Chapter 16 Financial Leverage and Capital Structure Policy

1. All else equal, higher financial leverage decreases a

firm's break-even EBIT.

True False

2. Business risk declines as the systematic risk of a firm's

assets increases.

True False

3. Business risk is a positive function of the systematic

risk of a firm's assets.

True False

4. Ignoring financial distress costs, borrowing money

decreases the value of the firm by increasing the firm's
tax liability.

True False

5. Suppose we wish to draw a graph illustrating M&M

Proposition II. Let the vertical axis represent the cost of
capital and the firm's debt-to-equity ratio represents the
horizontal axis. If the line representing the firm's
WACC has a negative slope, we must be incorporating
taxes into the analysis.

True False

6. Direct bankruptcy costs are those costs that are directly

associated with bankruptcy, such as legal and
administrative costs.

True False

7. Indirect bankruptcy costs include the costs of avoiding

a bankruptcy filing incurred by a financially distressed
firm.

True False

8. It has been observed that, when firms get into financial

trouble, they often find it difficult to attract and retain
high-quality employees. The additional costs incurred
in this situation would be considered direct bankruptcy
costs.

True False
9. When a firm files for bankruptcy, the firm often must
hire appraisers to determine the fair value of the firm's
assets. This is an example of a direct cost of
bankruptcy.

True False

10. According to the static theory of capital structure,

value-maximizing financial managers will borrow to
the point where the firm's business risk is just equal to
its financial risk.

True False

11. If the static theory of capital structure is true, then the

optimal level of debt for a given firm increases as its
marginal tax rate increases and decreases as the costs of
financial distress increase.

True False

12. In order to avoid bankruptcy, management sometimes

seeks to work with creditors. One method of
restructuring debt involves composition, which involves
a reduction in the amount of the payment to be made.

True False

13. The use of personal borrowing to change the overall

amount of financial leverage to which the individual is
exposed is called:

A.
B.
C.
D.
E.

14. The proposition that the value of the firm is

independent of its capital structure is called:

A.
B.
C.
D.
E.
15. The proposition that the cost of equity is a positive
linear function of capital structure is called:

A.
B.
C.
D.
E.

16. The equity risk derived from the firm's operating

activities is called ____________ risk.

A.
B.
C.
D.
E.

17. The equity risk derived from the firm's capital structure
policy is called ___________ risk.

A.
B.
C.
D.
E.

18. The tax savings of the firm derived from the

deductibility of interest expense is called the:

A.
B.
C.
D.
E.

19. The unlevered cost of capital is _________________.

A.
B.
C.
D.
E.
20. The explicit costs associated with corporate default,
such as legal expenses, are the ________ of the firm.

A.
B.
C.
D.
E.

21. The implicit costs associated with corporate default,

such as lost sales, are the __________ of the firm.

A.
B.
C.
D.
E.

22. The explicit and implicit costs associated with

corporate default are the ___________ of the firm.

A.
B.
C.
D.
E.

23. The proposition that a firm borrows up to the point

where the marginal benefit of the interest tax shield
derived from increased debt is just equal to the marginal
expense of the resulting increase in financial distress
costs is called the:

A.
B.
C.
D.
E.
24. The legal proceeding for liquidating or reorganizing a
firm operating in default is called a:

A.
B.
C.
D.
E.

25. A firm that has negative net worth is said to be:

A.
B.
C.
D.
E.

26. The complete termination of the firm as a going

business concern is called a ______________.

A.
B.
C.
D.
E.

27. The financial restructuring of a failing firm to attempt

to continue operations as a going concern is called a
________________.

A.
B.
C.
D.
E.

28. A capital restructuring occurs when a firm:

A.
B.
C.
D.
E.
29. The extent to which a firm relies on debt is referred to
as:

A.
B.
C.
D.
E.

30. The weighted average cost of capital can also be

defined as the:

A.
B.
C.
D.
E.

31. The cost of equity capital, based on M&M Proposition

II, can be defined as:

A.
B.
C.
D.
E.

32. The theory that a change in the capital structure weights

is exactly offset by the change in the cost of equity is
known as:

A.
B.
C.
D.
E.
33. The fact that individual investors can alter the amount
of financial leverage to which they are exposed is
referred to as:

A.
B.
C.
D.
E.

34. The static theory of capital structure states that firms

borrow up to the point where the tax benefit of one
additional dollar of debt is equal to the marginal cost
of:

A.
B.
C.
D.
E.

35. The option of keeping a financially distressed firm as

an operating concern is called a(n):

A.
B.
C.
D.
E.

36. The procedure for liquidating a corporation is outlined

in:

A.
B.
C.
D.
E.
37. The absolute priority rule establishes the order in
which:

A.
B.
C.
D.
E.

38. Which of the following is true about the WACC?

A.
B.
C.
D.
E.

39. When choosing a capital structure, the objective of the

firm should be to:

A.
B.
C.
D.
E.

40. The optimal capital structure is the mixture of debt and

equity which:

I. Maximizes the value of the firm.

II. Minimizes the firm's weighted average cost of
capital.
III. Maximizes the market price of the firm's bonds.

A.
B.
C.
D.
E.
41. Which of the following is NOT accurate regarding
financial leverage?

A.
B.
C.
D.
E.

42. All else the same, the financial leverage of a firm will
_________________.

A.
B.
C.
D.
E.

43. Suppose you work for the CFO of Danforth, Inc. He

believes sales and operating income will be sharply
higher each year for the foreseeable future. If he seeks
to maximize earnings per share, he should
_____________. (Assume there are no taxes.)

A.
B.
C.
D.
E.
44. Which of the following statements is/are true regarding
corporate borrowing when EBIT is positive?

I. Increasing financial leverage increases the sensitivity

of EPS and ROE to changes in EBIT
II. The effect of financial leverage depends on the
company's EBIT, that is, leverage is unfavourable when
EBIT is relatively high, and leverage is favourable
when EBIT is relatively low
III. High leverage decreases the returns to shareholders
(as measured by ROE)

A.
B.
C.
D.
E.

45. Which of the following statements regarding leverage is

false?

A.
B.
C.
D.
E.

46. Below the break-even EBIT, increased financial

leverage will _______ EPS, all else the same. Assume
there are no taxes.

A.
B.
C.
D.
E.
47. All else the same, which of the following claims on the
cash flows of the firm will tend to increase with
decreases in the debt/equity ratio?

I. Taxes
II. Bankruptcy costs
III. Stockholder claims
IV. Bondholder claims

A.
B.
C.
D.
E.

48. Which of the following statements is correct?

A.
B.
C.
D.
E.

49. According to _________, the value of the firm is

independent of its capital structure.

A.
B.
C.
D.
E.

50. The cost of debt is generally lower than the cost of

equity; however, according to __________, replacing
equity with debt will not change the value of the firm
because the savings attributable to the lower cost of
debt financing will be offset by the higher required
return on the remaining equity.

A.
B.
C.
D.
E.
51. _____________ implies that the firm should issue as
much debt as possible.

A.
B.
C.
D.
E.

52. According to M&M Proposition II without taxes, a

firm's cost of equity is a function of which of the
following factors?

I. The required rate of return on the firm's assets

II. The firm's debt/equity ratio
III. The firm's cost of debt

A.
B.
C.
D.
E.

53. Assume there are no corporate or personal taxes.

According to M&M Proposition:

A.
B.
C.
D.
E.
54. Assume there are no personal or corporate income taxes
and that the firm's WACC is unaffected by its capital
structure. Which of the following is true?

I. A firm's cost of equity depends on the firm's business

and financial risks.
II. The value of the firm is dependent on its capital
structure.
III. The cost of equity increases as the firm's leverage
decreases.

A.
B.
C.
D.
E.

55. Which of the following is true concerning the rate of

return earned on shares of a levered firm in terms of the
possible range of earnings? There are no taxes.

A.
B.
C.
D.
E.

56. The equity beta of a firm depends on which of the

following?

I. The firm's business risk.

II. The firm's financial policy.
III. The firm's advertising policy.

A.
B.
C.
D.
E.
57. A firm's systematic risk will ____________ as its
debt/equity ratio __________.

A.
B.
C.
D.
E.

58. __________ arises from decisions that affect the left-

hand side of the balance sheet, while
________________ arises from decisions that affect the
right-hand side of the balance sheet.

A.
B.
C.
D.
E.

59. Which of the following correctly completes this

sentence: All else the same, _____________.

A.
B.
C.
D.
E.

60. All else the same, which of the following is true about
the interest tax shield of a firm with positive EBIT?

A.
B.
C.
D.
E.
61. According to ___________, a firm's cost of equity
increases with greater debt financing, but the WACC
remains unchanged.

A.
B.
C.
D.
E.

62. According to ___________, a firm's cost of equity

increases with greater debt financing, and the WACC
decreases.

A.
B.
C.
D.
E.

63. Which of the following correctly completes the

following: M&M I with taxes shows
___________________.

A.
B.
C.
D.
E.

64. A firm that is approaching bankruptcy will find that

A.
B.
C.
D.
E.
65. Which of the following is NOT true about bankruptcy
and its costs?

A.
B.
C.
D.
E.

66. Which of the following would be considered an indirect

bankruptcy cost?

A.
B.
C.
D.
E.

67. When the value of a firm's assets exactly equals the

value of its debt, the firm:

A.
B.
C.
D.
E.

68. According to __________, a firm's cost of equity

increases with greater debt financing, while the WACC
first decreases and then increases.

A.
B.
C.
D.
E.

69. According to the static theory of capital structure,

____________________.

A.
B.
C.
D.
E.
70. Of the following, all are conclusions that can be drawn
from the capital structure puzzle EXCEPT:

A.
B.
C.
D.
E.

71. Which of the following individuals has NOT acquired a

marketed claim against RDJ, Inc.?

A.
B.
C.
D.
E.

72. Which of the following statements is/are true regarding

observed capital structures?

I. There appears to be some connection between

operating characteristics and capital structure
II. D/E ratios are significantly higher today than they
were in the 1960s.
III. It appears that, for whatever reason, capital
structures vary quite a bit across differing industry
groups

A.
B.
C.
D.
E.

73. In a(n) ______________ a business is liquidated,

usually at a loss for the creditors.

A.
B.
C.
D.
E.
74. If a firm fails to make the required interest payments on
its long-term bonds, it is said to be in:

A.
B.
C.
D.
E.

75. When a firm defaults on a legal obligation,

___________.

A.
B.
C.
D.
E.

76. Of the following, __________ does NOT necessarily

indicate financial distress.

A.
B.
C.
D.
E.

77. You are a secured creditor in a bankruptcy liquidation.

Listed below, in chronological order, are the steps in the
bankruptcy proceeding. Just prior to which step would
you expect to have to document the strength of your
claim on the firm's assets?

A.
B.
C.
D.
E.
78. Which of the following describes a correct priority of
claims in a bankruptcy liquidation?

A.
B.
C.
D.
E.

79. Which of the following DOES not correctly rank the

priority of claims of the parties to a corporate
bankruptcy? (Rank from strongest to weakest. )

A.
B.
C.
D.
E.

80. Which of the following is true regarding bankruptcy?

A.
B.
C.
D.
E.

81. Which of the following are true when a firm is

operating at its target capital structure point?

I. The WACC is at its minimum point.

II. The debt-equity ratio is equal to 1.
III. Shareholder value is maximized.
IV. The total value of the firm is maximized.

A.
B.
C.
D.
E.
82. The value of a restructuring is equal to the net present
value of the:

A.
B.
C.
D.
E.

83. Firm A has a debt-equity ratio of .5. Firm B has a debt-

equity ratio of .8. All other features of these firms are
identical. The return on equity of Firm A is:

A.
B.
C.
D.

84. Which one of the following statements concerning

financial leverage is correct in a world without taxes?

A.
B.
C.
D.
E.

85. In a world without taxes, M&M Proposition I contends

that:

A.
B.
C.
D.
E.
86. Which of the following apply to levered firms but not to
unlevered firms?

I. Financial risk
II. Systematic risk
III. Business risk
IV. Interest tax shield

A.
B.
C.
D.
E.

87. M&M Proposition I with taxes states that the:

A.
B.
C.
D.
E.

88. Which one of the following statements is true?

A.
B.
C.
D.
E.

89. Individual investors who lend out part of their personal

funds are in fact:

A.
B.
C.
D.
E.
90. Firm A is levered. Firm B is unlevered. In all other
aspects, Firms A and B are identical. There is no
depreciation expense. Considering taxes, Firm A will
have _____ net income and _____ cash flow from
operations than will Firm B.

