Test Bank Chapter 15: CAPITAL STRUCTURE POLICY EFS

I. True or False (Definitions and Concepts)

F 1. A firm’s mix of financing methods is called its capital budget. (FALSE: Should
be capital structure instead of capital budget.)

T 2. For most capital structure models, the required returns on equity and debt (re and
rd, respectively) depend on the amount of debt.

T 3. An arbitrage argument can be used to show that if two firms have identical
operating profitability but different capital structures, then buying and selling among investors
will ensure that the two firms have equal market values.

F 4. Tax differences paid on equity and debt gives rise to the personal tax view of
capital structure (FALSE: Should be corporate tax view of capital structure instead of personal
tax view of capital structure.)

T 5. According to the corporate tax view of capital structure, the expected after-tax
cash flows to investors increase with leverage because the government will collect fewer tax
dollars.

F 6. Investors with a high marginal income tax rate may find debt securities more
attractive. (FALSE: Should be less attractive instead of more attractive.)

F 7. Tax-exempt investors may find debt securities less attractive than other investors.
(FALSE: Should be more attractive instead of less attractive.)

T 8. With tax asymmetry, an all-equity firm can increase its value by issuing debt.

F 9. The expected costs of financial distress and bankruptcy depend totally on the
uniqueness, or degree of specialization, of the firm's assets. (FALSE: Should be depend in part
instead of depend totally.)

T 10. The difference in personal taxes for equity and debt offsets the corporate tax
asymmetry when (1 – Td) = (1 – Te)(1 – T).

F 11. The capital gain tax-timing option raises the effective tax rate on shareholder
income. (FALSE: Should be lowers instead raises.)

F 12. Agency conflicts between equityholders and debtholders can be minimized by

creating contracts without restrictive covenants. (FALSE: Should be with restrictive covenants
instead of without restrictive covenants.)

T 13. Loss carryforwards and loss carrybacks are sometimes limited, so that some of
the corporate tax shield resulting from leverage may be lost during a period financial distress.

T 14. The existence of various leverage clienteles mitigates some, but not all, of the
arguments in favor of capital structure relevance.
T 15. All of the views of capital structure, beyond that of a perfect capital market, are
based on minimizing the value lost to one or more imperfections.

II. Multiple Choice (Definitions and Concepts)

a 16. Capital structure is irrelevant in terms of firm value in a perfect capital market
environment where there are .
a. no taxes.
b. transaction costs.
c. bankruptcy costs.
d. a&b

d 17. There is an arbitrage argument for the irrelevance of capital structure based upon
the possibility that shareholders can .
a. create their own leverage by borrowing and investing in stock.
b. can borrow at a higher rate than the firm.
c. can reproduce any capital structure making a firm's choice of leverage irrelevant.
d. a&c

a 18. Ways of reducing the agency costs of debt include .

a. having a sinking fund provision.
b. securing debt by using intangible assets as collateral.
c. allowing additional debt or dividends.
d. none of these

d 19. Which of the following statements is true?

a. The Principle of Incremental Benefits says to consider the possible ways to
minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric
information, and transaction costs.
b. The Principle of Valuable Ideas suggests to look for opportunities to create value
by issuing securities that are in short supply, perhaps resulting from changes in tax law.
c. The Time Value of Money Principle advises to include any time-value-of-money
tax benefits from capital structure choices.
d. all of these

c 20. Which of the following statements is true?

a. The Principle of Capital Market Efficiency says to consider the possible ways to
minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric
information, and transaction costs.
b. The Behavioral Principle suggests to look for opportunities to create value by
issuing securities that are in short supply, perhaps resulting from changes in tax law.
c. The Signaling Principle says to consider any possible change in capital structure
carefully, because financing transactions and capital structure changes convey information to
outsiders and can be misunderstood.
d. all of these

b 21. Which of the following statements is true?

a. The Signaling Principle says to recognize that capital structure changes made at
fair market security prices, which also change equity-debt risk bearing, are simply a risk-return
trade-off. Such transactions don’t affect firm value (except for possible signaling effects).
 b. The Time Value of Money Principle advises to include any time-value-of-money
tax benefits from capital structure choices.
c. The Behavioral Principle suggests to look for opportunities to create value by
issuing securities that are in short supply, perhaps resulting from changes in tax law.
d. none of these

d 22. Which of the following statements is true?

a. The Principle of Capital Market Efficiency says to recognize that the potential to
increase firm value through capital structure is smaller than the potential to increase firm value
through the introduction of valuable new ideas and wise use of the firm's comparative advantages.
b. The Behavioral Principle states to look to the information contained in the capital
structure decisions and financing transactions of other firms for guidance in choosing a capital
structure.
c. The Signaling Principle says to consider any possible change in capital structure
carefully, because financing transactions and capital structure changes convey information to
outsiders and can be misunderstood.
d. all of these

b 23. Which of the following statements is true?

a. The Principle of Incremental Benefits says to recognize that the potential to
increase firm value through capital structure is smaller than the potential to increase firm value
through the introduction of valuable new ideas and wise use of the firm's comparative advantages.
b. The Behavioral Principle states to look to the information contained in the capital
structure decisions and financing transactions of other firms for guidance in choosing a capital
structure.
c. The Time Value of Money Principle says to consider any possible change in
capital structure carefully, because financing transactions and capital structure changes convey
information to outsiders and can be misunderstood.
d. none of these

a 24. Which of the following statements is true?

a. The Principle of Incremental Benefits says to consider the possible ways to
minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric
information, and transaction costs.
b. The Behavioral Principle suggests to look for opportunities to create value by
issuing securities that are in short supply, perhaps resulting from changes in tax law.
c. The Principle of Valuable Ideas advises to include any time-value-of-money tax
benefits from capital structure choices.
d. all of these

a 25. Which of the following represents the perfect capital market view of capital
structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. Corporate taxes cause debt to be cheaper than equity.
c. Maximum firm value results from being essentially all-debt financed.
d. none of these

d 26. Which of the following represents the perfect capital market view of capital
structure?
 a. The value of the leveraged firm is equal to the value of the unleveraged firm plus
the tax rate times the amount of debt.
b. Corporate taxes cause debt to be cheaper than equity.
c. Maximum firm value results from being essentially all-debt financed.
d. none of these

d 27. Which of the following represents the corporate tax view of capital structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. Corporate taxes cause debt to be cheaper than equity.
c. Maximum firm value results from being essentially all-debt financed.
d. b&c

b 28. Which of the following represents the corporate tax view of capital structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. The value of the leveraged firm is equal to the value of the unleveraged firm plus
the tax rate times the amount of debt.
c. Maximum firm value results from being essentially all-equity financed.
d. Corporate taxes cause debt to be more expensive than equity.

b 29. Which of the following represents the personal tax view of capital structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. The firm operates in a perfect capital market environment, except for corporate
and personal income taxes.
c. Maximum firm value results from being essentially all-equity financed.
d. Corporate taxes cause debt to be more expensive than equity.

c 30. Which of the following represents the personal tax view of capital structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. Corporate taxes cause debt to be cheaper than equity.
c. The differential between tax rates on personal income from equity and from debt
cancels out the corporate tax asymmetry.
d. a&b

d 31. Which of the following represents the personal tax view of capital structure?
a. The differential between tax rates on personal income from equity and from debt
cancels out the corporate tax asymmetry.
b. The firm operates in a perfect capital market environment, except for corporate
and personal income taxes.
c. A before-tax dollar singly taxed at Td provides the same net amount to an
investor as a before-tax dollar taxed at T and then taxed again at Te.
d. all of these

d 32. Which of the following represents the corporate tax view of capital structure?
a. The differential between tax rates on personal income from equity and from debt
cancels out the corporate tax asymmetry.
b. The firm operates in a perfect capital market environment, except for corporate
and personal income taxes.
 c. A before-tax dollar singly taxed at Td provides the same net amount to an
investor as a before-tax dollar taxed at T and then taxed again at Te.
d. none of these

b 33. Which of the following represents the corporate tax view of capital structure?
a. The differential between tax rates on personal income from equity and from debt
cancels out the corporate tax asymmetry.
b. The value of the leveraged firm is equal to the value of the unleveraged firm plus
the tax rate times the amount of debt.
c. A before-tax dollar singly taxed at Td provides the same net amount to an
investor as a before-tax dollar taxed at T and then taxed again at Te.
d. Corporate taxes cause debt to be more expensive than equity.

a 34. Which of the following represents the perfect capital market view of capital
structure?
a. Firm value depends only on its expected future operating cash flows and the cost
of capital, not on how those cash flows are divided between the debtholders and the shareholders.
b. The differential between tax rates on personal income from equity and from debt
cancels out the corporate tax asymmetry.
c. A before-tax dollar singly taxed at Td provides the same net amount to an
investor as a before-tax dollar taxed at T and then taxed again at Te.
d. none of these

c 35. WACC equals .

a. (1 – L)rd + L(1 – T)re where L is the leverage ratio consisting of debt divided by
firm value.
b. (1 – L)(1 – T)re + Lrd where L is the leverage ratio consisting of debt divided by
firm value.
c. (1 – L)re + L(1 – T)rd where L is the leverage ratio consisting of debt divided by
firm value.
d. (1 – L)re + L(1 – T)rd where L is the leverage ratio consisting of equity divided
by firm value.

d 36. With tax asymmetry, .

a. an all-debt firm can increase its value by issuing debt.
b. an all-equity firm can increase its value by retiring debt.
c. an all-equity firm can decrease its value by issuing debt.
d. an all-equity firm can increase its value by issuing debt.

c 37. The corporate tax view of capital structure states that WACC equals .
a. (1 – L)rd + L(1 – T)re.
b. r / (1 – TL).
c. r(1 – TL).
d. none of these

b 38. Capital structure irrelevance can be illustrated with a(n) argument.

a. information asymmetry.
b. arbitrage.
c. tax asymmetry.
d. transaction costs.
b 39. With tax asymmetry, .
a. an all-debt firm can increase its value by issuing debt.
b. an all-equity firm can increase its value by issuing debt.
c. an all-equity firm can decrease its value by issuing debt.
d. an all-debt firm can increase its value by issuing equity.

a 40. The value of an unleveraged firm can be written as .

a. VU = (1 – T) / r where is the expected perpetual cash inflow per year (on a
before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital.
b. VU = (1 – T) / r where is the expected perpetual cash inflow per year (on an
after-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital.
c. VU = (1 – T) / r where is the expected perpetual cash inflow per year (on a
before-tax basis), T is the applicable tax rate, and r is the leveraged cost of capital.
d. none of these

c 41. The value of an unleveraged firm can be written as .

a. VU = T( / r) where is the expected perpetual cash inflow per year (on a before-tax
basis), T is the applicable tax rate, and r is the unleveraged cost of capital.
b. VU = / r where is the expected perpetual cash inflow per year (on a before-tax
basis), T is the applicable tax rate, and r is the unleveraged cost of capital.
c. VU = (1 – T) / r where is the expected perpetual cash inflow per year (on a
before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital.
d. none of these

a 42. The corporate tax view of capital structure states that WACC equals .
a. r(1 – TL).
b. r / (1 – TL).
c. rT(1 –L).
d. none of these

c 43. The arbitrage argument shows .

a. that if two firms have identical operating profitability but different capital
structures, arbitrage among investors will ensure that the two firms have unequal market values.
b. that if two firms have different profitability but different capital structures,
arbitrage among investors will ensure that the two firms have equal market values.
c. that if two firms have identical operating profitability but different capital
structures, arbitrage among investors will ensure that the two firms have equal market values.
d. none of these

a 44. WACC equals .

a. (1 – L)re + L(1 – T)rd where L is the leverage ratio consisting of debt divided by
firm value.
b. (1 – L)(1 – T)re + L(1 – T)rd where L is the leverage ratio consisting of debt
divided by firm value.
c. (1 – L)re + L(T)rd where L is the leverage ratio consisting of debt divided by firm
value.
d. (1 – L)re + L(1 – T)rd where L is the leverage ratio consisting of equity divided
by firm value.

III. Multiple Choice (Problems)

b 45. A firm borrows $500 and its leveraged firm value is $850. What is its leverage
ratio (L)?
a. about 0.37
b. about 0.59
c. about 0.63
d. none of these
[ANSWER: L = D / (D + E) = D / V = $500 / $850 = 0.5882 or about 0.59.]

a 46. A firm borrows $500 and its leveraged firm value is $1,000. Its cost of equity and
debt are 12% and 8%. Its corporate tax rate is 30%. What is its weighted average cost of capital?
a. 8.80%
b. 11.60%
c. 12.00%
d. 20.00%
[ANSWER: Our formula is: WACC = (1 – L)re + L(1 – T)rd where L is the leverage ratio
consisting of debt divided by firm value. Given L = D / V = $500 / $1,000 = 0.5 and inserting our
other given values, we have: WACC = (1 – 0.5)12% + 0.5(1 – 0.3)8% = 6% + 2.8% = 8.80%.]

d 47. A firm borrows $500 and its debt-to-equity ratio is 0.7. Its cost of equity and debt
are 11% and 7.5%. Its corporate tax rate is 35%. What is its weighted average cost of capital?
a. 7.34%
b. 8.54%
c. 9.32%
d. none of these
[ANSWER: Our formula is: WACC = (1 – L)re + L(1 – T)rd where L is the leverage ratio
consisting of debt divided by firm value. Given D/E = 0.7 = 7/10, this implies that L =
D / (D + E) = 7 / (10 + 7) = 7 /17. Inserting this value for L and our other given values, we have:
WACC = (1 – [7/17])11% + [7/17])(1 – 0.35)7% = 6.4706% + 1.8735% = about 8.344%.]

c 48. Firm A and Firm B operate in a perfect capital market environment. Each
generates $10M (M = million) of operating income. Firm A pays $3.6M in interest giving a net
income of $6.4M. Firm B pays no interest and so its net income is $10M. Firm A and Firm B
have respective market values of $60M and $50M. Firm A’s debt is $30M while Firm B’s debt is
0. You own 1% of Firm A’s equity and can borrow at 12%. Assuming you seek to make a riskless
arbitrage profit by selling all of your shares, which of the following will occur?
a. You will borrow $0.6M, buy 1.2% of Firm B, and make an arbitrage profit of
$20,000 more per year.
b. You will borrow $0.3M, buy 1.0% of Firm B, and make an arbitrage profit of
$30,000 more per year.
c. You will borrow $0.3M, buy 1.2% of Firm B, and make an arbitrage profit of
$20,000 more per year.
d. You will borrow $0.3M, buy 1.2% of Firm B, and make an arbitrage profit of
$30,000 more per year.
[ANSWER: You sell your equity ownership at a market value of 0.01($30M) = $0.3M and
borrow $0.3M at 12% per year thereby mimicking Firm’s A capital structure where L = D / V =
$30M / $60M = 0.5 implying you have the same risk. You now use the $0.3M + $0.3M = $0.6M
to buy $0.6M / $50M = 0.012 or 1.2% of Firm B. In acquiring 1.2% of Firm B, you give up
income of 0.01($6.4M) = $64,000. In turn, you now received 0.012($10M) – 0.012($0.3M) =
$0.12M – $0.036 = $0.084M or $84,000. Thus, with identical risk, you have received an arbitrage
profit of $84,000 – $64,000 = $20,000 more per year.]
a 49. Firm A and Firm B operate in a perfect capital market environment. Each
generates $5M (M = million) of operating income. Firm A pays $1.8M in interest giving a net
income of $3.2M. Firm B pays no interest and so its net income is $5M. Firm A and Firm B have
respective market values of $30M and $25M. Firm A’s debt is $15M while Firm B’s debt is 0.
You own 1% of Firm A’s equity and can borrow at 12%. What amount can you make through the
arbitrage process without taking on additional risk?
a. $10,000
b. $10,250
c. $11,000
d. $11,250
[ANSWER: You sell your equity ownership at a market value of 0.01($15M) = $0.15M and
borrow $0.15M at 12% per year thereby mimicking Firm’s A capital structure where L = D / V =
$15M / $30M = 0.5 implying you have the same risk. You now use the $0.15M + $0.15M =
$0.3M to buy $0.3M / $25M = 0.012 or 1.2% of Firm B. In acquiring 1.2% of Firm B, you give
up income of 0.01($3.2M) = $32,000. In turn, you now received 0.012($5M) – 0.012($0.15M) =
$0.06M – $0.018 = $0.042M or $42,000. Thus, with identical risk, you have received an arbitrage
profit of $42,000 – $32,000 = $10,000 more per year.]

