-even EBIT?
A. $12,000
B. $15,000
C. $18,000
D. $19,000
E. $21,000
Type: Problems
208. Kate's Dry Goods currently has 15,000 shares of stock outstanding. Kate would like to
reduce the outstanding shares by one-third by issuing debt and repurchasing stock. The firm
has an EBIT of $8,400 and a cost of debt of 7%. How much debt does Kate have to issue to
accomplish her goal if she wishes EBIT to remain constant?
A. $32,000
B. $35,000
C. $37,000
D. $40,000
E. $42,000
Type: Problems
16-61
209. JoBo's is a 100% equity financed firm with a tax rate of 34% and a WACC of 13%. The
company can borrow money at a current rate of 8%. EBIT is $24,500 annually. What is the
current cost of equity?
A. 8.58%
B. 10.72%
C. 12.67%
D. 13.00%
E. 13.33%
Type: Problems
210. Blackstone, Inc. is currently an all equity firm that has 65,000 shares of stock
outstanding at a market price of $22 a share. The firm has decided to leverage its operations
by issuing $605,000 of debt at an interest rate of 6.5%. This new debt will be used to
repurchase shares of the outstanding stock. The restructuring is expected to increase the
earnings per share. What is the minimum level of earnings before interest and taxes that
Blackstone is expecting? Ignore taxes.
A. $92,950
B. $94,700
C. $95,250
D. $95,400
E. $96,150
Difficulty: Basic
Type: Problems
16-62
211. Martha White's Fabrics is currently an all equity firm that has 15,000 shares of stock
outstanding at a market price of $12.50 a share. Company management has decided to issue
$50,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The
interest rate on the debt will be 9%. What are the earnings per share at the break-even level of
earnings before interest and taxes? Ignore taxes.
A. $1.005
B. $1.125
C. $1.175
D. $1.200
E. $1.250
Difficulty: Basic
Type: Problems
212. You currently own 500 shares in K&S Stores. K&S is currently an all equity firm that
has 25,000 shares of stock outstanding at a market price of $10 a share. The company's
earnings before interest and taxes are $20,000. K&S has decided to issue $150,000 of debt at
a 6% rate of interest. This $150,000 will be used to repurchase shares of stock. How many
shares of K&S stock must you sell to unlever your position if you can lend out funds at a 6%
rate of interest?
A. 150 shares
B. 200 shares
C. 250 shares
D. 300 shares
E. 500 shares
Type: Problems
16-63
213. R&F Enterprises is an all equity firm with 70,000 shares of stock outstanding at a market
price of $8 a share. The company has earnings before interest and taxes of $42,000. R&F
decides to issue $200,000 of debt at a 7% rate of interest. The $200,000 will be used to
repurchase shares of the outstanding stock. Currently, you own 1,500 shares of R&F stock.
How many shares of this stock must you sell to unlever your position if you can loan out
funds at a 7% rate of interest?
A. 489 shares
B. 497 shares
C. 508 shares
D. 536 shares
E. 541 shares
Type: Problems
214. Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding.
The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000
shares of the outstanding stock. What is the value of this firm if you ignore taxes?
A. $20.0 million
B. $20.8 million
C. $21.0 million
D. $21.2 million
E. $21.3 million
Difficulty: Basic
Type: Problems
16-64
215. Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding.
The company has decided to borrow $1 million to buy out the shares of a deceased
stockholder who holds 2,500 shares. What is the total value of this firm if you ignore taxes?
A. $15.5 million
B. $15.6 million
C. $16.0 million
D. $16.8 million
E. $17.2 million
Difficulty: Basic
Type: Problems
216. You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your
shares in this closely held, all equity firm. The other shareholders have agreed to have the
firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of
this firm today if you ignore taxes?
A. $4.8 million
B. $5.1 million
C. $5.4 million
D. $5.7 million
E. $6.0 million
Difficulty: Basic
Type: Problems
217. Your firm has a debt-equity ratio of .75. Your pre-tax cost of debt is 8.5% and your
required return on assets is 15%. What is your cost of equity if you ignore taxes?
A. 11.25%
B. 12.21%
C. 16.67%
D. 19.88%
E. 21.38%
Difficulty: Basic
Type: Problems
16-65
218. Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The
required return on the assets is 11%. What is the firm's debt-equity ratio based on M&M II
with no taxes?
A. .60
B. .64
C. .72
D. .75
E. .80
Difficulty: Basic
Type: Problems
219. The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm's required return on
assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on M&M
II with no taxes?
A. 6.76%
B. 7.00%
C. 7.25%
D. 7.40%
E. 7.50%
Difficulty: Basic
Type: Problems
220. Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock
outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax
rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to her
capital structure. The debt will be sold at par value. What is the levered value of the equity?
A. $2.4 million
B. $2.7 million
C. $3.3 million
D. $3.7 million
E. $3.9 million
Difficulty: Basic
Type: Problems
16-66
221. The White Hills Co. has expected earnings before interest and taxes of $8,100, an
unlevered cost of capital of 11%, and debt with both a book and market value of $12,000. The
debt has an annual 8% coupon. The tax rate is 34%. What is the value of the firm?
A. $48,600
B. $50,000
C. $52,680
D. $56,667
E. $60,600
Difficulty: Basic
Type: Problems
222. Scott's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000.
The unlevered cost of capital is 10% and the tax rate is 34%. What is the value of this firm?
A. $567,600
B. $781,818
C. $860,000
D. $946,000
E. $1,152,400
Difficulty: Basic
Type: Problems
223. An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of
$150,000. A levered firm with the same operations and assets has both a book value and a
market value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%.
What is the value of the levered firm?
A. $696,429
B. $907,679
C. $941,429
