54.
|
Kelso Electric is debating between a leveraged and an unleveraged 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 $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.
EBIT/40,000 = [EBIT - ($280,000 × 0.07)]/25,000; EBIT = $52,267
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Break-even EBIT |
55.
|
Holly's is currently an all equity firm that has 9,000 shares of stock outstanding at a market price of $45 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. 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.
EBIT/9,000 = [EBIT - ($120,000 × 0.095)]/[9,000 - ($120,000/$45)]; EBIT = $38,475
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Break-even EBIT |
56.
|
Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes.
Number of shares repurchased = $30,000/$15 = 2,000
EBIT/5,000 = [EBIT - ($30,000 × .0.10)]/(5,000 - 2,000); EBIT = $7,500 EPS = [$7,500 - ($30,000 × 0.10)]/(5,000 - 2,000); EPS = $1.50 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Break-even EPS |
57.
|
Miller's Dry Goods is an all equity firm with 48,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes.
Miller's interest = $250,000 × 0.08 = $20,000
Miller's shares repurchased = $250,000/$50 = 5,000 Miller's shares outstanding with debt = 48,000 - 5,000 = 43,000 Miller's EPS, no debt = $128,000/48,000 = $2.666667 Miller's EPS, with debt = ($128,000 - $20,000)/43,000 = $2.511628 Miller's value of stock = 43,000 × $50 = $2,150,000 Miller's value of debt = $250,000 Miller's total value = $2,150,000 + $250,000 = $2,400,000 Miller's weight stock = $2,150,000/$2,400,000 = 0.895833 Miller's weight debt = $250,000/$2,400,000 = 0.104167 Your initial investment = 400 × $50 = $20,000 Your new stock position = 0.895833 × $20,000 = $17,916.67 Your new number of shares = $17,916.67/$50 = 358.3333 Number of shares sold = 400 - 358.3333 = 41.67 shares Check: Your new loans = 0.104167 × $20,000 = $2,083.33 Your total unlevered income = 400 × $2.666667 = $1,066.67 Your total levered income = (358.3333 × $2.511628) + ($2,083.33 × 0.08) = $11,066.67 |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Homemade leverage |
58.
|
You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest?
JKL interest = $1m × 0.08 = $80,000
JKL shares repurchased = $1m/$40 = 25,000 JKL shares outstanding with debt = 75,000 - 25,000 = 50,000 JKL EPS, no debt = $140,000/75,000 = $1.866667 JKL EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20 JKL value of stock = 50,000 × $40 = $2m JKL value of debt = $1m JKL total value = $2m + $1m = $3m JKL weight stock = $2m/$3m = 2/3 JKL weight debt = $1m/$3m = 1/3 Your initial investment = 600 × $40 = $24,000 Your new stock position = 2/3($24,000) = $16,000 Your new number of shares = $16,000/$40 = 400 Number of shares sold = 600 - 400 = 200 shares Check: Your new loans = 1/3($24,000) = $8,000 Your unlevered income = 600 × $1.866667 = $1,120 Your levered income = (400 × $1.20) + ($8,000 × 0.08) = $1,120 |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Homemade leverage |
59.
|
Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $102,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes.
Naylor's interest = $825,000 × 0.075 = $61,875
Naylor's shares repurchased = $825,000/$50 = 16,500 Naylor's shares outstanding with debt = 60,000 - 16,500 = 43,500 Naylor's EPS, no debt = $102,000/60,000 = $1.70 Naylor's EPS, with debt = ($102,000 - $61,875)/43,500 = $.9224138 Naylor's value of stock = 43,500 × $50 = $2,175,000 Naylor's value of debt = $825,000 Naylor's total value = $2,175,000 + $825,000 = $3,000,000 Naylor's weight stock = $2,175,000/$3,000,000 = 0.725 Naylor's weight debt = $825,000/$3,000,000 = 0.275 Your initial investment = 500 × $50 = $25,000 Your new stock position = 0.725 × $25,000 = $18,125 Your new number of shares = $18,125/$50 = 362.5 shares Check: Your new loans = 0.275 × $25,000 = $6,875 Your unlevered income = 500 × $1.70 = $850 Your levered income = (362.5 × $0.9224138) + ($6,875 × 0.075) = $850 |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Homemade leverage |
60.
|
Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?
Firm value = 80,000 × ($600,000/12,000) = $4 million
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: Firm value |
61.
|
The Jean Outlet is an all equity firm that has 146,000 shares of stock outstanding. The company has decided to borrow the $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes?
Firm value = 152,000 × ($1.1m/7,500) = $22,293,333
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: Firm value |
62.
|
Stacy owns 38 percent of The Town Centre. She has decided to retire and wants to sell all of her shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock. What is the total market value of The Town Centre? Ignore taxes.
Firm value = $650,000/0.38 = $1,710,526
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: Firm value |
63.
|
Winter's Toyland has a debt-equity ratio of 0.65. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes?
RE = 0.161 + (0.161 - 0.087) × 0.65 = 20.91 percent
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: M & M Proposition II |
64.
|
Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M & M II with no taxes?