A.
B.
C.
D.
E.

91. Which of the following are indirect costs of

bankruptcy?

I. Loss of key employees

II. Foregone profitable projects due to debt restrictions
III. Loss created by sale of assets which was required to
improve liquidity
IV. Accounting and legal fees incurred in the
bankruptcy process

A.
B.
C.
D.
E.

92. Which one of the following groups is most apt to push a

company towards filing bankruptcy once the firm
becomes financially distressed?

A.
B.
C.
D.
E.

93. The cost of bankruptcy:

A.
B.
C.
D.
E.
94. Shareholders generally prefer that a distressed firm:

A.
B.
C.
D.
E.

95. The optimal firm value is achieved when the:

A.
B.
C.
D.
E.

96. Which of the following statements concerning the

actual value of a firm are correct?

I. The actual firm value is equal to the M&M

Proposition I with tax value minus the financial distress
costs.
II. The actual value of a firm is equal to the value of the
firm with no debt plus the present value of the tax
shield on debt minus the financial distress costs.
III. The actual value of a firm with debt is generally
greater than the value of a firm without debt.
IV. The maximum value of a firm is at the point where
the additional gain from leverage is just offset by the
additional financial distress cost.

A.
B.
C.
D.
E.

97. The interest tax shield has more value when the amount
of debt is _____ and the tax rate is _____.

A.
B.
C.
D.
E.
98. Which of the following will affect the optimal level of
debt for a firm?

I. Tax rate
II. Volatility of earnings
III. Nature of assets
IV. Accumulated tax losses

A.
B.
C.
D.
E.

99. According to the absolute priority rule, which one of

the following represents the correct order of
distributions in liquidation, starting with the highest
priority first?

I. Employee wages
II. Government taxes
III. Administrative expenses of the bankruptcy
IV. Unsecured creditors

A.
B.
C.
D.
E.

100. The financial management goal as it pertains to the

capital structure of a firm is to operate at the point
where the debt-equity mix:

A.
B.
C.
D.
E.
101. The proposition that the value of the firm is
independent of its capital structure is called:

A.
B.
C.
D.
E.

102. The equity risk derived from a firm's operating

activities is called _____ risk.

A.
B.
C.
D.
E.

103. The equity risk derived from a firm's capital structure

policy is called _____ risk.

A.
B.
C.
D.
E.

104. The costs of avoiding a bankruptcy filing by a

financially distressed firm are classified as _____
costs.

A.
B.
C.
D.
E.

105. The legal proceeding for liquidating or reorganizing a

firm operating in default is called a

A.
B.
C.
D.
E.
106. A firm should select the capital structure which:

A.
B.
C.
D.
E.

107. The value of a firm is maximized when the:

A.
B.
C.
D.
E.

108. The optimal capital structure has been achieved when

the:

A.
B.
C.
D.
E.

109. ABC, Inc. is comparing two capital structures to

determine how to best finance the firm's operations.
The first option consists of 100% equity financing. The
second option is based on a debt-equity ratio of .40.
What should ABC do if expected earnings before
interest and taxes (EBIT) are less than the break-even
level? Assume there are no taxes.

A.
B.
C.
D.
E.
110. You have computed the break-even point between a
capital structure that has no debt and one that has debt.
Assume there are no taxes. At the break-even level,
the:

A.
B.
C.
D.
E.

111. Which one of the following statements is correct

concerning the relationship between a capital structure
with debt and one without debt? Assume there are no
taxes.

A.
B.
C.
D.
E.

112. Bryan invested in Bryco, Inc. stock when the firm was
financed solely with equity. The firm is now utilizing
debt in its capital structure. To unlever his position,
Bryan needs to:

A.
B.
C.
D.
E.

113. The capital structure chosen by a firm doesn't really

matter because of:

A.
B.
C.
D.
E.
114. M&M Proposition I with no tax supports the argument
that:

A.
B.
C.
D.
E.

115. The proposition that the value of a levered firm is equal

to the value of an unlevered firm is known as:

A.
B.
C.
D.
E.

116. The concept of homemade leverage is most associated

with:

A.
B.
C.
D.
E.

117. Which of the following statements are correct in

relation to M&M Proposition II with no taxes?

I. The return on assets is equal to the weighted average

cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of
leverage used by a firm rises.

A.
B.
C.
D.
E.
118. M&M Proposition I with tax supports the theory that:

A.
B.
C.
D.
E.

119. M&M Proposition I with taxes is based on the concept

that:

A.
B.
C.
D.
E.

120. M&M Proposition II is the proposition that:

A.
B.
C.
D.
E.

121. The business risk of a firm:

A.
B.
C.
D.
E.
122. Which of the following statements concerning financial
risk are correct?

I. Financial risk is the risk associated with the use of

debt financing.
II. As financial risk increases so too does the cost of
equity.
III. Financial risk is wholly dependent upon the
financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's
operations.

A.
B.
C.
D.
E.

123. The present value of the interest tax shield is expressed

as:

A.
B.
C.
D.
E.

124. The interest tax shield has no value for a firm when:

I. the tax rate is equal to zero.

II. the debt-equity ratio is exactly equal to 1.
III. the firm is unlevered.
IV. a firm elects 100% equity as its capital structure.

A.
B.
C.
D.
E.
125. The interest tax shield is a key reason why:

A.
B.
C.
D.
E.

126. Which of the following will tend to diminish the benefit

of the interest tax shield?

I. a reduction in tax rates

II. a large tax loss carry forward
III. a large depreciation tax deduction
IV. a sizeable increase in taxable income

A.
B.
C.
D.
E.

127. Which one of the following statements concerning

bankruptcy is correct?

A.
B.
C.
D.
E.

128. Indirect bankruptcy costs:

A.
B.
C.
D.
E.
129. When a firm is operating with the optimal capital
structure:

I. the debt-equity ratio will also be optimal.

II. the weighted average cost of capital will be at its
minimal point.
III. the required return on assets will be at its maximum
point.
IV. the increased benefit from additional debt is equal to
the increased bankruptcy costs of that debt.

A.
B.
C.
D.
E.

130. The optimal capital structure will tend to include more

debt for firms with:

A.
B.
C.
D.
E.

131. The optimal capital structure of a firm _____ the

marketed claims and _____ the nonmarketed claims
against the cash flows of the firm.

A.
B.
C.
D.
E.

132. The optimal capital structure:

A.
B.
C.
D.
E.
133. The basic lesson of M&M Theory is that the value of a
firm is dependent upon the:

A.
B.
C.
D.
E.

134. In general, observed capital structures:

A.
B.
C.
D.
E.

135. A firm is technically insolvent when:

A.
B.
C.
D.
E.

136. The static theory of capital structure:

A.
B.
C.
D.
E.

137. The static theory of capital structure supports the theory

that value-maximizing managers will:

A.
B.
C.
D.
E.
138. The cost of capital for a firm which has no debt is
called the _____ cost of capital.

A.
B.
C.
D.
E.

139. A reorganization is defined as:

A.
B.
C.
D.
E.

140. The capital structure of a firm refers to the firm's:

A.
B.
C.
D.
E.

141. M&M Proposition II is the proposition that:

A.
B.
C.
D.
E.

142. The ideal capital structure:

A.
B.
C.
D.
E.
143. Jageman Athletic Apparel has a debt-equity ratio of .4
and earnings before interest and taxes (EBIT) of
$265,000. The break-even level of EBIT is $338,000.
Based on this information, you know the:

A.
B.
C.
D.
E.

144. The use of homemade leverage:

A.
B.
C.
D.
E.

145. Homemade leverage makes which one of the following

irrelevant?

A.
B.
C.
D.
E.

146. The argument(s) that the value of a firm is independent

of the firm's capital structure is presented as:

A.
B.
C.
D.
E.

147. M&M Proposition I with no tax argues that:

A.
B.
C.
D.
E.
148. M&M Proposition II with no tax states that a firm's cost
of equity is dependent upon:

I. the firm's debt-equity ratio.

II. the required rate of return on the firm's assets.
III. the firm's interest tax shield.
IV. the firm's cost of debt financing.

A.
B.
C.
D.
E.

149. M&M Proposition I with tax states that the value of a

levered firm increases as the:

A.
B.
C.
D.
E.

150. M&M Proposition II with tax supports the argument

that a firm's:

A.
B.
C.
D.
E.

151. In general terms, M&M Proposition I deals with the

firm's ____ while M&M Proposition II deals with the
firm's _____.

A.
B.
C.
D.
E.
152. Which of the following are the two component parts of
a firm's cost of equity as illustrated by M&M
Proposition II?

A.
B.
C.
D.
E.

153. As the debt-equity ratio of a firm rises, the:

A.
B.
C.
D.
E.

154. According to M&M Proposition I with taxes, the

interest tax shield:

A.
B.
C.
D.
E.

155. Debt financing in a world of taxes:

I. increases the value of a firm.

II. lowers a firm's cost of equity.
III. creates positive value in the form of an interest tax
shield.
IV. lowers a firm's weighted average cost of capital.

A.
B.
C.
D.
E.
156. Which one of the following statements concerning
bankruptcy is correct?

A.
B.
C.
D.
E.

157. The static theory of capital structure states that the:

A.
B.
C.
D.
E.

158. The optimal capital structure of a firm maximizes the

value of the firm while:

A.
B.
C.
D.
E.

159. Which one of the following statements is correct?

A.
B.
C.
D.
E.

160. Which one of the following receives the highest priority

in the distribution of assets under a bankruptcy
proceeding?

A.
B.
C.
D.
E.
161. An unlevered firm with a market value of $1 million
has 50,000 shares outstanding. The firm restructures
itself by issuing 200 new bonds with face value $1,000
and an 8% coupon. The firm uses the proceeds to
repurchase outstanding stock. In considering the newly
levered versus formerly unlevered firm, what is the
break-even EBIT? Ignore taxes.

A.
B.
C.
D.
E.

162. An investor owns 500 shares of stock in a Montreal

firm with a debt/equity ratio = 1.0. The investor prefers
a debt/equity ratio = 1.5. If the stock price is $2 per
share, what should the investor do?

A.
B.
C.
D.
E.

163. An investor owns 500 shares of stock in a firm with a

debt/equity ratio = 1.0. The investor prefers an all-
equity firm. If the stock price is $2 per share, what
should the investor do?

A.
B.
C.
D.
E.
164. The Brassy Co. has expected EBIT of $910, debt with a
face and market value of $2,000 paying an 8.5% annual
coupon, and an unlevered cost of capital of 12%. If the
tax rate is 34%, what is the value of the Brassy's
equity?

A.
B.
C.
D.
E.

165. What is the cost of equity for a firm where the required
return on assets is 14%, the cost of debt is 11%, and the
target debt/equity ratio is 0.5? Ignore taxes.

A.
B.
C.
D.
E.

166. The unlevered cost of capital for Red Ryder, Inc. is

12%. Pretax debt costs are 8%. Assuming a debt equity
ratio of 0.33, what is the cost of equity? The tax rate is
34%.

A.
B.
C.
D.
E.

167. ABC, Inc. has a debt/equity ratio = 1.2. The firm has a
cost of equity of 12% and a cost of debt of 8%. What
will the cost of equity be if the target debt/equity ratio
increases to 2.0 and the cost of debt does not change?
Ignore taxes.

A.
B.
C.
D.
E.
168. RDJ Inc. has an asset beta of 0.95. Its current capital
structure is 60% debt, 40% equity. What is the firm's
equity beta? Ignore taxes.

A.
B.
C.
D.
E.

169. Suppose a Vancouver firm issues perpetual debt with a

face and market value of $5,000 and a coupon rate of
12%. If the firm is subject to a 40% tax rate and the
appropriate discount rate is 10%, what is the present
value of the interest tax shield?

A.
B.
C.
D.
E.

170. An unlevered firm has after-tax net income = $125,000.

The unlevered cost of capital is 13% and the corporate
tax rate is 34%. What is the value of this firm?

A.
B.
C.
D.
E.

171. A Calgary firm with no debt has 200,000 shares

outstanding valued at $20 each. Its cost of equity is
12%. The firm is considering adding $1 million in debt
to its capital structure. The coupon rate would be 8%
and the bonds would sell for par value. The firm's tax
rate is 34%. How much will the firm be worth after
adding the debt?

