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Corporate Finance, 12e (Ross)

Chapter 16 Capital Structure: Basic Concepts

1) The firm's capital structure refers to the:

A) mix of current and fixed assets a firm holds.
B) amount of capital invested in the firm.
C) amount of dividends a firm pays.
D) mix of debt and equity used to finance the firm's assets.
E) amount of cash versus receivables the firm holds.

Answer: D
Difficulty: 1
Easy
Section: 16.1 The Capital Structure Question
and the Pie Theory Topic: Capital structure
Bloom's:
Remember
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

2) A general rule for managers to follow is to set the firm's

capital structure such that the firm's:
A) size is
maximized.
B) value is
maximized.
C) bondholders are secured.
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D) suppliers of raw materials are satisfied.

E) dividend payout is maximized.

Answer: B
Difficulty: 1
Easy
Section: 16.2 Maximizing Firm Value versus
Maximizing Stockholder Interests Topic: Capital
structure and firm valuation
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

3) A manager should attempt to maximize the value of the

firm by changing the capital structure if and only if the value of
the firm increases:
A) as a result of the change.
B) to the sole benefit of the managers.
C) to the sole benefit of the debtholders.
D) while also decreasing shareholder value.
E) while holding stockholder value constant.

Answer: A
Difficulty: 1
Easy
Section: 16.2 Maximizing Firm Value versus
Maximizing Stockholder Interests Topic: Capital
structure and firm valuation
Bloom's:
Understand
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AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

4) A firm should always select the capital structure which:

A) produces the highest
cost of capital. B)
maximizes the value of
the firm.
C) minimizes taxes.
D) maximizes current dividends.
E) has no debt.

Answer: B
Difficulty: 1
Easy
Section: 16.2 Maximizing Firm Value versus
Maximizing Stockholder Interests Topic: Capital
structure and firm valuation
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

5) Bryan invested in Bryco stock when the firm was financed

solely with equity. The firm now has a debt-equity ratio of .3.
To maintain the same level of leverage he originally had,
Bryan needs to:
A) borrow some money and purchase additional shares of Bryco
stock.
B) maintain his current position in Bryco stock.
C) sell some shares of Bryco stock and hold
the proceeds in cash. D) sell some shares
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of Bryco stock and loan out the proceeds.

E) sell half of his Bryco stock and invest the proceeds in risk-free
securities.

Answer: D
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Homemade leverage
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

6) In the absence of taxes, the capital structure chosen by a firm

doesn't really matter because of:
A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on
the cost of equity. E)
homemade leverage.

Answer: E
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
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Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

7) MM Proposition I with no tax supports the argument that:

A) business risk determines the return on assets.
B) the cost of equity rises as leverage rises.
C) it is completely irrelevant how a firm arranges its finances.
D) a firm should borrow money to the point where the tax
benefit from debt is equal to the cost of the increased
probability of financial distress.
E) financial risk is determined by the debt-equity ratio.

Answer: C
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

8) The proposition that the value of a levered firm is equal to

the value of an unlevered firm is known as:
A) MM Proposition I with no tax.
B) MM Proposition II with no tax.
C) MM Proposition I with tax.
D) MM Proposition II with tax.
E) both MM I with and without tax.
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Answer: A
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

9) The concept of homemade leverage

is most associated with: A) MM
Proposition I with no tax.
B) MM Proposition II with no tax.
C) MM Proposition I with tax.
D) MM Proposition II with tax.
E) no MM Proposition.

Answer: A
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

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10) A levered firm is a company that has:

A) accounts payable as its
only liability. B) some debt
in its capital structure.
C) an all-equity capital structure.
D) a tax loss carry forward.
E) taxable income.

Answer: B
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

11) The effects of financial leverage depend on the operating

earnings of the company. Based on this relationship, assume
you graph the EPS and EBI for a firm, while ignoring taxes.
Which one of these statements correctly states a relationship
illustrated by the graph?
A) Financial leverage decreases the slope of the EPS line.
B) Below the break-even point unlevered structures have a
lower EPS for every dollar of EBI than levered structures do.
C) Above the break-even point the increase in EPS for
unlevered structures is greater than that of levered structures for
every dollar increase in EBI.
D) Leverage only provides value above the break-even point.
E) Above the break-even point, the unlevered structure is
preferred.
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Answer: D
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Financial and operating leverage
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

12) MM Proposition I without taxes proposes that:

A) the value of an unlevered firm exceeds that of a levered firm.
B) there is one ideal capital
structure for each firm. C)
leverage does not affect the value
of the firm.
D) shareholder wealth is directly affected by the capital structure
selected.
E) the value of a levered firm exceeds that of an unlevered firm.

