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True/False
Easy:
(16.1) Taxes and capital structure
Answer: a Diff: E
1
.
In a world with no taxes, MM show that a firms capital structure does
not affect the firms 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.
a. True
b. False
(16.1) Taxes and capital structure
Answer: b Diff: E
2
.
According to MM, in a world without taxes the optimal capital structure
for a firm is approximately 100% debt financing.
a. True
b. False
(16.1) MM models
Answer: a Diff: E
3
.
MM showed that in a world with taxes, a firms optimal capital structure
would be almost 100% debt.
a. True
b. False
(16.1) MM models
Answer: a Diff: E
4
.
MM showed that in a world without taxes, a firms value is not affected
by its capital structure.
a. True
b. False
(16.2) Miller model
Answer: a Diff: E
5
.
The Miller model begins with the MM model with taxes and then adds
personal taxes.
a. True
b. False
(16.2) Miller model
Answer: b Diff: E
6
.
The Miller model begins with the MM model without corporate taxes and
then adds personal taxes.
Chapter 16: Capital Structure Decisions: Part II
Page 3
a. True
b. False
(16.5) Financial leverage
Answer: a Diff: E
7
.
Other things held constant, an increase in financial leverage will
increase a firm's market (or systematic) risk as measured by its beta
coefficient.
a. True
b. False
Medium:
(16.2) MM models
Answer: a Diff: M
8
.
The MM model with corporate taxes is the same as the Miller model, but
with zero personal taxes.
a. True
b. False
(16.2) MM models
Answer: b Diff: M
9
.
The MM model is the same as the Miller model, but with zero corporate
taxes.
a. True
b. False
(16.4) MM extension with growth
Answer: a Diff: M
10
.
In the MM extension with growth, the appropriate discount rate for the
tax shield is the unlevered cost of equity.
a. True
b. False
(16.4) MM extension with growth
Answer: b Diff: M
11
.
In the MM extension with growth, the appropriate discount rate for the
tax shield is the WACC.
a. True
b. False
(16.4) MM extension with growth
Answer: b Diff: M
12
.
In the MM extension with growth, the appropriate discount rate for the
tax shield is the after-tax cost of debt.
a. True
b. False
(16.5) Equity as an option
Page 4
Answer: a
Diff: M
13
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
Page 5
Page 6
Conceptual Questions
Answer: d
Diff: M
17
Page 7
11.4%
12.0%
12.6%
13.3%
14.0%
Page 8
a.
b.
c.
d.
e.
$358,421
$377,286
$397,143
$417,000
$437,850
$92,571
$102,857
$113,143
$124,457
$136,903
Multi-part:
(The following data apply to Problems 23 through 25.
kept together.)
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%.
(16.1) MM with tax
Answer: c Diff: E
23
.
What is the value of the firm according to MM with corporate taxes?
a.
b.
c.
d.
e.
$475,875
$528,750
$587,500
$646,250
$710,875
Answer: e
Diff: E
21.0%
23.3%
25.9%
28.8%
32.0%
Page 9
b.
c.
d.
e.
Page 10
18.2%
20.2%
22.5%
25.0%
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%.
(16.4) MM extension with growth
Answer: e Diff: M
26
.
According to the MM extension with growth, what is the value of Gomezs
tax shield?
a.
b.
c.
d.
e.
$156,385
$164,616
$173,280
$182,400
$192,000
$1,296,000
$1,440,000
$1,600,000
$1,760,000
$1,936,000
$1,492,000
$1,529,300
$1,567,533
$1,606,721
$1,646,889
Trumbull, Inc., has total value (debt plus equity) of $500 million and $200
million face value of 1-year zero coupon debt. The volatility () of
Trumbulls total value is 0.60, and the risk-free rate is 5%. Assume that
N(d1) = 0.9720 and N(d2) = 0.9050.
(16.5) Equity as an option
Answer: d Diff: M
29
.
What is the value (in millions) of Trumbulls equity if it is viewed as
an option?
a. $228.77
b. $254.19
Chapter 16: Capital Structure Decisions: Part II
Page 11
c. $282.43
d. $313.81
e. $345.19
(16.5) Equity as an option
Answer: b Diff: M
30
.
What is the value (in millions) of Trumbulls debt if its equity is
viewed as an option?
a.
b.
c.
d.
e.
$167.57
$186.19
$204.81
$225.29
$247.82
Page 12
Answer: e
Diff: M
6.04%
6.36%
6.70%
7.05%
7.42%
CHAPTER 16
ANSWERS AND SOLUTIONS
Page 13
1
.(16.1) Taxes and capital structure
Answer: a
Diff: E
Answer: b
Diff: E
3.(16.1) MM models
Answer: a
Diff: E
4.(16.1) MM models
Answer: a
Diff: E
Answer: a
Diff: E
Answer: b
Diff: E
Answer: a
Diff: E
8.(16.2) MM models
Answer: a
Diff: M
9.(16.2) MM models
Answer: b
Diff: M
Answer: a
Diff: M
Answer: b
Diff: M
Answer: b
Diff: M
Answer: a
Diff: M
Answer: b
Diff: M
Answer: b
Diff: M
Answer: d
Diff: M
Answer: d
Diff: M
Answer: a
Diff: M
Answer: e
Diff: M
Answer: e
Diff: M
Answer: c
Diff: M
Debt: $200,000
rd: 9%
T: 40%
Equity: $300,000
rsU : 12%
g: 5%
Equity: $300,000
rsU : 12%
g: 5%
Firm L has a total value of $200,000 + $300,000 = $500,000. A similar firm with no debt should have a smaller
value. Here is the calculation:
VTotal = VU + VTS, so VU = VTotal VTS = D + S VTS.
Value tax shelter = VTS = rdTD/(r sU g) = 0.09(0.40)($200,000)/(0.12 0.05) = $102,857
VU = $300,000 + $200,000 $102,857 = $397,143
Answer: b
Diff: M
Answer: c
Diff: E
Answer: e
Diff: E
First, note that the leveraged value of the firm is $587,500 as found in Problem 23. Note also that the firm has
$500,000 of debt. Therefore, the value of its equity must be $87,500. Using these data, we find the leveraged cost
of equity as follows:
rsL = rsU + (rsU rd)(1 T)(D/S) = 16% + (16% 12%)(0.7)($500,000/$87,500) = 32.0%
25.(16.2) Miller model
Tc: 30%
Ts: 20%
Answer: e
Gain from leverage: $126,667
Debt: $500,000
(1 Tc) =
(1 Ts) =
(1 Tc) (1 Ts) =
Gain/Debt =
Gain/Debt 1 =
X = -0.56/-0.74666 =
X=
Td =
Diff: T
0.70
0.80
0.56
0.25333
-0.74667
0.75000
1 Td
0.25000
Answer: e
Diff: M
Answer: c
Diff: M
rsU: 11%
T: 40%
EBIT retained: 20%
Answer: a
Diff: M
Answer: d
Diff: M
Answer: b
Diff: M
Answer: e
Diff: M
d1 = 1.910485
N(d1) = 0.9720
d2 = 1.310485
N(d2) = 0.9050
Vs = PN(d1) Xe-RFtN(d2)
= $500(0.9720) $200e-0.05(1)(0.9050)
= $485.98 $172.17
= $313.81
30.(16.5) Equity as an option
VDebt = VTotal VEquity = $500 $313.81 = $186.19
31.(16.5) Equity as an option
Yield = [(Face Value/Price)1/Maturity] 1.0 = [$200/$186.19] 1 1.0 = 7.42%