D. $1,184,929
E. $1,396,429
Difficulty: Basic
Type: Problems
16-67
224. The Spartan Co. has an unlevered cost of capital of 11%, a cost of debt of 8%, and a tax
rate of 35%. What is the target debt-equity ratio if the targeted cost of equity is 12%?
A. .44
B. .49
C. .51
D. .56
E. .62
Difficulty: Basic
Type: Problems
225. Hey Guys!, Inc. has debt with both a book and a market value of $3,000. This debt has a
coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes
are $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the firm's
cost of equity?
A. 13.25%
B. 13.89%
C. 13.92%
D. 14.14%
E. 14.25%
Type: Problems
226. Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of
12%. The company has $5,000 in debt that is selling at par value. The levered value of the
firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt?
A. 7.92%
B. 8.10%
C. 8.16%
D. 8.84%
E. 9.00%
Type: Problems
16-68
227. Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity
ratio is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital?
A. 8.83%
B. 12.30%
C. 13.97%
D. 14.08%
E. 14.60%
Difficulty: Basic
Type: Problems
228. Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your
tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio?
A. .43
B. .49
C. .51
D. .54
E. .58
Difficulty: Basic
Type: Problems
229. Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while
the unlevered cost of capital is 14%. What is the cost of equity if the tax rate is 34%?
A. 7.52%
B. 8.78%
C. 15.98%
D. 16.83%
E. 17.30%
Difficulty: Basic
Type: Problems
16-69
230. Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon, pay
interest semiannually, and have a current market price equal to 103% of face value. What is
the amount of the annual interest tax shield given a tax rate of 35%?
A. $6,125
B. $6,309
C. $9,500
D. $17,500
E. $18,025
Difficulty: Basic
Type: Problems
231. Bertha's Boutique has 2,000 bonds outstanding with a face value of $1,000 each and a
coupon rate of 9%. The interest is paid semi-annually. What is the amount of the annual
interest tax shield if the tax rate is 34%?
A. $58,500
B. $60,100
C. $60,750
D. $61,200
E. $62,250
Difficulty: Basic
Type: Problems
232. Juanita's Steak House has $12,000 of debt outstanding that is selling at par and has a
coupon rate of 8%. The tax rate is 34%. What is the present value of the tax shield?
A. $2,823
B. $2,887
C. $4,080
D. $4,500
E. $4,633
Difficulty: Basic
Type: Problems
16-70
233. A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt
of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the firm's weighted average
cost of capital?
A. 7.29%
B. 7.94%
C. 8.87%
D. 10.40%
E. 11.05%
Type: Problems
234. 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?
A. 9.50%
B. 10.50%
C. 11.00%
D. 11.25%
E. 12.00%
Type: Problems
235. Your firm has earnings before interest and taxes of $160,000. Both the book and the
market value of debt is $300,000. Your unlevered cost of equity is 12% while your cost of
debt is 8%. The tax rate is 35%. What is your weighted average cost of capital?
A. 10.72%
B. 10.91%
C. 10.98%
D. 11.06%
E. 11.23%
Type: Problems
16-71
236. Olde Towne Industries is considering both an all equity and a debt-equity capital
structure. The all equity capital structure would consist of 40,000 shares of stock. The debt
and equity option would consist of 25,000 shares of stock plus $300,000 of debt at an interest
rate of 8%. What is the break-even level of earnings before interest and taxes between these
two options? Ignore taxes.
A. $52,000
B. $57,000
C. $64,000
D. $66,000
E. $74,000
Difficulty: Basic
Type: Problems
237. Roger's Trucking is currently an all equity firm that has 24,000 shares of stock
by issuing $280,000 of debt at an interest rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is expected to increase the earnings per
share. What is the minimum level of earnings before interest and taxes that Roger's is
expecting? Ignore taxes.
A. $72,500
B. $77,778
C. $86,667
D. $96,000
E. $101,333
Difficulty: Basic
Type: Problems
16-72
238. Angela's Quilt Shop is currently an all equity firm that has 5,000 shares of stock
outstanding at a market price of $32 a share. Company management has decided to issue
$100,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The
interest rate on the debt will be 7.5%. What are the earnings per share at the break-even level
of earnings before interest and taxes? Ignore taxes.
A. $2.34
B. $2.40
C. $2.44
D. $2.47
E. $2.51
Difficulty: Basic
Type: Problems
239. Parker & Thomas, Inc., (P&T) currently is an all equity firm with 20,000 shares of stock
outstanding at a market price of $40 a share. The company's earnings before interest and taxes
are $50,000. The firm's dividend payout ratio is 100%. P&T has decided to add leverage to its
financial operations by issuing $400,000 of debt at a 9% interest rate. This $400,000 will be
used to repurchase shares of stock. You own 2,500 shares of P&T stock. You lend funds at a
9% rate of interest. How many of your shares of stock in P&T must you sell to offset the
leverage that the firm is assuming? Assume that you loan out all of the funds you receive from
the sale of your stock.
A. 500 shares
B. 750 shares
C. 1,000 shares
D. 1,250 shares
E. 1,500 shares
Type: Problems
16-73
240. You own 400 shares of Kaiser. Kaiser is currently an all equity firm that has 12,000
shares of stock outstanding at a market price of $50 a share. The company's earnings before
interest and taxes are $20,000. The dividend payout ratio is 100%. Kaiser has decided to issue
$100,000 of debt at a 9% rate of interest. This $100,000 will be used to repurchase shares of
stock. How many shares of Kaiser stock must you sell to unlever your position if you can loan
out funds at a 9% rate of interest?
A. 67 shares
B. 100 shares
C. 133 shares
D. 160 shares
E. 200 shares
Type: Problems
241. Jensen Boat Works is an all equity firm that has 340,000 shares of stock outstanding. The
company is in the process of borrowing $4 million at 8% interest to repurchase 80,000 shares
of the outstanding stock. What is the value of this firm if you ignore taxes?
A. $15.8 million
B. $16.4 million
C. $17.0 million
D. $17.5 million
E. $18.1 million
Difficulty: Basic
Type: Problems
16-74
242. Watson's Feed Mill is an all equity firm that has 20,000 shares of stock outstanding. The
company has decided to borrow $400,000 to buy out the shares of a family stockholder who
holds 1,200 shares. What is the total value of this firm if you ignore taxes?
A. $5.48 million
B. $6.00 million
C. $6.42 million
D. $6.67 million
E. $7.00 million
Difficulty: Basic
Type: Problems
243. Your firm has a debt-equity ratio of .60. Your pre-tax cost of debt is 9% and your
required return on assets is 14%. What is your cost of equity if you ignore taxes?
A. 16.4%
B. 16.7%
C. 17.0%
D. 17.3%
E. 17.5%
Difficulty: Basic
Type: Problems
244. Hazardous Wastes, Inc. has a cost of equity of 23.2% and a pre-tax cost of debt of 10%.
The required return on the assets is 18%. What is the firm's debt-equity ratio based on M&M
II with no taxes?
A. .45
B. .50
C. .55
D. .60
E. .65
Difficulty: Basic
Type: Problems
16-75
245. Lucky Day Campgrounds has expected earnings before interest and taxes of $6,200, an
unlevered cost of capital of 12%, and a tax rate of 35%. The company also has $24,000 of
debt that carries an 8% coupon. The debt is selling at par value. What is the value of this
firm?
A. $32,609
B. $34,811
C. $37,141
D. $39,617
E. $41,983
Difficulty: Basic
Type: Problems
246. Winston's Super Market is currently an all equity firm that has 120,000 shares of stock
outstanding at a market price of $34.50 a share. The current cost of equity is 11% and the tax
rate is 35%. Winston's is considering adding $1.6 million of debt with a coupon rate of 7.5%
to the capital structure. The debt will be sold at par value. What is the levered value of the
equity?
A. $2.8 million
B. $3.1 million
C. $3.9 million
D. $4.3 million
E. $4.7 million
Difficulty: Basic
Type: Problems
16-76
247. 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?
A. $81,640
B. $85,383
C. $87,778
D. $90,114
E. $92,309
Difficulty: Basic
Type: Problems
16-77
248. Trudy's Pizza is an unlevered firm with an after-tax net income of $47,000. The
unlevered cost of capital is 7.5% and the tax rate is 35%. What is the value of this firm?
A. $219,333
B. $328,333
C. $407,334
D. $626,667
E. $733,333
Difficulty: Basic
Type: Problems
249. Castle Home Builders has an unlevered cost of capital of 12%, a cost of debt of 9%, and
a tax rate of 34%. What is the target debt-equity ratio if the targeted cost of equity is 14%?
A. .94
B. .96
C. .99
D. 1.01
E. 1.04
Difficulty: Basic
Type: Problems
250. Al's Pub has debt with both a book and a market value of $120,000. This debt has a
cost of equity?
A. 11.90%
B. 12.07%
C. 12.11%
D. 12.15%
E. 12.18%
Type: Problems
16-78
251. Deitweiler International has an unlevered cost of capital of 10%, a tax rate of 35%, and
expected earnings before interest and taxes of $26,500. The company has $40,000 in bonds
outstanding that have a 7% coupon and pay interest annually. The bonds are selling at par
value. What is the cost of equity?
A. 9.87%
B. 9.96%
C. 10.27%
D. 10.53%
E. 11.14%
Type: Problems
252. Jefferson Electrical Supply has a cost of equity of 12% and an unlevered cost of capital
of 10.5%. The company has $12,000 in debt that is selling at par value. The levered value of
the firm is $28,000 and the tax rate is 34%. What is the pre-tax cost of debt?
A. 6.67%
B. 7.23%
C. 7.47%
D. 7.65%
E. 7.71%
Difficulty: Basic
Type: Problems
253. Your firm has a pre-tax cost of debt of 8% and an unlevered cost of capital of 12.5%.
Your tax rate is 35% and your cost of equity is 14.34%. What is your debt-equity ratio?
A. .48
B. .52
C. .57
D. .63
E. .67
Difficulty: Basic
Type: Problems
16-79
254. Your firm has a $475,000 bond issue outstanding. These bonds have a 7.5% coupon, pay
interest semi-annually, and have a current market price equal to 99.6% of face value. What is
the amount of the annual interest tax shield given a tax rate of 34%?
A. $12,064
B. $12,087
C. $12,113
D. $23,418
E. $23,513
Difficulty: Basic
Type: Problems
255. 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
A. $81,250
B. $129,750
C. $182,000
D. $284,400
E. $338,000
Difficulty: Basic
Type: Problems
256. China Importers has $267,000 of debt outstanding that is selling at par and has a coupon
rate of 9.5%. The tax rate is 35%. What is the present value of the tax shield?
A. $8,878
B. $16,487
C. $93,450
D. $148,020
E. $173,550
Difficulty: Basic
Type: Problems
16-80
257. Your firm has expected earnings before interest and taxes of $2,400. Your unlevered cost
of capital is 12% and your tax rate is 35%. You have debt with both a book and a market value
of $5,000. This debt has a 7% coupon and pays interest annually. What is your weighted
average cost of capital?
A. 10.02%
B. 10.21%
C. 10.32%
D. 10.58%
E. 11.23%
Type: Problems
258. A Mississauga firm has debt of $18,000, equity of $42,000, a cost of debt of 7.5%, a cost
of equity of 11.6%, and a tax rate of 34%. What is the firm's weighted average cost of
capital?
A. 9.03%
B. 9.11%
C. 9.38%
D. 9.46%
E. 9.61%
Difficulty: Basic
Type: Problems
259. Your firm has earnings before interest and taxes of $210,000. Both the book and the
market value of debt is $500,000. Your unlevered cost of equity is 9% while your cost of debt
is 7%. The tax rate is 35%. What is your weighted average cost of capital?
A. 8.07%
B. 8.19%
C. 8.31%
D. 8.54%
E. 8.67%
Type: Problems
16-81
260. Juno Industrial Products is debating between a leveraged and an unleveraged capital
structure. The all equity capital structure would consist of 20,000 shares of stock. The debt
and equity option would consist of 14,000 shares of stock plus $170,000 of debt with an
interest rate of 8%. What is the break-even level of earnings before interest and taxes between
these two options? Ignore taxes.
A. $42,208
B. $44,141
C. $45,333
D. $46,667
E. $48,928
EBIT/20,000 = [EBIT - ($170,000  .08)]/14,000; 14,000EBIT = 20,000EBIT -

$272,000,000; EBIT = $45,333
Type: Problems
261. Lester's Meat Market is currently an all equity firm that has 24,000 shares of stock
by issuing $200,000 of debt at an interest rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is expected to increase the earnings per
share. What is the minimum level of earnings before interest and taxes that the firm is
expecting? Ignore taxes.
A. $48,000
B. $52,400
C. $57,620
D. $60,200
E. $61,340
EBIT/24,000 = [EBIT - ($200,000  .08)]/[24,000 - ($200,000/$25)]; 16,000EBIT =

24,000EBIT - $384,000,000; EBIT = $48,000
Type: Problems
16-82
262. The Quilt Shoppe is an all equity firm that has 2,500 shares of stock outstanding at a
market price of $20 a share. Company management has decided to issue $10,000 worth of
debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the
debt will be 8.5%. What are the earnings per share at the break-even level of earnings before
interest and taxes? Ignore taxes.
A. $1.63
B. $1.70
C. $1.82
D. $1.88
E. $1.94
Number of shares repurchased = $10,000/$20 = 500; EBIT/2,500 = [EBIT - ($10,000  .

085)]/(2,500 - 500); 2,000EBIT = 2,500EBIT - $2,125,000; EBIT = $4,250; EPS = [$4,250 -
($10,000  .085)]/(2,500 - 500); EPS = $1.70
Type: Problems
16-83
263. Abco is 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.
A. 97 shares
B. 103 shares
C. 249 shares
D. 497 shares
E. 503 shares
Abco interest = $220,000  .09 = $19,800

Abco shares repurchased = $220,000/$40 = 5,500
Abco shares outstanding with debt = 32,000 - 5,500 = 26,500Abco EPS, no debt =
$92,000/32,000 = $2.875
Abco EPS, with debt = ($92,000 - $19,800)/26,500 = $2.724528
Your unlevered income from Abco = 600  $2.875 = $1,725
Your levered income from Abco = 600  $2.724528 = $1,634.7168
Abco value of stock = 26,500  $40 = $1,060,000
Abco value of debt = $220,000
Abco total value = $1,060,000 + $220,000 = $1,280,000
Abco weight stock = $1,060,000/$1,280,000 = .828125
Abco weight debt = $220,000/$1,280,000 = .171875
Your initial investment = 600  $40 = $24,000
Your new stock position = .828125  $24,000 = $19,875
Your new number of shares = $19,875/$40 = 496.875
Your new loans = .171875  $24,000 = $4,125
Your unlevered income = 600  $2.875 = $1,725
Your levered income = (496.875  $2.724528) + ($4,125  .09) = $1,353.74985 + $371.25 =
$1,725.00
Number of shares sold = 600 - 496.875 = 103.125 = 103 shares
Difficulty: Challenge
Type: Problems
16-84
264. You currently own 250 shares of Pluto, Inc. Pluto is an all equity firm that has 36,000
shares of stock outstanding at a market price of $25 a share. The company's earnings before
interest and taxes are $48,000. Pluto, Inc. has decided to issue $200,000 of debt at a 9% rate
of interest. This debt will be used to repurchase shares of stock. How many shares of Pluto,
Inc. stock must you sell to unlever your position if you can lend out funds at a 9% rate of
interest?
A. 43 shares
B. 51 shares
C. 56 shares
D. 64 shares
E. 72 shares
Pluto interest = $200,000  .09 = $18,000

Pluto shares repurchased = $200,000/$25 = 8,000
Pluto shares outstanding with debt = 36,000 - 8,000 = 28,000
Pluto EPS, no debt = $48,000/36,000 = $1.333333
Pluto EPS, with debt = ($48,000 - $18,000)/28,000 = $1.071429
Your unlevered income from Pluto = 250  $1.333333 = $333.333333
Your levered income from Pluto = 250  $1.071429 = $267.857143
Pluto value of stock = 28,000  $25 = $700k
Pluto value of debt = $200k
Pluto total value = $700k + $200k = $900k
Pluto weight stock = $700k/$900k = .777778
Pluto weight debt = $200k/$900k = .222222Your initial investment = 250  $25 = $6,250
Your new stock position = .777778  $6,250 = $4,861.111125
Your new number of shares = $4,861.111125/$25 = 194.444445
Your new loans = .222222  $6,250 = $1,388.88875
Your unlevered income = 250  $1.333333 = $333.333333
Your levered income = (194.444445  $1.071429) + ($1,388.88875  .09) = $208.33 +
$125.00 = $333.33
Type: Problems
16-85
265. Clover Fields is an all equity firm with 55,000 shares of stock outstanding at a market
price of $17.50 a share. The company has earnings before interest and taxes of $115,500.
Clover Fields decides to issue $350,000 of debt at an 8% rate of interest. The debt will be
used to repurchase shares of the outstanding stock. Currently, you own 800 shares of Clover
Fields stock. How many shares of this stock must you sell to unlever your position if you can
lend out funds at an 8% rate of interest?
A. 177 shares
B. 209 shares
C. 236 shares
D. 274 shares
E. 291 shares
Clover Fields interest = $350,000  .08 = $28,000