Answer: C
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation
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13) A key underlying assumption of MM Proposition I without

taxes is that:
A) financial leverage increases risk.
B) individuals can borrow at lower
rates than corporations. C) individuals
and corporations borrow at the same
rate.
D) managers always act to maximize the value of the firm.
E) corporations are all-equity financed.

Answer: C
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

14) In an EPS-EBI graphical relationship, the slope of the debt

ray is steeper than the equity ray. The debt ray has a lower
intercept because:
A) more shares are outstanding for the same level of EBI.
B) the break-even point is higher with debt.
C) a fixed interest charge must be paid even at low earnings.
D) the amount of interest per share has only a positive effect on
the intercept.
E) the break-even point is lower with debt.

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Answer: C
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Financial and operating leverage
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

15) When comparing levered versus unlevered capital

structures, leverage works to increase EPS for high levels of
EBIT because interest payments on the debt:
A) vary with EBIT levels.
B) stay fixed, leaving less income to be
distributed over fewer shares. C) stay fixed,
leaving more income to be distributed over
fewer shares.
D) stay fixed, leaving less income to be distributed over more
shares.
E) stay fixed, leaving more income to be distributed over more
shares.

Answer: C
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Financial and operating leverage
Bloom's:
Understand
AACSB: Reflective
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Thinking
Accessibility: Keyboard Navigation

16) The increase in risk to shareholders when financial

leverage is introduced is best evidenced by:
A) higher EPS as EBIT increases.
B) a higher variability of EPS with debt than with all-equity
financing.
C) increased use of homemade leverage.
D) the increase in taxes.
E) decreasing earnings as EBIT increases.

Answer: B
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Financial and operating leverage
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

17) 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.
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Answer: A
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic:
Homemade leverage
Bloom's:
Remember
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

18) 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 (no
taxes).
C) MM Proposition II (no taxes).
D) the law of one price.
E) the efficient markets hypothesis.

Answer: B
Difficulty: 1
Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Remember
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation
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19) 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 an all-equity firm.
E) equal to the profit margin for a firm with some debt in its
capital structure.

Answer: B
Difficulty: 1
Easy
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's:
Remember
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

20) According to MM Proposition II with no taxes, the:

A) return on assets is determined by financial risk.
B) required return on equity is a linear function of the firm's
debt-equity ratio.
C) cost of equity in inversely related to the firm's debt-equity
ratio.
D) cost of debt must equal the cost of equity.
E) required return on assets exceeds the weighted average cost
of capital.
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Answer: B
Difficulty: 1
Easy
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

21) MM Proposition II with no taxes supports the argument that

a firm's:
A) unlevered equity is risk-free.
B) cost of equity is inversely related to the firm's debt-equity
level.
C) cost of equity is unaffected by the firm's unlevered cost of
capital.
D) WACC will exceed the unlevered firm's cost of equity.
E) WACC remains constant even if the firm changes its capital
structure.

Answer: E
Difficulty: 1
Easy
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's:
Understand
AACSB: Reflective
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Thinking
Accessibility: Keyboard Navigation

22) The tax savings of the firm derived from the deductibility
of interest expense is called the: A) tax shield from debt.
B) depreciable basis.
C) financing umbrella.
D) current yield.
E) tax-loss carryback.

Answer: A
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Remember
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

23) The reason that MM Proposition I without taxes does not

hold in the presence of corporate taxation is because:
A) levered firms pay less taxes compared with identical
unlevered firms.
B) bondholders require higher rates of return than stockholders
do.
C) earnings per share are no longer relevant with taxes.
D) dividends become a tax shield.
E) debt is more expensive than equity.

Answer: A
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Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

24) MM Proposition I with taxes supports the theory that:

A) there is a positive linear relationship between the amount of
debt in a levered firm and the firm's value.
B) the value of a firm is inversely related to the amount of
leverage used by the firm.
C) the value of an unlevered firm is equal to the value of a
levered firm plus the value of the interest tax shield.
D) a firm's cost of capital is the same regardless of the mix of debt
and equity used by the firm.
E) a firm's weighted average cost of capital increases as the debt-
equity ratio of the firm rises.

Answer: A
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

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25) MM Proposition I with taxes states that:

A) capital structure does not affect firm value.
B) increasing the debt-equity ratio increases firm value.
C) firm value is maximized when the firm is all-equity financed.
D) the cost of equity rises as the debt-equity ratio increases.
E) the unlevered cost of equity is equal to RWacc.
Answer: B
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

26) MM Proposition I with taxes is based on the concept that

the:
A) optimal capital structure is the one that is totally financed
with equity.
B) capital structure of the firm does not matter because
investors can use homemade leverage.
C) firm is better off with debt based on the
weighted average cost of capital. D) presence of
taxes causes debt to be valuable to a firm.
E) cost of equity increases as the debt-equity ratio of a firm
increases.

Answer: D
Difficulty: 1
Easy
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Section: 16.5 Taxes

Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

27) MM Proposition II with taxes:

A) explains how a firm's WACC increases with the use of
financial leverage.
B) reveals how utilizing the tax shield on debt causes an
increase in the value of a firm.
C) supports the argument that business risk is determined by
the capital structure employed by a firm.
D) supports the argument that the cost of equity decreases as the
debt-equity ratio increases.
E) reaches the final conclusion that the capital structure
decision is irrelevant to the value of a firm.

Answer: B
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

28) MM Proposition II is the proposition that:

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A) supports the argument that the capital structure of a firm is

irrelevant to the value of the firm.
B) the cost of levered equity depends solely on the return on
debt, the debt-equity ratio, and the tax rate.
C) a firm's cost of equity capital is a positive linear function of
the firm's capital structure.
D) the cost of equity is equivalent to the required return on the
total assets of a levered firm.
E) the cost of debt is inversely related to a firm's debt-equity
ratio.

Answer: C
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

29) The tax shield on debt has no value for a firm when:
A) the firm's debt-equity ratio is exactly equal to 1.
B) the firm's debt-equity
ratio is exactly .5. C) the
firm is unlevered.
D) shareholders fully utilize homemade leverage.
E) RS is less than R0.

Answer: C
Difficulty: 1
Easy
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Section: 16.5 Taxes

Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

30) The tax shield on debt is one reason why:

A) the required rate of return on assets rises when debt is added
to the capital structure.
B) the value of an unlevered firm is equal to
the value of a levered firm. C) the net cost of
debt to a firm is generally less than the cost of
equity.
D) the cost of debt is equal to the cost of equity for a levered firm.
E) firms prefer equity financing over debt financing.

Answer: C
Difficulty: 1
Easy
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

31) CT Stores has debt with a book value of $325,000 and a

market value of $319,000. The firm's equity has a book value
of $526,000 and a market value of $684,000. The tax rate is
21 percent and the cost of capital is 11.2 percent. What is the
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market value of this firm based on MM Proposition I without

taxes?
A)
$923,250
B)
$1,003,0
00 C)
$984,300
D) $851,000
E) $769,750

Answer: B
Explanation: V ≡ B+S = $319,000 + 684,000
V ≡ $1,003,000
Difficulty: 2 Medium
Section: 16.1 The Capital Structure Question
and the Pie Theory Topic: M and M
Proposition I without taxes
Bloom's: Apply
AACSB: Knowledge
Application Accessibility:
Keyboard Navigation

32) Thompson & Thomson is an all-equity firm that has

280,000 shares of stock outstanding. The company is in the
process of borrowing $2.4 million at 5.5 percent interest to
repurchase 75,000 shares of the outstanding stock. What is
the value of this firm if you ignore taxes? A) $8,960,000
B) $9,240,000
C) $10,710,000
D) $12,500,000
E) $11,360,000

Answer: A
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Explanation: Firm value =

($2,400,000/75,000)(280,000) Firm
value = $8,960,000
Difficulty: 2 Medium
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

33) Uptown Interior Designs is an all-equity firm that has

40,000 shares of stock outstanding. The company has decided
to borrow $74,000 to buy out the 2,100 shares of a deceased
stockholder. What is the total value of this firm if you ignore
taxes?
A) $2,008,157
B)
$1,388,0
56 C)
$1,409,5
24 D)
$3,885,0
00
E) $2,630,620

Answer: C
Explanation: Firm value =
($74,000/2,100)(40,000) Firm value
= $1,409,524
Difficulty: 2 Medium
Section: 16.3 Financial Leverage and
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Firm Value: An Example Topic: M and

M Proposition I without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

34) You own 25 percent of Unique Vacations, Inc. You have

decided to retire and want to sell your shares in this closely
held, all-equity firm. The other shareholders have agreed to
have the firm borrow $1.5 million to purchase your 1,000
shares of stock. What is the total value of this firm if you
ignore taxes?
A) $4.8 million
B) $5.1 million
C) $5.4 million
D) $5.7
million E)
$6.0
million

