**15_Exam III Practice problems - Good Morning**

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**Instructions**:

- Please write your name in the space provided on this page, and circle your section.

- The exam is closed book and closed notes.

- You have two hours to do the exam. There are 100 total points; points per question are indicated below. Allocate your time carefully.

- For multiple choice questions, circle the answer that
**best**answers the questions.**Circle only one answer for each question**. No partial credit is given on multiple choice questions or T and F questions, so you do not need to show your work on these questions.

- For the rest of the exam, your grade will be based only on work in this exam book
**. Show your work and explain any additional assumptions you make; you will not get full credit for your answer unless you do so**. If you need additional space, please continue on the back of the page and indicate clearly that you are doing so. It is important to avoid mistakes, especially ones that lead to glaringly wrong answers, so**check your work carefully**.

- You are preparing a valuation for Acrobatics Corp. Based on the firm’s most recent statement, the firm has debt of $1,000 and free cash flow of $2,250. The firm is stable and the constant, nominal growth rate is 7%. The firm’s current stock price is $3 with 1,000 shares outstanding. Additionally, the firm has an equity beta of 1.2 and a cost of debt of 10%. Assume that the expected return on the market is 14%, the risk free rate is 5%, and the tax rate is 30%. Carry all percentages to 2 decimal places, for example, 11.25% is not rounded to 11%.

**Calculate**each of the following:

- The firm’s cost of equity

- The portion of the cost of equity attributable to the firm’s operating risk.

- The portion of the cost of equity attributable to the firm’s financial risk.

- The firm’s Weighted Average Cost of Capital

- Acrobatics Corp. is considering altering their capital structure and issues $500 of stock and uses the proceeds to reduce debt by $500. Further, assume that the stock will be issued at the current market price of $3 and the stock price did not change. Additionally, assume that the change in leverage would have no impact on the firm’s risk of default. Ignoring agency problems (i.e. considering only the impact of taxes and default),
**calculate**each of the following:

- The firm’s cost of equity

- The firm’s Weighted Average Cost of Capital

- ABC Inc. has a debt to equity ratio of 0.2. The firm recently repurchased a large amount of stock and financed the stock repurchase by issuing debt. This resulted in the debt to equity ratio increasing to 0.4. For each of the following scenarios, state the impact of this change in leverage by
**circling**either increase, decrease, or unchanged.

- If we consider a world with no taxes, no default risk, no agency problems and homogeneous information, state what will happen to the firm’s

- Cost of Equity – increase decrease unchanged

- Weighted Average Cost of Capital – increase decrease unchanged

- Value – increase decrease unchanged

- Free Cash Flow – increase decrease unchanged

- If we consider a world with taxes and default risk but no other market imperfections and we know that the firms optimal leverage ratio is 0.2, state what will happen to the firm’s

- Cost of Equity – increase decrease unchanged

- Weighted Average Cost of Capital – increase decrease unchanged

- Value – increase decrease unchanged

- Free Cash Flow – increase decrease unchanged

- Cash Cow Corp is a stable firm with few growth prospects. Its current assets in place generate high free cash flow.
**Explain**why this firm may benefit from debt.

- Modigliani and Miller show that in a world without market imperfections (referred to in class as a perfect world) capital structure does not matter. Thus, the value of a levered firm is equal to the value of an unlevered firm as long as everything else about the two firms are the same. However, our world is not a perfect world.
**List**3 of Modigliani and Miller’s assumptions and**briefly explain**why debt impacts value if the assumption is not made.

- The market value of United Frypan Company is $160 (total firm value). Its book values are below and the market value of debt equals the book value of debt. Assume that Modigliani and Miller’s theory with corporate taxes holds (i.e. consider only the influence of corporate taxes). There is no growth and the $40 of debt is expected to be permanent (i.e they will not borrow or repay this debt). Also, assume a 40% corporate tax rate. (20 points)

Net Working Capital |
$ 20 |
Debt |
$ 40 |

Fixed Assets |
80 |
Equity |
60 |

Total |
$100 |
Total |
$100 |

**Calculate**how much of the firm’s market value is accounted for by the debt-generated corporate tax shield?**Show**the value of the unlevered firm.

- Assume that in part a, you determined that debt adds $20 of value to the firm and that the unlevered firm is worth $140.
**Calculate**the market value of UF’s equity if the firm borrows an additional $30 and uses the proceeds to repurchase stock?

- Again, assume that in part a, you determined that debt adds $20 of value to the firm and that the unlevered firm is worth $140. Now suppose that Congress passes a law eliminating the deductibility of interest for tax purposes after a grace period of five years (i.e. the firm can deduct interest from taxable income for 2 more years). Assuming everything else equal, the firm has the capital structure from part a, and an 8% cost of debt;
**calculate**the new value of the firm.

- The following three questions relate to the costs and benefit of debt discussed in class and how they impact firms in specific situations.

**State**if the following statement is**True or False**and**briefly explain**your answer. “A company can incur costs of financial distress without ever going bankrupt, filing chapter 11, or hiring anyone to assist in legal or administrative procedures associated with these possible events.”

- Assume that the corporate tax laws are set up such that companies cannot carry losses forward or back; thus, the firm pays taxes on positive taxable income and pays nothing (nor receives benefit) for losses. If a company has earnings before interest (expense), taxes and depreciation (EBITD) of $100, interest expense of $150, total debt of $15,000 (with a 10% interest rate) and depreciation expense of $115.
**Calculate**the benefit to the corporate interest tax shield assuming the corporate tax rate is 30%.

- ABC Corp. has debt to equity ratio of 0.3 using the market value of equity and book value of debt. Using the book value of equity, the firm’s debt to equity ratio is 0.5. The firm has cost of equity of 14% and a cost of debt of 10%.

- Assume that the corporate tax rate is 30%.
**Calculate**the required return investors demand because of the business risk of the firm (i.e. the portion of the return on equity associated with the business risk).**Calculate**the required return associated with the financial risk of the firm.

- Assume that the firm issues debt and uses the proceeds to repurchase stock and its new debt to equity ratio is 0.5 using the market value of equity and book value of debt. Using the book value of equity, the firm’s debt to equity ratio is 0.6. The corporate tax rate remains 30%.
**Calculate**the firm’s WACC, assuming that the cost of debt does not change with the increased leverage?

- Assume that the WACC incorporating all costs and benefits of debt for Abracadabra Inc. is 15%, the cost of capital for the firm if it had no debt is 16%, the nominal free cashflow expected next year is $10,000, and that the free cashflow will grow at 9% forever. Also, assume that the entire $10,000 is considered risky cashflow and that the tax rate is 30%. Further, Abracadabra has $50,000 in debt, pays $5,000 in interest expense each year, and has a stock price of $5 per share at year-end and 25,000 shares outstanding. (10 points)

**Calculate**the value of the levered firm.

**Calculate**the value of the unlevered firm.

**Calculate**the value of leverage to Abracadabra. Show what portion of this value is due to the debt tax shield.

- According to the theory of optimal capital structure, there are many costs and benefits to debt. Firms weigh these costs and benefits to determine their optimal capital structure.
**State five**costs or benefits of debt and if this will increase or decrease a firm’s optimal leverage ratio. If it cannot be determined, put it depends.

**The following dividend questions is not applicable to FALL 2002:**

- If the marginal investor as a tax rate of 33% and a company has announced a dividend of $3.00:

- The price of stock should decrease by $2.00 immediately after the date of record.
- The price of stock should decrease by $2.00 immediately after the ex-dividend date.
- The price of stock should decrease by $4.48 immediately after the date of record.
- The price of stock should decrease by $4.48 immediately after ex-dividend date.
- Both b & c.

- Which of the following statement concerning dividends is not true?
- Dividends are relevant.
- Dividend policy is argued to be irrelevant.
- Firms should never give up positive NPV projects to increase a dividend.
- A key assumption in the dividend irrelevance proposition is that the firm’s investment policy is set ahead of time and is not altered by the dividend.
- None of the above.

12) In the presence of personal taxes the MM irrelevance proposition does not hold because:

- Managers have an incentive to seek alternative uses for these funds.
- Personal taxes always increase the value of dividends.
- Personal taxes reduce the value of diviends but are not sufficient to eliminate all dividends.
- a) and b)
- a) and c)

13) If dividends are taxed at higher rates than are capital gains, then high dividend payout stocks should sell at lower prices, everything else equal, compared to low dividend paying stocks. One implication of this is that investors in ( ) tax brackets will tend to prefer high dividend payout stocks.

- Very high
- Slightly highers than average
- Average
- Slightly lower than average

Zero

**Category:**Business, General Business

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