A.
B.
C.
D.
E.
172. An unlevered firm has an EBIT = $250,000, after-tax
net income = $165,000, and a cost of capital of 12%. A
levered firm with the same assets and operations has
$1.25 million in face value debt paying an 8% annual
coupon; the debt sells for par value in the marketplace.
What is the value of the levered firm? The tax rate is
34%.

A.
B.
C.
D.
E.

173. The Wrangler Co. has expected EBIT = $9,250, debt

with a face and market value of $14,000 paying a 9%
annual coupon, and an unlevered cost of capital of 12%.
If the tax rate is 39%, what is the value of Wrangler's
equity?

A.
B.
C.
D.
E.

174. The Wrangler Co. has expected EBIT = $9,250, and

debt with a face and market value of $14,000 paying a
9% annual coupon. The market value of the firm is
$58,525. If the tax rate is 34%, what is Wranger's
unlevered cost of capital?

A.
B.
C.
D.
E.
175. A firm has an unlevered cost of capital of 10%, a cost
of debt of 9%, and a tax rate of 34%. If it desires a cost
of equity of 14%, what is its target debt/equity ratio?

A.
B.
C.
D.
E.

176. The Brassy Co. has expected EBIT = $910, an

unlevered cost of capital of 12%, and debt with a face
and market value of $2,000 paying an 8.5% annual
coupon. If the tax rate is 34%, what is the WACC of
Brassy Co.?

A.
B.
C.
D.
E.

177. Given the following, what is the WACC? EBIT = $2

million; tax rate = 34%; market value and book value of
debt = $4 million; unlevered cost of capital = 14%; cost
of debt = 9%.

A.
B.
C.
D.
E.

There are no taxes. EBIT is expected to be $2.5 million,

but could be as high as $3.5 million if an economic
expansion occurs, or as low as $2 million if a recession
occurs. All values are market values.
178. How many shares are outstanding under the proposed
capital structure?

A.
B.
C.
D.
E.

179. What is EPS under the current capital structure if there

is a recession?

A.
B.
C.
D.

180. What is EPS during an expansion for the proposed

capital structure?

A.
B.
C.
D.
E.

181. What is ROE for the proposed capital structure if the

expected state occurs?

A.
B.
C.
D.
E.

182. What is the break-even EPS for these two capital

structures?

A.
B.
C.
D.
E.
 UNLEV has an expected perpetual EBIT = $4,000. The
unlevered cost of capital = 15% and there are 20,000
shares of stock outstanding. The firm is considering
issuing $8,800 in new par bonds to add financial
leverage to the firm. The proceeds of the debt issue will
be used to repurchase equity. The cost of debt = 10%
and the tax rate = 34%. There are no flotation costs.

183. Assume a stockholder owns 1,000 shares of UNLEV

before the restructuring. The stockholder prefers a
debt/equity ratio = 1.0. How could the stockholder use
homemade leverage to achieve the restructuring without
the help of UNLEV? Assume there are no taxes.

A.
B.
C.
D.
E.

184. Assume a stockholder owns 1,000 shares of UNLEV

before the restructuring. Also assume UNLEV's
debt/equity ratio will be 0.493 after the restructuring.
How could the stockholder use homemade leverage to
unlever her investment in the firm after the
restructuring? Assume there are no taxes.

A.
B.
C.
D.
E.

185. If there were no taxes, what would be the value of

UNLEV before the restructuring?

A.
B.
C.
D.
E.
186. Including the effect of taxes, what is the value of
UNLEV before the restructuring?

A.
B.
C.
D.
E.

187. What is the value of UNLEV after the restructuring?

A.
B.
C.
D.
E.

188. What is the value of UNLEV's equity after the

restructuring?

A.
B.
C.
D.
E.

189. What is UNLEV's cost of equity after the

restructuring?

A.
B.
C.
D.
E.
190. The projected EBIT of a firm is $300,000. The firm
currently has 100,000 shares of common stock
outstanding at a value of $18 per share. The firm has no
debt. By how much will the ROE change if the firm
borrows $600,000 at 8% interest and uses the funds to
repurchase shares of stock at the market price? Ignore
taxes.

A.
B.
C.
D.
E.

191. ADA, Inc. currently has 20,000 shares of stock

outstanding at a market value of $40 a share. The firm
is currently 100% financed with equity. ADA is
considering a restructuring which will include issuing
$400,000 of bonds at par value with a coupon rate of
6%. What is the break-even EBIT?

A.
B.
C.
D.
E.

192. A firm has a tax rate of 35%, an unlevered rate of return

of 14%, total debt of $1,000, and an EBIT of $300.00.
What is the unlevered value of the firm?

A.
B.
C.
D.
E.

193. A firm has a 34% tax rate, EBIT of $400, total debt of
$600, and an unlevered value of $1,000. What is the
value of the firm with debt?

A.
B.
C.
D.
E.
194. A firm is worth $1,400, has a 35% tax rate, total debt of
$600, an unlevered return of 15%, and a cost of debt of
9%. What is the cost of equity?

A.
B.
C.
D.
E.

195. A firm has $500 in debt at a cost of 7%, a 34% tax rate,
a total firm value of $1,100, and an unlevered return of
14%. What is the WACC?

A.
B.
C.
D.
E.

196. A firm has a debt-equity ratio of .40, a WACC of 16%,

and a yield-to-maturity on its debt of 13%. Ignoring
taxes, what is the cost of equity?

A.
B.
C.
D.
E.

197. The Addopa Co. has a projected annual EBIT of

$5,000. The company is currently 100% equity financed
with a cost of equity of 14%. The tax rate is 34% and
the cost of debt is 10%. What is the value of the firm if
they borrow $12,000?

A.
B.
C.
D.
E.
198. A firm has 30,000 shares of stock outstanding,
$450,000 in debt at a 9% rate, an EBIT of $112,000,
and a tax rate of 0%. What is the EPS?

A.
B.
C.
D.
E.

199. McMillin Industries is currently 100% equity financed,

has 25,000 shares outstanding at a price of $30 a share,
and produces an annual EBIT of $150,000. The firm is
considering issuing $300,000 of debt and repurchasing
shares. The cost of debt is 12%. Ignore taxes. By how
much will EPS change if the company issues the debt
and EBIT remains constant?

A.
B.
C.
D.
E.

200. Lance owns 200 shares of ABC stock with a current

market value of $10 a share. ABC has an annual EBIT
of $400,000 and a cost of debt of 8%. Currently, ABC is
100% equity financed with 100,000 shares outstanding.
ABC is going to a 25% debt capital structure by issuing
debt and redeeming shares. Ignore taxes. What does
Lance have to do to return his capital structure position
to approximately its original position?

A.
B.
C.
D.
E.
201. A firm has total debt of $900 and total equity of $1,600.
The cost of debt is 10% and the unlevered rate of return
is 13%. The tax rate is 34%. What is the cost of equity?

A.
B.
C.
D.
E.

202. Martha's Grapevines, Inc. has an EBIT of $46,000, no

debt, a 34% tax rate, and a 15% cost of capital. What
will the value of the firm be if Martha's Grapevines
issues $75,000 in debt?

A.
B.
C.
D.
E.

203. The Tee Company has total assets of $20,000 and total
debt of $8,000. The yield-to-maturity on its bonds is
9%. The cost of capital with no debt is 15%. The tax
rate is 34%. What is the WACC?

A.
B.
C.
D.
E.

204. BK Inc. has a cost of debt of 10% and a WACC of 15%.

The debt-equity ratio is .6. The tax rate is 35%. What is
the cost of equity?

A.
B.
C.
D.
E.
205. LKP, Inc. has an unlevered cost of capital of 14%, a
cost of debt of 9%, a 34% tax rate, and an EBIT of
$60,000. The company has $120,000 in total assets, no
accounts payable, and $70,000 in total equity. What is
the value of LKP, Inc.?

A.
B.
C.
D.
E.

206. A firm has earnings per share of $2.12 on 40,000 shares

outstanding. The firm also has $360,000 in debt at a
cost of 9%. Ignore taxes. What is the EBIT?

A.
B.
C.
D.
E.

207. A Winnipeg firm is considering two separate capital

structures. The first is an all equity plan consisting of
25,000 shares of stock. The second plan would consist
of 10,000 shares of stock and $90,000 in debt at a cost
of 8%. Ignore taxes. What is the break-even EBIT?

A.
B.
C.
D.
E.
208. Kate's Dry Goods currently has 15,000 shares of stock
outstanding. Kate would like to reduce the outstanding
shares by one-third by issuing debt and repurchasing
stock. The firm has an EBIT of $8,400 and a cost of
debt of 7%. How much debt does Kate have to issue to
accomplish her goal if she wishes EBIT to remain
constant?

A.
B.
C.
D.
E.

209. JoBo's is a 100% equity financed firm with a tax rate of

34% and a WACC of 13%. The company can borrow
money at a current rate of 8%. EBIT is $24,500
annually. What is the current cost of equity?

A.
B.
C.
D.
E.

210. Blackstone, Inc. is currently an all equity firm that has

65,000 shares of stock outstanding at a market price of
$22 a share. The firm has decided to leverage its
operations by issuing $605,000 of debt at an interest
rate of 6.5%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that Blackstone is expecting? Ignore taxes.

A.
B.
C.
D.
E.
211. Martha White's Fabrics is currently an all equity firm
that has 15,000 shares of stock outstanding at a market
price of $12.50 a share. Company management has
decided to issue $50,000 worth of debt and use the
funds to repurchase shares of the outstanding stock. The
interest rate on the debt will be 9%. What are the
earnings per share at the break-even level of earnings
before interest and taxes? Ignore taxes.

A.
B.
C.
D.
E.

212. You currently own 500 shares in K&S Stores. K&S is

currently an all equity firm that has 25,000 shares of
stock outstanding at a market price of $10 a share. The
company's earnings before interest and taxes are
$20,000. K&S has decided to issue $150,000 of debt at
a 6% rate of interest. This $150,000 will be used to
repurchase shares of stock. How many shares of K&S
stock must you sell to unlever your position if you can
lend out funds at a 6% rate of interest?

A.
B.
C.
D.
E.

213. R&F Enterprises is an all equity firm with 70,000

shares of stock outstanding at a market price of $8 a
share. The company has earnings before interest and
taxes of $42,000. R&F decides to issue $200,000 of
debt at a 7% rate of interest. The $200,000 will be used
to repurchase shares of the outstanding stock. Currently,
you own 1,500 shares of R&F stock. How many shares
of this stock must you sell to unlever your position if
you can loan out funds at a 7% rate of interest?

A.
B.
C.
D.
E.
214. Thompson & Thomson is an all equity firm that has
500,000 shares of stock outstanding. The company is in
the process of borrowing $8 million at 9% interest to
repurchase 200,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

215. Uptown Interior Designs is an all equity firm that has

40,000 shares of stock outstanding. The company has
decided to borrow $1 million to buy out the shares of a
deceased stockholder who holds 2,500 shares. What is
the total value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

216. You own 25% 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 today if you ignore taxes?

A.
B.
C.
D.
E.

217. Your firm has a debt-equity ratio of .75. Your pre-tax

cost of debt is 8.5% and your required return on assets
is 15%. What is your cost of equity if you ignore taxes?

A.
B.
C.
D.
E.
218. Bigelow, Inc. has a cost of equity of 13.56% and a pre-
tax cost of debt of 7%. The required return on the assets
is 11%. What is the firm's debt-equity ratio based on
M&M II with no taxes?

A.
B.
C.
D.
E.

219. The Backwoods Lumber Co. has a debt-equity ratio

of .80. The firm's required return on assets is 12% and
its cost of equity is 15.68%. What is the pre-tax cost of
debt based on M&M II with no taxes?

A.
B.
C.
D.
E.

220. Gail's Dance Studio is currently an all equity firm that

has 80,000 shares of stock outstanding with a market
price of $42 a share. The current cost of equity is 12%
and the tax rate is 34%. Gail is considering adding $1
million of debt with a coupon rate of 8% to her capital
structure. The debt will be sold at par value. What is the
levered value of the equity?

A.
B.
C.
D.
E.
221. The White Hills Co. has expected earnings before
interest and taxes of $8,100, an unlevered cost of
capital of 11%, and debt with both a book and market
value of $12,000. The debt has an annual 8% coupon.
The tax rate is 34%. What is the value of the firm?

A.
B.
C.
D.
E.

222. Scott's Leisure Time Sports is an unlevered firm with an

after-tax net income of $86,000. The unlevered cost of
capital is 10% and the tax rate is 34%. What is the value
of this firm?

