Capital Structure - 2
Quiz
1. ________ financial world is one without taxes, bankruptcy, and other imperfections.
a. An imperfect
b. A friction-full
c. A perfect
d. A realistic
2. Which of the statements below is FALSE?
a. Two different individuals or companies could go to the same bank and request exactly the same amount of funding for their projects and yet could be required to pay different costs for their funds.
b. It is important to remember that a public company is a separate entity and in that capacity can borrow from bondholders, preferred stockholders, and common shareholders, but not from banks.
c. Lenders, regardless of their classification, all consider their funds as investments, for which they hope to make a positive return.
d. The return to the investor is the cost to the seller.
Comment: It is important to remember that a public company is a separate entity and in that capacity can borrow from bondholders, preferred stockholders, common shareholders, AND banks.
3. In a perfect financial world, a company's value is dependent on its capital structure.
FALSE
Comment: in a perfect financial world, a company’s value is INDEPENDENT OF its capital structure.
4. The more ________ used, the greater the leverage a company employs on behalf of its owners.
a. Debt
b. Equity
c. Debt and equity
d. All of these
5. Which of the statements below is FALSE?
a. When a company performs well, it can handle more debt and benefit the owners.
b. Borrowing from debt lenders at one rate and investing the money in the business and making a higher rate is bad for the owners.
c. Assume that the more debt the company has sold, the better off the shareholders are. This is the case where the earnings reflect a return greater than the cost of debt.
d. Financial leverage is the degree to which a firm or individual utilizes borrowed money to make money.
Comment: Borrowing from debt lenders at one rate and investing the money in the business and making a higher rate is GOOD for the owners.
6. Consider two companies that are alike except in borrowing choices. Barry Corp. has no debt financing, and Crawford Corp. uses debt financing. The EBIT for both companies is $100. Barry Corp. has 40 shares outstanding and pays no interest. Crawford Corp. has 30 shares outstanding and pays $25 in interest. What is the EPS for each company?
a. Both companies have an EPS of $2.50.
b. Both companies have an EPS of $2.00.
c. Barry Corp. has an EPS of $2.50 and Crawford Corp. has an EPS of $2.00.
d. Barry Corp. has an EPS of $2.00 and Crawford Corp. has an EPS of $2.50.
Comment: Barry Corp.: Net Income = EBIT - interest = $100 - 0 = $100.
EPS = Net Income / Shares outstanding = $100/40 = $2.50.
Crawford Corp.: Net Income = EBIT - interest = $100 - $25 = $75.
EPS = ($75/30) = $2.50.
7. Shareholders can be made better off in terms of EPS with financial leverage when earnings are sufficiently high to offset the interest expense of debt.
TRUE
8. When earnings are less than the cost of debt, it follows that the more debt, the lower the percentage of earnings available for distribution to shareholders.
TRUE
9. Above the break-even EBIT, there is no benefit in debt financing.
Answer: FALSE
Comment: BELOW the break-even EBIT, there is no benefit in debt financing.
10. Garson Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each share of stock is $6.00. The CEO of Garson is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10% annually, and the current corporate tax rate for Garson is 30%. If the CEO believes that Garson will earn $100,000 per year before interest and taxes, what is the EPS in each case?
a. $0.35, $0.28
b. $0.28, 0.35
c. 0.30, $0.25
d. 0.35, 0.40
Answer: Find the EPS under the two financing structures with an EBIT of $100,000:
With All-Equity EPS = $100,000*(1-0.3) / 200,000 = $0.35
Annual Interest Payment for Debt = $600,000 × 0.10 = $60,000.
With 50/50 Debt-to-Equity: EPS = ($100,000-$60,000)*(1-0.3) / 100,000 = $0.28
So the shareholders will be worse off by $0.07 per share under a firm with $600,000 in debt financing versus a firm that is all-equity. The CEO of Garson Corp. should NOT add this much debt to the firm as it would not benefit the owners of the company. The CEO might look at smaller amounts of debt to determine if debt can be valuable. Smaller amounts of debt might lower the cost of debt borrowing and make leverage value-enhancing for shareholders.
11. Moving from one source of funding to another in a particular order is called the ________.
a. Pecking Order Hypothesis
b. Barnyard Order Hypothesis
c. Funding Order Hypothesis
d. Capital Market Hypothesis
12. The Pecking Order Hypothesis predicts which of the following?
a. Firms prefer internal financing first.
b. If external financing is required, firms should first seek debt financing.
c. If external financing is required, firms will choose to issue the safest or cheapest security first, starting with debt financing and using equity as a last resort.
d. All of these
13. In regards to the formula WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc), which of the statements below is FALSE?
a. Tc is the corporate tax rate.
b. E/V is the equity to firm value ratio.
c. Re is the cost of equity.
d. Rd × (1 - Tc) is the before-tax cost of debt.
Comment: Rd × (1 - Tc) is the AFTER-TAX cost of debt.
