FIN60204 – CORPORATE FINANCE

TUTORIAL QUESTIONS

TOPIC 7 – CHAPTER 16 (CAPITAL STRUCTURE)

CONCEPT QUESTIONS

1. The use of personal borrowing to change the overall amount of financial leverage to which an
individual is exposed is called: 
 
A. homemade leverage.

B. dividend recapture.

C. the weighted average cost of

capital.

D. private debt placement.

E. personal offset.

2. The proposition that the value of the firm is independent of its capital structure is called: 
 
A. the capital asset pricing
model.

B. MM Proposition I.

C. MM Proposition II.

D. the law of one price.

E. the efficient markets hypothesis.

 
3. The proposition that the cost of equity is a positive linear function of capital structure is called: 
 
A. the capital asset pricing
model.

B. MM Proposition I.

C. MM Proposition II.

D. the law of one price.

E. the efficient markets hypothesis.

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TUTORIAL QUESTIONS

4. The tax savings of the firm derived from the deductibility of interest expense is called the: 
 
A. interest tax shield.

B. depreciable basis.

C. financing
umbrella.

D. current yield.

E. tax-loss carry forward savings.

 
5. The unlevered cost of capital is: 
 
A. the cost of capital for a firm with no equity in its capital
structure.

B. the cost of capital for a firm with no debt in its capital

structure.

C. the interest tax shield times pretax net

income.

D. the cost of preferred stock for a firm with equal parts debt and common stock in its capital
structure.

E. equal to the profit margin for a firm with some debt in its capital
structure.

 
6. The cost of capital for a firm, R-WACC, in a zero tax environment is: 

A. equal to the expected earnings divided by market value of the unlevered firm.

B. equal to the rate of return for that business risk

class.

C. equal to the overall rate of return required on the levered firm.

D. is constant regardless of the amount of leverage.

E. All of
these.
 

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TUTORIAL QUESTIONS

7. The firm's capital structure refers to: 

 
A. the way a firm invests its assets.

B. the amount of capital in the

firm.

C. the amount of dividends a firm pays.

D. the mix of debt and equity used to finance the firm's assets.

E. how much cash the firm holds.

8. A general rule for managers to follow is to set the firm's capital structure such that: 

A. the firm's value is

minimized.

B. the firm's value is maximized.

C. the firm's bondholders are made well

off.

D. the firms suppliers of raw materials are

satisfied.

E. the firms dividend payout is

maximized.

 
9. A levered firm is a company that has: 
 
A. Accounts Payable as the only liability on the balance sheet.

B. some debt in the capital

structure.

C. all equity in the capital structure.

D. All of these.

E. None of these.
 

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TUTORIAL QUESTIONS

10. A manager should attempt to maximize the value of the firm by: 
A. changing the capital structure if and only if the value of the firm increases.
B. changing the capital structure if and only if the value of the firm increases to the benefit of
inside management.
C. changing the capital structure if and only if the value of the firm increases only to the benefits
of the debtholders.
D. changing the capital structure if and only if the value of the firm increases although it
decreases the stockholders' value.
E.  changing the capital structure if and only if the value of the firm increases and stockholder
wealth is constant.

PROBLEM QUESTIONS

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TUTORIAL QUESTIONS

1. Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding.
The company is in the process of borrowing $8 million at 9% interest to repurchase
200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? 

Answer
VL = VU

Price per share = $8m ÷ 200k = $40

Total value of the firm = (Current outstanding share – new outstanding share) x price per
share + borrowings

Total value of the firm = [(500,000 - 200,000) × $40] + $8m = $20m

2. Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding.
The company has decided to borrow $1 million to buy out the shares of a deceased
stockholder who holds 2,500 shares. What is the total value of this firm if you ignore
taxes? 

Answer

Price per share = $1m ÷ 2,500 = $400;

Total value of the firm = (Current outstanding share – new outstanding share) x price per
share + borrowings

Total value of the firm = [(40,000 - 2,500) × $400] + $1m = $16m

3. Your firm has a debt-equity ratio of 0.75. Your pre-tax cost of debt is 8.5% and your
required return on assets is 15%. What is your cost of equity if you ignore taxes? Rs = ?