A.
B.
C.
D.
E.

223. An unlevered firm has a cost of capital of 14% and

earnings before interest and taxes of $150,000. A
levered firm with the same operations and assets has
both a book value and a market value of debt of
$700,000 with a 7% annual coupon. The applicable tax
rate is 35%. What is the value of the levered firm?

A.
B.
C.
D.
E.

224. The Spartan Co. has an unlevered cost of capital of

11%, a cost of debt of 8%, and a tax rate of 35%. What
is the target debt-equity ratio if the targeted cost of
equity is 12%?

A.
B.
C.
D.
E.
225. Hey Guys!, Inc. has debt with both a book and a market
value of $3,000. This debt has a coupon rate of 7% and
pays interest annually. The expected earnings before
interest and taxes are $1,200, the tax rate is 34%, and
the unlevered cost of capital is 12%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.

226. Walter's Distributors have a cost of equity of 13.84%

and an unlevered cost of capital of 12%. The company
has $5,000 in debt that is selling at par value. The
levered value of the firm is $12,000 and the tax rate is
34%. What is the pre-tax cost of debt?

A.
B.
C.
D.
E.

227. Rosita's has a cost of equity of 13.8% and a pre-tax cost

of debt of 8.5%. The debt-equity ratio is .60 and the tax
rate is .34. What is Rosita's unlevered cost of capital?

A.
B.
C.
D.
E.

228. Your firm has a pre-tax cost of debt of 7% and an

unlevered cost of capital of 13%. Your tax rate is 35%
and your cost of equity is 15.26%. What is your debt-
equity ratio?

A.
B.
C.
D.
E.
229. Wild Flowers Express has a debt-equity ratio of .60.
The pre-tax cost of debt is 9% while the unlevered cost
of capital is 14%. What is the cost of equity if the tax
rate is 34%?

A.
B.
C.
D.
E.

230. Your firm has a $250,000 bond issue outstanding. These

bonds have a 7% coupon, pay interest semiannually,
and have a current market price equal to 103% of face
value. What is the amount of the annual interest tax
shield given a tax rate of 35%?

A.
B.
C.
D.
E.

231. Bertha's Boutique has 2,000 bonds outstanding with a

face value of $1,000 each and a coupon rate of 9%. The
interest is paid semi-annually. What is the amount of
the annual interest tax shield if the tax rate is 34%?

A.
B.
C.
D.
E.

232. Juanita's Steak House has $12,000 of debt outstanding

that is selling at par and has a coupon rate of 8%. The
tax rate is 34%. What is the present value of the tax
shield?

A.
B.
C.
D.
E.
233. A firm has debt of $5,000, equity of $16,000, a
leveraged value of $8,900, a cost of debt of 8%, a cost
of equity of 12%, and a tax rate of 34%. What is the
firm's weighted average cost of capital?

A.
B.
C.
D.
E.

234. Your firm has a debt-equity ratio of .60. Your cost of

equity is 11% and your after-tax cost of debt is 7%.
What will your cost of equity be if the target capital
structure becomes a 50/50 mix of debt and equity?

A.
B.
C.
D.
E.

235. Your firm has earnings before interest and taxes of

$160,000. Both the book and the market value of debt is
$300,000. Your unlevered cost of equity is 12% while
your cost of debt is 8%. The tax rate is 35%. What is
your weighted average cost of capital?

A.
B.
C.
D.
E.
236. Olde Towne Industries is considering both an all equity
and a debt-equity capital structure. The all equity
capital structure would consist of 40,000 shares of
stock. The debt and equity option would consist of
25,000 shares of stock plus $300,000 of debt at an
interest rate of 8%. What is the break-even level of
earnings before interest and taxes between these two
options? Ignore taxes.

A.
B.
C.
D.
E.

237. Roger's Trucking is currently an all equity firm that has

24,000 shares of stock outstanding at a market price of
$50 a share. The firm has decided to leverage its
operations by issuing $280,000 of debt at an interest
rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that Roger's is expecting? Ignore taxes.

A.
B.
C.
D.
E.

238. Angela's Quilt Shop is currently an all equity firm that

has 5,000 shares of stock outstanding at a market price
of $32 a share. Company management has decided to
issue $100,000 worth of debt and use the funds to
repurchase shares of the outstanding stock. The interest
rate on the debt will be 7.5%. What are the earnings per
share at the break-even level of earnings before interest
and taxes? Ignore taxes.

A.
B.
C.
D.
E.
239. Parker & Thomas, Inc., (P&T) currently is an all equity
firm with 20,000 shares of stock outstanding at a
market price of $40 a share. The company's earnings
before interest and taxes are $50,000. The firm's
dividend payout ratio is 100%. P&T has decided to add
leverage to its financial operations by issuing $400,000
of debt at a 9% interest rate. This $400,000 will be used
to repurchase shares of stock. You own 2,500 shares of
P&T stock. You lend funds at a 9% rate of interest.
How many of your shares of stock in P&T must you
sell to offset the leverage that the firm is assuming?
Assume that you loan out all of the funds you receive
from the sale of your stock.

A.
B.
C.
D.
E.

240. You own 400 shares of Kaiser. Kaiser is currently an all

equity firm that has 12,000 shares of stock outstanding
at a market price of $50 a share. The company's
earnings before interest and taxes are $20,000. The
dividend payout ratio is 100%. Kaiser has decided to
issue $100,000 of debt at a 9% rate of interest. This
$100,000 will be used to repurchase shares of stock.
How many shares of Kaiser stock must you sell to
unlever your position if you can loan out funds at a 9%
rate of interest?

A.
B.
C.
D.
E.
241. Jensen Boat Works is an all equity firm that has
340,000 shares of stock outstanding. The company is in
the process of borrowing $4 million at 8% interest to
repurchase 80,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

242. Watson's Feed Mill is an all equity firm that has 20,000
shares of stock outstanding. The company has decided
to borrow $400,000 to buy out the shares of a family
stockholder who holds 1,200 shares. What is the total
value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

243. Your firm has a debt-equity ratio of .60. Your pre-tax

cost of debt is 9% and your required return on assets is
14%. What is your cost of equity if you ignore taxes?

A.
B.
C.
D.
E.

244. Hazardous Wastes, Inc. has a cost of equity of 23.2%

and a pre-tax cost of debt of 10%. The required return
on the assets is 18%. What is the firm's debt-equity
ratio based on M&M II with no taxes?

A.
B.
C.
D.
E.
245. Lucky Day Campgrounds has expected earnings before
interest and taxes of $6,200, an unlevered cost of
capital of 12%, and a tax rate of 35%. The company
also has $24,000 of debt that carries an 8% coupon. The
debt is selling at par value. What is the value of this
firm?

A.
B.
C.
D.
E.

246. Winston's Super Market is currently an all equity firm

that has 120,000 shares of stock outstanding at a market
price of $34.50 a share. The current cost of equity is
11% and the tax rate is 35%. Winston's is considering
adding $1.6 million of debt with a coupon rate of 7.5%
to the capital structure. The debt will be sold at par
value. What is the levered value of the equity?

A.
B.
C.
D.
E.

247. The Coffee Shop has expected earnings before interest

and taxes of $14,600, an unlevered cost of capital of
12%, and debt with both a book and face value of
$18,000. The debt has an annual 8.25% coupon. The tax
rate is 35%. What is the value of the firm?

A.
B.
C.
D.
E.
248. Trudy's Pizza is an unlevered firm with an after-tax net
income of $47,000. The unlevered cost of capital is
7.5% and the tax rate is 35%. What is the value of this
firm?

A.
B.
C.
D.
E.

249. Castle Home Builders has an unlevered cost of capital

of 12%, a cost of debt of 9%, and a tax rate of 34%.
What is the target debt-equity ratio if the targeted cost
of equity is 14%?

A.
B.
C.
D.
E.

250. Al's Pub has debt with both a book and a market value
of $120,000. This debt has a coupon rate of 9% and
pays interest annually. The expected earnings before
interest and taxes are $42,600, the tax rate is 34%, and
the unlevered cost of capital is 11%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.
251. Deitweiler International has an unlevered cost of capital
of 10%, a tax rate of 35%, and expected earnings before
interest and taxes of $26,500. The company has
$40,000 in bonds outstanding that have a 7% coupon
and pay interest annually. The bonds are selling at par
value. What is the cost of equity?

A.
B.
C.
D.
E.

252. Jefferson Electrical Supply has a cost of equity of 12%

and an unlevered cost of capital of 10.5%. The
company has $12,000 in debt that is selling at par value.
The levered value of the firm is $28,000 and the tax rate
is 34%. What is the pre-tax cost of debt?

A.
B.
C.
D.
E.

253. Your firm has a pre-tax cost of debt of 8% and an

unlevered cost of capital of 12.5%. Your tax rate is 35%
and your cost of equity is 14.34%. What is your debt-
equity ratio?

A.
B.
C.
D.
E.
254. Your firm has a $475,000 bond issue outstanding. These
bonds have a 7.5% coupon, pay interest semi-annually,
and have a current market price equal to 99.6% of face
value. What is the amount of the annual interest tax
shield given a tax rate of 34%?

A.
B.
C.
D.
E.

255. Jemison Foods has 6,500 bonds outstanding with a face

value of $1,000 each and a coupon rate of 8%. The
interest is paid semi-annually. What is the amount of
the annual interest tax shield if the tax rate is 35%?

A.
B.
C.
D.
E.

256. China Importers has $267,000 of debt outstanding that

is selling at par and has a coupon rate of 9.5%. The tax
rate is 35%. What is the present value of the tax shield?

A.
B.
C.
D.
E.

257. Your firm has expected earnings before interest and

taxes of $2,400. Your unlevered cost of capital is 12%
and your tax rate is 35%. You have debt with both a
book and a market value of $5,000. This debt has a 7%
coupon and pays interest annually. What is your
weighted average cost of capital?

A.
B.
C.
D.
E.
258. A Mississauga firm has debt of $18,000, equity of
$42,000, a cost of debt of 7.5%, a cost of equity of
11.6%, and a tax rate of 34%. What is the firm's
weighted average cost of capital?

A.
B.
C.
D.
E.

259. Your firm has earnings before interest and taxes of

$210,000. Both the book and the market value of debt is
$500,000. Your unlevered cost of equity is 9% while
your cost of debt is 7%. The tax rate is 35%. What is
your weighted average cost of capital?

A.
B.
C.
D.
E.

260. Juno Industrial Products is debating between a

leveraged and an unleveraged capital structure. The all
equity capital structure would consist of 20,000 shares
of stock. The debt and equity option would consist of
14,000 shares of stock plus $170,000 of debt with an
interest rate of 8%. What is the break-even level of
earnings before interest and taxes between these two
options? Ignore taxes.

A.
B.
C.
D.
E.
261. Lester's Meat Market is currently an all equity firm that
has 24,000 shares of stock outstanding at a market price
of $25 a share. The firm has decided to leverage its
operations by issuing $200,000 of debt at an interest
rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that the firm is expecting? Ignore taxes.

A.
B.
C.
D.
E.

262. The Quilt Shoppe is an all equity firm that has 2,500
shares of stock outstanding at a market price of $20 a
share. Company management has decided to issue
$10,000 worth of debt and use the funds to repurchase
shares of the outstanding stock. The interest rate on the
debt will be 8.5%. What are the earnings per share at
the break-even level of earnings before interest and
taxes? Ignore taxes.

A.
B.
C.
D.
E.
263. Abco is an all equity firm with 32,000 shares of stock
outstanding at a market price of $40 a share. The
company's earnings before interest and taxes are
$92,000. Abco has decided to add leverage to its
financial operations by issuing $220,000 of debt at a
9% rate of interest. The debt will be used to repurchase
shares of stock. You own 600 shares of Abco stock. You
also lend out funds at a 9% rate of interest. How many
shares of Abco stock must you sell to offset the
leverage that Abco is assuming? Assume you lend out
all of the funds you receive from the sale of stock.

A.
B.
C.
D.
E.

264. You currently own 250 shares of Pluto, Inc. Pluto is an

all equity firm that has 36,000 shares of stock
outstanding at a market price of $25 a share. The
company's earnings before interest and taxes are
$48,000. Pluto, Inc. has decided to issue $200,000 of
debt at a 9% rate of interest. This debt will be used to
repurchase shares of stock. How many shares of Pluto,
Inc. stock must you sell to unlever your position if you
can lend out funds at a 9% rate of interest?

