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Exam 15: Capital Structure Decisions

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Question 51

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The following information has been presented to you about the Gibson Corporation. $\begin{array} { l c } \text { Total assets } & \$ 3,000 \text { millionTax rate } &25\%\\\text { Operating income (EB TT) } & \$ 800 \text { millionDebt ratio } &0\%\\\text { Interest expense } & \$ 0 \text { millionW } \mathrm { ACC } &10\%\\\text { Net income } & \$ 480 \text { millionM/B ratio } &1.00×\\\text { Share price } & \$ 32.00 \mathrm { EPS } = \text { DPS }&\$3.20\end{array}$ The company has no growth opportunities (g = 0) , so the company pays out all of its earnings as dividends (EPS = DPS) .The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 8%.If the company makes this change, what would be the total market value (in millions) of the firm?

A) $4,400
B) $4,800
C) $5,200
D) $5,400
E) $6,000

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Question 52

Multiple Choice

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Pennewell Publishing Inc.(PP) Pennewell Publishing Inc.(PP) is a zero growth company.It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000.PP's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00. -Refer to the data for Pennewell Publishing Inc.(PP) .Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity.This results in a weighted average cost of capital equal to 9.125% and a new value of operations of $657,534.Assume PP raises $230,137 in new debt and purchases T-bills to hold until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase?

A) $55.04
B) $61.15
C) $65.75
D) $71.01
E) $74.56

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Question 53

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It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Which of the following statements is CORRECT?

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS.Thus, the two firms must have the same business risk.

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

If debt financing is used, which of the following is CORRECT?

A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more.What sales volume would be required in order to meet this profit goal?

VanMannen Foundations, Inc.(VF) VanMannen Foundations, Inc.(VF) is a zero-growth company that currently has zero debt, and it has the data shown below. $\begin{array}{lr}\text { EBIT }= & \$ 80,000 \\\text { Growth }= & 0 \% \\\text { Orig cost of equity, } \mathrm{r}_{\mathrm{s}}= & 10.0 \% \\\text { No. of shares }= & 10,000 \\\text { Price per share } & \$ 60.00 \\\text { Tax rate }= & 25 \%\end{array}$ ​ -Refer to the data for VanMannen Foundations, Inc.(VF) .What would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC) , and their ROIC exceeds their after-tax cost of debt, (1-T) r_d.However, Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

NorthWest Water (NWW) Five years ago, NorthWest Water (NWW) issued $50,000,000 face value of 30-year bonds carrying a 14% (annual payment) coupon.NWW is now considering refunding these bonds.It has been amortizing $3 million of flotation costs on these bonds over their 30-year life.The company could sell a new issue of 25-year bonds at an annual interest rate of 11.67% in today's market.A call premium of 14% would be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million.NWW's marginal tax rate is 40%.The new bonds would be issued when the old bonds are called. -Refer to the data for NorthWest Water (NWW) .The amortization of flotation costs reduces taxes and thus provides an annual cash flow.What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its return on invested operating capital (ROIC) is 14.5%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value.If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

The Miller model begins with the MM model with corporate taxes and then adds personal taxes.

Which of the following statements concerning capital structure theory is NOT CORRECT?

After an intensive research and development effort, two methods for producing playing cards have been identified by the Turner Company.One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards.The other method would use a less expensive machine (fixed cost = $5,000) , but it would require greater variable costs ($1.50 per deck of cards) .If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income (EBIT) ?

Two operationally similar companies, HD and LD, have the same total assets, operating income (EBIT) , tax rate, and business risk.Company HD, however, has a much higher debt ratio than LD.Also HD's return on invested capital (ROIC) exceeds its after-tax cost of debt, (1-T) r_d.Which of the following statements is CORRECT?

Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%.Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Incorporated.What is the value of the firm according to MM with corporate taxes?