Question details

MULTIPLE CHOICE +SHORT ANSWER |Result 100%
$ 33.00

Chapter 12—Capital Structure: Theory and Taxes

 

MULTIPLE CHOICE

 

     1.   PureMeds is a highly profitable pharmaceutical company that places great importance on funding research and development projects. According to finance research, the expected capital structure for PureMeds:

a.

would show a high market-value leverage level

b.

would show a high book-value leverage level

c.

would contain a high long-term debt level

d.

would contain a high total debt level

e.

would show a low financial leverage level

 

 

ANS:                        PTS:   1                    REF:   12.1              

OBJ:   TYPE: application of concepts

 

     2.   If the bankruptcy laws of a country change such that debtors are afforded increased protection, then over the long-term, market-value of financial leverage:

a.

should tend to increase

b.

should tend to decrease

c.

will remain unchanged

d.

will only be affected in countries with heavy reliance on capital markets versus banks for corporate financing

e.

will only be affected in developing countries

 

 

ANS:                        PTS:   1                    REF:   12.1               OBJ:   TYPE: fact retention

 

     3.   Given an increase in personal tax rates on both dividends and interest income, companies should:

a.

decrease retained earnings and increase leverage levels over time

b.

increase retained earnings and decrease leverage levels over time

c.

decrease retained earnings and decrease debt financing over time

d.

increase dividend payments to investors and increase leverage levels over time

e.

cannot say without knowing the values of the tax rates

 

 

ANS:                        PTS:   1                    REF:   12.1              

OBJ:   TYPE: application of concepts

 

     4.   Devard, CFO of Buymore, Inc., must create a financing plan for a proposed acquisition offer. Buymore's existing shareholders would likely consider the purchase to be "good news" if:

a.

Buymore issued new shares to finance the acquisition

b.

current Buymore shares were accepted as payment for the acquisition

c.

Buymore employed a debt-financed cash tender for the acquisition

d.

Buymore offered to exchange debt holdings for equity holdings in the new corporation

e.

the entire remaining balance of cash reserves were used for the acquisition

 

 

ANS:                        PTS:   1                    REF:   12.1              

OBJ:   TYPE: application of concepts

 

     5.   In a frictionless capital market, if the market value of a levered firm's outstanding securities differs from the market value of an otherwise identical all-equity firm's outstanding securities, M & M demonstrate that:

a.

investors are willing to pay a premium price for shares of levered firms

b.

investors will require "too high" an expected return on levered equity

c.

investors are maximizing personal profits

d.

the market value of levered equity is given by capitalizing operating income at a rate equal to the firm's WACC

e.

an arbitrage opportunity exists

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: fact retention

 

     6.   Two firms, Top-Dog and Under-Dog, generate $20000 in net operating income each year. Top-Dog has a capital structure consisting of 100% equity, whereas Under-Dog uses 50% debt and 50% equity. Under-Dog must pay $10000 in interest on its debt each year. If the tax on corporate profits is 30%, what is the value of the tax shield for Under-Dog each period, employing the M&M "modified" model?

a.

$9850

b.

$2300

c.

$3000

d.

$1700

e.

cannot be computed with the information provided

 

 

ANS: 

 

 

PTS:   1                    REF:   12.4               OBJ:   TYPE: application of concepts

 

     7.   Consider the following hypothetical situation: In a given year, the corporate tax rate is 35% and personal tax rates on interest income and income from stock are 40% and 20%, respectively (assume the same tax rate applies to dividends and capital gains). If BestCo uses 100% equity to finance its operations, no dividends are paid and all profits are plowed back as retained earnings. Alternatively, BestCo can finance its operations with some proportion of debt. Suppose BestCo earns a net operating profit of $300000. Which of the following statements is true?

a.

Shareholders are worse off if the company finances part of its operations with debt.

b.

The introduction of a 35% tax on corporate profits causes an immediate increase in the market value of BestCo if it is all-equity financed.

c.

The tax code offers an incentive to increase firm value by increasing equity issues.

d.

The tax code offers firms an incentive to use leverage.

e.

The tax code offers individuals an opportunity to capitalize on dividend income.

 

 

ANS: 

 

 

PTS:   1                    REF:   12.4               OBJ:   TYPE: application of concepts

 

     8.   Firms in the __________ industry(ies) use a great deal of debt.

a.

computer software

b.

computer software and pharmaceutical

c.

aerospace

d.

aerospace and retailing

e.

utility and auto manufacturing

 

 

ANS:                        PTS:   1                    REF:   12.1               OBJ:   TYPE: fact retention

 

     9.   __________ firms use almost no debt in their capital structure.

a.

Aerospace

b.

High-tech

c.

Aerospace and pharmaceutical

d.

Aerospace and retailing

e.

Utility

 

 

ANS:                        PTS:   1                    REF:   12.1               OBJ:   TYPE: fact retention

 

   10.   If a firm has $6.5 million in debt, $27.8 million in equity, a tax rate of 35%, and pays 7% interest on debt, what is the firm's PV of the interest tax shields?

a.

$202200

b.

$327200

c.

$8.5 million

d.

$2.275 million

e.

$418910

 

 

ANS: 

 

PTS:   1                    REF:   12.4               OBJ:   TYPE: application of concepts

 

   11.   What do you need to know to calculate the gains from using leverage for individual companies?

a.

tax rate on corporate profits

b.

market value of a firm's outstanding debt

c.

personal tax rate on income from debt

d.

personal tax rate on income from stock

e.

all of the above

 

 

ANS:                        PTS:   1                    REF:   12.4              

OBJ:   TYPE: application of concepts

 

   12.   In attempting to develop a model, M & M showed that capital structure could not affect the firm value in a world with __________.

a.

perfect markets

b.

target leverage zones

c.

homemade leverage

d.

arbitrage

e.

none of the above

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: fact retention

 

   13.   When M & M assume that capital markets are frictionless it means __________.

a.

no taxes

b.

no transaction costs

c.

investors can borrow and lend at the same rate that corporations can

d.

all of the above

e.

none of the above

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: fact retention

 

   14.   M & M Proposition II says that the WACC is not influenced by changing the mix of debt and equity because changes in leverage cause an offsetting change in the __________.

a.

WACC

b.

required return on equity

c.

target leverage zones

d.

secured debt hypothesis

e.

none of the above

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: fact retention

 

   15.   The logic of the Modigliani and Miller’s proposition 1 crucially depends on investors having __________.

a.

risk neutral preferences.

b.

mean-variance preferences.

c.

Neither of these preference types are essential.

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: critical thinking

 

   16.   Using M&M propositions with corporate taxes and the following information, what is the value of the levered firm?  NOI = $80000; Corporate Taxes = 40%; the firm borrows $750000 at a rate of 8%.

a.

$900000

c.

$618461

b.

$856211

d.

$839518

 

 

ANS: 

 

 

 

PTS:   1                    REF:   12.3               OBJ:   TYPE: application of concepts

 

   17.   The relationship of corporate income taxes, personal income taxes on equity investments, and personal income taxes on interest income should have a predictable change in debt ratios; which of the following predicts increasing debt ratios?

a.

Higher corporate income taxes, higher personal taxes on equity investments, lower personal taxes on interest income

b.

Lower corporate income taxes, higher personal taxes on equity investments, lower personal taxes on interest income

c.

Higher corporate income taxes, lower personal taxes on equity investments, lower personal taxes on interest income

d.

Higher corporate income taxes, higher personal taxes on equity investments, higher personal taxes on interest income

 

 

ANS:                        PTS:   1                    REF:   12.3               OBJ:   TYPE: fact retention

 

   18.   Financial leverage

 

a.

Increases expect EPS and Increases EPS volatility

b.

Increases expect EPS and Decreases EPS volatility

c.

