Corporate and International Finance (N1563)
Seminar 5 (questions)
SHORT ANSWER
Q1. State the generalized version of Modigliani-Miller Proposition I.
Q2. State and explain MM's Proposition II
Q3. Briefly explain the trade-off theory of capital structure.
Q4. Explain the pecking order theory of capital structure.
MULTIPLE CHOICE
5) Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the expected return on equity if the expected return on assets is 14%? Ignore taxes.
A) 14.92%
B) 17.86%
C) 15.50%
D) 16.14%
6) An implicit cost of adding debt to the capital structure is that it:
A) increases the required return on equity.
B) reduces the expected return on assets.
C) decreases the firm's beta.
D) adds interest expense to the operating statement.
7) A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%?
A) $3,500,000
B) $10,000,000
C) $245,000
D) $700,000
8) When taxes are considered, the value of a levered firm equals the value of the:
A) unlevered firm plus the value of the debt plus the value of the tax shield.
B) unlevered firm plus the present value of the tax shield.
C) unlevered firm.
D) unlevered firm plus the value of the debt.
9) Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 35%.
A) 12.83%
B) 14.40%
C) 18.20%
D) 14.00%
10) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt?
A. EPS decreases by 33.3% to $10.00.
B. EPS stays at $12.50.
C. EPS increases by 140% to $30.00.
D. EPS increases by 240% to $42.50.
11) The common stock and debt of Northern Sludge are valued at $50 million and $30 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt on the stock and that there are no taxes.
12) Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.
a. How is the market price of the stock affected by the announcement?
b. How many shares can the company buy back with the $160 million of new debt that it issues?
c. What is the market value of the firm (equity plus debt) after the change in capital structure?
d. What is the debt ratio after the change in structure?
e. Who (if anyone) gains or loses?