14. M&M's Proposition II suggests that in a world of no taxes and no bankruptcy, ________.
a. No matter what the debt-equity ratio is, the Ra or WACC of the firm increases with debt.
b. The value of the firm is sensitive to the funding choice between debt and equity.
c. In simple terms, as the firm adds more debt to the financing mix, the shareholders require a higher and higher return on equity such that it exactly offsets the use of the cheaper debt.
d. Statements A through C are all incorrect.
Comment: No matter what the debt-equity ratio is the Ra or WACC of the firm does not changes. The value of the firm is INSENSITIVE to the funding choice between debt and equity.
15. Pain-Free Inc. is a business dealing in pain reduction medication. It has a required return on its assets of 18%. It can borrow in the debt market at 10%. If there are no taxes and M&M's proposition II holds, what is the cost of equity if there is 50% equity financing and 50% debt financing?
a. 18%
b. 26%
c. 28%
d. None of these
Comment: Cost of Equity: Re = Ra + (Ra - Rd) × (D/E) = 18% + (18% - 10%) × (5/5) = 26%.
16. Consider the M&M world of corporate taxes. The interest expense is $10 million, the corporate tax rate is 20%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?
a. $19 million
b. $20 million
c. $29 million
d. $30 million
Comment: Tax Shield = (Int Expense * Tax Rate) / Discount Rate = $20 million.
17. When bankruptcy is added to the M&M world of capital structure, which of the following statements is true as more debt is added to the financing mix of the company?
a. The interest tax shield is a benefit to equity holders, although they bear increasing risk.
b. The advantage of the tax shield starts to be offset by financial distress costs.
c. The WACC of the company starts to increase past a certain level of debt.
d. All of the above
18. A rising WACC ________ the values of the firm's future cash flows.
a. Increases
b. Reduces
c. Keeps constant
d. Has no effect on
19. At the optimal debt-to-equity ratio, the cost of capital (WACC) is ________ for the firm. This point reflects the maximum benefit of leverage.
a. The lowest
b. The highest
c. At the midpoint
d. Irrelevant
20. Bankruptcy is the point at which the equity value of the firm is zero. That is, the value of the assets is equal to or less than the value of the liabilities of the firm.
Answer: TRUE
21. Consider the Modigliani and Miller's world of corporate taxes. An unleveraged (all-equity) firm value is $100 million. By adding debt, the annual interest expense is $10 million, the corporate tax rate is 40%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?
a. $100 million
b. $120 million
c. $140 million
d. $160 million
Comment: We first compute the tax shield: (Int Expense * Tax Rate) / Discount Rate = $40 million. We can now compute firm value: VL = VE + Tax Shield = $100 million + $40 million = $140 million.
22. Which of the formulations below expresses the weighted average cost of capital (WACC) formula?
a. WACC = (E/V) × Re + (D/V) × Rd x( 1 - Tc)
b. WACC = (D/V) × Re + (E/V) × Rd × (1 - Tc)
c. WACC = (E/V) × Re × (1 - Tc) + (D/V) × Rd
d. WACC = (E/V) × Rd + (D/V) × Re × (1 - Tc)
23. Fresh out of SP Jain Center of Management, Mr. Deeraj, the new CFO of Deeraj Associates, wants to shake things up at his sleepy little food company. The firm is currently an all-equity firm because "that's the way we've always done it." Under pressure from a new group of major stockholders, however, he is considering acquiring some debt (leverage) in an effort to boost earnings per share. The company currently has 600 shares, but he is thinking about borrowing $6,000 at 10% per year and buying back 200 of those shares. What level of EBIT would make this an attractive strategy?
a. $2,000
b. $1,800
c. $1,600
d. $1,400
Comment: Set the two EPS's of SC Co., before and after debt, equal to each other and solve for EBIT. Thus,
All-equity EPS = EBIT/600shares
Leveraged EPS = (EBIT - $6000 × 10%)/400 shares
So EBIT/600 = (EBIT - $600)/400.
Solving, we get EBIT = $1,800.
24. Coffee Treat, a coffee chain is the gulf is looking at two possible capital structures. Currently, the firm is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of each share is $6.00. The CEO of Coffee Treat is thinking of leveraging the firm by selling $300,000 of debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is 5% annually, and the current corporate tax rate for Coffee Treat is 30%. The CEO believes that Coffee Treat will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE?
a. All-equity EPS is $0.35
b. 50/50 debt-to-equity EPS is $0.49
c. Shareholders will be better off with a price of $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all-equity
d. Statements (A) through (C) are all true
Comment: Find the EPS under the two financing structures with an EBIT of $50,000:
With All-Equity: EPS = $50,000*(1-0.3) / 100,000 = $0.35
Annual Interest Payment for Debt = $300,000 × 0.05 = $15,000.
With 50/50 Debt to Equity: EPS = ($50,000 - $15,000)*(1-0.3) / 100,000 = $0.49
So the shareholders will be better off by $0.14 per share under a firm with $300,000 in debt financing versus a firm that is all equity. The CEO of Coffee Treat Corp. should add debt to the firm as it would benefit the owners of the company.
25. Capital structure refers to how the firm finances its operations and growth through a combination of ________
a. Equity types
b. Security types
c. Types of earnings
d. Types of Debt
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