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Exam 21: Capital Structure Decisions

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Question 1

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Manitoba Flat Land (MFL) Company has a perpetual EBIT of $10,000, an unlevered cost of equity of 5%, zero debt, and an income tax rate of 40%.The firm currently has 1,000 shares outstanding.MFL issues $5,000 of perpetual debt which pays interest of $500 per year and uses the proceeds of that debt issue to repurchase shares.The change in the value of the firm is:

A) no change in the value.
B) increase of $2,000.
C) increase of $3,000.
D) increase of $5,000.

E) A) and B)
F) C) and D)

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Question 2

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M&M Co.has the following characteristics: perpetual EBIT of $25,000, zero financial distress costs, unlevered cost of equity = 15%, cost of levered equity 20%, before-tax cost of debt = 10%, and the tax rate is 35%.If the value of M&M Co.is $140,000, then the D/E ratio of M&M Co.is:

A) 0.2923
B) 0.5473
C) 1.8270
D) 3.4211

E) B) and D)
F) None of the above

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Question 3

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Use the following statements to answer this question: I.Credit rating is the number one factor mentioned by most firms in the 2006 Deutsche Bank survey. II.Globally most firms have a target capital structure.

Briefly explain the trade-off theory of capital structure.

Winnipeg Skaters Company (WSC) has a before-tax cost of debt of 8%, a debt/equity ratio of 0, and pays tax at the rate of 40%.The unlevered cost of equity for a firm with WSC's risk characteristics is 15%.If WSC expects a perpetual EBIT of $20,000, then the value of the firm is:

The pecking order theory of capital structure suggests that firms follow which order when raising capital?

In the context of the M&M Irrelevance theorem, in the absence of taxes and bankruptcy costs, which of the following is true?

Explain the importance of debt in minimizing the agency cost problem between the managers and the shareholders.

Northwest Territories Bikini Company reported the following financial data for the year ended 2022. The return on equity (ROE) of Northwest Territories Bikini Company is o:

The equity holders of a firm in financial distress have an incentive:

Bankruptcy occurs when: I.A firm fails to pay interest on debt and the creditors enforce their legal rights II.A firm has insufficient assets to repay all the debt due in 10 years

If the personal tax rate on dividends (T_D) equals the tax rate on interest income (T_P) ,

Which one of the following theories about capital structure is based on agency cost?

Compared to non-investment grade firms, investment grade firms, in general, do not exhibit:

In 2022, Toronto Skaters earned a return on investment (ROI) of 15% and had a cost of debt of 7%.The book value of debt was $25,000 and the book value of shareholders' equity was $30,000.The firm faces a tax rate of 30%.The firm's return on equity (ROE) is:

Use the following statements to answer this question: I.The correlation between a high Altman Z score and the rating by rating agencies is positive II.Investment-grade firms have a low yield to maturity

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.What is the cost of equity for Whispering Pines Resort?

In the context of the M&M Irrelevance theorem, in a world with no taxes and no bankruptcy costs,

A firm's capital structure is made up of 200,000 common shares and $1,000,000 debt at 12% interest.The company's tax rate is 50%.An additional $500,000 has to be raised, and the following financing alternatives are available: Option 1: Common shares: The company can sell additional shares at $10 a share.Hence, 50,000 new shares would have to be issued. Option 2: Debt: Debt can be issued at 12%, requiring interest payments of $60,000. Compute EPS as a function of EBIT for both alternatives and derive the break-even point.

Direct costs of bankruptcy do not include: