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Exam 13: Leverage and Capital Structure

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Question 1

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Explain how taxes affect the value of a firm based on M&M Proposition I.

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M&M Proposition I states the value of a ...

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Question 2

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Which one of the following statements concerning financial leverage is correct?

A) Financial leverage increases profits and decreases losses.
B) Financial leverage has no effect on a firm's return on equity.
C) Financial leverage refers to the use of common stock.
D) Financial leverage magnifies both profits and losses.
E) Increasing financial leverage will always decrease the earnings per share.

F) A) and D)
G) A) and B)

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Question 3

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Which one of the following statements is correct?

Which one of the following is the equity risk arising from the capital structure selected by a firm?

Which one of the following statements concerning financial leverage is correct?

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

Which one of the following is an implication of M&M Proposition II, without taxes?

Glass Growers has no debt. Its cost of capital is 8.7 percent. Suppose the firm converts to a debt-equity ratio of 0.65. The interest rate on the debt is 6.9 percent. What is its new WACC?

Which one of the following statements is the core principle of M&M Proposition I, without taxes?

Shoe Box Stores is currently an all-equity firm with 28,000 shares of stock outstanding. Management is considering changing the capital structure to 40 percent debt. The interest rate on the debt would be 9 percent. Ignore taxes. Jamie owns 300 shares of Shoe Box Stores stock that is priced at $17 a share. What should Jamie do if she prefers the all-equity structure but Shoe Box Stores adopts the new capital structure?

Assume a fellow student made these statements during a class discussion: "Bankruptcy costs only affect a firm if the firm files a bankruptcy petition with the court. Therefore, the static theory of capital structure only applies to bankrupt firms." Write a response to your fellow student that either supports or contradicts that student's statements.

The Gable Inn is an all-equity firm with 16,000 shares outstanding at a value per share of $14.50. The firm is issuing $50,000 of debt and using the proceeds to reduce the number of outstanding shares. How many shares of stock will be outstanding once the debt is issued? Ignore taxes.

Jasper Industrial has no debt outstanding and a total market value of $110,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 15 percent higher. If there is a recession, then EBIT will be 20 percent lower. Jasper Industrial is considering a $35,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 7,500 shares outstanding. Ignore taxes for this problem. What is the percentage change in EPS when a normal economy slips into recession?

Which one of the following terms is inclusive of both direct and indirect bankruptcy costs?

Katz is an all-equity development company that has 36,000 shares of stock outstanding at a market price of $25 a share. The firm's earnings before interest and taxes are $29,000. Katz has decided to issue $200,000 of debt at a rate of 6 percent and use the proceeds to repurchase shares. What should Faith do if she owns 500 shares of Katz stock and wants to use homemade leverage to offset the leverage being assumed by the firm?

Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $826,000 annually forever. Currently, the firm has no debt but is considering borrowing $650,000 at 6.75 percent interest. The tax rate is 34 percent and the current cost of equity is 17.2 percent. What is the value of the levered firm?

Explain why the capital structure of a firm is irrelevant to equity investors.

You are considering a firm under three separate scenarios: 1) no debt, taxes or bankruptcy costs, 2) with debt and taxes but no bankruptcy costs, and 3) with debt, taxes, and bankruptcy costs. Under which one of these three scenarios will the firm have the highest value?

Assume both corporate taxes and financial distress costs apply to a firm. Given this, the static theory of capital structure illustrates that:

Glass Ornaments, Inc. is an all-equity firm with a total market value of $386,000 and 15,000 shares of stock outstanding. Management is considering issuing $75,000 of debt at an interest rate of 8 percent and using the proceeds on a stock repurchase. As an all-equity firm, management believes the earnings before interest and taxes (EBIT) will be $31,000 if the economy is normal, $11,000 if it is in a recession, and $37,000 if the economy booms. Ignore taxes. What will the earnings per share (EPS) be if the economy falls into a recession and the firm maintains its all-equity status?