Clover Fields shares repurchased = $350,000/$17.50 = 20,000
Clover Fields shares outstanding with debt = 55,000 - 20,000 = 35,000
Clover Fields EPS, no debt = $115,500/55,000 = $2.10
Clover Fields EPS, with debt = ($115,500 - $28,000)/35,000 = $2.50
Your unlevered income from Clover Fields = 800  $2.10 = $1,680
Your levered income from Clover Fields = 800  $2.50 = $2,000
Clover Fields value of stock = 35,000  $17.50 = $612,500
Clover Fields value of debt = $350k
Clover Fields total value = $612,500 + $350k = $962,500
Clover Fields weight stock = $612,500/$962,500 = .636364
Clover Fields weight debt = $350k/$962,500 = .363636
Your initial investment = 800  $17.50 = $14,000
Your new stock position = .636364  $14,000 = $8,909.09
Your new number of shares = $8,909.09/$17.50 = 509.090857
Your new loans = .363636  $14,000 = $5,090.9096
Your unlevered income = 800  $.2.10 = $1,680
Your levered income = (509.090857  $2.50) + ($5090.9096  .08) = $1,272.73 + $407.27 =
$1,680
Type: Problems
16-86
266. United Landscaping is an all equity firm that has 140,000 shares of stock outstanding.
The company is in the process of borrowing $1.2 million at 8% interest to repurchase 30,000
shares of the outstanding stock. What is the value of this firm if you ignore taxes?
A. $2.57 million
B. $4.14 million
C. $5.60 million
D. $7.00 million
E. $8.13 million
Firm value = 140,000  ($1.2m/30,000) = $5.6m
Difficulty: Basic
Type: Problems
267. Frontier Markets is an all equity firm that has 35,000 shares of stock outstanding. The
company has decided to borrow the $35,000 that is needed to repurchase 1,000 shares of stock
from the estate of a deceased shareholder. What is the total value of Frontier Markets if you
ignore taxes?
A. $1.207 million
B. $1.225 million
C. $1.250 million
D. $1.350 million
E. $1.375 million
Firm value = 35,000  ($35,000/1,000) = $1.225m
Difficulty: Basic
Type: Problems
16-87
268. You own 20% of Holiday Travels, Inc. You have decided to retire and want to sell your
shares in this closely held, all equity firm. The other shareholders have agreed to have the
firm borrow $800,000 to purchase your 500 shares of stock. What is the total value of Holiday
Travels Inc. if you ignore taxes?
A. $2.9 million
B. $3.2 million
C. $3.7 million
D. $4.0 million
E. $4.8 million
Firm value = $800,000/.20 = $4m
Difficulty: Basic
Type: Problems
269. Marshall's has a debt-equity ratio of .60. The pre-tax cost of debt is 9.1% and the
required return on assets is 14%. What is the cost of equity if you ignore taxes?
A. 11.06%
B. 11.34%
C. 13.87%
D. 15.48%
E. 16.94%
Re = .14 + (.14 - .091)  .60 = .1694 = 16.94%
Difficulty: Basic
Type: Problems
16-88
270. Thompson Feed has a cost of equity of 11.9% and a pre-tax cost of debt of 9%. The
required return on the assets is 11%. What is the firm's debt-equity ratio based on M&M II
with no taxes?
A. .40
B. .45
C. .50
D. .55
E. .60
.119 = .11 + (.11 - .09)  D/E; D/E = .45
Difficulty: Basic
Type: Problems
271. Lizzie's Kitchen has a debt-equity ratio of .60. The firm's required return on assets is
11% and its cost of equity is 14.7%. What is the pre-tax cost of debt based on M&M II with
no taxes?
A. 4.83%
B. 5.39%
C. 5.70%
D. 6.17%
E. 6.67%
.147 = .11 + (.11 - Rd)  .60; Rd = .0483 = 4.83%
Difficulty: Basic
Type: Problems
16-89
272. Victoria Dry Goods has expected earnings before interest and taxes of $14,600, an
unlevered cost of capital of 15%, and a tax rate of 35%. The company also has $3,500 of debt
that carries a 6% coupon. The debt is selling at par value. What is the value of this firm?
A. $63,267
B. $64,184
C. $64,492
D. $65,211
E. $66,267
VU = [$14,600  (1 - .35)]/.15 = $63,266.67; VL = $63,266.67 + (.35  $3,500) = $64,491.67

= $64,492
Type: Problems
273. Hanover Tech is currently an all equity firm that has 130,000 shares of stock outstanding
with a market price of $36 a share. The current cost of equity is 14% and the tax rate is 35%.
The firm is considering adding $1.5 million of debt with a coupon rate of 7% to its capital
structure. The debt will be sold at par value. What is the levered value of the equity?
A. $3.180m
B. $3.520m
C. $3.705m
D. $4.875m
E. $5.205m
VL = (130,000  $36) + (.35  $1.5m) = $4.68m + .525m = $5.205m; VE = $5.205m - $1.5m =

$3.705m
Type: Problems
16-90
274. Back Woods Coffee has expected earnings before interest and taxes of $34,500, an
unlevered cost of capital of 14%, and debt with both a book and face value of $20,000. The
debt has an annual 7% coupon. The tax rate is 35%. What is the value of the firm?
A. $167,179
B. $174,015
C. $177,778
D. $203,518
E. $241,414
VU = [$34,500  (1 - .35)]/.14 = $160,178.57; VL = $160,178.57 + (.35  $20,000) = $167,179
Type: Problems
275. Swedish Imports is an unlevered firm with an after-tax net income of $79,000. The
unlevered cost of capital is 12% and the tax rate is 35%. What is the value of this firm?
A. $427,916
B. $514,250
C. $579,333
D. $611,407
E. $658,333
VU = $79,000/.12 = $658,333
Type: Problems
16-91
276. An unlevered firm has a cost of capital of 16% and earnings before interest and taxes of
$225,000. A levered firm with the same operations and assets has both a book value and a face
value of debt of $850,000 with an 8% annual coupon. The applicable tax rate is 34%. What is
the value of the levered firm?
A. $928,125
B. $1,110,125
C. $1,178,125
D. $1,217,125
E. $1,778,125
VU = [$225,000  (1 - .34)]/.16 = $928,125; VL = $928,125 + (.34  $850k) = $1,217,125
Type: Problems
277. Salem Mills has an unlevered cost of capital of 14%, a cost of debt of 9%, and a tax rate
of 34%. What is the target debt-equity ratio if the targeted cost of equity is 16.5%?
A. 63
B. 69
C. 73
D. 76
E. 84
.165 = .14 + (.14 - .09)  D/E  (1 - .34); .025 = .033D/E; D/E = .76
Type: Problems
16-92
278. The Fabric Mill has debt with both a face and a market value of $6,500. This debt has a
cost of equity?
A. 17.90%
B. 18.56%
C. 22.40%
D. 23.59%
E. 25.14%
VU = [EBIT  (1 - Tc)]/RU = [$1,400  (1 - .35)]/.14 = $6,500

VL = VU + (Tc  D) = $6,500 + (.35  $6,500) = $8,775
VL - VD = VE = $8,775 - $6,500 = $2,275
RE = RU + (RU - RD)  D/E  (1 - TC) = .14 + [(.14 - .08)  ($6,500/$2,275)  (1 - .35)] =
25.14%
Type: Problems
279. Uptown Appliances has an unlevered cost of capital of 14%, a tax rate of 35%, and
expected earnings before interest and taxes of $8,200. The company has $15,000 in bonds
outstanding that have a 7.5% coupon and pay interest annually. The bonds are selling at par
value. What is the cost of equity?
A. 16.03%
B. 16.11%
C. 16.24%
D. 16.48%
E. 16.97%
VU = [EBIT  (1 - Tc)]/RU = [$8,200  (1 - .35)]/.14 = $38,071.43

VL = VU + (Tc  D) = $38,071.43 + (.35  $15,000) = $43,321.43
VL - VD = VE = $43,321.43 - $15,000 = $28,321.43
RE = RU + (RU - RD)  D/E  (1 - TC) = .14 + [(.14 - .075)  ($15,000/$28,321.43)  (1 - .35)]
= 16.24%
Type: Problems
16-93
280. The Pizza Palace has a cost of equity of 14.4% and an unlevered cost of capital of 10%.
The company has $18,000 in debt that is selling at par value. The levered value of the firm is
$32,000 and the tax rate is 35%. What is the pre-tax cost of debt?
A. 4.73%
B. 6.18%
C. 6.59%
D. 7.38%
E. 9.92%
.144 = .10 + (.10 - RD)  [$18,000/($32,000 - $18,000)]  (1 - .35); .044 = .083571 - .