RE = 0.146 = 0.132 + (0.132 - 0.078) × D/E; D/E = 0.26
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: M & M Proposition II |
65.
|
The Corner Bakery has a debt-equity ratio of 0.62. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M & M Proposition II with no taxes?
RE = 0.161 = 0.142 + (0.142 - Rd) × 0.62; Rd = 11.14 percent
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: M & M Proposition II |
66.
|
L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm?
VU = [$48,900 × (1 - 0.34)]/0.145 = $222,579.31
VL = $222,579.31 + 0.34 ($8,000) = $225,299.31 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
67.
|
Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?
VL = (320,000 × $19) + (0.34 × $1.2m) = $6.488m
VE = $6.488m - $1.2m = $5.288m |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
68.
|
Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm?
VU = [$48,600 × (1 - 0.34)]/0.132 = $243,000
VL = $243,000 + (0.34 × $25,000) = $251,500 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
69.
|
Exports Unlimited is an unlevered firm with an aftertax net income of $52,300. The unlevered cost of capital is 14.1 percent and the tax rate is 36 percent. What is the value of this firm?
VU = $52,300/0.141 = $370,922
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
70.
|
An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500. A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon. The applicable tax rate is 38 percent. What is the value of the levered firm?
VU = [$327,500 × (1 - 0.38)]/0.175 = $1,160,285.71
VL = $1,160,285.71 + 0.38($650k) = $1,407,286 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
71.
|
Down Bedding has an unlevered cost of capital of 14 percent, a cost of debt of 7.8 percent, and a tax rate of 32 percent. What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent?
RE = 0.1551 = 0.14 + (0.14 - 0.078) × D/E × (1 - 0.32); D/E = 0.358
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
72.
|
Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity?
VU = [$2,100 × (1 - 0.30)]/0.117 = $12,564.10
VL = $12,564.10 + (0.30 × $12,000) = $16,164.10 VE = $16,164.10 - $12,000 = $4,164.10 RE = 0.117 + [(0.117 - 0.06) × ($12,000/$4,164.10) × (1 - 0.30)] = 23.20 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
73.
|
Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?
VU = [$15,700 × (1 - 0.38)]/0.12 = $81,116.67
VL = $81,116.67 + (0.38 × $12,000) = $85,676.67 VE = $85,676.67 - $12,000 = $73,676.67 RE = 0.12 + [(0.12 - 0.06) × ($12,000/$73,676.67) × (1 - 0.38)] = 12.61 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
74.
|
The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $41,000 and the tax rate is 34 percent. What is the pre-tax cost of debt?
RE = 0.153 = 0.118 + (0.118 - RD) × [$22,000/($41,000 - $22,000)] × (1 - 0.34);
RD = 7.22 percent |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
75.
|
The Green Paddle has a cost of equity of 12.1 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?
RE = 0.121 = RU + (RU - 0.076) × 0.65 × (1 - 0.32); RU = 10.72 percent
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
76.
|
Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio?
RE = 0.18 = 0.146 + (0.146 - 0.084) × D/E × (1 - 0.37); D/E = 0.87
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
77.
|
Douglass & Frank has a debt-equity ratio of 0.35. The pre-tax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent?
RE = 0.133 + (0.133 - 0.082) × 0.35 × (1 - 0.39) = 14.39 percent
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
78.
|
The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield?
Annual interest tax shield = $270,000 × 0.075 × 0.39 = $7,897.50
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: Interest tax shield |
79.
|
Georga's Restaurants has 5,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent?
Annual interest tax shield = 5,000 × $1,000 × 0.0825 × 0.37 = $152,625.00
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: Interest tax shield |
80.
|
D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield?
Present value of the tax shield = 0.32 × $21,000 = $6,720
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: PV of tax shield |
81.
|
Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?
VU = [$6,200 × (1 - 0.34)]/0.14 = $29,228.57
VL = $29,228.57 + (0.34 × $2,500) = $30,078.57 VE = $30,078.57 - $2,500 = $27,578.57 RE = 0.14 + (0.14 - 0.09) × ($2,500/$27,578.57) × (1 - 0.34) = 0.142991 WACC = [($27,578.57/$30,078.57) × 0. 142991] + [($2,500/$30,078.57) × 0.09 × (1 - 0.34)] = 13.60 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: WACC |
82.
|
A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital?
WACC = {[($26,400 - $12,000)/$26,400] × 0.176} + [($12,000/$26,400) × 0.092 × (1 - 0.37)] = 12.23 percent
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: WACC |
83.
|
Young's Home Supply has a debt-equity ratio of 0.80. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.9 percent. What will the firm's cost of equity be if the debt-equity ratio is revised to 0.70?
WACC = [(1.0/1.8) × 0.145] + [(0.8/1.8) × 0.049] = 0.102333;
WACC = 0.102333 = [(1.0/1.70) × RE] + [(0.70/1.70) × 0.049; RE = 13.97 percent |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: WACC |
84.
|
Percy's Wholesale Supply has earnings before interest and taxes of $106,000. Both the book and the market value of debt is $170,000. The unlevered cost of equity is 15.5 percent while the pre-tax cost of debt is 8.6 percent. The tax rate is 38 percent. What is the firm's weighted average cost of capital?
