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Exam 16: Capital Structure Decisions

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Question 51

True/False

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Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

A) True
B) False

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Question 52

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Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Inc.What is the firm's cost of equity according to MM with corporate taxes?

A) 21.0%
B) 23.3%
C) 25.9%
D) 28.8%
E) 32.0%

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

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Question 53

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Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value. Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM σ rRF, is 5%. Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 40%. What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

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.

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.

The following information has been presented to you about the Gibson Corporation. $\begin{array}{l}\begin{array} { l } \text { Total assets } & \$ 3,000 \text { million Tax rate } \\\text { Operating income (EBIT) } & \$ 800 \text { million Debt ratio } \\\text { Interest expense } & \$ 0 \text { million WACC } \\\text { Net income } & \$ 480 \text { million M/B ratio } \\\text { Share price } & \$ 32.00 \mathrm{EPS}=\mathrm{DPS}\end{array}\begin{array} { l } 40 \% \\0 \% \\10 \% \\1.00 x\\\$ 3.20\end{array}\end{array}$ The company has no growth opportunities (g = 0) , so the company pays out all of its earnings as dividends (EPS = DPS) . The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company makes this change, what would be the total market value (in millions) of the firm?

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations.