IFM10 CH 16 Test Bank

CHAPTER 16
CAPITAL STRUCTURE DECISIONS: PART II

(Difficulty: E = Easy, M = Medium, and T = Tough)
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
Answer: b Diff: M
11
.
tax shield is the WACC.
a. True
b. False
Answer: b Diff: M
12
.
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

Answer: b Diff: M
14
.
When a firm has risky debt, its debt can be viewed as an option on the
total value of the firm with an exercise price equal to the face value of
the equity.
a. True
b. False
Multiple Choice: Conceptual

Medium:
(16.2) Miller model
Answer: b Diff: M
15
.
The major contribution of the Miller model is that it demonstrates that
a. personal taxes increase the value of using corporate debt.
b. personal taxes decrease the value of using corporate debt.
c. financial distress and agency costs reduce the value of using
corporate debt.
d. equity costs increase with financial leverage.
e. debt costs increase with financial leverage.
(16.3) MM and Miller
Answer: d Diff: M
16
.
Which of the following statements concerning capital structure theory is
NOT CORRECT?
a. The major contribution of Miller's theory is that it demonstrates that
personal taxes decrease the value of using corporate debt.
b. Under MM with zero taxes, financial leverage has no effect on a firms
value.
c. Under MM with corporate taxes, the value of a levered firm exceeds the
value of the unlevered firm by the product of the tax rate times the
market value dollar amount of debt.
d. Under MM with corporate taxes, rs increases with leverage, and this
increase exactly offsets the tax benefits of debt financing.
e. Under MM with corporate taxes, the effect of business risk is
automatically incorporated because rsL is a function of rsU.
Page 6
Conceptual Questions
Answer: d
Diff: M
Chapter 17: Cap Structure: Extns
17
Which of the following statements concerning the MM extension with growth

is NOT CORRECT?
a. The tax shields should be discounted at the unlevered cost of equity.
b. The value of a growing tax shield is greater than the value of a
constant tax shield.
c. For a given D/S, the levered cost of equity is greater than the
levered cost of equity under MMs original (with tax) assumptions.
d. For a given D/S, the WACC is less than the WACC under MMs original
(with tax) assumptions.
e. The total value of the firm increases with the amount of debt.
Page 7

Answer: a Diff: M
18
.
is NOT CORRECT?
a. The tax shields should be discounted at the cost of debt.
d. For a given D/S, the WACC is greater than the WACC under MMs original
e. The total value of the firm increases with the amount of debt.
Answer: e Diff: M
19
.
is NOT CORRECT?
a. The tax shields should be discounted at the unlevered cost of equity.
d. For a given D/S, the WACC is greater than the WACC under MMs original
e. The total value of the firm is independent of the amount of debt it
uses.
Multiple Choice: Problems

Medium:
Answer: e Diff: M
20
.
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?
a.
b.
c.
d.
e.
11.4%
12.0%
12.6%
13.3%
14.0%

Answer: c Diff: M
21
.
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 5% rate, 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 would
Firm L's total value be if it had no debt?
Page 8
a.
b.
c.
d.
e.
$358,421
$377,286
$397,143
$417,000
$437,850

Answer: b Diff: M
22
.
Your firm has debt worth $200,000, with a yield of 9%, and equity worth
$300,000. It is growing at a 5% rate, 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 the value of your firms tax shield,
i.e., how much value does the use of debt add?
a.
b.
c.
d.
e.
$92,571
$102,857
$113,143
$124,457
$136,903
Multi-part:
(The following data apply to Problems 23 through 25.
kept together.)
The problems MUST be
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
(16.1) MM with tax

24
.
What is the firm's cost of equity?
a.
b.
c.
d.
e.
Answer: e
Diff: E
21.0%
23.3%
25.9%
28.8%
32.0%
(16.2) Miller model

Answer: e Diff: T
25
.
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?
a. 16.4%
Page 9
b.
c.
d.
e.
Page 10
18.2%
20.2%
22.5%
25.0%

kept together.)
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%.
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

Answer: c Diff: M
27
.
According to the MM extension with growth, what is Gomezs unlevered
value?
a.
b.
c.
d.
e.
$1,296,000
$1,440,000
$1,600,000
$1,760,000
$1,936,000

Answer: a Diff: M
28
.
According to the MM extension with growth, what is Gomezs value of
equity?
a.
b.
c.
d.
e.
$1,492,000
$1,529,300
$1,567,533
$1,606,721
$1,646,889

kept together.)
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.
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
Page 11
c. $282.43
d. $313.81
e. $345.19
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

31
.
What is the yield on Trumbulls debt?
a.
b.
c.
d.
e.
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
2.(16.1) Taxes and capital structure
Answer: b
Diff: E
3.(16.1) MM models
Answer: a
Diff: E
4.(16.1) MM models
Answer: a
Diff: E
5.(16.2) Miller model
Answer: a
Diff: E
Answer: b
Diff: E
7.(16.5) Financial leverage
Answer: a
Diff: E
8.(16.2) MM models
Answer: a
Diff: M
9.(16.2) MM models
Answer: b
Diff: M
10.(16.4) MM extension with growth
Answer: a
Diff: M
Answer: b
Diff: M
Answer: b
Diff: M
13.(16.5) Equity as an option
Answer: a
Diff: M
Answer: b
Diff: M
Answer: b
Diff: M
16.(16.3) MM and Miller
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%
rsL = rsU + (rsU rd)(D/S) = 12% + (12% 9%)($200,000/$300,000) = 14.0%

Debt: $200,000
rd: 9%
T: 40%
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
Debt: $200,000 Equity: $300,000

rd: 9%
rsU: 12%
T: 40%
g: 5%
VTotal = VU + VTS
Value tax shelter = VTS = rdTD/(r sU g)
VTS = r dTD/(r sU g) = 0.09(0.40)($200,000)/(0.12 0.05) = $102,857
23.(16.1) MM with tax
EBIT: $100,000 rd: 12% Tc: 30%
Debt: $500,000 rsU: 16%
VU = EBIT(1 T)/r sU = $100,000(0.7)/0.16 = $437,500
VL = VU + TD = $437,500 + 0.3($500,000) = $587,500
24.(16.1) MM with tax
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%
Tc: 30%
Ts: 20%
Answer: e
Gain from leverage: $126,667
Debt: $500,000
[1 (1 Tc)(1 Ts)/(1 Td)]D = $126,667

[1 (0.7)(0.8)/X]$500,000 = $126,667
1 0.56/X = 0.25333
0.56/X = 0.74667
X = 0.75000
1 Td = 0.75000
Td = 25.00%
(1 Tc) =
(1 Ts) =
(1 Tc) (1 Ts) =
Gain/Debt =
Gain/Debt 1 =
X = -0.56/-0.74666 =
X=
Td =

EBIT: $200,000
Debt: $300,000
rd: 8%
g: 6%
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%
VTS = r dTD/(r sU g) = 0.08(0.40)($300,000)/(0.11 0.06) = $192,000

FCF = NOPAT Net investment in operating assets
= EBIT(1 T) EBIT(0.20)
= $200,000(0.60) $200,000(0.20)
= $120,000 $40,000 = $80,000
VU = FCF/(r sU g)
= $80,000/(0.11 0.06)
= $1,600,000
Answer: a
Diff: M
Answer: d
Diff: M
Answer: b
Diff: M
Answer: e
Diff: M
VEquity = VTotal Debt.

VTotal = VU + VTS so, VEquity = VU + VTS Debt.
VTS = $192,000 (from above).
VU = $1,600,000 (from above).
VEquity = $1,600,000 + $192,000 $300,000 = $1,492,000
Total value = P = $500.0
Debt = X = $200.0
Volatility () = 0.6
rRF = 5%
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
VDebt = VTotal VEquity = $500 $313.81 = $186.19
Yield = [(Face Value/Price)1/Maturity] 1.0 = [$200/$186.19] 1 1.0 = 7.42%

IFM10 CH 16 Test Bank

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CHAPTER 16

CAPITAL STRUCTURE DECISIONS: PART II

Chapter 16: Capital Structure Decisions: Part II

Chapter 16: Capital Structure Decisions: Part II

(16.5) Equity as an option

Multiple Choice: Conceptual

Chapter 17: Cap Structure: Extns

Which of the following statements concerning the MM extension with growth

Chapter 16: Capital Structure Decisions: Part II

(16.4) MM extension with growth

Multiple Choice: Problems

(16.4) MM extension with growth

Chapter 16: Capital Structure Decisions: Part II

(16.4) MM extension with growth

The problems MUST be

(16.1) MM with tax

(16.2) Miller model

Chapter 16: Capital Structure Decisions: Part II

(The following data apply to Problems 26 through 28.

The problems MUST be

(16.4) MM extension with growth

(16.4) MM extension with growth

(The following data apply to Problems 29 through 31.

The problems MUST be

(16.5) Equity as an option

Chapter 16: Capital Structure Decisions: Part II

Chapter 16: Capital Structure Decisions: Part II

2.(16.1) Taxes and capital structure

5.(16.2) Miller model

6.(16.2) Miller model

7.(16.5) Financial leverage

10.(16.4) MM extension with growth

11.(16.4) MM extension with growth

12.(16.4) MM extension with growth

13.(16.5) Equity as an option

14.(16.5) Equity as an option

15.(16.2) Miller model

16.(16.3) MM and Miller

17.(16.4) MM extension with growth

18.(16.4) MM extension with growth

19.(16.4) MM extension with growth

20.(16.4) MM extension with growth

rsL = rsU + (rsU rd)(D/S) = 12% + (12% 9%)($200,000/$300,000) = 14.0%

22.(16.4) MM extension with growth

Debt: $200,000 Equity: $300,000

[1 (1 Tc)(1 Ts)/(1 Td)]D = $126,667

26.(16.4) MM extension with growth

VTS = r dTD/(r sU g) = 0.08(0.40)($300,000)/(0.11 0.06) = $192,000

28.(16.4) MM extension with growth

VEquity = VTotal Debt.

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