Decreases expect EPS and Increases EPS volatility

d.

Decreases expect EPS and Decreases EPS volatility

 

 

ANS:                        PTS:   1                    REF:   12.1               OBJ:   TYPE: fact retention

 

   19.   According to M&M’s Proposition II the expected return on a levered firm’s equity

 

a.

Falls to the debt-to-equity ratio

b.

The levered firm’s equity expect return does not change with the debt-to-equity level

Rises with the debt-to-equity ratio

c.

Rises with the debt-to-equity ratio

d.

Proposition II does not address the leveraged firm’s expected return on equity

 

 

ANS:                        PTS:   1                    REF:   12.2               OBJ:   TYPE: fact retention

 

   20.   Using M&M propositions with corporate taxes and the following information, what is the value of the levered firm?  NOI = $70000; Corporate Taxes = 40%; the firm borrows $450000 at a rate of 8%.

a.

$705000

b.

$510000

c.

$520000

d.

$320000

 

 

ANS: 

 

 

PTS:   1                    REF:   12.3               OBJ:   TYPE: application of concepts

 

MATCHING

 

Match the following relationships:

a.

M&M theory

b.

managerial opportunism theory

c.

trade-off theory

 

 

     1.   capital structure is the result of market timing

 

     2.   firms balance costs and benefits of debt

 

     3.   firm value does not depend on capital structure

 

     1.   ANS:                        PTS:   1                    REF:   12.2 - 12.3    

OBJ:   TYPE: fact retention | TYPE: application of concepts    

NOT:  Managerial opportunism and trade-off theory are introduced in chapter 13

 

     2.   ANS:                        PTS:   1                    REF:   12.2 - 12.3    

OBJ:   TYPE: fact retention | TYPE: application of concepts

 

     3.   ANS:                        PTS:   1                    REF:   12.2 - 12.3    

OBJ:   TYPE: fact retention | TYPE: application of concepts

 

Match the following statements:

a.

increases the tax gain from leverage

b.

decreases the tax gain from leverage

c.

Proposition I

d.

Proposition II

e.

Pecking order model

f.

Homemade leverage

 

 

     4.   a reduction in the corporate tax rate

 

     5.   higher debt increases the cost of equity

 

     6.   a reduction in personal taxes on interest income

 

     7.   explains why firms want financial slack

 

     8.   says capital structure cannot affect firm value

 

     9.   investors can unwind firms' capital structures

 

     4.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

NOT:  Pecking order is introduced in chapter 13

 

     5.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

 

     6.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

 

     7.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

 

     8.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

 

     9.   ANS:                        PTS:   1                    REF:   12.2 - 12.3     OBJ:   TYPE: fact retention

 

SHORT ANSWER

 

     1.   In the late 1990s Ford Motor company held a large cash balance that was often called a war chest. In terms of the pecking order hypothesis, discuss why Ford might have been willing to maintain large cash balances over this period of time. At the end of this period, Ford decided that it no longer had a need for these excess funds for investment opportunities and it made a large payout to existing shareholders. How does this corporate behavior fit with the pecking order hypothesis?

 

 

     2.   Consider two firms in the same industry that operate in frictionless markets. Both firms, DebtHungry and Ner-aBorrower, have identical net operating income of $240000 per year. The riskiness of each company's assets suggests a fair weighted average cost of capital of 10 percent.

a.

What is the value of each company?

b.

If DebtHungry has borrowed $600000 at a required rate of return of 4 percent, what is the fair required rate of return on the firm's equity?

c.

Given that the expected rate of return on an investment at the corporate level in Ner-aBorrower is 10 percent, explain how you create an investment identical to an equity investment in Ner-aBorrower with only an investment in DebtHungry's equity and riskless debt (that earns 4 percent).

d.

Suppose the actual market value of Ner-aBorrower is $3.0 million. Explain how you can exploit this mispricing via arbitrage.

 

 

ANS: 

 

 

     3.   Couglin Inc. has net operating income of $120000 per year. Couglin uses no debt in its capital structure and the required rate of return to equity holders is 12 percent.

a.

Calculate the value of the unlevered firm if the firm has a marginal tax rate of 0%.

b.

Calculate the value of the unlevered firm if the firm has a marginal tax rate of 30%.

c.

Interpret the difference in your findings to parts a. and b.

d.

If your answer to part a. is less than your answer to part b, can we increase firm value by taking on debt? If so, will these benefits always continue as we add more and more debt?

 

 

 

 

 

     4.   Kylie Surfboards Ltd. runs a successful enterprise on the Northeastern coast of Australia. Kylie Surfboards has a tax rate of 40 percent and a before tax cost of debt of 7 percent on $4000000 of debt.

a.

What is Kylie Surfboard's PV of interest tax shields?

b.

Would your answer change if you expected the company to be unwound in ten years when Kylie retires?

 

 

ANS: 

 

     5.   Your firm, FloThru, has a net operating profit of $700000, or $455000 after corporate taxes. FloThru's tax rate is 35 percent and the personal tax rates on interest and income from stock are 40 percent and 20 percent, respectively.

a.

If FloThru paid the entire $455000 in after-tax income as a dividend, what is the after-tax cash flow to the shareholders?

b.

If operations were financed entirely with debt (so that all of the net operating income escaped corporate taxes), how much cash flow would bondholders receive after paying the required personal tax?

c.

Considering only taxation issues, should the firm finance its operations mostly through debt or mostly through equity given the information above?

d.

Suppose that in part a. above the $455000 in after corporate tax income was retained by the firm. How would that affect your answer to part c.?

 

 

ANS: 

 

     6.   The equation , shows the gains from leverage. Discuss how the traditional M&M findings can be obtained as special cases by using different tax rate assumptions.

 

     7.   Consider a firm with $5000000 in total debt, a corporate tax rate of 30 percent, and a personal tax rate on interest income of 40 percent. According to the gains from leverage equation , at what personal tax rate on income from stock should the firm be indifferent to using more or less borrowing? If the firm's total borrowings were twice as large, how does you answer change?

 

ANS: 

 

     8.   Within industries, what is the relationship between profitability and leverage? How does this line up with the trade-off model?

 

 

     9.   Why do firms with high-value intangible assets use less debt than firms that invest in more tangible assets?

 

 

   10.   What is the best single predictor of new equity issues?

 

ANS: 

The best single predictor of new equity issues is the recent trend in the stock price. Companies tend to issue common shares following unusually large increases in the stock price and essentially refuse to issue new equity after share prices have fallen.

 

PTS:   1                    REF:   12.2               OBJ:   TYPE: critical thinking

 

   11.   What are the assumptions of the pecking order hypothesis?

 

 

   12.   In the M & M world without corporate and personal taxes, will replacing a security that has a high required rate of return (equity) with one that requires a lower return (debt) lower the average cost of capital?

 

 

   13.   What do you conclude as an investor if a firm sells stock and uses the proceeds to repurchase some of its outstanding bonds?

 

ANS: 

 

PTS:   1                    REF:   12.1               OBJ:   TYPE: critical thinking

 

   14.   What is the relationship between the value of a firm and its capital structure in the M & M world without taxes?

 

ANS: 

 

   15.   What is the relationship between the value of the firm and its capital structure in the M & M world with corporate taxes?

 

ANS: 

 

   16.   What is the relationship between the value of the firm and its capital structure in the M & M world with corporate and personal taxes?

 

ANS: 

 

   17.   What is the asymmetric information assumption?

 

ANS: 

 

   18.   If the D corporation has a market valuation of equity equal to $103800, a 15% required rate of return on equity, and 3000 shares of stock, what is the market value of a share of common stock?

 

ANS: 

 

 

   19.   Upon introduction of corporate and personal income taxes, why are interest rates not bid up immediately to compensate investors for taxes due?