Answer: E
Explanation: Firm value =
$1.5 million/.25 Firm value =
$6.0 million
Difficulty: 2 Medium
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation
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35) Assume an unlevered firm has total assets of $6,000,

earnings before interest and taxes of
$600, and 500 shares of stock outstanding. Further assume the
firm decides to change 40 percent of its capital structure to debt
with an interest rate of 8 percent. Ignore taxes. What will be the
amount of the change in the earnings per share as a result of this
change in the capital structure? A) $.16
B) $.09
C) No change
D) −$.09
E) −$.16

Answer: A
Explanation: EPSUnlevered
= $600/500 EPSUnlevered
= $1.20
EPSLevered = [$600 − .08(.4)($6,000)]/[500(1 − .4)]
EPSLevered
= $1.36
ΔEPS =
$1.36 − 1.20
ΔEPS = $.16
Difficulty: 2 Medium
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

36) Assume an initial scenario where a levered firm has total

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assets of $8,000, earnings before interest and taxes of $600,

400 shares of stock outstanding, a debt-equity ratio of .25, and
a cost of debt of 7 percent. Now assume a second scenario
where the firm changes to an all-equity structure by issuing
new shares to pay off debt while a shareholder holding 10
percent of the stock borrows funds at 7 percent and uses
homemade leverage to offset the firm's change in capital
structure. Ignore taxes. What are the net earnings for this
shareholder under the initial scenario? Under the second
scenario?
A) $90.00; $90.00
B) $90.00; $112.50
C) $48.80; $38.80
D) $48.80; $48.80
E) $45.00; $48.80

Answer: D
Explanation: For the firm:
EPSLevered = [$600 − .07(.25/1.25)($8,000)]/400
EPSLevered = $1.22
Price per share =
1/1.25($8,000)/400
Price per share = $16
New shares issued
= .25/1.25($8,000)/$16
New shares issued = 100
EPSUnlevered =
$600/(400 + 100)
EPSUnlevered = $1.20
For the shareholder:
Net earningsInitial scenario =
$1.22(.1)(400) Net
earningsInitial scenario =
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$48.80
For the second scenario:
Initial shareholder equity
= .1(400)($16) Initial
shareholder equity = $640
Shareholder debt
= .25($640) Shareholder
debt = $160
Net earningsSecond scenario = [.1(400) +
$160/$16)]($1.20) − .07($160) Net
earningsSecond scenario = $48.80
Difficulty: 2 Medium
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

37) A firm has a debt-equity ratio of .64, a pretax cost of

debt of 8.5 percent, and a required return on assets of 12.6
percent. What is the cost of equity if you ignore taxes?
A) 8.06 percent
B) 8.55 percent
C) 11.12 percent
D) 15.22 percent
E) 16.38 percent

Answer: D
Explanation: RS = .126 + .64(.126 − .085)
RS = .1522, or 15.22%
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Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

38) Bigelow has a levered cost of equity of 14.29 percent and a

pretax cost of debt of 7.23 percent. The required return on the
assets is 11 percent. What is the firm's debt-equity ratio based
on MM Proposition II with no taxes?
A) .67
B) .87
C) .72
D) .75
E) .81

Answer: B
Explanation: RS = .1429 = .11 + B/S(.11 − .0723)
B/S = .87
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

39) The Backwoods Lumber Co. has a debt-equity ratio

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 lOMoARcPSD|22015318

of .68. The firm's required return on assets is 11.7 percent and

its levered cost of equity is 15.54 percent. What is the pretax
cost of debt based on MM Proposition II with no taxes?
A) 6.76 percent
B) 6.39 percent
C) 7.25 percent
D) 6.05 percent
E) 7.50 percent

Answer: D
Explanation: RS = .1554 = .117 +
.68(.117 − RB) RB = .0605, or
6.05%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

40) A firm has zero debt in its capital structure and has an
overall cost of capital of 10 percent. The firm is considering a
new capital structure with 60 percent debt at an interest rate of
8 percent. Assuming there are no taxes or other imperfections,
what would be the cost of equity with the new capital
structure?
A) 9 percent
B) 10 percent
C) 13 percent
D) 14 percent
E) 11 percent

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Answer: C
Explanation: Rs = .10 + .60/.40(.10 − .08)
Rs = .13, or 13%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

41) A firm has a debt-equity ratio of .48. Its cost of debt is

7 percent and its WACC is 10.8 percent. What is its cost of
equity if there are no taxes or other imperfections?
A) 10.97 percent
B) 13.05 percent
C) 12.62 percent
D) 11.46 percent
E) 13.67 percent

