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Exam 15: Capital Structure Decisions

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Question 21

True/False

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When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

A) True
B) False

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Question 22

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Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT) , tax rates, and business risk.Company HD, however, has a much higher debt ratio than LD.Company HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d.Which of the following statements is CORRECT?

A) Company HD has a higher times interest earned (TIE) ratio than Company LD.
B) Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's.
C) The two companies have the same ROE.
D) Company HD's ROE would be higher if it had no debt.
E) Company HD has a higher return on assets (ROA) than Company LD.

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

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Question 23

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Wilson Dover Inc. The total value (debt plus equity) of Wilson Dover Inc.is $500 million and the face value of its 1-year coupon debt is $200 million.The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%.Assume that N(d₁) = 0.9720 and N(d₂) = 0.9050. ​ -Refer to the data for Wilson Dover Inc.What is the value (in millions) of Wilson Dover's equity if it is viewed as an option?

Pennewell Publishing Inc.(PP) Pennewell Publishing Inc.(PP) is a zero growth company.It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000.PP's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to the data for Pennewell Publishing Inc.(PP) .PP is considering changing its capital structure to one with 30% debt and 70% equity, based on market values.The debt would have an interest rate of 8%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the added leverage would cause the required rate of return on equity to rise to 12%.If this plan were carried out, what would be PP's new value of operations?

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders.Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Palmer Company has $5,000,000 of 15-year maturity bonds outstanding.Each bond has a maturity value of $1,000, an annual coupon of 12.0%.The bonds can be called at any time with a premium of $50 per bond.If the bonds are called, the company must pay flotation costs of $10 per new refunding bond.Ignore tax considerations⎯assume that the firm's tax rate is zero. The company's decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds.What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds.The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so.The call premium would be 5% of the face amount.Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%.What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.

Refer to the data for the Anson Jackson Court Company (AJC) .Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50% debt and 50% equity.If it makes this change, its resulting market value would be $820,000.What would be its new stock price per share?

NorthWest Water (NWW) Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon.NWW is now considering refunding these bonds.It has been amortizing $3 million of flotation costs on these bonds over their 30-year life.The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market.A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million.NWW's marginal tax rate is 40%.The new bonds would be issued when the old bonds are called. -Refer to the data for NorthWest Water (NWW) .What will the after-tax annual interest savings for NWW be if the refunding takes place?

Which of the following statements is CORRECT?

10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds.The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so.The call premium would be 6% of the face amount.New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold.What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.

The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings.

Anson Jackson Court Company (AJC) The Anson Jackson Court (AJC) currently has $150,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%.Its earnings before interest and taxes (EBIT) are $89,000, and it is a zero growth company.AJC's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to the data for the Anson Jackson Court Company (AJC) .What is AJC's current total market value and weighted average cost of capital? Total Market Value; WACC

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Which of the following statements is most CORRECT?

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.