 

ANS: 

 

   20.   Do companies with large amounts of depreciation, investment tax credits, R & D expenditures, and other nondebt tax shields employ less debt financing?

 

ANS: 

 

   21.   If a firm operates in a perfect capital market, has a required return on its outstanding debt of 8%, a required return on its common stock of 14%, and a WACC of 12%, what is the firm's debt-to-equity ratio?

 

ANS: 

 

   22.   An unlevered corporation has net income of $60000 and a required rate of return of 14%. What would the value of this firm be if it borrowed $140000 to buy back some of its stock? Assume a corporate tax rate of 40%.

                    

ANS: 

   23.   If a company with no debt decides to change its capital structure and add $20000 in debt to repurchase $20000 in common stock, how much would the value of the company change if it has a 40% corporate tax rate?

 

ANS: 

 

   24.   Assume that capital markets are perfect. If a firm finances its operations with $40000 in common stock with a required return of 17% and $16000 in bonds with a required return of 7%, what would happen to the required rate of return on the common stock if the firm issues $15000 in additional bonds at 7% to retire $15000 worth of equity?

 

ANS: 

 

   25.   The personal tax rate on debt is 21% and the personal tax on equity is 10%. The corporate tax rate is 15%. There is a firm, initially with no debt and market value $3 billion. This firm decides to issue $200 million of perpetual risk-free debt paying the riskfree interest rate of 3%. The proceeds from the sale of debt are used to buy back shares at a price appropriately reflecting the gains from leverage. What is the new value of the remaining equity in the firm?

 

ANS: 

 

   26.   There are two firms, Beautiful Widgets (BW) and Glamorous Thingamajigs (GT). Each has expected Net Operating Income (NOI) of $5 million each year forever, and the NOI to BW will always be exactly the same as that to GT, whether it ends up above or below the expected amount. After any interest payments, all income is paid out to equity holders. BW is all equity (stock). GT has some equity, along with $20 million (market value and face value) in perpetual debt. GT’s debt pays riskfree 6% interest each year, while BW has expected return on its equity of . There are no taxes, and the rest of the Modigliani-Miller assumptions hold.

 

a.

What is the value of BW equity?

b.

What is the value of GT equity?

c.

What is the expected cash flow to GT equity holders each year?

d.

What is the expected return on GT stock

 

 

ANS: 

 

   27.   There are two firms, Hello and olleH. Each has expected Net Operating Income (NOI) of $18 million each year forever, and the cash flow to Hello will always be exactly the same as that to olleH, whether it ends up above or below the expected amount. Hello is all equity (stock). olleH has some equity, along with $100 million in debt (market value and face value). olleH’s debt pays 5% interest at the end of each year, and olleH has expected return on its equity of 6.5%. There are no taxes, and the rest of the Modigliani-Miller assumptions hold.

 

a.

What is the expected cash flow to olleH equity holders each year?

b.

What is the value of olleH equity?

c.

What is the value of Hello equity?

d.

What is the expected return on Hello stock?

e.

Your friend, whom you admire greatly, has $6000 of olleH stock. You would like to put your spare cash of $6000 toward an investment with exactly the same risk and expected return. However, you don’t wish to be a copycat, so you will buy some Hello stock financed partly with your cash and partly with borrowing. How much borrowing do you do and how much Hello stock do you buy?

 

 

ANS: 

 

 

     1.   Clearly state proposition I of Modigliani and Miller. Intuitively, how can one rationalize the apparent patterns in financial leverage choices and this proposition?

 

ANS: 

 

     2.   Identify and explain the three key empirical patterns of the pecking order hypothesis.

 

ANS: 

 

     3.   How is arbitrage used to prove that the use of leverage has no impact on the firm's

total market value?

 

ANS: 

 

     4.   Explain Miller’s claim that capital structure shouldn’t matter, even in the presence of corporate and personal taxes.

 

ANS: 

 

 

Available solutions