Answer
R0 = return on asset (unlevered equity, 100% equity financing)
M&M II without tax
Rs = R0 + B/S x (R0 – RB)
Rs = Cost of equity (levered equity)
R0 = Cost of capital (unlevered equity)
RB = Cost of debt (interest rate)
B = Value of debt
S = Value of levered equity
B/S = D/E Page 5 of 11

All equity finance = WACC = R0 = RS

FIN60204 – CORPORATE FINANCE
TUTORIAL QUESTIONS

Rs = R0 + B/S x (R0 – RB)

Rs = 15% + 0.75 x (15% - 8.5%)= 19.88%

4. Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The
required return on the assets is 11%. What is the firm's debt-equity ratio based on MM
Proposition II with no taxes? 

Answer

Rs = R0 + B/S x (R0 – RB)

13.56% = 11% + D/E x (11% - 7%)
D/E = 0.64

5. The Backwoods Lumber Co. has a debt-equity ratio of 0.80. The firm's required return on
assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on
MM Proposition II with no taxes? 

Answer

Rs = R0 + B/S x (R0 – RB)

15.68% = 12% + 0.8 x (12% - RB)
RB = 7.40%

6. The Winter Wear Company has expected earnings before interest and taxes of $2,100, an
unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of
debt that carries a 7% coupon. The debt is selling at par value. What is the value of this
firm? 

Answer

VL = VU + T C B
VU = EBIT x (1 – t)
R0
VL = VU + T C B

VL = [$2,100 × (1 – 34%)] + ($2,800 x 34%)

14%

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TUTORIAL QUESTIONS

VL = $10,852

7. Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock
outstanding with a market price of $42 a share. The current cost of equity is 12% and the
tax rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to
her capital structure. The debt will be sold at par value. What is the levered value of the
equity? 

Answer

VL = VU + T C B
VL = (80,000 × $42) + (34% × $1m) = $3.7m
Total value of firm = E + B
$3.7m = E + $1m
E = $3.7m - $1m = $2.7m

8. Joe's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000.
The unlevered cost of capital is 10% and the tax rate is 34%. What is the value of this firm? 

Answer

VL = VU + T C B
VU = EBIT x (1 – t)
R0

VU = $86,000 ÷ 10% = $860,000

9. An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of
$150,000. A levered firm with the same operations and assets has both a book value and
a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%.
What is the value of the levered firm? 

Answer

VL = VU + T C B
VU = EBIT x (1 – t)
R0

VL = [$150,000 × (1 – 35%)] ÷ 14% + (35% × $700k) = $941,429

10. Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a
coupon rate of 7% and pays interest annually. The expected earnings before interest and
taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the
firm's cost of equity? Rs =?

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TUTORIAL QUESTIONS

Answer

VL = VU + T C B
VU = EBIT x (1 – t)
R0

VL = [$1,200 × (1 – 34%)] + ($3,000 x 34%)

12%
VL = $7,620

Total value of firm = E + B

$7,620 = E + $3,000
E = $4,620
M&M II with tax
Rs = R0 + B/S x (1 – T) x (R0 – RB)
Rs = Cost of equity (levered equity)
R0 = Cost of capital (unlevered equity)
RB = Cost of debt (interest rate)
B = Value of debt
S = Value of levered equity
B/S = D/E

All equity finance = WACC = R0 = RS

Rs = R0 + B/S x (1 – T) x (R0 – RB)
= 12% + [($3,000 ÷ $4,620) × (1 – 34%) x (12% - 7%)]
Rs = 14.14%

11. Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your
tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio? 

Answer
M&M II with tax
Rs = R0 + B/S x (1 – T) x (R0 – RB)
Rs = Cost of equity (levered equity)
R0 = Cost of capital (unlevered equity)
RB = Cost of debt (interest rate)
B = Value of debt
S = Value of levered equity
B/S = D/E

All equity finance = WACC = R0 = RS

Rs = R0 + B/S x (1 – T) x (R0 – RB)

15.26% = 13% + B/S x (1 – 35%) x (13% - 7%)
B/S = D/E = 58%

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TUTORIAL QUESTIONS

12. A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of
8%, a cost of equity of 12%, and a tax rate of 34%. What is the firm's weighted average
cost of capital? 

Answer
B@D = $5,000 S@E = $16,000B + S = $21,000 ($16,000 + $5,000)
VL = $8,900 RB = 8% Rs = 12% T = 34%

RWACC = [S/(S + B) x Rs] + [B/(S+B) x RB x (1 – T)]

RWACC = [($16k ÷ $21k) × .12] + [($5k ÷ $21k) × .08 × (1 - .34) = .091429 + .012571 =
10.40%

13. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%.
If there are no taxes or other imperfections, what would be its cost of equity if the debt-to-
equity ratio were 0? 