c 50. Firm A and Firm B operate in a perfect capital market environment. Each
generates $5M (M = million) of operating income. Firm A pays $1.8M in interest giving a net
income of $3.2M. Firm B pays no interest and so its net income is $5M. Firm A and Firm B have
respective market values of $30M and $25M. Firm A’s debt is $15M while Firm B’s debt is 0.
You own 2% of Firm A’s equity and can borrow at 12%. What amount can you make through the
arbitrage process without taking on additional risk?
a. $19,000
b. $19,250
c. $20,000
d. $21,250
[ANSWER: You sell your equity ownership at a market value of 0.02($15M) = $0.3M and
borrow $0.3M at 12% per year thereby mimicking Firm’s A capital structure where L = D / V =
$15M / $30M = 0.5 implying you have the same risk. You now use the $0.3M + $0.3M = $0.6M
to buy $0.6M / $25M = 0.024 or 2.4% of Firm B. In acquiring 2.4% of Firm B, you give up
income of 0.02($3.2M) = $64,000. In turn, you now received 0.024($5M) – 0.024($0.15M) =
$0.12M – $0.036 = $0.084M or $84,000. Thus, with identical risk, you have received an arbitrage
profit of $84,000 – $64,000 = $20,000 more per year.]

a 51. Firm A and Firm B operate in a perfect capital market environment. Each
generates $10M (M = million) of operating income. Firm A pays $3.6M in interest giving a net
income of $6.4M. Firm B pays no interest and so its net income is $10M. Firm A and Firm B
have respective market values of $60M and $50M. Firm A’s debt is $30M while Firm B’s debt is
0. You own 1% of Firm A’s equity and can borrow at 12%. Assuming you seek to make a riskless
arbitrage profit by selling all of your shares, which of the following will occur in the process of
making this profit?
a. You will give up $64,000 income in Firm A to acquire 1.2% of Firm B, achieve a
personal leverage ratio of 0.5, and generate an arbitrage profit of $20,000 more per year.
b. You will borrow $0.6M, buy 1.2% of Firm B, and make an arbitrage profit of
$20,000 more per year.
c. You will give up $64,000 income in Firm A to acquire 1.0% of Firm B, pay
interest of $36,000, and generate an arbitrage profit of $20,000 more per year.
d. You will achieve a personal leverage ratio of 0.5, give up $84,000 income in
Firm A to acquire 1.2% of Firm B, and generate an arbitrage profit of $40,000 more per year.
[ANSWER: You sell your equity ownership at a market value of 0.01($30M) = $0.3M and
borrow $0.3M at 12% per year thereby mimicking Firm’s A capital structure where L = D / V =
$30M / $60M = 0.5 implying you have the same risk. You now use the $0.3M + $0.3M = $0.6M
to buy $0.6M / $50M = 0.012 or 1.2% of Firm B. In acquiring 1.2% of Firm B, you give up
income of 0.01($6.4M) = $64,000. In turn, you now received 0.012($10M) – 0.012($0.3M) =
$0.12M – $0.036 = $0.084M or $84,000. Thus, with identical risk, you have received an arbitrage
profit of $84,000 – $64,000 = $20,000 more per year.]

a 52. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $300, which can be larger or smaller, but is never
less than $50 per year. What is your its expected after-tax net income?
a. $180 per year
b. $170 per year
c. $160 per year
d. $150.00
[ANSWER: Your expected after-tax net income is: (1 – T) = (1 – 0.4)$300 = $180 per year.]

d 53. You are managing a firm that pays corporate taxes on its net income (T = 0.375)
but operates in an otherwise perfect capital market environment. Your firm has a perpetual
expected cash inflow each year () of $150, which can be larger or smaller, but is never less than
$50 per year. Your cost of capital is 12%. What is your net worth?
a. $1,250
b. $1,230
c. $791.25
d. $781.25
[ANSWER: Your expected after-tax net income is: (1 – T) = (1 – 0.375)$150 = $93.75 per year.
Your net worth is $93.75 / 0.12 = $781.25, compared to $150 / 0.12 = $1,250 value without
corporate taxes.]

c 54. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $1,500. Your cost of capital is 10%. How much
would your net worth increase if you did not pay taxes?
a. $6,200
b. $6,125
c. $6,000
d. none of these
[ANSWER: Your expected after-tax net income is: (1 – T) = (1 – 0.4)$1,500 = $900 per year.
Your net worth is $900 / 0.1 = $9,000, compared to $1,500 / 0.1 = $15,000 value without
corporate taxes. Thus, you could increase your net worth by $15,000 – $9,000 = $6,000.]

c 55. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.3) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $40,000.Your cost of capital is 12%. Suppose
your firm borrows $15,000 at 8% per year and gives the $15,000 to the shareholders. Which
below statement is true?
a. You will pay $3,200 a year in interest with an after-tax payment of only $2,240.
b. You will pay $2,400 a year in interest with an after-tax payment of only $1,494.
c. You will pay $1,200 a year in interest with an after-tax payment of only $840.
d. none of these
[ANSWER: This debt will require 0.08($15,000) = $1,200 per year in interest payments.
Because the interest payments are made before corporate taxes are assessed, the after-tax
payment on this debt is only (1 – 0.3)$1,200 = $840.]

b 56. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. You issue debt
causing a $40 annual coupon payment (CPN). Your cost of debt (rd) is 8%. The leverage would
increase the shareholders' required return (rL) to 16%. What was your firm worth when all-equity
financed (VU), and what is it now worth with leverage (VL)?
a. VU = $500 and VL = $912.50
b. VU = $750 and VL = $912.50
c. VU = $750 and VL = $1,162.50
d. VU = $1,000 and VL = $1,162.50
[ANSWER: Before issuing debt, your net worth is: VU = (1 – T) / r = (1 – 0.4)$150 =
$90 / 0.12 = $750. Under the proposed leveraging, D = CPN / rd = $40 / 0.08 = $500 and the
value of the levered firm is: EL = (1 – T)( – CPN) / rL = (1 – 0.4)($150 – $40) / 0.16 =
$66 / 0.16 = $412.50. The total value is VL = D + EL = $500 + $412.50 = $912.50.]

d 57. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. Now suppose
your firm borrows money. Your coupon payment (CPN) is $48. Your cost of debt (rd) is 8% per
year and gives the $600 to the shareholders. The leverage would increase the shareholders'
required return (rL) to 15%. What is the gain in leverage (GL)?
a. GL = $140
b. GL = $158
c. GL = $230
d. none of these
[ANSWER: Before issuing debt, your net worth is: VU = (1 – T) / r = (1 – 0.4)$150 =
$90 / 0.12 = $750. Under the proposed leveraging, D = CPN / rd = $48 / 0.08 = $600 and the
value of the levered firm is: EL = (1 – T)( – CPN) / rL = (1 – 0.4)($150 – $48) / 0.16 =
$61.2 / 0.15 = $408. The total value is VL = D + EL = $600 + $408 = $1,008. Thus, in this
environment, the proposed leveraging increases shareholder value by: GL = VL – VU =
$1,008 – $750 = $258.]