835714RD; RD = 4.73%
Type: Problems
281. The Rose Bush has a cost of equity of 14.5% and a pre-tax cost of debt of 9%. The debt-
equity ratio is .70 and the tax rate is .35. What is The Rose Bush's unlevered cost of capital?
A. 11.84%
B. 12.78%
C. 14.29%
D. 14.46%
E. 15.08%
.145 = RU + (RU - .09)  .70  (1 - .35); .18595 = 1.455RU; RU = 12.78%
Type: Problems
16-94
282. Glover Tools has a pre-tax cost of debt of 9% and an unlevered cost of capital of 13.5%.
The firm's tax rate is 34% and the cost of equity is 15%. What is the firm's debt-equity ratio?
A. .42
B. .48
C. .51
D. .58
E. .64
.15 = .135 + (.135 - .09)  D/E  (1 - .34); .015 = .0297D/E; D/E =.51
Type: Problems
283. Prescription Express has a debt-equity ratio of .70. The pre-tax cost of debt is 8.5% while
the unlevered cost of capital is 15%. What is the cost of equity if the tax rate is 35%?
A. 13.79%
B. 14.28%
C. 17.96%
D. 18.40%
E. 18.87%
RE = .15 + (.15 - .085)  .70  (1 - .35) = 17.96%
Type: Problems
16-95
284. Webb Street Books has a $130,000 bond issue outstanding. These bonds have an 8%
coupon, pay interest semiannually, and have a current market price equal to 101.5% of face
value. The tax rate is 35%. What is the amount of the annual interest tax shield?
A. $3,515
B. $3,640
C. $4,480
D. $5,920
E. $6,760
Annual interest tax shield = $130,000  .08  .35 = $3,640
Type: Problems
285. Sam's Men's Wear has 2,500 bonds outstanding with a face value of $1,000 each and a
coupon rate of 7.5%. The interest is paid semi-annually. What is the amount of the annual
A. $63.75
B. $123.75
C. $31,400.00
D. $63,750.00
E. $123,750.00
Annual interest tax shield = 2,500  $1,000  .075  .34 = $63,750
Type: Problems
16-96
286. Joe's BBQ Grill has $21,000 of debt outstanding that is selling at par and has a coupon
rate of 6.5%. The tax rate is 35%. What is the present value of the tax shield?
A. $478
B. $790
C. $1,365
D. $4,780
E. $7,350
Present value of the tax shield = .35  $21,000 = $7,350
Type: Problems
287. Berkley's has expected earnings before interest and taxes of $3,800. Its unlevered cost of
capital is 14.5% and its tax rate is 35%. Berkley's has debt with both a book and a face value
of $2,200. This debt has a 7.5% coupon and pays interest annually. What is the firm's
weighted average cost of capital?
A. 12.48%
B. 12.99%
C. 13.87%
D. 14.14%
E. 14.37%
VU = [$3,800  (1 - .35)]/.145 = $17,034.48

VL = $17,034.48 + (.35  $2,200) = $17,804.48
VE = VL - VD = $17,804.48 - $2,200 = $15,604.48
RE = .145 + (.145 - .075)  ($2,200/$15,604.48)  (1 - .35) = .1514148
WACC = [($15,604.48/$17,804.48)  .1514148] + [($2,200/$17,804.48)  .075  (1 - .35)] =
13.87%
Type: Problems
16-97
288. A firm has debt of $8,000, a leveraged value of $18,800, a cost of debt of 8.75%, a cost
of equity of 13%, and a tax rate of 35%. What is the firm's weighted average cost of capital?
A. 9.89%
B. 10.33%
C. 10.69%
D. 11.19%
E. 12.48%
WACC = {[($18,800 - $8,000)/$18,800]  .13} + ($8,000/$18,800)  .0875  (1 - .35) =

9.89%
Type: Problems
289. Exley's Farms has a debt-equity ratio of .75. The cost of equity is 15% and the after-tax
cost of debt is 5.4%. What will the firm's cost of equity be if the debt-equity ratio is revised to
.60?
A. 10.89%
B. 11.47%
C. 11.70%
D. 13.89%
E. 14.18%
WACC = [(1.0/1.75)  .15] + [(.75/1.75)  .054] = .108857; .108857 = [(1.0/1.60)  RE] +

(.60/1.60)  .054; RE = 14.18%
Type: Problems
16-98
290. Thompson & Jones has earnings before interest and taxes of $149,000. Both the book
and the market value of debt is $265,000. The unlevered cost of equity is 13.5% while the
pre-tax cost of debt is 9%. The tax rate is 34%. What is Thompson & Jones' weighted average
cost of capital?
A. 10.94%
B. 11.65%
C. 11.72%
D. 12.01%
E. 12.37%
VU = [$149,000  (1 - .34)]/.135 = $728,444.44