A.
B.
C.
D.
E.
265. Clover Fields is an all equity firm with 55,000 shares of
stock outstanding at a market price of $17.50 a share.
The company has earnings before interest and taxes of
$115,500. Clover Fields decides to issue $350,000 of
debt at an 8% rate of interest. The debt will be used to
repurchase shares of the outstanding stock. Currently,
you own 800 shares of Clover Fields stock. How many
shares of this stock must you sell to unlever your
position if you can lend out funds at an 8% rate of
interest?

A.
B.
C.
D.
E.

266. United Landscaping is an all equity firm that has

140,000 shares of stock outstanding. The company is in
the process of borrowing $1.2 million at 8% interest to
repurchase 30,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

267. Frontier Markets is an all equity firm that has 35,000

shares of stock outstanding. The company has decided
to borrow the $35,000 that is needed to repurchase
1,000 shares of stock from the estate of a deceased
shareholder. What is the total value of Frontier Markets
if you ignore taxes?

A.
B.
C.
D.
E.
268. You own 20% of Holiday Travels, 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 $800,000 to
purchase your 500 shares of stock. What is the total
value of Holiday Travels Inc. if you ignore taxes?

A.
B.
C.
D.
E.

269. Marshall's has a debt-equity ratio of .60. The pre-tax

cost of debt is 9.1% and the required return on assets is
14%. What is the cost of equity if you ignore taxes?

A.
B.
C.
D.
E.

270. Thompson Feed has a cost of equity of 11.9% and a

pre-tax cost of debt of 9%. The required return on the
assets is 11%. What is the firm's debt-equity ratio based
on M&M II with no taxes?

A.
B.
C.
D.
E.

271. Lizzie's Kitchen has a debt-equity ratio of .60. The

firm's required return on assets is 11% and its cost of
equity is 14.7%. What is the pre-tax cost of debt based
on M&M II with no taxes?

A.
B.
C.
D.
E.
272. Victoria Dry Goods has expected earnings before
interest and taxes of $14,600, an unlevered cost of
capital of 15%, and a tax rate of 35%. The company
also has $3,500 of debt that carries a 6% coupon. The
debt is selling at par value. What is the value of this
firm?

A.
B.
C.
D.
E.

273. Hanover Tech is currently an all equity firm that has

130,000 shares of stock outstanding with a market price
of $36 a share. The current cost of equity is 14% and
the tax rate is 35%. The firm is considering adding $1.5
million of debt with a coupon rate of 7% to its capital
structure. The debt will be sold at par value. What is the
levered value of the equity?

A.
B.
C.
D.
E.

274. Back Woods Coffee has expected earnings before

interest and taxes of $34,500, an unlevered cost of
capital of 14%, and debt with both a book and face
value of $20,000. The debt has an annual 7% coupon.
The tax rate is 35%. What is the value of the firm?

A.
B.
C.
D.
E.
275. Swedish Imports is an unlevered firm with an after-tax
net income of $79,000. The unlevered cost of capital is
12% and the tax rate is 35%. What is the value of this
firm?

A.
B.
C.
D.
E.

276. An unlevered firm has a cost of capital of 16% and

earnings before interest and taxes of $225,000. A
levered firm with the same operations and assets has
both a book value and a face value of debt of $850,000
with an 8% annual coupon. The applicable tax rate is
34%. What is the value of the levered firm?

A.
B.
C.
D.
E.

277. Salem Mills has an unlevered cost of capital of 14%, a

cost of debt of 9%, and a tax rate of 34%. What is the
target debt-equity ratio if the targeted cost of equity is
16.5%?

A.
B.
C.
D.
E.
278. The Fabric Mill has debt with both a face and a market
value of $6,500. This debt has a coupon rate of 8% and
pays interest annually. The expected earnings before
interest and taxes are $1,400, the tax rate is 35%, and
the unlevered cost of capital is 14%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.

279. Uptown Appliances has an unlevered cost of capital of

14%, a tax rate of 35%, and expected earnings before
interest and taxes of $8,200. The company has $15,000
in bonds outstanding that have a 7.5% coupon and pay
interest annually. The bonds are selling at par value.
What is the cost of equity?

A.
B.
C.
D.
E.

280. The Pizza Palace has a cost of equity of 14.4% and an

unlevered cost of capital of 10%. The company has
$18,000 in debt that is selling at par value. The levered
value of the firm is $32,000 and the tax rate is 35%.
What is the pre-tax cost of debt?

A.
B.
C.
D.
E.
281. The Rose Bush has a cost of equity of 14.5% and a pre-
tax cost of debt of 9%. The debt-equity ratio is .70 and
the tax rate is .35. What is The Rose Bush's unlevered
cost of capital?

A.
B.
C.
D.
E.

282. Glover Tools has a pre-tax cost of debt of 9% and an

unlevered cost of capital of 13.5%. The firm's tax rate is
34% and the cost of equity is 15%. What is the firm's
debt-equity ratio?

A.
B.
C.
D.
E.

283. Prescription Express has a debt-equity ratio of .70. The

pre-tax cost of debt is 8.5% while the unlevered cost of
capital is 15%. What is the cost of equity if the tax rate
is 35%?

A.
B.
C.
D.
E.

284. Webb Street Books has a $130,000 bond issue

outstanding. These bonds have an 8% coupon, pay
interest semiannually, and have a current market price
equal to 101.5% of face value. The tax rate is 35%.
What is the amount of the annual interest tax shield?

A.
B.
C.
D.
E.
285. Sam's Men's Wear has 2,500 bonds outstanding with a
face value of $1,000 each and a coupon rate of 7.5%.
The interest is paid semi-annually. What is the amount
of the annual interest tax shield if the tax rate is 34%?

A.
B.
C.
D.
E.

286. Joe's BBQ Grill has $21,000 of debt outstanding that is

selling at par and has a coupon rate of 6.5%. The tax
rate is 35%. What is the present value of the tax shield?

A.
B.
C.
D.
E.

287. Berkley's has expected earnings before interest and

taxes of $3,800. Its unlevered cost of capital is 14.5%
and its tax rate is 35%. Berkley's has debt with both a
book and a face value of $2,200. This debt has a 7.5%
coupon and pays interest annually. What is the firm's
weighted average cost of capital?

A.
B.
C.
D.
E.

288. A firm has debt of $8,000, a leveraged value of

$18,800, a cost of debt of 8.75%, a cost of equity of
13%, and a tax rate of 35%. What is the firm's weighted
average cost of capital?

A.
B.
C.
D.
E.
289. Exley's Farms has a debt-equity ratio of .75. The cost of
equity is 15% and the after-tax cost of debt is 5.4%.
What will the firm's cost of equity be if the debt-equity
ratio is revised to .60?

A.
B.
C.
D.
E.

290. Thompson & Jones has earnings before interest and

taxes of $149,000. Both the book and the market value
of debt is $265,000. The unlevered cost of equity is
13.5% while the pre-tax cost of debt is 9%. The tax rate
is 34%. What is Thompson & Jones' weighted average
cost of capital?

A.
B.
C.
D.
E.

291. Janess Corporation is an all equity firm with 500,000

shares outstanding. It is considering changing its capital
structure to include debt. If it does, its shares will
reduce to 375,000 and it will incur interest of $200,000.
Given this information, calculate the indifference
EBIT.

A.
B.
C.
D.
E.
292. Klassen Corporation is an all equity firm with 170,000
shares outstanding. It is considering changing its capital
structure to include debt. If it does, its shares will
reduce to 90,000 and it will incur interest of $100,000.
Given this information, calculate the indifference
EBIT.

A.
B.
C.
D.
E.

293. Lombardo Company had net income of $70,000 and

interest expense of $10,000. If the corporate tax rate
was 30%, determine its Degree of Financial Leverage
(DFL).

A.
B.
C.
D.
E.

294. Manchu company had net income of $140,000 and

interest expense of $30,000. If the corporate tax rate
was 30%, determine its Degree of Financial Leverage
(DFL).

A.
B.
C.
D.
E.

295. Bodmore Corporation's EBIT and EPS in the previous

year were $525,000 and $3.23. This year EBIT and EPS
were $750,000 and $5.26. Given this information,
calculate the company's DFL.

A.
B.
C.
D.
E.
296. Due to a prolonged economic downturn, Keely
Corporation's EBIT and EPS in the previous year were
$225,000 and $1.35. This year EBIT and EPS were
$35,000 and $0.70. Given this information, calculate
the company's DFL.

A.
B.
C.
D.
E.

297. Calculate the company's cost of equity given the

following information: return on assets 7.0%; return on
debt 3.25%; 25% debt; 75% equity.

A.
B.
C.
D.
E.

298. Calculate the company's cost of equity given the

following information: return on assets 10.50%; return
on debt 8.75%; total debt $995,000; total equity
$1,520,000.

A.
B.
C.
D.
E.

299. Calculate the company's cost of equity given the

following information: return on assets 13.25%; return
on debt 8.25%; total debt $525,000; total equity
$775,000.

A.
B.
C.
D.
E.
300. Calculate the company's cost of equity given the
following information: return on assets 10.5%; return
on debt 8.75%; total debt $995,000; total equity
$1,520,000. Tax rate 40%.

A.
B.
C.
D.
E.

301. Calculate the company's cost of equity given the

following information: return on assets 6.75%; return
on debt 4.5%; total debt $200,000; total equity
$800,000. Tax rate 35%.

A.
B.
C.
D.
E.

302. Explain homemade leverage and why it matters.

303. Given that rational investors are risk averse, the cost of
debt will generally be lower than the cost of equity;
however, M&M Proposition I states that replacing
equity with debt will not change the value of the firm.
Explain.

304. Describe some of the sources of business risk and

financial risk. Do financial decision makers have the
ability to "trade off" one type of risk for the other?

305. 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 minimize
shareholder costs)?
306. According to the capital structure theories we
examined, a firm benefits by having debt since the
interest expense is deductible for tax purposes, creating
an interest tax shield. The interest tax shield, on the
other hand, increases in value the higher the coupon
rate on the debt and the higher the tax rate. Ignoring
financial distress costs, shouldn't the firm then choose
to pay as high a coupon rate as possible?

307. In a world of corporate taxes only, show that the WACC

can be written as WACC = RU × [1 - TC × (D/V)].

308. Is there an easily identifiable debt/equity ratio that will

maximize the value of a firm? Why or why not?
309. Based on M&M without taxes and with taxes, how
much time should a financial manager spend analyzing
the capital structure of their firm? How about based on
the static theory?

310. Draw the following two graphs, one above the other: In
the top graph, plot firm value on the vertical axis and
total debt on the horizontal. Use the graph to illustrate
the value of a firm under M&M without taxes, M&M
with taxes, and the static theory of capital structure. On
the lower graph, plot the WACC on the vertical axis and
the debt/equity ratio on the horizontal axis. Use the
graph to illustrate the value of the firm's WACC under
M&M without taxes, M&M with taxes, and the static
theory. Briefly explain what the two graphs tell us about
firm value and its cost of capital under the three
different theories.
311. Differentiate between (A) business failure, (B) legal
bankruptcy, (C) technical insolvency, and (D)
accounting insolvency.

312. What are the advantages for a firm using a pre-

packaged bankruptcy? Disadvantages?

313. Explain why the optimal capital structure is one that

maximizes the value of marketed claims and minimizes
the value of nonmarketed claims.
314. Using the variables of total debt and firm value, draw a
graph contrasting M&M Proposition I with taxes with
M&M Proposition I without taxes. Explain the
difference between these two propositions.

315. Using the cost of capital and the debt-equity ratio,

illustrate how the cost of capital for an unlevered firm
varies from the weighted average cost of capital of a
levered firm.

316. Using a graph of firm value against total debt, explain

how M&M Proposition I with taxes differs from the
static theory of capital structure.
 Chapter 16 Financial Leverage and Capital Structure Policy Key
1. All else equal, higher financial leverage decreases a
firm's break-even EBIT.

FALSE
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #1
Type: Concepts

2. Business risk declines as the systematic risk of a firm's

assets increases.

FALSE
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #2
Type: Concepts

3. Business risk is a positive function of the systematic

risk of a firm's assets.

TRUE
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #3
Type: Concepts

4. Ignoring financial distress costs, borrowing money

decreases the value of the firm by increasing the firm's
tax liability.

FALSE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #4
Type: Concepts

5. Suppose we wish to draw a graph illustrating M&M

Proposition II. Let the vertical axis represent the cost of
capital and the firm's debt-to-equity ratio represents the
horizontal axis. If the line representing the firm's
WACC has a negative slope, we must be incorporating
taxes into the analysis.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #5
Type: Concepts
6. Direct bankruptcy costs are those costs that are directly
associated with bankruptcy, such as legal and
administrative costs.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #6
Type: Concepts

7. Indirect bankruptcy costs include the costs of avoiding

a bankruptcy filing incurred by a financially distressed
firm.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #7
Type: Concepts

8. It has been observed that, when firms get into financial

trouble, they often find it difficult to attract and retain
high-quality employees. The additional costs incurred
in this situation would be considered direct bankruptcy
costs.

FALSE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #8
Type: Concepts

9. When a firm files for bankruptcy, the firm often must

hire appraisers to determine the fair value of the firm's
assets. This is an example of a direct cost of
bankruptcy.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #9
Type: Concepts

10. According to the static theory of capital structure,

value-maximizing financial managers will borrow to
the point where the firm's business risk is just equal to
its financial risk.

FALSE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #10
Type: Concepts
11. If the static theory of capital structure is true, then the
optimal level of debt for a given firm increases as its
marginal tax rate increases and decreases as the costs of
financial distress increase.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #11
Type: Concepts

12. In order to avoid bankruptcy, management sometimes

seeks to work with creditors. One method of
restructuring debt involves composition, which involves
a reduction in the amount of the payment to be made.

TRUE
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #12
Type: Concepts

13. The use of personal borrowing to change the overall

amount of financial leverage to which the individual is
exposed is called:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #13
Type: Definitions

14. The proposition that the value of the firm is

independent of its capital structure is called:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #14
Type: Definitions
15. The proposition that the cost of equity is a positive
linear function of capital structure is called:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #15
Type: Definitions

16. The equity risk derived from the firm's operating

activities is called ____________ risk.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #16
Type: Definitions

17. The equity risk derived from the firm's capital structure
policy is called ___________ risk.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #17
Type: Definitions

18. The tax savings of the firm derived from the

deductibility of interest expense is called the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
 Ross - Chapter 16 #18
Type: Definitions

19. The unlevered cost of capital is _________________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #19
Type: Definitions

20. The explicit costs associated with corporate default,

such as legal expenses, are the ________ of the firm.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #20
Type: Definitions

21. The implicit costs associated with corporate default,

such as lost sales, are the __________ of the firm.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #21
Type: Definitions
22. The explicit and implicit costs associated with
corporate default are the ___________ of the firm.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #22
Type: Definitions

23. The proposition that a firm borrows up to the point

where the marginal benefit of the interest tax shield
derived from increased debt is just equal to the marginal
expense of the resulting increase in financial distress
costs is called the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #23
Type: Definitions

24. The legal proceeding for liquidating or reorganizing a

firm operating in default is called a:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #24
Type: Definitions
25. A firm that has negative net worth is said to be:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #25
Type: Definitions

26. The complete termination of the firm as a going

business concern is called a ______________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #26
Type: Definitions

27. The financial restructuring of a failing firm to attempt

to continue operations as a going concern is called a
________________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #27
Type: Definitions

28. A capital restructuring occurs when a firm:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #28
 Type: Definitions

29. The extent to which a firm relies on debt is referred to

as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #29
Type: Definitions

30. The weighted average cost of capital can also be

defined as the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #30
Type: Definitions

31. The cost of equity capital, based on M&M Proposition

II, can be defined as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #31
Type: Definitions
32. The theory that a change in the capital structure weights
is exactly offset by the change in the cost of equity is
known as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #32
Type: Definitions

33. The fact that individual investors can alter the amount
of financial leverage to which they are exposed is
referred to as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #33
Type: Definitions

34. The static theory of capital structure states that firms

borrow up to the point where the tax benefit of one
additional dollar of debt is equal to the marginal cost
of:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #34
Type: Definitions
35. The option of keeping a financially distressed firm as
an operating concern is called a(n):

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #35
Type: Definitions

36. The procedure for liquidating a corporation is outlined

in:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #36
Type: Definitions

37. The absolute priority rule establishes the order in

which:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #37
Type: Definitions

38. Which of the following is true about the WACC?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #38
 Type: Concepts

39. When choosing a capital structure, the objective of the

firm should be to:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #39
Type: Concepts

40. The optimal capital structure is the mixture of debt and

equity which:

I. Maximizes the value of the firm.

II. Minimizes the firm's weighted average cost of
capital.
III. Maximizes the market price of the firm's bonds.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #40
Type: Concepts

41. Which of the following is NOT accurate regarding

financial leverage?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #41
Type: Concepts
42. All else the same, the financial leverage of a firm will
_________________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #42
Type: Concepts

43. Suppose you work for the CFO of Danforth, Inc. He

believes sales and operating income will be sharply
higher each year for the foreseeable future. If he seeks
to maximize earnings per share, he should
_____________. (Assume there are no taxes.)

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #43
Type: Concepts

44. Which of the following statements is/are true regarding

corporate borrowing when EBIT is positive?

I. Increasing financial leverage increases the sensitivity

of EPS and ROE to changes in EBIT
II. The effect of financial leverage depends on the
company's EBIT, that is, leverage is unfavourable when
EBIT is relatively high, and leverage is favourable
when EBIT is relatively low
III. High leverage decreases the returns to shareholders
(as measured by ROE)

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #44
Type: Concepts
45. Which of the following statements regarding leverage is
false?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #45
Type: Concepts

46. Below the break-even EBIT, increased financial

leverage will _______ EPS, all else the same. Assume
there are no taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #46
Type: Concepts

47. All else the same, which of the following claims on the
cash flows of the firm will tend to increase with
decreases in the debt/equity ratio?

I. Taxes
II. Bankruptcy costs
III. Stockholder claims
IV. Bondholder claims

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #47
Type: Concepts
48. Which of the following statements is correct?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #48
Type: Concepts

49. According to _________, the value of the firm is

independent of its capital structure.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #49
Type: Concepts

50. The cost of debt is generally lower than the cost of

equity; however, according to __________, replacing
equity with debt will not change the value of the firm
because the savings attributable to the lower cost of
debt financing will be offset by the higher required
return on the remaining equity.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #50
Type: Concepts
51. _____________ implies that the firm should issue as
much debt as possible.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #51
Type: Concepts

52. According to M&M Proposition II without taxes, a

firm's cost of equity is a function of which of the
following factors?

I. The required rate of return on the firm's assets

II. The firm's debt/equity ratio
III. The firm's cost of debt

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #52
Type: Concepts

53. Assume there are no corporate or personal taxes.

According to M&M Proposition:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #53
Type: Concepts
54. Assume there are no personal or corporate income taxes
and that the firm's WACC is unaffected by its capital
structure. Which of the following is true?

I. A firm's cost of equity depends on the firm's business

and financial risks.
II. The value of the firm is dependent on its capital
structure.
III. The cost of equity increases as the firm's leverage
decreases.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #54
Type: Concepts

55. Which of the following is true concerning the rate of

return earned on shares of a levered firm in terms of the
possible range of earnings? There are no taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #55
Type: Concepts

56. The equity beta of a firm depends on which of the

following?

I. The firm's business risk.

II. The firm's financial policy.
III. The firm's advertising policy.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #56
 Type: Concepts

57. A firm's systematic risk will ____________ as its

debt/equity ratio __________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #57
Type: Concepts

58. __________ arises from decisions that affect the left-

hand side of the balance sheet, while
________________ arises from decisions that affect the
right-hand side of the balance sheet.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #58
Type: Concepts

59. Which of the following correctly completes this

sentence: All else the same, _____________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #59
Type: Concepts
60. All else the same, which of the following is true about
the interest tax shield of a firm with positive EBIT?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #60
Type: Concepts

61. According to ___________, a firm's cost of equity

increases with greater debt financing, but the WACC
remains unchanged.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #61
Type: Concepts

62. According to ___________, a firm's cost of equity

increases with greater debt financing, and the WACC
decreases.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #62
Type: Concepts
63. Which of the following correctly completes the
following: M&M I with taxes shows
___________________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #63
Type: Concepts

64. A firm that is approaching bankruptcy will find that

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #64
Type: Concepts

65. Which of the following is NOT true about bankruptcy

and its costs?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #65
Type: Concepts

66. Which of the following would be considered an indirect

bankruptcy cost?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
 Ross - Chapter 16 #66
Type: Concepts

67. When the value of a firm's assets exactly equals the

value of its debt, the firm:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #67
Type: Concepts

68. According to __________, a firm's cost of equity

increases with greater debt financing, while the WACC
first decreases and then increases.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #68
Type: Concepts

69. According to the static theory of capital structure,

____________________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #69
Type: Concepts
70. Of the following, all are conclusions that can be drawn
from the capital structure puzzle EXCEPT:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #70
Type: Concepts

71. Which of the following individuals has NOT acquired a

marketed claim against RDJ, Inc.?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #71
Type: Concepts

72. Which of the following statements is/are true regarding

observed capital structures?

I. There appears to be some connection between

operating characteristics and capital structure
II. D/E ratios are significantly higher today than they
were in the 1960s.
III. It appears that, for whatever reason, capital
structures vary quite a bit across differing industry
groups

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #72
Type: Concepts
73. In a(n) ______________ a business is liquidated,
usually at a loss for the creditors.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #73
Type: Concepts

74. If a firm fails to make the required interest payments on

its long-term bonds, it is said to be in:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #74
Type: Concepts

75. When a firm defaults on a legal obligation,

___________.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #75
Type: Concepts

76. Of the following, __________ does NOT necessarily

indicate financial distress.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
 Ross - Chapter 16 #76
Type: Concepts

77. You are a secured creditor in a bankruptcy liquidation.

Listed below, in chronological order, are the steps in the
bankruptcy proceeding. Just prior to which step would
you expect to have to document the strength of your
claim on the firm's assets?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #77
Type: Concepts

78. Which of the following describes a correct priority of

claims in a bankruptcy liquidation?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #78
Type: Concepts

79. Which of the following DOES not correctly rank the

priority of claims of the parties to a corporate
bankruptcy? (Rank from strongest to weakest. )

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #79
Type: Concepts
80. Which of the following is true regarding bankruptcy?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #80
Type: Concepts

81. Which of the following are true when a firm is

operating at its target capital structure point?

I. The WACC is at its minimum point.

II. The debt-equity ratio is equal to 1.
III. Shareholder value is maximized.
IV. The total value of the firm is maximized.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #81
Type: Concepts

82. The value of a restructuring is equal to the net present

value of the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #82
Type: Concepts
83. Firm A has a debt-equity ratio of .5. Firm B has a debt-
equity ratio of .8. All other features of these firms are
identical. The return on equity of Firm A is:

A.
B.
C.
D.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #83
Type: Concepts

84. Which one of the following statements concerning

financial leverage is correct in a world without taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #84
Type: Concepts

85. In a world without taxes, M&M Proposition I contends

that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #85
Type: Concepts
86. Which of the following apply to levered firms but not to
unlevered firms?

I. Financial risk
II. Systematic risk
III. Business risk
IV. Interest tax shield

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #86
Type: Concepts

87. M&M Proposition I with taxes states that the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #87
Type: Concepts

88. Which one of the following statements is true?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #88
Type: Concepts
89. Individual investors who lend out part of their personal
funds are in fact:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #89
Type: Concepts

90. Firm A is levered. Firm B is unlevered. In all other

aspects, Firms A and B are identical. There is no
depreciation expense. Considering taxes, Firm A will
have _____ net income and _____ cash flow from
operations than will Firm B.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #90
Type: Concepts

91. Which of the following are indirect costs of

bankruptcy?

I. Loss of key employees

II. Foregone profitable projects due to debt restrictions
III. Loss created by sale of assets which was required to
improve liquidity
IV. Accounting and legal fees incurred in the
bankruptcy process

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #91
Type: Concepts
92. Which one of the following groups is most apt to push a
company towards filing bankruptcy once the firm
becomes financially distressed?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #92
Type: Concepts

93. The cost of bankruptcy:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #93
Type: Concepts

94. Shareholders generally prefer that a distressed firm:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #94
Type: Concepts

95. The optimal firm value is achieved when the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #95
Type: Concepts
96. Which of the following statements concerning the
actual value of a firm are correct?

I. The actual firm value is equal to the M&M

Proposition I with tax value minus the financial distress
costs.
II. The actual value of a firm is equal to the value of the
firm with no debt plus the present value of the tax
shield on debt minus the financial distress costs.
III. The actual value of a firm with debt is generally
greater than the value of a firm without debt.
IV. The maximum value of a firm is at the point where
the additional gain from leverage is just offset by the
additional financial distress cost.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #96
Type: Concepts

97. The interest tax shield has more value when the amount
of debt is _____ and the tax rate is _____.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #97
Type: Concepts
98. Which of the following will affect the optimal level of
debt for a firm?

I. Tax rate
II. Volatility of earnings
III. Nature of assets
IV. Accumulated tax losses

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #98
Type: Concepts

99. According to the absolute priority rule, which one of

the following represents the correct order of
distributions in liquidation, starting with the highest
priority first?

I. Employee wages
II. Government taxes
III. Administrative expenses of the bankruptcy
IV. Unsecured creditors

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #99
Type: Concepts

100. The financial management goal as it pertains to the

capital structure of a firm is to operate at the point
where the debt-equity mix:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #100
 Type: Concepts

101. The proposition that the value of the firm is

independent of its capital structure is called:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #101
Type: Definitions

102. The equity risk derived from a firm's operating

activities is called _____ risk.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #102
Type: Definitions

103. The equity risk derived from a firm's capital structure

policy is called _____ risk.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #103
Type: Definitions
104. The costs of avoiding a bankruptcy filing by a
financially distressed firm are classified as _____
costs.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #104
Type: Definitions

105. The legal proceeding for liquidating or reorganizing a

firm operating in default is called a

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #105
Type: Definitions

106. A firm should select the capital structure which:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #106
Type: Concepts

107. The value of a firm is maximized when the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #107
 Type: Concepts

108. The optimal capital structure has been achieved when

the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #108
Type: Concepts

109. ABC, Inc. is comparing two capital structures to

determine how to best finance the firm's operations.
The first option consists of 100% equity financing. The
second option is based on a debt-equity ratio of .40.
What should ABC do if expected earnings before
interest and taxes (EBIT) are less than the break-even
level? Assume there are no taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #109
Type: Concepts

110. You have computed the break-even point between a

capital structure that has no debt and one that has debt.
Assume there are no taxes. At the break-even level,
the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #110
Type: Concepts
111. Which one of the following statements is correct
concerning the relationship between a capital structure
with debt and one without debt? Assume there are no
taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #111
Type: Concepts

112. Bryan invested in Bryco, Inc. stock when the firm was
financed solely with equity. The firm is now utilizing
debt in its capital structure. To unlever his position,
Bryan needs to:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #112
Type: Concepts

113. The capital structure chosen by a firm doesn't really

matter because of:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #113
Type: Concepts
114. M&M Proposition I with no tax supports the argument
that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #114
Type: Concepts

115. The proposition that the value of a levered firm is equal

to the value of an unlevered firm is known as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #115
Type: Concepts

116. The concept of homemade leverage is most associated

with:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #116
Type: Concepts
117. Which of the following statements are correct in
relation to M&M Proposition II with no taxes?

I. The return on assets is equal to the weighted average

cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of
leverage used by a firm rises.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #117
Type: Concepts

118. M&M Proposition I with tax supports the theory that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #118
Type: Concepts

119. M&M Proposition I with taxes is based on the concept

that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #119
Type: Concepts
120. M&M Proposition II is the proposition that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #120
Type: Concepts

121. The business risk of a firm:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #121
Type: Concepts

122. Which of the following statements concerning financial

risk are correct?

I. Financial risk is the risk associated with the use of

debt financing.
II. As financial risk increases so too does the cost of
equity.
III. Financial risk is wholly dependent upon the
financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's
operations.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #122
Type: Concepts
123. The present value of the interest tax shield is expressed
as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #123
Type: Concepts

124. The interest tax shield has no value for a firm when:

I. the tax rate is equal to zero.

II. the debt-equity ratio is exactly equal to 1.
III. the firm is unlevered.
IV. a firm elects 100% equity as its capital structure.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #124
Type: Concepts

125. The interest tax shield is a key reason why:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #125
Type: Concepts
126. Which of the following will tend to diminish the benefit
of the interest tax shield?

I. a reduction in tax rates

II. a large tax loss carry forward
III. a large depreciation tax deduction
IV. a sizeable increase in taxable income

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #126
Type: Concepts

127. Which one of the following statements concerning

bankruptcy is correct?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #127
Type: Concepts

128. Indirect bankruptcy costs:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #128
Type: Concepts
129. When a firm is operating with the optimal capital
structure:

I. the debt-equity ratio will also be optimal.

II. the weighted average cost of capital will be at its
minimal point.
III. the required return on assets will be at its maximum
point.
IV. the increased benefit from additional debt is equal to
the increased bankruptcy costs of that debt.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #129
Type: Concepts

130. The optimal capital structure will tend to include more

debt for firms with:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #130
Type: Concepts

131. The optimal capital structure of a firm _____ the

marketed claims and _____ the nonmarketed claims
against the cash flows of the firm.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #131
Type: Concepts
132. The optimal capital structure:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #132
Type: Concepts

133. The basic lesson of M&M Theory is that the value of a

firm is dependent upon the:

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #133
Type: Concepts

134. In general, observed capital structures:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #134
Type: Concepts

135. A firm is technically insolvent when:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #135
Type: Concepts
136. The static theory of capital structure:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #136
Type: Concepts

137. The static theory of capital structure supports the theory

that value-maximizing managers will:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #137
Type: Concepts

138. The cost of capital for a firm which has no debt is

called the _____ cost of capital.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #138
Type: Definitions

139. A reorganization is defined as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #139
Type: Definitions
140. The capital structure of a firm refers to the firm's:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #140
Type: Definitions

141. M&M Proposition II is the proposition that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #141
Type: Definitions

142. The ideal capital structure:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #142
Type: Definitions

143. Jageman Athletic Apparel has a debt-equity ratio of .4

and earnings before interest and taxes (EBIT) of
$265,000. The break-even level of EBIT is $338,000.
Based on this information, you know the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #143
 Type: Concepts

144. The use of homemade leverage:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #144
Type: Concepts

145. Homemade leverage makes which one of the following

irrelevant?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #145
Type: Concepts

146. The argument(s) that the value of a firm is independent

of the firm's capital structure is presented as:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #146
Type: Concepts

147. M&M Proposition I with no tax argues that:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #147
 Type: Concepts

148. M&M Proposition II with no tax states that a firm's cost

of equity is dependent upon:

I. the firm's debt-equity ratio.

II. the required rate of return on the firm's assets.
III. the firm's interest tax shield.
IV. the firm's cost of debt financing.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #148
Type: Concepts

149. M&M Proposition I with tax states that the value of a

levered firm increases as the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #149
Type: Concepts

150. M&M Proposition II with tax supports the argument

that a firm's:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #150
Type: Concepts
151. In general terms, M&M Proposition I deals with the
firm's ____ while M&M Proposition II deals with the
firm's _____.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #151
Type: Concepts

152. Which of the following are the two component parts of

a firm's cost of equity as illustrated by M&M
Proposition II?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #152
Type: Concepts

153. As the debt-equity ratio of a firm rises, the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #153
Type: Concepts
154. According to M&M Proposition I with taxes, the
interest tax shield:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #154
Type: Concepts

155. Debt financing in a world of taxes:

I. increases the value of a firm.

II. lowers a firm's cost of equity.
III. creates positive value in the form of an interest tax
shield.
IV. lowers a firm's weighted average cost of capital.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #155
Type: Concepts

156. Which one of the following statements concerning

bankruptcy is correct?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #156
Type: Concepts
157. The static theory of capital structure states that the:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #157
Type: Concepts

158. The optimal capital structure of a firm maximizes the

value of the firm while:

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #158
Type: Concepts

159. Which one of the following statements is correct?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #159
Type: Concepts

160. Which one of the following receives the highest priority

in the distribution of assets under a bankruptcy
proceeding?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #160
 Type: Concepts

161. An unlevered firm with a market value of $1 million

has 50,000 shares outstanding. The firm restructures
itself by issuing 200 new bonds with face value $1,000
and an 8% coupon. The firm uses the proceeds to
repurchase outstanding stock. In considering the newly
levered versus formerly unlevered firm, what is the
break-even EBIT? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #161
Type: Problems

162. An investor owns 500 shares of stock in a Montreal

firm with a debt/equity ratio = 1.0. The investor prefers
a debt/equity ratio = 1.5. If the stock price is $2 per
share, what should the investor do?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #162
Type: Problems

163. An investor owns 500 shares of stock in a firm with a

debt/equity ratio = 1.0. The investor prefers an all-
equity firm. If the stock price is $2 per share, what
should the investor do?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #163
Type: Problems
164. The Brassy Co. has expected EBIT of $910, debt with a
face and market value of $2,000 paying an 8.5% annual
coupon, and an unlevered cost of capital of 12%. If the
tax rate is 34%, what is the value of the Brassy's
equity?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #164
Type: Problems

165. What is the cost of equity for a firm where the required
return on assets is 14%, the cost of debt is 11%, and the
target debt/equity ratio is 0.5? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #165
Type: Problems

166. The unlevered cost of capital for Red Ryder, Inc. is

12%. Pretax debt costs are 8%. Assuming a debt equity
ratio of 0.33, what is the cost of equity? The tax rate is
34%.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #166
Type: Problems
167. ABC, Inc. has a debt/equity ratio = 1.2. The firm has a
cost of equity of 12% and a cost of debt of 8%. What
will the cost of equity be if the target debt/equity ratio
increases to 2.0 and the cost of debt does not change?
Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #167
Type: Problems

168. RDJ Inc. has an asset beta of 0.95. Its current capital
structure is 60% debt, 40% equity. What is the firm's
equity beta? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #168
Type: Problems

169. Suppose a Vancouver firm issues perpetual debt with a

face and market value of $5,000 and a coupon rate of
12%. If the firm is subject to a 40% tax rate and the
appropriate discount rate is 10%, what is the present
value of the interest tax shield?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #169
Type: Problems
170. An unlevered firm has after-tax net income = $125,000.
The unlevered cost of capital is 13% and the corporate
tax rate is 34%. What is the value of this firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #170
Type: Problems

171. A Calgary firm with no debt has 200,000 shares

outstanding valued at $20 each. Its cost of equity is
12%. The firm is considering adding $1 million in debt
to its capital structure. The coupon rate would be 8%
and the bonds would sell for par value. The firm's tax
rate is 34%. How much will the firm be worth after
adding the debt?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #171
Type: Problems

172. An unlevered firm has an EBIT = $250,000, after-tax

net income = $165,000, and a cost of capital of 12%. A
levered firm with the same assets and operations has
$1.25 million in face value debt paying an 8% annual
coupon; the debt sells for par value in the marketplace.
What is the value of the levered firm? The tax rate is
34%.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #172
Type: Problems
173. The Wrangler Co. has expected EBIT = $9,250, debt
with a face and market value of $14,000 paying a 9%
annual coupon, and an unlevered cost of capital of 12%.
If the tax rate is 39%, what is the value of Wrangler's
equity?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #173
Type: Problems

174. The Wrangler Co. has expected EBIT = $9,250, and

debt with a face and market value of $14,000 paying a
9% annual coupon. The market value of the firm is
$58,525. If the tax rate is 34%, what is Wranger's
unlevered cost of capital?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #174
Type: Problems

175. A firm has an unlevered cost of capital of 10%, a cost

of debt of 9%, and a tax rate of 34%. If it desires a cost
of equity of 14%, what is its target debt/equity ratio?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #175
Type: Problems
176. The Brassy Co. has expected EBIT = $910, an
unlevered cost of capital of 12%, and debt with a face
and market value of $2,000 paying an 8.5% annual
coupon. If the tax rate is 34%, what is the WACC of
Brassy Co.?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #176
Type: Problems

177. Given the following, what is the WACC? EBIT = $2

million; tax rate = 34%; market value and book value of
debt = $4 million; unlevered cost of capital = 14%; cost
of debt = 9%.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #177
Type: Problems

There are no taxes. EBIT is expected to be $2.5 million,

but could be as high as $3.5 million if an economic
expansion occurs, or as low as $2 million if a recession
occurs. All values are market values.
Ross - Chapter 16
178. How many shares are outstanding under the proposed
capital structure?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #178
Type: Problems

179. What is EPS under the current capital structure if there

is a recession?