VU = [$106,000 × (1 - 0.38)]/0.155 = $424,000
VL = $424,000 + (0.38 × $170,000) = $488,600 VE = $488,600 - $170,000 = $318,600 RE = 0.155 + (0.155 - 0.086) × ($170,000/$318,600) × (1 - 0.38) = 0.177827 WACC = [($318,600/$488,600) × 0.177827] + [($170,000/$488,600) × 0.086 × (1 - 0.38)] = 13.45 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: WACC |
85.
|
East Side, Inc. has no debt outstanding and a total market value of $136,000. 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 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.
Share price = $136,000/2,000 = $68
Shares repurchased = $54,000/$68 = 794.117647 Annual interest = $54,000 × 0.05 = $2,700 EPSNormal = ($12,000 - $2,700)/(2,000 - 794.117647) = $7.712195 EPSRecession = {[$12,000 × (1 - 0.55)] - $2,700}/(2,000 - 794.117647) = $2.239024 Percentage change = ($2.239024 - $7.712195)/$7.712195 = -70.97 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy EOC: 16-1 Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: EBIT and leverage |
86.
|
North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.
Share price = $175,000/2,500 = $70
Shares repurchased = $70,000/$70 = 1,000 Annual interest = $70,000 × 0.07 = $4,900 EPS Normal = [($16,000 - $4,900)(1 - 0.34)]/(2,500 - 1,000) = $4.884 EPS Expansion = [(16,000(1.3) - 4,900)(1 - .34)]/(2,500 - 1,000) = $6.996 Percentage change = ($6.996 - $4.884)/$4.884 = 43.24 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy EOC: 16-2 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.2 Topic: EBIT, taxes, and leverage |
87.
|
Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Galaxy would have 178,500 shares of stock outstanding. Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. What is the breakeven EBIT?
EBIT/178,500 = [EBIT - 0.10($1,790,000)]/71,400; EBIT = $298,333.33
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy EOC: 16-4 Learning Objective: 16-01 The effect of financial leverage. Section: 16.2 Topic: Break-even EBIT |
88.
|
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.
ABC: RE = RA = $58,400/$480,000 = 12.17 percent
XYZ: RE = 0.1217 + (0.1217 - 0.09) x (1) = 15.33 percent Note: ABC: Equity = $480,000 XYZ: Equity = $240,000; Debt = $480,000 - $240,000 = $240,000; D/E = 1 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy EOC: 16-9 Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: Cost of equity |
89.
|
Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?
V = $38,000,000 = EBIT/0.11; EBIT = $4,180,000
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy EOC: 16-10 Learning Objective: 16-01 The effect of financial leverage. Section: 16.3 Topic: M & M Proposition I with no tax |
90.
|
The SLG Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $31 million and the corporate tax rate is 34 percent. What is EBIT?
VU = $31,000,000 = EBIT (1 - 0.34)/0.11; EBIT = $5,166,667
|
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy EOC: 16-11 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
91.
|
W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its cost of debt is 9 percent. The corporate tax rate is 33 percent. What is the firm's unlevered cost of equity capital?
WACC = 0.10 = (1/2.4) RE + (1.4/2.4) (0.09) (1 - 0.33); RE = 0.15558
RE = 0.15558 = RU + (RU - 0.09)(1.4)(1 - 0.33); RU = 12.38 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy EOC: 16-12 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes |
92.
|
Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 10 percent. Bruce currently has no debt, and its cost of equity is 20 percent. The tax rate is 34 percent. What will the value of Bruce & Co. be if the firm borrows $54,000 and uses the loan proceeds to repurchase shares?
VU = $100,000 (1 - 0.34)/0.20; V = $330,000
VL = $330,000 + 0.34($54,000) = $348,360 |
AACSB: Analytic
Blooms: Apply Difficulty: 1 Easy EOC: 16-14 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
93.
|
Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization?
VU = $100,000(1 - 0.31)/0.18 = $383,333.33
VL = $383,333.33 + 0.31($61,000) = $402,243.33 RE = 0.18 + (0.18 - 0.11)($61,000/$402,243.33 - $61,000)(1 - 0.31) = 0.1886 WACC = 0.1886($402,243.33 - $61,000)/$402,243.33 + 0.11($61,000/$402,243.33) (1 - 0.31) = 17.15 percent |
AACSB: Analytic
Blooms: Analyze Difficulty: 1 Easy EOC: 16-15 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition II with taxes and WACC |
94.
|
New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt?
VU = $7,000 (1 - 0.34)/0.15 = $30,800.00
VL = $30,800.00 + 0.34 (0.50) ($30,800.00) = $36,036.00 Note: When levered, the value of debt is equal to one-half of the unlevered value of the firm. |
AACSB: Analytic
Blooms: Analyze Difficulty: 2 Medium EOC: 16-17 Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice. Section: 16.4 Topic: M & M Proposition I with taxes |
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