VL = $728,444.44 + (.34  $265k) = $818,544.44
VE = VL - VD = $818,544.44 - $265k = $553,544.44
RE = .135 + (.135 - .09)  ($265k/$553,544.44)  (1 - .34) = .149218
WACC = [($553,544.44/$818,544.44)  .149218] + [($265k/$818,544.44)  .09  (1 - .34)] =
12.01%
Type: Problems
16-99
291. Janess Corporation is an all equity firm with 500,000 shares outstanding. It is
considering changing its capital structure to include debt. If it does, its shares will reduce to
375,000 and it will incur interest of $200,000. Given this information, calculate the
indifference EBIT.
A. $800,000
B. $850,000
C. $875,000
D. $900,000
E. $925,000
Type: Problems
16-100
292. Klassen Corporation is an all equity firm with 170,000 shares outstanding. It is
considering changing its capital structure to include debt. If it does, its shares will reduce to
90,000 and it will incur interest of $100,000. Given this information, calculate the
indifference EBIT.
A. $200,000
B. $212,500
C. $225,000
D. $237,500
E. $250,000
Type: Problems
16-101
293. Lombardo Company had net income of $70,000 and interest expense of $10,000. If the
corporate tax rate was 30%, determine its Degree of Financial Leverage (DFL).
A. 1.30
B. 1.25
C. 1.20
D. 1.15
E. 1.10
Type: Problems
16-102
294. Manchu company had net income of $140,000 and interest expense of $30,000. If the
corporate tax rate was 30%, determine its Degree of Financial Leverage (DFL).
A. 1.00
B. 1.05
C. 1.10
D. 1.15
E. 1.20
Type: Problems
16-103
295. Bodmore Corporation's EBIT and EPS in the previous year were $525,000 and $3.23.
This year EBIT and EPS were $750,000 and $5.26. Given this information, calculate the
company's DFL.
A. 1.80
B. 1.90
C. 2.00
D. 2.10
E. 2.20
16-104
Type: Problems
16-105
296. Due to a prolonged economic downturn, Keely Corporation's EBIT and EPS in the
previous year were $225,000 and $1.35. This year EBIT and EPS were $35,000 and $0.70.
Given this information, calculate the company's DFL.
A. 0.47
B. 0.50
C. 0.57
D. 0.60
E. 0.67
16-106
Type: Problems
16-107
297. Calculate the company's cost of equity given the following information: return on assets
7.0%; return on debt 3.25%; 25% debt; 75% equity.
A. 7.50%
B. 8.25%
C. 9.00%
D. 9.75%
E. 10.50%
Type: Problems
16-108
10.50%; return on debt 8.75%; total debt $995,000; total equity $1,520,000.
A. 8.65%
B. 9.65%
C. 10.65%
D. 11.65%
E. 12.65%
Type: Problems
16-109
13.25%; return on debt 8.25%; total debt $525,000; total equity $775,000.
A. 17.74%
B. 16.64%
C. 15.54%
D. 14.44%
E. 13.34%
Type: Problems
16-110
10.5%; return on debt 8.75%; total debt $995,000; total equity $1,520,000. Tax rate 40%.
A. 11.19%
B. 12.29%
C. 13.39%
D. 14.49%
E. 15.59%
Type: Problems
16-111
6.75%; return on debt 4.5%; total debt $200,000; total equity $800,000. Tax rate 35%.
A. 10.42%
B. 9.32%
C. 8.22%
D. 7.12%
E. 6.02%
Type: Problems
16-112
Essay Questions
302. Explain homemade leverage and why it matters.
Homemade leverage is the ability of investors to alter their own financial leverage to achieve
a desired capital structure no matter the firm's capital structure choice. If investors can use
homemade leverage to create additional leverage or to undo existing leverage of the firm at
their discretion, then the actual capital structure decision of the firm itself becomes irrelevant.
Type: Essay
303. Given that rational investors are risk averse, the cost of debt will generally be lower than
the cost of equity; however, M&M Proposition I states that replacing equity with debt will not
change the value of the firm. Explain.
The student is asked to demonstrate his/her understanding of the basic M&M model. The
astute student will recognize that, in terms of logical consistency, M&M is "bulletproof"; i.e.,
given the assumptions, you will arrive at M&M's conclusions -- period. Second, no one
believes that the Case I model accurately describes reality; rather, it provides a jumping off
point from which we can readily assess the importance of market "imperfections" such as
taxes, bankruptcy costs, etc. One would hope that the responses to this question reflect these
aspects of the issue, as well as the basic mechanics involved.
Type: Essay
16-113
304. Describe some of the sources of business risk and financial risk. Do financial decision
makers have the ability to "trade off" one type of risk for the other?
Students should intuitively recognize that some of the observed variation in capital structures
across industries, for example, reflect differences in the nature of the industries themselves;
i.e., business risk. Similarly, intuition would suggest that firms with large capital requirements
and stable cash flows (e.g., electric utilities) are more likely to be willing to raise funds via
large amounts of borrowing. Alternatively, firms with lower tangible asset needs and highly
uncertain cash flows (e.g., small software companies) are more likely to employ equity.
Type: Essay
305. In each of the theories of capital structure, the cost of equity rises 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, isn't the goal of the firm to maximize share value (and minimize
shareholder costs)?
This question requires students to differentiate between the cost of equity and the weighted
average cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades
off higher equity costs for lower debt costs. The shareholders benefit (to a point, according to
the static theory) because their investment in the firm is leveraged, enhancing the return on
their investment. Thus, even though the cost of equity rises, the overall cost of capital declines
(again, up to a point according to the static theory) and firm value rises.
Type: Essay
16-114
306. According to the capital structure theories we examined, a firm benefits by having debt
since the interest expense is deductible for tax purposes, creating an interest tax shield. The
interest tax shield, on the other hand, increases in value the higher the coupon rate on the debt
and the higher the tax rate. Ignoring financial distress costs, shouldn't the firm then choose to
pay as high a coupon rate as possible?
This odd question challenges the students to differentiate between tax benefits and after-tax
costs. The interest tax shield measures the benefits of having debt, but ignores the cost side.
What matters to the firm is the WACC, which is minimized by adding low-cost debt to the
mix. As debt costs rise, the after-tax cost of debt rises, the WACC rises, and the benefits of
debt decline.
Type: Essay
307. In a world of corporate taxes only, show that the WACC can be written as WACC = RU 
[1 - TC  (D/V)].
The student will need to use the M&M propositions to derive the WACC. The student should
begin with:
RE = RU + (RU - RD)  D/E  (1 - TC)