Answer
Rs = ? D/E = 0 (means 100% equity financing)
M&M II without tax
Rs = R0 + B/S x (R0 – RB)
Rs = Cost of equity (levered equity)
R0 = Cost of capital (unlevered equity)
RB = Cost of debt (interest rate)
B = Value of debt
S = Value of levered equity
B/S = D/E

All equity finance = WACC = R0 = RS

Step 1
Rs = R0 + B/S x (R0 – RB)
16% = R0 + 1 x (R0 -.08)
R0 = 12%

Step 2 (Alternative 1)
Rs = R0 + B/S x (R0 – RB)
= 12% + 0 x (R0 -.08)
Rs = 12%

Step 2 (Alternative 2)
D/E = 1 each 50%
RWACC = [S/(S + B) x Rs] + [B/(S+B) x RB x (1 – T)] * no tax so no need (1-T)
= [50% x 16%] + [50%x 8%)

RWACC = 12%

R0 = Rs = RWACC (all equity finance, debt equity ratio = 0)

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TUTORIAL QUESTIONS

14. Weston Industries has a debt – equity ratio of 1.5. Its WACC is 11% and its cost of debt is
7%. The corporate tax rate is 35%.
a. What’s Weston’s cost of equity? Rs = ? WACC
b. What’s Weston unlevered cost of capital?
c. What would the cost of equity be if the debt – equity ratio were 2?

Answer

a. D = 1.5 E = 1 D+E = 2.5

The company has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and
the weight of equity is 1/2.5.

With the information provided, we can use the equation for calculating WACC to find the
cost of equity. The equation for WACC is:

RWACC = [S/(S + B) x Rs] + [B/(S+B) x RB x (1 – T)]

11% = [(1/2.5) x RS] + [(1.5/2.5) x (7%) x (1 – 35%)]
Rs= .2068, or 20.68%

b. To find the unlevered cost of equity, R0 = ?

M&M II with tax
Rs = R0 + B/S x (1 – T) x (R0 – RB)
Rs = Cost of equity (levered equity)
R0 = Cost of capital (unlevered equity)
RB = Cost of debt (interest rate)
B = Value of debt
S = Value of levered equity
B/S = D/E

All equity finance = WACC = R0 = RS

Rs = R0 + B/S x (1 – T) x (R0 – RB)
20.68% = R0 + (1.5)x(1 – 35%) x (R0 – 7%)
R0 = .1393, or 13.93%

c. To find the cost of equity under different capital structures, we can again use M&M
Proposition II with taxes. With a debt-equity ratio of 2, the cost of equity is:

Rs = R0 + B/S x (1 – T) x (R0 – RB)

= 13.92% + (2)(1 – 35%)x(13.92% – 7%)
Rs = .2294, or 22.94%

15. Shadow Corp. has no debt but can borrow at 8%. The firm’s WACC is currently at 11%,
and the tax rate is 35%.
a. What is Shadow’s cost of equity? Rs = ?
b. If the firm converts to 25% debt, what will its cost of equity be? Rs = ?
c. If the firm converts to 50% debt, what will its cost of equity be?
d. What is the Shadow’s WACC in part (b) & part (c)?

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Answer

a. For an all-equity financed company (no debt, 100% stock @ equity financing)

WACC = R0 = RS = .11 or 11%

To counter check:
RS = R0 + (B/S) x (1-T) x (R0 – RB)
= 11% + 0 = 11%

b. To find the cost of equity for the company with leverage, we need to use M&M
Proposition II with taxes, so:

D = 25% E = 75% D+E = 100%

RS = R0 + (B/S) x (1-T) x (R0 – RB)

RS = 11% + (0.25/0.75) x (1-35%) (11% – 8%)
RS = .1165, or 11.65%

c. Using M&M Proposition II with taxes again, we get:

D = 50% E = 50%

RS = R0 + (B/S) x (1-T) x (R0 – RB)

RS = 11% + (0.50/0.50) x (1-35%) (11% – 8%)
RS = .1295 or 12.95%

d. The WACC with 25 percent debt is:

RWACC = [S/(S + B) x Rs] + [B/(S+B) x RB x (1 – T)]

= .75(.1165) + .25(.08)(1 – .35)
= .1004 or 10.04%

And the WACC with 50 percent debt is:

RWACC = [S/(S + B) x Rs] + [B/(S+B) x RB x (1 – T)]

= .50(.1295) + .50(.08)(1 – .35)
= .0908 or 9.08%

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