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Exam 26: Analysis of Capital Structure Theory

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Question 1

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Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility ( $\sigma$ ) of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050. -What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?

A) $167.57
B) $186.19
C) $204.81
D) $225.29
E) $247.82

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

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Question 2

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MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

A) True
B) False

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Question 3

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Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L's cost of equity?

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.

The Miller model begins with the MM model with taxes and then adds personal taxes.

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

The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?

Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -According to the MM extension with growth, what is Gomez's value of equity?

The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -What is the value of the firm according to MM with corporate taxes?

The MM model is the same as the Miller model, but with zero corporate taxes.

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

Which of the following statements concerning capital structure theory is NOT CORRECT?

The major contribution of the Miller model is that it demonstrates that

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar company with no debt has a cost of equity of 11%. -According to the MM extension with growth, what is the value of Gomez's tax shield?

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

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.

The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -What is the firm's cost of equity?