d 58. You are managing an unleveraged firm that pays corporate taxes on its net
income (T = 0.4) but operates in an otherwise perfect capital market environment. Your firm has
a perpetual expected cash inflow each year () of $150. Your cost of capital is 12%. Now suppose
your firm borrows $500 at rd = 8% per year. The leverage would increase the shareholders'
required return (rL) to 16%. Which of the following is true?
a. VL = $912.50, D = 500, and GL = $162.50
b. VU = $750 and the residual expected future cash flow to be paid out to
shareholders each year is $66
c. EL = $412.50 and the annual payment to debtholders is $40 ($24 on an after-tax
basis)
d. all of these
[ANSWER: Your expected after-tax net income is: (1 – T) = (1 – 0.4)$150 = $90 per year. Your
net worth is: VU = (1 – T) / r = (1 – 0.4)$150 = $90 / 0.12 = $750, compared to VU =
(1 – T) / r = (1 – 0)$150 / 0.12 = $1,250 value without corporate taxes. This debt will require
rdCPN = 0.08($500) = $40 per year in interest payments. Because the interest payments are made
before corporate taxes are assessed, they cost only rd(1 – T)CPN = 0.08(1 – 0.4)$500 = $24 on an
after-tax basis. After the capital structure change, the residual expected future cash flow to be
paid out to shareholders each year is (given = $150 and CPN = $40): (1 – T)( – CPN) =
(1 – 0.4)($150 – $40) = $66. Therefore, under the proposed leveraging, shareholders would get D
= CPN / rd = $40 / 0.08 = $500 from the debtholders in cash to invest as they wish and have a
remaining investment worth: EL = (1 – T)( – CPN) / rL = (1 – 0.4)($150 – $40) / 0.16 =
$66 / 0.16 = $412.50 for a total value of VL = D + EL = $500 + $412.50 = $912.50. Thus, in this
environment, the proposed leveraging increases shareholder value by: GL = VL – VU =
$912.50 – $750 = $162.50.]

a 59. Assume the corporate tax view of capital structure. Your unleveraged cost of
capital is 15%. Your leveraged cost of equity is 20% and your cost of debt is 10%. Your
corporate tax rate is 37.5%. Your firm proposes to borrow $500 and its leveraged firm value is
$812.50. What is your cost of capital under the proposed leveraging?
a. 11.5385%
b. 11.3077%
c. 11.2399%
d. 11.1282%
[ANSWER: Your leveraged capital structure would be L = D / (D + E) = $500 / $812.50 =
0.6153846. Your WACC = r(1 – [T(L)]) = 15%(1 – [0.375(0.6153846)]) = 15%(1 – 0.2307692) =
15%(0.7692307) = 11.538462% or about 11.5385%. NOTE. You can also use the equation:
WACC = (1 – L)re + L(1 – T)rd = (1 – 0.6153846)20% + 0.6153846(1 – 0.375)10% =
7.692308% + 3.846154 = 11.5385%.]

c 60. Assume the corporate tax view of capital structure. Your unleveraged cost of
capital is 13%. Your corporate tax rate is 30%. Your firm proposes to borrow $800 and its
leveraged firm value is $1,600. What is your cost of capital under the proposed leveraging?
a. 11.53%
b. 11.33%
c. 11.05%
d. 10.94%
[ANSWER: Your leveraged capital structure would be L = D / (D + E) = $800 / $1,600 = 0.5.
Your WACC = r(1 – [T(L)]) = 13%(1 – [0.3 (0.5)]) = 13%(1 – 0.15) = 13%(0.85) = 0.1105 or
11.05%.]

c 61. Acme, Inc. is an all-equity firm. Its shareholders' personal tax rate (Te) is 20%.
Acme pays corporate taxes on its net income but otherwise operates in a perfect capital market
environment. Acme has a perpetual expected cash inflow each year () of $150. Its corporate tax
rate (T) is 37.5% and its unleveraged cost of capital (r) is 15%. What is Acme’s unleveraged
value with both personal and corporate taxes considered?
a. $400
b. $475
c. $500
d. $575
[ANSWER: Acme’s unleveraged value is: VU = (1 - Te)(1 – T) / r =
(1 – 0.2)(1 – 0.375)$150 / 0.15 = $75 / 0.15 = $500M.]

c 62. Acme, Inc. is an all-equity firm. Its shareholders' personal tax rate (Te) is 10%.
Acme pays corporate taxes on its net income but otherwise operates in a perfect capital market
environment. Acme has a perpetual expected cash inflow each year () of $15M (M = million). Its
corporate tax rate (T) is 30% and its unleveraged cost of capital (r) is 12%. What is Acme’s
unleveraged value with both personal and corporate taxes considered?
a. $40M
b. $60M
c. $70M
d. $80M
[ANSWER: Acme’s unleveraged value is: VU = (1 - Te)(1 – T) / r =
(1 – 0.2)(1 – 0.3)$15M / 0.12 = $8.4M / 0.12 = $70M.]

c 63. Acme, Inc. is an all-equity firm. Acme can issue debt to debtholders whose
personal tax rate (Td) is 50%. Its shareholders' personal tax rate (Te) is 20%. Acme pays corporate
taxes on its net income but otherwise operates in a perfect capital market environment. Acme has
a perpetual expected cash inflow each year () of $150M (M = million). Its corporate tax rate (T) is
37.5% and its unleveraged cost of capital (r) is 15%. Now suppose the firm can borrows at a
personal before-taxes required return (rd) of 10%. If its before-tax payment (CPN) is $50M, how
much money will Acme borrow on an after-tax basis?
a. $242M
b. $246M
c. $250M
d. $254M
[ANSWER: Acme’s after-tax borrowing is: D = (1 - Td)CPN / rD = (1 – 0.5)($50M) / 0.1 =
0.1($250) / 0.1 = $250M.]

c 64. Acme, Inc. is an all-equity firm. Acme can issue debt to debtholders whose
personal tax rate (Td) is 50%. Its shareholders' personal tax rate (Te) is 20%. Acme pays corporate
taxes on its net income but otherwise operates in a perfect capital market environment. Acme has
a perpetual expected cash inflow each year () of $150M (M = million). Its corporate tax rate (T) is
37.5% and its unleveraged cost of capital (r) is 15%. Now suppose the firm can borrows at a
personal before-taxes required return (rd) of 10% and its before-tax payment (CPN) is $50M.
Debt will increase the firm’s cost of borrowing. Its required rate of return on leveraged equity (rL)
will be 20%. What is Acme’s leveraged equity value (EL)?
a. $242M
b. $246M
c. $250M
d. $254M
[ANSWER: Acme’s leveraged equity value is: EL = (1 - Te)(1 – T)( - CPN) / rL =
(1 – 0.2)(1 – 0.375)($150 - $50) / 0.2 = $50 / 0.2 = $250M.]

x 65. Acme, Inc. is an all-equity firm. Acme can issue debt to debtholders whose
personal tax rate (Td) is 50%. Its shareholders' personal tax rate (Te) is 20%. Acme pays corporate
taxes on its net income but otherwise operates in a perfect capital market environment. Acme has
a perpetual expected cash inflow each year () of $150M (M = million). Its corporate tax rate (T) is
37.5% and its unleveraged cost of capital (r) is 15%. Now suppose the firm can borrows at a
personal before-taxes required return (rd) of 10% and its before-tax payment (CPN) is $50M.
Debt will increase the firm’s cost of borrowing. Its required rate of return on leveraged equity (rL)
will be 20%. What is Acme’s leveraged firm value (VL)?
a. $242M
b. $246M
c. $250M
d. $254M
[ANSWER: Leveraged firm value = VL = EL + D. Acme’s leveraged equity value is: EL =
(1 - Te)(1 – T)( - CPN) / rL = (1 – 0.2)(1 – 0.375)($150 - $50) / 0.2 = $50 / 0.2 = $250M. Acme’s
after-tax borrowing is: D = (1 - Td)CPN / rD = (1 – 0.5)($50M) / 0.1 = 0.1($250) / 0.1 = $250M.
Thus, VL = EL + D = $250M + $250M = $500M.]

c 66. The Pecking Order Theory of capital structure posits that firms will only issue
equity as a last resort. Reasons include the cost of equity financing and the negative signaling that
can accompany stock offerings due to investors’ suspicion about firm’s issuing stock when it is
overvalued. Exquisite, Inc. has 20M (M = million) shares outstanding at $10 per share. Exquisite
announces a new offering of 10M new shares at $9.50 per share. Its issue costs are 10% of the
offering value and that the announcement of a stock offering causes its outstanding stock value to
fall 6%. How much of the fall in price can be explained by issue costs?
a. about 75.12%
b. about 79.17%
c. about 85.23%
d. about 87.11%
[ANSWER: Acme will raise $9.50(10M new shares) = $95M. The issue costs are 0.1($95M) =
$9.5M. This cost will be spread out over 20M outstanding shares. The cost per share =
$9.5M / 20M = $0.475 per share. The stock price should fall to $10 - $0.475 = $9.525 based on
issue costs alone. The market response causes the shares to fall 6% or 0.06($10) = $0.60. Thus,
$0.475 / $0.6 = 0.79167 or about 79.17% of the fall can be explained by issue costs.]

b 67. The Pecking Order Theory of capital structure posits that firms will only issue
equity as a last resort. Reasons include the cost of equity financing and the negative signaling that
can accompany stock offerings due to investors’ suspicion about firm’s issuing stock when it is
overvalued. Finale, Inc. has 30M (M = million) shares outstanding at $20 per share. Finale
announces a new offering of 10M new shares at $19 per share. Its issue costs are 10% of the
offering value and that the announcement of a stock offering causes its outstanding stock value to
fall 4%. How much of the fall in price can be explained by issue costs?
a. about 75.12%
b. about 79.13%
c. about 85.23%
d. about 87.11%
[ANSWER: Acme will raise $19(10M new shares) = $190M. The issue costs are 0.1($190M) =
$19M. This cost will be spread out over 30M outstanding shares. The cost per share =
$19M / 30M = $0.6333 per share. The stock price should fall to $20 - $0.6333 = $19.3667 or
about $19.37 based on issue costs alone. The market response causes the shares to fall 4% or
0.04($20) = $0.80. Thus, $0.63333 / $0.80 = 0.79125 or about 79.13% of the fall can be
explained by issue costs.]

c 68. Acme, Inc. attempts to capture the impact of all the relevant dimensions
connected with debt financing by using the net-benefit-to-leverage factor (T*). T* is assumed to
be derived from a linear approximation to the actual net-benefit-to-leverage relationship over
some relevant range of values for the leverage ratio L. Acme’s unleveraged value (VU) is $100M
(M = million) and it estimates T* to be 0.2. It issues $20M in debt. According to the corporate tax
view of capital structure, what is its leveraged firm value (VL) and gain to leverage (GL)?
a. $3M and $103M
b. $4M and $103M
c. $4M and $104M
d. $5M and $104M
[ANSWER: The gain to leverage is: GL = T*D = 0.2($20M) = $4M. Leveraged firm value is: VL
= VU + GL = $100M + $4M = $104M.]
x 69. Acme, Inc. attempts to capture the impact of all the relevant dimensions
connected with debt financing by using the net-benefit-to-leverage factor (T*). T* is assumed to
be derived from a linear approximation to the actual net-benefit-to-leverage relationship over
some relevant range of values for the leverage ratio L. Acme’s unleveraged value (VU) is $100M
(M = million) and it estimates T* to be 0.2. It issues $20M in debt. According to the corporate tax
view of capital structure, what is its WACC if its unleveraged cost of capital is 12%?
a. $3M and $103M
b. $4M and $103M
c. $4M and $104M
d. $5M and $104M
[ANSWER: Leveraged firm value is: VL = VU + T*D = $100M + 0.2($20M) = $104M. Thus, L =
D / VL = $20M / $104M = 0.1923. The weighted average cost of capital is: WACC =
r(1 – [T*L]) = 0.12(1 – [0.2]0.1923) = 0.12(0.9615384) = 0.1153846 or about 11.538%.]

IV. Longer Problems

70. The corporate tax view of capital structure model asserts that the gain to leverage (GL) is the
corporate tax rate (T) multiplied by debt value (D). The equation is:
GL = TD
where D = CPN / rd, CPN is the perpetual cash flow for debt owners, and rd is the required rate of
return for debt or cost of debt (rd is traditionally viewed as the riskless rate). Answer the below
questions using this equation.
(1) What is the gain to leveraged if T = 0.3 and D = $2 billion? What is GL if T falls to 0.2?
(2) What is the gain to leveraged if T = 0.3, CPN = $50 million, and rd = 0.05? What is GL if
T falls to 0.2?
(3) Is this equation complete? For example, exactly what variables are missing from this
equation?

ANSWER (1): GL = TD = 0.3($2 billion) = $600 million. If T falls to 0.2 then GL = TD =

0.2($2 billion) = $400 million.

ANSWER (2): GL = TD = T(CPN / rd) = 0.3($50 million / 0.05) = 0.3($1 billion) = $300 million. If
T falls to 0.2 then GL = 0.2($50 million / 0.05) = 0.2($1 billion) = $200 million.

ANSWER (3): This equation is incomplete since it ignores possible effects stemming from either
personal taxes or leverage costs such as agency and financial distress (including bankrupctcy). In
particular, this equation does not contain the personal tax rates on equity and debt income and the
required rates of return on equity. This equation also assumes that the cost of debt is not influenced
by the amount of debt issued in which case debt is riskless (or at least unchanging).

71. Acme, Inc. currently has no debt and has an unleveraged value (VU) of $2 billion. It has
100 million shares outstanding. It decides to retire 50 million shares by issuing debt. Its corporate
tax rate (T) is 20% and all of the debt can be raised with a coupon rate of 5%. Answer the below
questions.
(1) Using the corporate tax view of capital structure, what is Acme’s leveraged value (VL)
after its exchange of debt for stock?
(2) What would be Acme’s value be if it decided to retire all of its shares?
(3) Is your answer in (2) possible? Explain.
(4) Realistically, could a firm ever achieve a debt level reaching 100% debt?
ANSWER (1): According to the corporate tax view of capital, we have: VL = VU + GL = VU + TD
= $2 billion + (0.2)$1B = $2.2 billion.

ANSWER (2): If Acme decides to retire all of its shares, we have: VL = VU + GL = VU + TD = $2

billion + (0.2)$2B = $2.4 billion.

ANSWER (3): This answer is not possible because by definition a company is a legal entity
controlled by shareholders. With all debt, we have no shareholders and all debtholders become
the new owners. Their payments would no longer be tax deductible.

ANSWER (4): Realistically, the capital markets would not lend money to companies with such
high debt levels due to the risk involved. Also, stakeholders would not want to take on so much
risk. Jobs and livelihood would be threatened.

72. Early advocates of the personal tax view of capital structure argued that personal taxes on
equity and debt income offset the positive corporate tax shield. The gain to leverage (GL) is captured
by the following equation:
GL = [1 – α]D
where α = (1 – Te)(1 – T) / (1 – Td); Te = the personal tax rate applicable to income from equity; Td =
personal tax rate applicable to income from debt; T = applicable corporate tax rate; D =
(1 – Td)CPN / rd; CPN = perpetual before-tax cash flow for debt owners; and, rd is the required rate
of return for debt or the cost of debt (which is considered riskless or at least assumed not to change
with increasing debt levels). Answer the following questions using the above the gain to leverage
equation.
(1) Suppose Te, T, Td, CPN, and rd are 0%, 20%, 0%, $50M (M = million), and 5%,
respectively. What is α? What is GL? How does this answer compare with using the GL equation
for the corporate tax view of capital structure?
(2) Suppose Te, T, Td, CPN, and rd are 0.10%, 20%, 0.15%, $50M (M = million), and 5%,
respectively. What is α? What is GL? How does this answer compare with using the GL equation
for the corporate tax view of capital structure? How do you explain the difference?
(3) Assume that values for all other variables are the same as in (2) with the exception that
the personal tax rates on equity and debt income are equal. What can we say about α? What can we
say about GL?
(4) Is the equation, GL = [1 – α]D, complete? For example, exactly what variables are
missing from this equation?

ANSWER (1): Solving for α, we have: α = (1 – Te)(1 – T) / (1 – Td) = (1 – 0)(1 – 0.3) / (1 – 0) = (1

– 0.3) or 0.7. GL = [1 – α]D = [1 – α](1 – Td)CPN / rd = (1 – 0.7) (1 – 0.15)$50M / 0.05 =
(1 – 0.15)$300 million. This is similar to the answer using the corporate tax view of capital structure
where we have: GL = TD = T(1 – Td)(CPN / rd) = 0.3($50M / 0.05) = 0.3($1 billion) = $300 million.
Thus, the answer for GL for the corporate tax view is like that for the personal tax except that $300
million is multiplied by (1 – Td), which takes into account debtholders pay taxes. The similarity in
answers results because (1 – α) reduces to T when Te = Td.

ANSWER (2): Solving for α, we have: α = (1 – Te)(1 – T) / (1 – Td) = (1 – 0.1)(1 – 0.2) / (1 – 0.15)
= (0.9)(0.8) / (0.85) = 0.8470588 or about 0.8471. GL = [1 – α]D = [1 – α](1 – Td)CPN / rd =
(1 – 0.8470588)(1 – 0.15)$50M / 0.05 = $130 million. This is the not same answer as using the
corporate tax view of capital structure where we have: GL = TD = T(CPN / rd) =
0.2($50 million / 0.05) = 0.2($1 billion) = $200 million. The answer disagrees because we consider
personal taxes on equity and debt income. The $200 million falls to $130 because of the overall
effect of personal tax rates. In particular, the personal tax rate on debt income is greater than that on
equity income which helps to explain some of the difference. Most of the difference can be explained
by the fact debtholders now pay taxes. Note that even without considering the impact of (1 – α), we
have: (1 – Td)CPN / rd = (1 – 0.85)$50M / 0.05 = $850 million. For the corporate tax view, this value
would be $1 billion because debtholders do not pay personal taxes.

ANSWER (3): If personal tax rates are equal (Te = Td), then α = (1 – Te)(1 – T) / (1 – Td) = (1 – T) =
(1 – 0.2) = 0.8. GL = [1 – α]D = [1 – α](1 – Td)CPN / rd = (1 – 0.8)(1 – Td)$50M / 0.05 =
(1 – Td)$200 million. For the corporate tax view, we have: GL = TD = T(CPN / rd) =
0.2($50M / 0.05) = 0.2($1 billion) = $200 million. Thus, the answer for GL for the corporate tax
view is like that for the personal tax except that $200 million is multiplied by (1 – Td), which takes
into account the situation that debtholders now pay taxes. The similarity in answers results because
(1 – α) reduces to T when Te = Td.

ANSWER (4): This equation is incomplete since it ignores possible effects stemming from leverage
costs associated with agency and financial distress (including bankruptcy). In particular, this equation
does not contain the required rates of return on unleveraged equity and leveraged equity which
captures risks associated with leverage related costs. This equation also assumes that the cost of debt
is not influenced by the amount of debt issued in which case debt is riskless (or at least unchanging).

73. Early advocates of the personal tax view of capital structure argued that personal taxes on
equity and debt income offset the positive corporate tax shield. The gain to leverage (GL) is captured
by the following equation: GL = [1 – α]D where α = (1 – Te)(1 – T) / (1 – Td). Te and Td are the
personal tax rates applicable to income from equity and debt, T is the applicable corporate tax rate,
and D = (1 – Td)CPN / rd where CPN is the perpetual before-tax cash flow for debt owners and rd is
the required rate of return for debt or the cost of debt (which is considered riskless or at least
assumed not to change with increasing debt levels). Acme, Inc. will use this equation in making its
choice of leverage. Currently, Acme has no debt and has an unleveraged value (VU) of $2 billion
given by VU = [(1 – Te)(1 – T) / r] where is the uncertain perpetual before-tax cash flow for
unleveraged equity owners and r is the required rate of return on unleveraged equity. Acme has 100
million shares outstanding. It decides to retire 50 million shares by issuing $1B in debt. The $1B
in debt results from taking on a $50 million a year interest payment (with CPN = $50M this
implies Acme’s cost of debt is rd = 5%). Tax variables and rates are: Te = 10%, T = 20%, and Td =
15%. Answer the below questions.
(1) What is the value of equity when the firm is unleveraged? What is ? What would be
the values for VU and if equityholders do not pay taxes?
(2) What is GL? Using the equation, VL = VU + GL, what is the value of the leveraged
firm?
(3) Compare your answers for firm values in (1) and (2). What is the difference? How
does this answer compare with using the GL equation for the corporate tax view of capital structure
and the personal tax view of capital structure?

ANSWER (1): When there is no debt the firm value (VU) equals the equity value (EU). Thus, VU
= EU = $2 billion. If we take into account all after-tax cash flows, then this means EU =
(1 – Te)(1 – T) / r = $2 billion. We can solve for using this equation. We get: =
[r(EU) / (1 – Te)(1 – T)] = [0.1($2) / (1 – 0.1)(1 – 0.2)] = $0.277777 billion. If equityholders do
not pay taxes then the value of the firm is $2 billion / (1 – 0.10) or about $2.222 billion and the
value of the unleveraged cash flow is $0.277777 / (1 – 0.10) or about $0.309 billion.

ANSWER (2): To solve for GL, first we solve for α. We have α = (1 – Te)(1 – T) / (1 – Td) = (1 –
0.1)(1 – 0.2) / (1 – 0.15) = 0.8470588. Using this value, we have GL = [1 – α]D =
[1 – α](1 – Td)CPN / rd = (1 – 0.8470588)(1 – 0.15)$50M / 0.05 = $130M or $0.13 billion. Solving
for the value of the leveraged firm, we have: VL = VU + GL = $2 + $0.13 = $2.13 billion.

ANSWER (3): We see that VL – VU = $2.13 – $2 = $0.13 billion. Since this value is just GL, we
can show that GL for the personal tax view is greater than the GL for the corporate tax view. For
the corporate tax view, we have: GL = TD = T(CPN / rd ) = 0.2(50 / 0.05) = $0.2 billion. Thus, the
corporate tax view gives a value that is $0.2 – $0.13 = $0.07 billion or $70,000 million more.
Most of the difference can be explained by the fact debtholders now pay taxes. Note that even
without considering the impact of (1 – α), we have: (1 – Td)CPN / rd = (1 – 0.85)$50M / 0.05 = $850
million. For the corporate tax view, this value would be $1 billion because debtholders do not pay
personal taxes.

74. Consider the following definitions.

The gain to leverage (GL) equals leveraged firm value (VL) minus unleveraged firm value
(VU).
VL equals leveraged equity value (EL) plus debt value (D).
EL equals (1 – Te)(1 – T)( – CPN) / rL where Te is the applicable tax rate on equity income, T
is the firm's applicable corporate tax rate, is the uncertain perpetual before-tax cash flow for
unleveraged equity owners, CPN is the perpetual before-tax cash flow for debt owners, and rL is the
endogenously determined cost of leveraged equity.
VU is unleveraged equity value (EU) and equals (1 – Te)(1 – T) / r where r is the exogenous
cost of unleveraged equity.
D is (1 – Td)CPN / rd where Td is the applicable tax rate on debt income, and rd is the cost of
debt.
Given these definitions answer the below questions.
(1) Substitute the definitions of EL and D into the formula for VL and then substitute this
expression into the definition for GL. After doing this, use algebra to see if you can get gain to
leverage = GL = [1 – αrd / rL]D – [1 – (r / rL)]EU where α = (1 – Te)(1 – T) / (1 – Td). NOTE. The
derivation is unimpeded regardless of whether rd is the exogenous riskless rate or is endogenously
determined by the choice of D.
(2) Why might this expression for gain to leverage be more valuable than other expressions?

ANSWER (1): Substituting the definitions of EL and D into the formula for VL gives:
VL = EL + D = [(1 – Te)(1 – T)( – CPN) / rL ] + D.
Substituting this expression along with the definition VU = EU into the definition GL = VL – VU gives:
GL = [(1 – Te)(1 – T)( – CPN) / rL ] + D – EU.
Multiplying out the first component and rearranging:
GL = D – [(1 – Te)(1 – T)CPN / rL ] – EU + [(1 – Te)(1 – T) / rL ].
Multiplying the second component by (1 – Td)rd / (1 – Td)rd = 1 and noting that this is equivalent to
– {(1 – Te)(1 – T)rd / (1 – Td)rL}(1 – Td)CPN / rd which is – [(1 – Te)(1 – T)rd / (1 – Td)rL]D, and
factoring out D:
GL = [1 – {(1 – Te)(1 – T)rd / (1 – Td)rL}D – EU + [(1 – Te)(1 – T) / rL ].
Multiplying the last component by r / r = 1 and noting this equals (r / rL)(1 – Te)(1 – T) / r which is (r
/ rL)EU, and factoring out EU:
GL = [1 – {(1 – Te)(1 – T}rd / (1 – Td)rL}]D – [1 – (r / rL)]EU.
Setting α = (1 – Te)(1 – T) / (1 – Td) in the first component gives
GL = [1 – (α rd / rL)]D – [1 – (r / rL)]EU.
Q.E.D.
ANSWER (2): This expression for GL in valuable because all tax rates and discount rates are
incorporated. Any gain or loss resulting from paying cash flows to investors with different tax rates
can be accounted for. Also, discount rates can capture other positive or negative effects resulting
from agency and financial distress (including bankruptcy concerns).

75. Acme, Inc. is an unleveraged company worth $2B (B = billion) when we consider the
effects of personal and corporate taxes. It has 100 million shares outstanding. It decides to retire
50 million shares by issuing $1B in debt once again consider the effects of personal and corporate
taxes. The $1B in debt results from taking on a $50 million a year interest payment (with CPN =
$50M this implies Acme’s cost of debt is rd = 5%). You want to know what gain Acme might
expect from undertaking this exchange of debt for equity. To solve this problem, you decide to
use the equation for gain to leverage derived in the previous problem:
GL = [1 – (αrd / rL)]D – [1 – (r / rL)]EU
where α = (1 – Te)(1 – T) / (1 – Td) and D = (1 – Td)CPN / rd. Suppose Te, T, and Td are 10%, 20%,
and 15%, respectively. Using this equation, answer the following questions.
(1) Assuming r, rL, and EU are also 10%, 12%, and $2B (B = billion) what is GL if half of
the value of unleveraged equity is retired by issuing the new debt?
(2) How does this compare with the personal and corporate tax views of capital structure?
For this question use the following equations: GL = [1 – α]D for the personal tax view and
GL = TD = T(CPN / rd) for corporate tax view.
(3) How do you explain the differences in the three GL values?
(4) Suppose we decided we made a mistake and that the $50M coupon payment should have
been considered on an after-personal tax basis so that we should have used $50M / (1 – 0.15) =
$58.823529M instead of $50 million when computing the gain to leverage. What value for GL will
you now get? How do you explain this result.

ANSWER (1): First, we solve for α. We have: α = (1 – Te)(1 – T) / (1 – Td) =

(1 – 0.1)(1 – 0.2) / (1 – 0.15) = (0.9)(0.8) / (0.85) = 0.8470588. Next, let’s solve for D. We have: D
= (1 – Td)CPN / rd = (1 – 0.85)$50M / 0.05 = $850M or $0.85B. Inserting these values along with
our other given values, we have: G L = [1 – (αrd / rL)][D] – [1 – (r / rL)]EU =
[1 – {0.8470588(0.05) / 0.12}][$0.85B] – [1 – (0.10 / 0.12)]$2B =
[1 – {0.3529411}][$0.85B] – [1 – 0.8333333]$2B = [0.6470588][$0.85B] – [0.1666666]$2B =
$0.55B – $0.333333333B = $0.2166666666 or about $0.217 billion.

ANSWER (2): For the personal tax view of capital structure, we have GL = [1 – α]D =
[1 – α](1 – Td)CPN / rd = (1 – 0.8470588)(1 – 0.15)$50M / 0.05 = $130M or $0.13 billion. For the
personal tax view of capital structure, we have GL = TD = T(CPN / rd) = 0.2($50 million / 0.05) =
0.2($1 billion) = $0.20 million.

ANSWER (3): We can offer two explanations for the fact the gain to leverage in (1) is greater
than that found for either the personal or corporate tax view of capital structure. First, we can
explain it due to the differences in taxes. Equity value has declined in half with only half as many
shareholders. This implies that equityholders now pay fewer taxes. The taxes paid by debtholders
will be more than offset since the corporate tax rate is greater than the rate paid by debtholders
(20% versus 15%). So we will have a net tax savings resulting in an enhanced value for the firm.
Second, the increase in debt can result in positive agency effects which can be captured by
incorporating discount rates. We now have cash flows to debtholders that are discounted by a
lower rate than those to unleveraged equityholders (5% rate versus 10% rate). Although, the
leverage equity rate is greater than the unleveraged rate (12% versus 10%), its discrepancy is not
as great as that between debtholders and unleveraged equityholders. Positive agency effects can
result when firms increase debt. This is because fixed debt payments can help monitor managers’
behavior and lower the possibility that they will squander excess cash on bad projects.
ANSWER (4): We still have α = 0.8470588. However, D has changed. We now have:
D = (1 – Td)CPN / rd = $58.823529 / 0.05 = $1.1764706B (even though the market value is only $1
billion because it does not include the taxes paid by debtholders). Inserting these values along with
our other given values, we have: G L = [1 – (αrd / rL)][D] – [1 – (r / rL)]EU =
[1 – {0.8470588(0.05) / 0.12}][$1.1764706B] – [1 – (0.10 / 0.12)]$2B =
[1 – {0.3529411}][$1.1764706B] – [1 – 0.8333333]$2B = [0.6470588][ $1.1764706B] –
[0.1666666]$2B = $0.4186851B – $0.333333333B = $0.0853518 or about $0.08535 billion.
Although the gain to leverage is still positive, the value is lower than the previous values. We
conclude that impact of leverage is not as great because of the increased risk from agency and
financial distress (including bankruptcy costs) that can result when a firm increases its debt.

V. Short Answers

76. What type of risk comes with leveraged?

Financial risk results from the use of debt. This contrasts with business risk which results from
the choice of assets.

77. What is capital structure?

Capital structure is the makeup of the liabilities and stockholders’ equity side of the balance
sheet, especially the ratio of debt to equity.

78. What is the perfect market view of capital structure?

The perfect market view of capital structure is the analysis in a perfect capital market
environment, which shows that a firm’s capital structure does not affect its value in a perfect
capital market environment.

79. What does the corporate tax view of capital structure refer to?

The corporate tax view of capital structure refers to the argument that double (corporate and
individual) taxation of equity returns makes debt a cheaper financing method.

80. What does the personal tax view of capital structure refer to?

The personal tax view of capital structure refers to the argument that the difference in personal
tax rates between income from debt and income from equity eliminates the disadvantage from the
double (corporate and individual) taxation of income from equity.

81. What does the agency cost view of capital structure refer to?

The agency cost view of capital structure refers to the argument that the various agency costs
create a complex environment in which total agency costs are at a minimum with some, but less
than 100%, debt financing.

82. What does the bankruptcy cost view of capital structure refer to?

The bankruptcy cost view of capital structure refers to the argument that the expected indirect and
direct costs of financial distress and bankruptcy reduce the benefits to additional debt financing.
83. What does the pecking order view of capital structure refer to?

The pecking order view of capital structure refers to the argument that external financing
transaction costs create a preference, or pecking order, of preferred sources of financing.

84. What does the clientele effect refer to?

The clientele effect refers to the grouping of investors who have a preference that the firm follow
a particular financing policy, such as the amount of leverage it uses.

85. What does the capital market imperfections view of capital structure refer to?

The capital market imperfections view of capital structure refers to view that debt financing is
generally valuable, but a firm’s optimal choice of capital structure is a dynamic process in a
complex environment that involves a mixture of financing methods. The exact mix at any
particular point results from considerations of asymmetric taxes, asymmetric information, and
transaction costs.

86. What is the net-benefit-to-leverage factor?

The net-benefit-to-leverage factor is a linear approximation of a factor, T*, that allows us to

operationalize the total impact of leverage on firm value in the capital market imperfections view
of capital structure.

87. What is WACC?

With only equity and debt, the WACC is the weighted average of re and rd adjusted for taxes.

88. What is the formula for WACC?

WACC = (1 – L)re + L(1 – T)rd where L = D / (D + E), re is the required return for equity, T is the
corporate tax rate, and rd is the required return for debt.

89. Describe the formula for the value of the unleveraged firm.

The formula for the value of the unleveraged firm is VU = [(1 – T) / r ] where the before-tax
perpetuity, T is the corporate tax rate, and r is the unleveraged cost of capital.

90. Describe the formula for the value of the leveraged firm for the corporate tax view of
capital structure.

The formula for the value of the leveraged firm is VL = [(1 – T) / r ] + TD where the before-tax
perpetuity, T is the corporate tax rate, r is the unleveraged cost of capital, and D is the value of
debt. In this formula, the value of the leveraged firm is simply the value of the unleveraged firm
plus the value of the debt tax shield.

91. What is the formula for WACC for the corporate tax view of capital structure?

WACC = r(1 – TL) where r is the unleveraged cost of capital, T is the corporate tax rate, and L is
the market-value proportion of debt financing given by L = D / (D + E) where D is the value of
debt and E is the value of equity.
92. What is the arbitrage argument for the irrelevance of capital structure based on?

There is an arbitrage argument for the irrelevance of capital structure based on the possibility that
shareholders can create their own leverage by borrowing and investing in stock.

93. How does tax asymmetry influence a manager’s debt and equity choices?

The interest paid on debt (unlike the dividends paid to stockholders) lowers the firm's taxable
income. This favors a manager choose debt financing over equity financing.

94. What does a tax-timing option give to security holders?

A tax-timing option gives security holders the opportunity to sell assets when there is a tax loss
that can be realized.

95. Name some ways of reducing the agency costs of debt.

Ways of reducing the agency costs of debt include having a sinking fund provisions and securing
debt by using tangible assets as collateral.

VI. Essays or Longer Answers

96. Nobel Prize winners Modigliani and Miller (1963), referred to as MM, developed a capital
structure model for an unleveraged (or all-equity) firm issuing perpetual riskless debt to replace risky
equity. This model was described in your text as the corporate tax view of capital structure. Discuss
the strengths and weakness of this model.

This model states that the gain to leverage (GL) equals the corporate tax rate times debt value. The
simplicity of this MM equation for GL makes it (even today) a popular mathematical expression to
describe the impact of debt on firm value. Financial managers can use it as an ad hoc estimate of the
impact of debt on firm value.

This view stemming from the MM equation is limited in its applicability since it implies that
financial executives issue unrestricted amounts of debt. Its limitations have inspired theoreticians to
examine personal taxes and a variety of leverage costs. The post-MM research offers managers
marginal practical improvement since specified leverage costs are hard to measure. From a utility
perspective, how are the indirect and direct costs of bankruptcy or the various agency costs to be
measured? Researchers offer diverse opinions concerning these costs. Some argue that such costs are
negligible, while others offer contrary evidence.

97. Describe the corporate tax view of capital structure which is the Modigliani and Miller
(1963) tax model. What does this view ignore?

The corporate tax view of capital structure model posits a positive change in firm value when
managers issue perpetual riskless debt to retire risky equity. The model stems from the work of
Modigliani and Miller (1963). They assert that the gain to leverage (GL) is the corporate tax rate (T)
multiplied by debt value (D). Their equation (referred to for simplicity at the MM) equation is:
GL = TD
with D = CPN / rd where CPN is the perpetual cash flow for debt owners, and rd is the cost of debt (rd
is the riskless rate for MM). This equation is incomplete since its derivation ignores possible effects
stemming from either personal taxes or leverage costs.

98. There are other significant taxes besides corporate income taxes. Discuss these.

The firm pays taxes on its income, but investors then pay personal income taxes on their income
from the firm. And the rates investors pay are not all the same. The rates depend on the form of
the investment, in particular whether it is equity or debt.

Interest and dividends are taxed when they are received, but capital gains are not taxed until the
asset is sold. Therefore, a shareholder can postpone the tax on a gain by not selling the shares. At
the same time, there is a mirror image treatment of losses. The shareholder can claim the tax
shield resulting from a loss right away by selling the asset.

99. Discuss the relationship between debt and agency conflicts.

A major agency conflict that arises from the use of debt financing is the possibility that
shareholders (agents) will expropriate wealth from the debtholders (principals) using asset
substitution. Suppose debtholders loan money to shareholders assuming that the firm will invest
in a low-risk project, and therefore they agree to a low interest rate on the loan. If the firm then
invests in a (substitute) high-risk project, the risk of the loan will increase. This increases the
required return on the loan and lowers the present value of the loan. In this case the shareholders
(agents) have expropriated wealth from debtholders (principals).

As a second example, consider the problem of claim dilution. Let's assume that the firm borrows
money to invest in its business, and immediately thereafter the firm's managers do a leveraged
buyout. That is, they take over ownership of the firm with a very small amount of equity
financing and a tremendous amount of debt. What happens to the value of the original debt?
Because of the higher risk, the present value of the original debt decreases, and the decrease is
lost to those debtholders, but gained by the shareholders. Once again, the shareholders (agents)
have expropriated wealth from debtholders (principals).

100. Discuss some of the expected financial distress or bankruptcy costs when a firm takes on
debt. Mention both the direct and indirect costs in your discussion.

The expected cost of financial distress and bankruptcy includes indirect costs and direct costs
such as notification costs, court costs, and legal fees. Somewhat surprisingly, the direct costs are
relatively small when compared to the firm’s value or the indirect costs of bankruptcy.

The indirect costs of financial distress and bankruptcy can involve virtually every aspect of the
firm. It can be very costly to have management's attention diverted from the day-to-day operation
of the business in order to deal with the financial distress and bankruptcy process. After filing for
bankruptcy, every major decision a firm makes may require approval by the Bankruptcy Court. A
firm may lose tax shields during periods of financial distress.

The most significant potential cost of financial distress and bankruptcy is an indirect cost that can
be difficult to measure but should not be underestimated. It arises because of the possibility that
the firm will not continue as a going concern. This likelihood is important, because it can
dramatically affect the value of the firm’s products and dramatically hurt sales. When potential
customers fear product discontinuation, they will force the firm to sell its product for a lower
price than what it would otherwise be worth. Even though it is an opportunity cost that’s difficult
to measure, this loss is the largest of the financial distress and bankruptcy costs by a wide margin.