RA = RE  E/V + RD  D/V  (1 - TC) = WACC
From there, substituting RE into the RA equation leads to the final answer.
Type: Essay
16-115
308. Is there an easily identifiable debt/equity ratio that will maximize the value of a firm?
Why or why not?
Students should explain that in a world with taxes, transaction costs, and financial distress
costs, there are both benefits and costs to higher debt loads, and there is no way to target
exactly what the ideal capital structure should be.
Type: Essay
309. Based on M&M without taxes and with taxes, how much time should a financial
manager spend analyzing the capital structure of their firm? How about based on the static
theory?
Under either M&M scenario, the financial manager should invest no time in analyzing the
firm's capital structure. With no taxes, capital structure is irrelevant. With taxes, M&M says a
firm will maximize its value by using 100% debt. In both cases, the manager has nothing to
decide. With the static theory, however, the manager decides the optimal amount of debt and
equity by analyzing the tradeoff between the benefits of the interest tax shield versus financial
distress costs. Ultimately, finding the optimal capital structure is challenging in this case.
Type: Essay
310. 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. 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 student should replicate and explain Figure 16.8 from the text.
Type: Essay
16-116
311. Differentiate between (A) business failure, (B) legal bankruptcy, (C) technical
insolvency, and (D) accounting insolvency.
This a straightforward question requiring the student to know and understand the terminology
in section 16.9.
Type: Essay
312. What are the advantages for a firm using a pre-packaged bankruptcy? Disadvantages?
A prepack allows a firm to minimize its stay in bankruptcy court, and should allow the firm to
minimize its bankruptcy costs as well. In either case, management is freed up to spend time
on more productive tasks, such as operating the firm. The negative side of a prepack is a little
more difficult to discern. Astute students will recognize that prepacks take time to negotiate,
that is, they may save time during bankruptcy, but they likely take more time up front than a
straight bankruptcy filing. Furthermore, it is also likely that the firm must give creditors a
better deal in order to get them to sign on to the bankruptcy agreement. If so, the firm may
actually get better terms from its creditors by going through with a full bankruptcy process.
Type: Essay
313. Explain why the optimal capital structure is one that maximizes the value of marketed
claims and minimizes the value of nonmarketed claims.
Marketed claims are claims the bondholders and shareholders have on a firm. Nonmarketed
claims include taxes, bankruptcy costs, and other similar items. The optimal capital structure
should ensure full payment of debt in a timely manner and provide the maximum return for
shareholders. Nonmarketed claims reduce the return to shareholders and thus, should be
minimized.
Type: Essay
16-117
314. Using the variables of total debt and firm value, draw a graph contrasting M&M
Proposition I with taxes with M&M Proposition I without taxes. Explain the difference
between these two propositions.
Students should duplicate Figure 16.4 from the textbook. M&M Proposition I without taxes
states that the value of an unlevered firm is equal to the value of a levered firm. M&M
Proposition I with taxes states that the value of a levered firm is equal to the value of an
unlevered firm plus the present value of the interest tax shield. The difference between the
two propositions is the present value of the interest tax shield.
Difficulty: Basic
Type: Essay
315. Using the cost of capital and the debt-equity ratio, illustrate how the cost of capital for an
unlevered firm varies from the weighted average cost of capital of a levered firm.
Students should duplicate Figure 16.5 from the textbook. The unlevered cost of capital is
constant. The weighted average cost of capital declines as the debt-equity ratio rises from
zero.
Difficulty: Basic
Type: Essay
316. Using a graph of firm value against total debt, explain how M&M Proposition I with
taxes differs from the static theory of capital structure.
Students should duplicate the graph in Figure 16.6 from the textbook. M&M Proposition I
with taxes depicts the value of a firm as a linear function with an upward slope. The value of
the firm according to the static theory is dome-shaped such that the value rises up to a point
and thereafter if the debt level rises, the value of the firm declines.
Difficulty: Basic
Type: Essay
16-118

Chapter 16 - Financial Leverage and Capital Structure Policy

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Chapter 16 - Financial Leverage and Capital Structure Policy

True / False Questions

2. Business risk declines as the systematic risk of a firm's assets increases.

3. Business risk is a positive function of the systematic risk of a firm's assets.

Multiple Choice Questions

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

36. The procedure for liquidating a corporation is outlined in:

37. The absolute priority rule establishes the order in which:

38. Which of the following is true about the WACC?

I. Maximizes the value of the firm.

41. Which of the following is NOT accurate regarding financial leverage?

45. Which of the following statements regarding leverage is false?

48. Which of the following statements is correct?

I. The required rate of return on the firm's assets

56. The equity beta of a firm depends on which of the following?

I. The firm's business risk.

64. A firm that is approaching bankruptcy will find that

66. Which of the following would be considered an indirect bankruptcy cost?

69. According to the static theory of capital structure, ____________________.

75. When a firm defaults on a legal obligation, ___________.

80. Which of the following is true regarding bankruptcy?

I. The WACC is at its minimum point.

85. In a world without taxes, M&M Proposition I contends that:

88. Which one of the following statements is true?

91. Which of the following are indirect costs of bankruptcy?

I. Loss of key employees

93. The cost of bankruptcy:

94. Shareholders generally prefer that a distressed firm:

95. The optimal firm value is achieved when the:

106. A firm should select the capital structure which:

107. The value of a firm is maximized when the:

114. M&M Proposition I with no tax supports the argument that:

116. The concept of homemade leverage is most associated with:

I. The return on assets is equal to the weighted average cost of capital.

118. M&M Proposition I with tax supports the theory that:

119. M&M Proposition I with taxes is based on the concept that:

120. M&M Proposition II is the proposition that:

121. The business risk of a firm:

I. the tax rate is equal to zero.

125. The interest tax shield is a key reason why:

I. a reduction in tax rates

127. Which one of the following statements concerning bankruptcy is correct?

128. Indirect bankruptcy costs:

129. When a firm is operating with the optimal capital structure:

I. the debt-equity ratio will also be optimal.

132. The optimal capital structure:

134. In general, observed capital structures:

135. A firm is technically insolvent when:

136. The static theory of capital structure:

139. A reorganization is defined as:

140. The capital structure of a firm refers to the firm's:

141. M&M Proposition II is the proposition that:

142. The ideal capital structure:

144. The use of homemade leverage:

145. Homemade leverage makes which one of the following irrelevant?

147. M&M Proposition I with no tax argues that:

I. the firm's debt-equity ratio.

153. As the debt-equity ratio of a firm rises, the: