Quiz 10 - LAMS Quiz 10 PDF

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1. Compare the amount of taxes paid by the two firms. Which firm pays less taxes? Why? Answer:Firm L pays less taxes because of the tax-deductibility of interest expense, i. the interest is deducted before calculating taxable income, therefore taxable income for L is lesser. Although L has to pay in...

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1. Compare the amount of taxes paid by the two firms. Which firm pays less taxes? Why? Answer: Firm L pays less taxes because of the tax-deductibility of interest expense, i.e. the interest is deducted before calculating taxable income, therefore taxable income for L is lesser. - Although L has to pay interest expense, L pays less taxes and net income us distributed over less equity/no. of shares outstanding 2. Which firm has higher expected values? Which firm has a higher risk? Answer: Firm L has the higher expected values. Although L has to pay interest expense, L pays less taxes and net income is distributed over less equity/ number of shares outstanding. Firm L has the higher risk, as measured by CV of EPS and ROE. Firm U has only business risk. Firm L has the same level of business risk as Firm U and additional financial risk because of the use financial leverage. - L has higher E(ROE) and E(EPS) as they are exposed to additional financial risk, L has the same amount of business risk as M but spread over less equity (0.24 BUSINESS RISK, 0.15 FINANCIAL RISK) - Firm U only has business risk associated with operations (0.24) 3. What have you learnt about the effect of debt on the expected profitability and risk faced by shareholders? What is the implication for determining the optimal capital structure?

Answer: Financial leverage increases the expected profitability to shareholders but also increases the risk to shareholders. Therefore, when determining the optimal capital structure that maximizes stock price, we have to consider both the increased profitability and increased risk resulting from the use of debt.There would be a tradeoff between increased profitability and increased risk when we increase the debt level in the capital structure. - As debt to capital ratio increases, financial risks will always increase but business risk will always stay constant (only involves operations) Questions 

Given that Cheetah Café Company has no preferred stock, can you calculate the WACC at each debt level by filling in the blanks in the spreadsheet below?

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Which debt level minimises the WACC?

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Plot the cost of equity, after-tax cost of debt, and WACC on a graph where the x-axis is the debt/capital ratio. What do you notice?

Notes: To fill in the blanks (those labelled X), click the cell, type in your answer and press Enter. Click Save to submit your answers before going to the next activity.

The debt level that minimises the WACC is at 25% debt/capital ratio. Note that this is also the debt level that maximises stock price. The cost of equity and cost of debt are always upward-sloping. As debt increases, default risk increases and financial risk increases, leading debtholders and shareholders to require higher returns. However, WACC will decrease first as we shift from higher cost equity to lower cost debt since WACC is a weighted average of the two. But, as we shift more to debt, rapid increases in the costs of debt and equity offset the fact that more low-cost debt is being used.

1. Which of the following companies do you think would have more debt in its capital structure? Why? Choose one of the following answers. A company selling toothpaste

The company selling toothpaste would have more debt in its capital structure. The toothpaste company has less business risk and therefore less volatile operating income, i.e., the chances of low or negative EBIT is lower. Therefore, at any debt level, compared to a company with high business risk, the likelihood of bankruptcy is lower for the low-business-risk company. In general, companies with less business risk tend to have higher debt/capital ratio due to lower likelihood of bankruptcy. 2. When the government announces an increase in corporate tax rates, what do you think is the most likely scenario? Choose one of the following answers. Companies increase their debt/capital ratio

Companies decrease their debt/capital ratio

The correct answer is Option 1. When the corporate tax rates increases, the tax benefit of debt increases. Therefore, companies will increase the amount of debt in their capital structure to take advantage of the tax-deductibility of interest expense. 3. If a company is very uncertain about its future financing needs, the company will tend to have ____ debt in its capital structure. Choose one of the following answers. less

According to the signaling theory, when companies are uncertain about its future financing needs, they will tend to have less debt in its capital structure so as to maintain financial flexibility. If the company wants to raise capital in the future, the company can avoid costly equity and issue debt whenever it wants to. 

Question 1 10 out of 10 points James Corporation currently has 20 million common shares with market price of $2 per share, and 50,000 bonds with market value of $900 per bond. The company intends to change its current capital structure to achieve Debt/Equity ratio of 1, without changing the value of its total assets. To achieve this, which of the following actions can the company take? (Assuming the market share price and bond price remain unchanged) Selected Answer:

B. The company can issue 1.25 million common shares at $2 per share, and use all the proceeds to repurchase some of its bonds.

Answers:

A. The company can issue 2.5 million common shares at $2 per share, and use all the proceeds to repurchase some of its bonds. B. The company can issue 1.25 million common shares at $2 per share, and use all the proceeds to repurchase some of its bonds. C. The company can issue 5,556 bonds at $900, and use all the proceeds to repurchase some of its common shares. D. The company can issue 2.5 million common shares at $2 per share, without changing the number of bonds. E. The company can issue 2,778 bonds at par to achieve its target Debt/Equity ratio, without changing the number of common shares.

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Question 2 10 out of 10 points

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU? Selected Answer:

E. 0.87

Answers:

A. 0.71 B. 0.75 C. 0.79 D. 0.83 E. 0.87

Response Feedback: bL wd Tax rate D/E = wd/(1-wd) bU = bL/(1 + (D/E) x (1-T)) 

1.25 0.40 35% 0.67 0.87

Question 3 10 out of 10 points Which of the following statements is CORRECT? Selected Answer:

E. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC.

Answers:

A. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. B. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC. C. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company’s WACC. D. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity. E. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC.

Response Feedback:

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Question 4

An increase in debt ratio will increase the rd and rc. According to the formula of WACC: WACC = wdrd(1-T) + wcrc where wd and wc are the debt ratio and equity ratio, respectively. If the increase in the first component is less than the decrease in the second component (due to the decrease in the wc),the company’s WACC may lower.

10 out of 10 points You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? 60% Debt, 0% Debt, U L Operating income (EBIT) $400,000 $400,000 Required Investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common Equity $2,500,000 $1,000,000 Interest Rate NA 10.00% Tax Rate 35% 35% Selected Answer:

A. 5.85%

Answers:

A. 5.85% B. 6.14% C. 6.45% D. 6.77% E. 7.11%

Response Feedback:

0% Debt, U 60% Debt, L Required investment $2,500,000 $2,500,000 % Debt 0.00% 60.00% $ of Debt $0 $1,500,000 $ of Common equity $2,500,00 $1,000,000 Interest rate NA 10.00% Tax rate 35.00% 35.00% Operating income (EBIT) $400,000 $400,000 Interest 0 ____150,000 Taxable income $400,000 $250,000 Taxes ___140,000 _____87,500 Net income __$260,000 ____162,500 ROE 10.40% 16.25%

Difference in ROEs = 5.85% 

Question 5 10 out of 10 points Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It

is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? Wd = 55% Original cost of equity, rs =10.0% Wc = 45% New cost of equity, rs =11.0% Interest new, rd =7.0% Tax Rate =40% Selected Answer:

A. 2.74%

Answers:

A. 2.74% B. 3.01% C. 3.32% D. 3.65% E. 4.01%

Response Feedback: wd wc Tax rate

55% 45% 40%

Interest rate = rd New cost of equity = rs Old cost of equity

7.0% 11.0% 10.0%

WACCOLD = wd(1-T)rd + wcrs = 0.00% + 10.00% = 10.00% WACCNEW = wd(1-T)rd + wcrs= 2.31% + 4.95% = 7.26% Change in WACC = WACC Old - WACC NEW = 2.74% 

Question 6 10 out of 10 points Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk? Selected Answer:

C. The extent to which interest rates on the firm's debt fluctuate.

Answers:

A. Demand variability. B. Input price variability. C. The extent to which interest rates on the firm's debt fluctuate. D. The extent to which operating costs are fixed. E. Sales price variability.

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Question 7 10 out of 10 points Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT. Selected Answer:

False True

Answers:

False Response Feedback:

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Operating leverage is the uncertainty in EBIT therefore it affects both EBIT and EPS. Financial leverage is the use of debt and preferred stock. The interest of debt will affect EPS, not EBIT

Question 8 10 out of 10 points If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk. Selected Answer: False True

Answers:

False 

Question 9 10 out of 10 points Which of the following statements is CORRECT? Selected Answer:

E. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.

Answers:

A. The capital structure that maximises the stock price is also the capital structure that maximises the firm’s times interest earned (TIE) ratio. B. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. C. The capital structure that maximises the stock price is also the capital structure that maximises earnings per share. D. The capital structure that maximises the stock price is also the capital structure that minimises the cost of equity from retained earnings (rs). E. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.

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Question 10 10 out of 10 points In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant. Selected Answer: True Answers: True False...