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Exam 13: Leverage and Capital Structure

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Question 1

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The Fruit Mart is an all-equity firm with a current cost of equity of 19.6 percent.The estimated earnings before interest and taxes are $315,000 annually forever.Currently,the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest.The tax rate is 33 percent.What is the value of the unlevered firm?

A) $849,207
B) $853,571
C) $856,411
D) $1,019,307
E) $1,076,786

F) A) and B)
G) A) and C)

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Question 2

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Christmas 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,$12,000 if it is in a recession,and $37,000 if the economy booms.Ignore taxes.What will the EPS be if the economy falls into a recession and the firm maintains its all-equity status?

A) $0.78
B) $0.80
C) $1.21
D) $1.67
E) $2.07

F) B) and D)
G) B) and E)

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Question 3

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The level of financial risk to which a firm is exposed is dependent on the firm's:

Northern Wood Products is an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000.Based on its current capital structure,the firm is expected to have earnings before interest and taxes of $26,000 if the economy is normal,$3,000 if the economy is in a recession,and $33,000 if the economy booms.Ignore taxes.Management is considering issuing $88,000 of debt with a 6 percent coupon rate.If the firm issues the debt,the proceeds will be used to repurchase stock.What will the earnings per share be if the debt is issued and the economy is in a recession?

Which one of the following terms refers to the termination of a firm as a going concern?

Marcos & Sons has no debt.Its current total value is $58 million.What will the company's value be if it sells $21 million in debt and has a tax rate of 34 percent? Assume debt proceeds are used to repurchase equity.

The Tree House has a pretax cost of debt of 7.9 percent and a return on assets of 11.7 percent.The debt-equity ratio is 0.50.Ignore taxes.What is the cost of equity?

Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process.Which one of the following terms best applies to this situation?

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?

T.L.C.Enterprises just revised its capital structure from a debt-equity ratio of 0.30 to a debt-equity ratio of 0.45.The firm's shareholders who prefer the old capital structure should:

Gabe's Market is comparing two different capital structures.Plan I would result in 11,000 shares of stock and $225,000 in debt.Plan II would result in 14,000 shares of stock and $150,000 in debt.The interest rate on the debt is 8 percent.Ignoring taxes,compare both of these plans to an all-equity plan assuming that EBIT will be $45,000.The all-equity plan would result in 20,000 shares of stock outstanding.Of the three plans,the firm will have the highest EPS with _____ and the lowest EPS with ____.

Which one of the following statements matches M&M Proposition I?

The Bethlehem Inn is an all-equity firm with 18,000 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.

Sand Mountain Resort has a 45 percent tax rate.Its total interest payment for the year just ended was $6.8 million.What is the interest tax shield?

Which one of the following statements is correct?

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 400 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?

Brick House Cafe has a 35 percent tax rate and total taxes of $35,280.What is the value of the interest tax shield if the interest expense is $16,700?

Gulf Shores Inn is comparing two separate capital structures.The first structure consists of 260,000 shares of stock and no debt.The second structure consists of 200,000 shares of stock and $1.5 million of debt.What is the price per share of equity?

Florence Mills is an all-equity firm with a total market value of $250,000.The firm has 8,000 shares of stock outstanding.Management is considering issuing $50,000 of debt at an interest rate of 7 percent and using the proceeds on a stock repurchase.Ignore taxes.How many shares can the firm repurchase if it issues the debt securities?

Soul Foods has a $12 million bond issue outstanding with a coupon rate of 6.75 percent and a yield to maturity of 7.27 percent.What is the present value of the tax shield if the tax rate is 30 percent?