Answer: C
Explanation: .108 = (.48/1.48)
(.07) + (1/1.48)RS RS = .1262, or
12.62%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: Weighted
average cost of capital
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation
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42) A firm has a debt-equity ratio of 1, a cost of equity of 16

percent, and a cost of debt of 8 percent. If there are no taxes
or other imperfections, what is its unlevered cost of equity?
A) 8 percent
B) 10 percent
C) 12 percent
D) 14 percent
E) 16 percent

Answer: C
Explanation: .16 = r0 + 1(r0 − .08)
r0 = .12, or 12%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

43) A firm has a debt-equity ratio of .55 with a cost of debt of

6.7 percent. If it had no debt, its cost of equity would be 14.5
percent. What is its levered cost of equity assuming there are
no taxes or other imperfections?
A) 18.96 percent
B) 15.82 percent
C) 17.94 percent
D) 18.79 percent
E) 13.67 percent

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Answer: D
Explanation: Rs = .145 + .55(.145 − .067)
Rs = .1879, or 18.79%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

44) If a firm is unlevered and has a cost of equity capital of

13.7 percent, what would be the cost of equity if its debt-equity
ratio was revised to .4? The expected cost of debt is 7.4 percent
and there are no taxes.
A) 15.54 percent
B) 15.67 percent
C) 16.09 percent
D) 16.22 percent
E) 16.36 percent

Answer: D
Explanation: Rs = .137 + .4(.137 − .074)
Rs = .1622, or 16.22%
Difficulty: 2 Medium
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation
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45) Reena Industries has $138,000 of debt outstanding that is

selling at par and has a coupon rate of 7 percent. If the tax rate is
21 percent, what is the present value of the tax shield on debt?
A) $28,412
B) $31,010
C) $28,980
D) $3,284
E) $2,029

Answer: C
Explanation: PVTax shield
= .21($138,000) PVTax
shield = $28,980
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

46) A firm has debt of $7,000, equity of $12,000, a cost of

debt of 7 percent, a cost of equity of 14 percent, and a tax rate
of 21 percent. What is the firm's weighted average cost of
capital?
A) 8.45 percent
B) 9.90 percent
C) 10.88 percent
D) 12.50 percent
E) 11.27 percent

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Answer: C
Explanation: RWACC = [$12,000/($7,000 + 12,000)(.14)] +
[$7,000/($7,000 + 12,000)](.07)(1 −
.21)
RWACC = .1088, or 10.88%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: Weighted average
cost of capital Bloom's:
Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

47) The Winter Wear Company has expected earnings before

interest and taxes of $3,800, an unlevered cost of capital of
15.4 percent and a tax rate of 22 percent. The company also
has
$2,600 of debt with a coupon rate of 5.7 percent. The debt is
selling at par value. What is the value of this firm?
A) $15,585
B) $19,819
C) $12,115
D) $12,055
E) $17,700

Answer: B
Explanation: VL = [$3,800(1 − .22)]/.154 + .22($2,600)
VL = $19,819
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
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Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

48) The Dance Studio is currently an all-equity firm that has

22,000 shares of stock outstanding with a market price of $27 a
share. The current cost of equity is 12 percent and the tax rate is
23 percent. The firm is considering adding $225,000 of debt
with a coupon rate of 6.25 percent to its capital structure. The
debt will sell at par. What will be the levered value of the
equity?
A) $325,500
B) $420,750
C) $521,250
D) $472,750
E) $594,000

Answer: B
Explanation: VL = 22,000($27) + .23($225,000)
VL = $645,750
VE = $645,750 − 225,000
VE = $420,750
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

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49) The Montana Hills Co. has expected earnings before

interest and taxes of $17,100, an unlevered cost of capital of
12.4 percent, and debt with both a book and face value of
$25,000. The debt has an annual 6.2 percent coupon. If the tax
rate is 21 percent, what is the value of the firm?
A) $91,016
B) $137,903
C) $114,194
D) $106,667
E) $146,403

Answer: C
Explanation: VL = [$17,100(1 − .21)]/.124 + .21($25,000)
VL = $114,194
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

50) Joe's Leisure Time Sports is an unlevered firm with an

aftertax net income of $78,400. The unlevered cost of capital
is 11.4 percent and the tax rate is 23 percent. What is the value
of this firm?
A) $447,017
B) $581,818
C) $687,719
D) $613,309
E) $537,900

Answer: C
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Explanation: VU = $78,400/.114
VU = $687,719
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

51) An unlevered firm has a cost of capital of 13.6 percent and

earnings before interest and taxes of $138,000. A levered firm
with the same operations and assets has both a book value and a
face value of debt of $520,000 with an annual coupon of 7
percent. The applicable tax rate is 21 percent. What is the value
of the levered firm?
A) $996,421
B) $907,679
C) $1,184,929
D) $910,818
E) $1,191,506

Answer: D
Explanation: VL = [$138,000(1 − .21)/.136] + .21($520,000)
VL = $910,818
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
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Thinking Accessibility:
Keyboard Navigation

52) The Spartan Co. has an unlevered cost of capital of 11.6

percent, a cost of debt of 7.9 percent, and a tax rate of 23
percent. What is the target debt-equity ratio if the targeted
levered cost of equity is 12.6 percent?
A) .44
B) .39
C) .35
D) .56
E) .53

Answer: C
Explanation: .126 = .116 + B/S(.116 − .079)(1 − .23)
B/S = .35
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

53) Salmon Inc. has debt with both a face and a market value
of $227,000. This debt has a coupon rate of 7 percent and pays
interest annually. The expected earnings before interest and
taxes is $87,200, the tax rate is 21 percent, and the unlevered
cost of capital is 12 percent. What is the firm's cost of equity?
A) 13.25 percent
B) 13.89 percent
C) 13.92 percent
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D) 14.27 percent
E) 14.14 percent

Answer: D
Explanation: VL = [$87,200(1 − .21)/.12] + .21($227,000)
VL = $621,736.67
VS = $621,736.67 − 227,000
VS = $394,736.67
Rs = .12 + ($227,000/$394,736.67)(1 − .21)(.12 − .07)
Rs = .1427, or 14.27%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

54) Anderson's Furniture Outlet has an unlevered cost of

capital of 10.3 percent, a tax rate of 21 percent, and expected
earnings before interest and taxes of $1,900. The company has
$4,000 in bonds outstanding that have an annual coupon of 7
percent. If the bonds are selling at par, what is the cost of
equity?
A) 11.33 percent
B) 9.34 percent
C) 10.72 percent
D) 9.99 percent
E) 11.21 percent

Answer: E
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Explanation: VL = [$1,900(1 − .21)/.103] + .21($4,000)

VL = $15,412.82
VS = $15,412.82 − 4,000
VS = 11,412.82
RS = .103 + [($4,000/$11,412.82)(1 − .21)(.103 − .07)]
RS = .1121, or 11.21%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

55) Aspen's Distributors has a levered cost of equity of 13.84

percent and an unlevered cost of capital of 12.5 percent. The
company has $5,000 in debt that is selling at par. The levered
value of the firm is $14,600 and the tax rate is 25 percent.
What is the pretax cost of debt?
A) 7.92 percent
B) 9.07 percent
C) 8.16 percent
D) 8.84 percent
E) 9.00 percent

Answer: B
Explanation: VE = $14,600 − 5,000
VE = $9,600
.1384 = .125 + ($5,000/$9,600)(1 − .25)(.125 − RB)
RB = .0907, or 9.07%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
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Proposition II with taxes

Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

56) Rosita's has a cost of equity of 13.76 percent and a pretax

cost of debt of 8.5 percent. The debt-equity ratio is .60 and the
tax rate is 21 percent. What is Rosita's unlevered cost of
capital?
A) 11.83 percent
B) 12.07 percent
C) 13.97 percent
D) 14.08 percent
E) 14.60 percent

Answer: B
Explanation: .1376 = RU + .60(1 − .21)(RU − .085)
RU = .1207, or 12.07%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

57) An all-equity firm has a cost of capital of 12.8 percent

and a tax rate of 23 percent. At the firm's target debt-equity
ratio, the pretax cost of debt is 7.35 percent and the cost of
equity is
15.07 percent. What is the target
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debt-equity ratio? A) .67

B) .49
C) .51
D) .61
E) .54

Answer: E
Explanation: .1507 = .128 + B/S(1 − .23)(.128 − .0735)
B/S = .54
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

58) Wild Flowers Express has a debt-equity ratio of .60. The

pretax cost of debt is 9 percent while the unlevered cost of
capital is 14 percent. What is the cost of equity if the tax rate
is 23 percent?
A) 7.52 percent
B) 8.78 percent
C) 16.31 percent
D) 16.83 percent
E) 17.30 percent

Answer: C
Explanation: RS = .14 + .60(1 − .23)(.14 − .09)
RS = .1631, or 16.31%
Difficulty: 2 Medium
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Section: 16.5 Taxes

Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

59) Your firm has a bond issue with a face value of $250,000
outstanding. These bonds have a coupon rate of 7 percent, pay
interest semiannually, and have a current market price equal to
103 percent of face value. What is the amount of the annual tax
shield on debt given a tax rate of 21 percent?
A) $3,675
B) $6,309
C) $4,500
D) $47,500
E) $52,500

Answer: A
Explanation: Annual tax shield on debt =
$250,000(.07)(.21) Annual tax shield on
debt = $3,675
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Apply
AACSB: Knowledge
Application Accessibility:
Keyboard Navigation

60) Jasmine's Boutique has 2,000 bonds outstanding with a

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face value of $1,000 each, a market value of $1,060 each, and

a coupon rate of 9 percent. The interest is paid semiannually.
What is the amount of the annual tax shield on debt if the tax
rate is 23 percent?
A) $44,872
B) $460,000
C) $43,884
D) $41,400
E) $487,600

Answer: D
Explanation: Annual interest tax shield =
2,000($1,000)(.09)(.23) Annual interest tax
shield = $41,400
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Apply
AACSB: Knowledge
Application Accessibility:
Keyboard Navigation

61) Juanita's Steak House has $12,000 of debt outstanding that

is selling at 101.2 percent of par and has a coupon rate of 8
percent and a current yield of 7.91 percent. The tax rate is 21
percent. What is the present value of the tax shield on debt?
A) $3,188
B) $3,887
C) $2,520
D) $2,500
E) $2,550

Answer: C
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Explanation: PVTax shield

= .21($12,000) PVTax shield
= $2,520
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Apply
AACSB: Knowledge
Application Accessibility:
Keyboard Navigation

62) A firm has debt of $5,000, equity of $16,000, a cost of

debt of 8 percent, a cost of equity of 12 percent, and a tax rate
of 21 percent. What is the firm's weighted average cost of
capital?
A) 10.20 percent
B) 9.94 percent
C) 10.90 percent
D) 10.65 percent
E) 11.05 percent

Answer: D
Explanation: RWACC = [$16,000/($5,000 + 16,000)](.12) +
[$5,000/($5,000 + 16,000)](.08)(1 −
.21)
RWACC = .1065, or 10.65%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: Weighted average
cost of capital Bloom's:
Analyze
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AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

63) A firm has zero debt and an overall cost of capital of 13.8
percent. The firm is considering a new capital structure with 40
percent debt. The interest rate on the debt would be 7.2 percent
and the corporate tax rate is 21 percent. What would be the cost
of equity with the new capital structure?
A) 16.90 percent
B) 16.11 percent
C) 17.28 percent
D) 17.34 percent
E) 17.59 percent

Answer: C
Explanation: Rs = .138 + (.4/.6)(1 − .21)(.138 − .072)
Rs = .1728, or 17.28%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

64) A firm has a debt-equity ratio of .64, a cost of equity of

13.04 percent, and a cost of debt of 8 percent. Assume the
corporate tax rate is 25 percent. What would be the cost of
equity if the firm were all-equity financed?
A) 11.30 percent

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B) 11.41 percent
C) 13.33 percent
D) 12.42 percent
E) 12.25 percent

Answer: B
Explanation: .1304 = R0 + .64(1 − .25)(R0 − .08)
R0 = .1141, or 11.41%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

65) A firm has an equity multiplier of 1.57, an unlevered cost

of equity of 14 percent, a levered cost of equity of 15.6
percent, and a tax rate of 21 percent. What is the cost of debt?
A) 11.25 percent
B) 10.50 percent
C) 10.45 percent
D) 11.00 percent
E) 10.33 percent

Answer: C
Explanation: B/S = 1.57 − 1
B/S = .57
.156 = .14 + .57(1 −.21)(.14 − RB)
RB = .1045, or 10.45%
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
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Proposition II with taxes

Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

66) Lyme Home has 5,000 bonds outstanding with a face value
of $1,000 each and a coupon rate of 7.65 percent. Interest is
paid semiannually. What is the amount of the annual tax shield
on debt if the tax rate is 23 percent?
A) $157,650
B) $160,125
C) $1,062,500
D) $1,150,000
E) $87,975

Answer: E
Explanation: Annual interest tax shield =
5,000($1,000)(.0765)(.23) Annual interest tax
shield = $87,975
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

67) Alexandria's Dance Studio is currently an all-equity firm

with earnings before interest and taxes of $338,000 and a cost
of equity of 14.2 percent. Assume the tax rate is 22 percent.
The firm is considering adding $400,000 of debt with a
coupon rate of 7 percent to its capital structure. The debt will
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be sold at par value. What is the levered value of the equity?

A) $1,987,408
B) $1,544,620
C) $2,038,519
D) $986,420
E) $1,944,620

Answer: B
Explanation: VL = {[$338,000(1 − .22)]/.142} + .22($400,000)
VL = $1,944,620
VE = $1,944,620 − 400,000
VE = $1,544,620
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

68) Boutelle Homes has an all-equity value of $648,200, a cost

of equity of 11.7 percent, and a tax rate of 35 percent. Assume
the firm's capital structure changes to 30 percent debt followed
by a lowering of the tax rate to 21 percent. What will be the
change in the levered value of the firm due to the reduction in
the tax rate?
A) $16,020
B) $17,520
C) $29,169
D) −$27,224
E) −$17,520

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Answer: D
Explanation: ΔV = .21(.3)($648,200)
− .35(.3)($648,200) ΔV = −$27,224
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

69) Explain homemade leverage and why it matters.

Answer: Homemade leverage is the ability of investors to alter

their own financial leverage to achieve a desired capital structure
no matter what a firm's capital structure might be. If investors
can, at their discretion, use homemade leverage to create
additional leverage or to undo any existing leverage of the firm
then the actual capital structure decision of the firm itself
becomes irrelevant.
Difficulty: 1 Easy
Section: 16.3 Financial Leverage and
Firm Value: An Example Topic: M and
M Proposition I without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

70) Explain why the weighted average cost of capital is

invariant to the firm's debt-equity ratio in the absence of
corporate taxes.
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Answer: In a world without taxes, the cost of equity increases as

the debt-equity ratio increases. This increase in equity cost is
just sufficient to offset the increased risk, allowing WACC to
remain constant. This is MM Proposition II with no corporate
taxes.
Difficulty: 1 Easy
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

71) Discuss MM Propositions I and II in a world without

taxes. List the basic assumptions, results, and intuition of
the model.

Answer: MM I and II without taxes:

Assumptions:
∙ No taxes
∙ No transaction costs
∙ Individuals and corporations borrow at same rate

Results:
∙ Proposition I: VL = VU
∙ Proposition II: RS = R0 + B/S(R0 − RB)

Intuition:
∙ Proposition I: Through homemade leverage individuals
can either duplicate or undo the effects of corporate
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leverage.
∙ Proposition II: The cost of equity rises with leverage
because the risk to equity rises with leverage.
Difficulty: 1 Easy
Section: 16.4 Modigliani and Miller:
Proposition II (No Taxes) Topic: M and M
Proposition II without taxes
Bloom's:
Understand
AACSB: Reflective
Thinking
Accessibility: Keyboard Navigation

72) In each of the theories of capital structure, the cost of equity

rises as the amount of debt increases. So why don't financial
managers use as little debt as possible to keep the cost of equity
down? After all, isn't the goal of the firm to maximize share
value and doesn't a lower discount rate applied to the firm's cash
flows increase the present value of those cash flows?

Answer: This question requires students to differentiate between

the cost of equity and the WACC. The firm trades off higher
equity costs for a lower WACC via both the lower pretax cost of
debt and the tax shield on debt. Thus, even though the cost of
equity rises, the overall cost of capital (which is used as the
discount rate when computing the PV of the firm's cash flows)
declines and thus the value of the firm rises.
Difficulty: 2 Medium
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Analyze
AACSB: Analytical
Thinking Accessibility:
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Keyboard Navigation

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73) Based on MM Propositions, with and without taxes,

how much time should a financial manager spend analyzing
the capital structure of his firm?

Answer: Under either MM scenario, the financial manager

should invest no time in analyzing the firm's capital structure.
With no taxes, capital structure is irrelevant. With taxes, MM
says a firm will maximize its value by using 100 percent debt. In
both cases, the manager has nothing to decide.
Difficulty: 3 Hard
Section: 16.5 Taxes
Topic: M and M
Proposition I with taxes
Bloom's: Evaluate
AACSB: Analytical
Thinking Accessibility:
Keyboard Navigation

74) Discuss MM Propositions I and II in a world with taxes.

List the basic assumptions, results, and intuition of the model.

Answer: MM Proposition I and II with taxes:

Assumptions:
∙ Corporations are taxed at the rate tC, on earnings after interest.
∙ No transaction costs
∙ Individuals and corporations borrow at same rate.

Results:
∙ Proposition I: VL = VU + tCB
∙ Proposition II: RS = R0 + B/S(1 − tC)(R0 − RB)

Intuition:
∙ Proposition I: Because corporations can deduct interest
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payments but not dividend payments, corporate leverage lowers

tax payments, thereby increasing firm value.
∙ Proposition II: The cost of equity rises with leverage
because the risk to equity rises with leverage.
Difficulty: 1 Easy
Section: 16.5 Taxes
Topic: M and M
Proposition II with taxes
Bloom's: Understand
AACSB: Reflective
Thinking Accessibility:
Keyboard Navigation

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