A.
B.
C.
D.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #179
Type: Problems

180. What is EPS during an expansion for the proposed

capital structure?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #180
Type: Problems

181. What is ROE for the proposed capital structure if the

expected state occurs?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #181
 Type: Problems

182. What is the break-even EPS for these two capital

structures?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #182
Type: Problems

UNLEV has an expected perpetual EBIT = $4,000. The

unlevered cost of capital = 15% and there are 20,000
shares of stock outstanding. The firm is considering
issuing $8,800 in new par bonds to add financial
leverage to the firm. The proceeds of the debt issue will
be used to repurchase equity. The cost of debt = 10%
and the tax rate = 34%. There are no flotation costs.
Ross - Chapter 16

183. Assume a stockholder owns 1,000 shares of UNLEV

before the restructuring. The stockholder prefers a
debt/equity ratio = 1.0. How could the stockholder use
homemade leverage to achieve the restructuring without
the help of UNLEV? Assume there are no taxes.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #183
Type: Problems
184. Assume a stockholder owns 1,000 shares of UNLEV
before the restructuring. Also assume UNLEV's
debt/equity ratio will be 0.493 after the restructuring.
How could the stockholder use homemade leverage to
unlever her investment in the firm after the
restructuring? Assume there are no taxes.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #184
Type: Problems

185. If there were no taxes, what would be the value of

UNLEV before the restructuring?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #185
Type: Problems

186. Including the effect of taxes, what is the value of

UNLEV before the restructuring?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #186
Type: Problems
187. What is the value of UNLEV after the restructuring?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #187
Type: Problems

188. What is the value of UNLEV's equity after the

restructuring?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #188
Type: Problems

189. What is UNLEV's cost of equity after the

restructuring?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #189
Type: Problems
190. The projected EBIT of a firm is $300,000. The firm
currently has 100,000 shares of common stock
outstanding at a value of $18 per share. The firm has no
debt. By how much will the ROE change if the firm
borrows $600,000 at 8% interest and uses the funds to
repurchase shares of stock at the market price? Ignore
taxes.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #190
Type: Problems

191. ADA, Inc. currently has 20,000 shares of stock

outstanding at a market value of $40 a share. The firm
is currently 100% financed with equity. ADA is
considering a restructuring which will include issuing
$400,000 of bonds at par value with a coupon rate of
6%. What is the break-even EBIT?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #191
Type: Problems

192. A firm has a tax rate of 35%, an unlevered rate of return

of 14%, total debt of $1,000, and an EBIT of $300.00.
What is the unlevered value of the firm?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #192
Type: Problems
193. A firm has a 34% tax rate, EBIT of $400, total debt of
$600, and an unlevered value of $1,000. What is the
value of the firm with debt?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #193
Type: Problems

194. A firm is worth $1,400, has a 35% tax rate, total debt of
$600, an unlevered return of 15%, and a cost of debt of
9%. What is the cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #194
Type: Problems

195. A firm has $500 in debt at a cost of 7%, a 34% tax rate,
a total firm value of $1,100, and an unlevered return of
14%. What is the WACC?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #195
Type: Problems
196. A firm has a debt-equity ratio of .40, a WACC of 16%,
and a yield-to-maturity on its debt of 13%. Ignoring
taxes, what is the cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #196
Type: Problems

197. The Addopa Co. has a projected annual EBIT of

$5,000. The company is currently 100% equity financed
with a cost of equity of 14%. The tax rate is 34% and
the cost of debt is 10%. What is the value of the firm if
they borrow $12,000?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #197
Type: Problems

198. A firm has 30,000 shares of stock outstanding,

$450,000 in debt at a 9% rate, an EBIT of $112,000,
and a tax rate of 0%. What is the EPS?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #198
Type: Problems
199. McMillin Industries is currently 100% equity financed,
has 25,000 shares outstanding at a price of $30 a share,
and produces an annual EBIT of $150,000. The firm is
considering issuing $300,000 of debt and repurchasing
shares. The cost of debt is 12%. Ignore taxes. By how
much will EPS change if the company issues the debt
and EBIT remains constant?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #199
Type: Problems

200. Lance owns 200 shares of ABC stock with a current

market value of $10 a share. ABC has an annual EBIT
of $400,000 and a cost of debt of 8%. Currently, ABC is
100% equity financed with 100,000 shares outstanding.
ABC is going to a 25% debt capital structure by issuing
debt and redeeming shares. Ignore taxes. What does
Lance have to do to return his capital structure position
to approximately its original position?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #200
Type: Problems

201. A firm has total debt of $900 and total equity of $1,600.
The cost of debt is 10% and the unlevered rate of return
is 13%. The tax rate is 34%. What is the cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #201
Type: Problems
202. Martha's Grapevines, Inc. has an EBIT of $46,000, no
debt, a 34% tax rate, and a 15% cost of capital. What
will the value of the firm be if Martha's Grapevines
issues $75,000 in debt?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #202
Type: Problems

203. The Tee Company has total assets of $20,000 and total
debt of $8,000. The yield-to-maturity on its bonds is
9%. The cost of capital with no debt is 15%. The tax
rate is 34%. What is the WACC?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #203
Type: Problems

204. BK Inc. has a cost of debt of 10% and a WACC of 15%.

The debt-equity ratio is .6. The tax rate is 35%. What is
the cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #204
Type: Problems
205. LKP, Inc. has an unlevered cost of capital of 14%, a
cost of debt of 9%, a 34% tax rate, and an EBIT of
$60,000. The company has $120,000 in total assets, no
accounts payable, and $70,000 in total equity. What is
the value of LKP, Inc.?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #205
Type: Problems

206. A firm has earnings per share of $2.12 on 40,000 shares

outstanding. The firm also has $360,000 in debt at a
cost of 9%. Ignore taxes. What is the EBIT?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #206
Type: Problems

207. A Winnipeg firm is considering two separate capital

structures. The first is an all equity plan consisting of
25,000 shares of stock. The second plan would consist
of 10,000 shares of stock and $90,000 in debt at a cost
of 8%. Ignore taxes. What is the break-even EBIT?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #207
Type: Problems
208. Kate's Dry Goods currently has 15,000 shares of stock
outstanding. Kate would like to reduce the outstanding
shares by one-third by issuing debt and repurchasing
stock. The firm has an EBIT of $8,400 and a cost of
debt of 7%. How much debt does Kate have to issue to
accomplish her goal if she wishes EBIT to remain
constant?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #208
Type: Problems

209. JoBo's is a 100% equity financed firm with a tax rate of

34% and a WACC of 13%. The company can borrow
money at a current rate of 8%. EBIT is $24,500
annually. What is the current cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #209
Type: Problems

210. Blackstone, Inc. is currently an all equity firm that has

65,000 shares of stock outstanding at a market price of
$22 a share. The firm has decided to leverage its
operations by issuing $605,000 of debt at an interest
rate of 6.5%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that Blackstone is expecting? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
 Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #210
Type: Problems

211. Martha White's Fabrics is currently an all equity firm

that has 15,000 shares of stock outstanding at a market
price of $12.50 a share. Company management has
decided to issue $50,000 worth of debt and use the
funds to repurchase shares of the outstanding stock. The
interest rate on the debt will be 9%. What are the
earnings per share at the break-even level of earnings
before interest and taxes? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #211
Type: Problems

212. You currently own 500 shares in K&S Stores. K&S is

currently an all equity firm that has 25,000 shares of
stock outstanding at a market price of $10 a share. The
company's earnings before interest and taxes are
$20,000. K&S has decided to issue $150,000 of debt at
a 6% rate of interest. This $150,000 will be used to
repurchase shares of stock. How many shares of K&S
stock must you sell to unlever your position if you can
lend out funds at a 6% rate of interest?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #212
Type: Problems
213. R&F Enterprises is an all equity firm with 70,000
shares of stock outstanding at a market price of $8 a
share. The company has earnings before interest and
taxes of $42,000. R&F decides to issue $200,000 of
debt at a 7% rate of interest. The $200,000 will be used
to repurchase shares of the outstanding stock. Currently,
you own 1,500 shares of R&F stock. How many shares
of this stock must you sell to unlever your position if
you can loan out funds at a 7% rate of interest?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #213
Type: Problems

214. Thompson & Thomson is an all equity firm that has

500,000 shares of stock outstanding. The company is in
the process of borrowing $8 million at 9% interest to
repurchase 200,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #214
Type: Problems

215. Uptown Interior Designs is an all equity firm that has

40,000 shares of stock outstanding. The company has
decided to borrow $1 million to buy out the shares of a
deceased stockholder who holds 2,500 shares. What is
the total value of this firm if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #215
 Type: Problems

216. You own 25% 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 today if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #216
Type: Problems

217. Your firm has a debt-equity ratio of .75. Your pre-tax

cost of debt is 8.5% and your required return on assets
is 15%. What is your cost of equity if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #217
Type: Problems

218. Bigelow, Inc. has a cost of equity of 13.56% and a pre-

tax cost of debt of 7%. The required return on the assets
is 11%. What is the firm's debt-equity ratio based on
M&M II with no taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #218
Type: Problems
219. The Backwoods Lumber Co. has a debt-equity ratio
of .80. The firm's required return on assets is 12% and
its cost of equity is 15.68%. What is the pre-tax cost of
debt based on M&M II with no taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #219
Type: Problems

220. Gail's Dance Studio is currently an all equity firm that

has 80,000 shares of stock outstanding with a market
price of $42 a share. The current cost of equity is 12%
and the tax rate is 34%. Gail is considering adding $1
million of debt with a coupon rate of 8% to her capital
structure. The debt will be sold at par value. What is the
levered value of the equity?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #220
Type: Problems

221. The White Hills Co. has expected earnings before

interest and taxes of $8,100, an unlevered cost of
capital of 11%, and debt with both a book and market
value of $12,000. The debt has an annual 8% coupon.
The tax rate is 34%. What is the value of the firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #221
Type: Problems
222. Scott's Leisure Time Sports is an unlevered firm with an
after-tax net income of $86,000. The unlevered cost of
capital is 10% and the tax rate is 34%. What is the value
of this firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #222
Type: Problems

223. An unlevered firm has a cost of capital of 14% and

earnings before interest and taxes of $150,000. A
levered firm with the same operations and assets has
both a book value and a market value of debt of
$700,000 with a 7% annual coupon. The applicable tax
rate is 35%. What is the value of the levered firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #223
Type: Problems

224. The Spartan Co. has an unlevered cost of capital of

11%, a cost of debt of 8%, and a tax rate of 35%. What
is the target debt-equity ratio if the targeted cost of
equity is 12%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #224
Type: Problems
225. Hey Guys!, Inc. has debt with both a book and a market
value of $3,000. This debt has a coupon rate of 7% and
pays interest annually. The expected earnings before
interest and taxes are $1,200, the tax rate is 34%, and
the unlevered cost of capital is 12%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #225
Type: Problems

226. Walter's Distributors have a cost of equity of 13.84%

and an unlevered cost of capital of 12%. The company
has $5,000 in debt that is selling at par value. The
levered value of the firm is $12,000 and the tax rate is
34%. What is the pre-tax cost of debt?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #226
Type: Problems

227. Rosita's has a cost of equity of 13.8% and a pre-tax cost

of debt of 8.5%. The debt-equity ratio is .60 and the tax
rate is .34. What is Rosita's unlevered cost of capital?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #227
Type: Problems
228. Your firm has a pre-tax cost of debt of 7% and an
unlevered cost of capital of 13%. Your tax rate is 35%
and your cost of equity is 15.26%. What is your debt-
equity ratio?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #228
Type: Problems

229. Wild Flowers Express has a debt-equity ratio of .60.

The pre-tax cost of debt is 9% while the unlevered cost
of capital is 14%. What is the cost of equity if the tax
rate is 34%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #229
Type: Problems

230. Your firm has a $250,000 bond issue outstanding. These

bonds have a 7% coupon, pay interest semiannually,
and have a current market price equal to 103% of face
value. What is the amount of the annual interest tax
shield given a tax rate of 35%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #230
Type: Problems
231. Bertha's Boutique has 2,000 bonds outstanding with a
face value of $1,000 each and a coupon rate of 9%. The
interest is paid semi-annually. What is the amount of
the annual interest tax shield if the tax rate is 34%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #231
Type: Problems

232. Juanita's Steak House has $12,000 of debt outstanding

that is selling at par and has a coupon rate of 8%. The
tax rate is 34%. What is the present value of the tax
shield?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #232
Type: Problems

233. A firm has debt of $5,000, equity of $16,000, a

leveraged value of $8,900, a cost of debt of 8%, a cost
of equity of 12%, and a tax rate of 34%. What is the
firm's weighted average cost of capital?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #233
Type: Problems
234. Your firm has a debt-equity ratio of .60. Your cost of
equity is 11% and your after-tax cost of debt is 7%.
What will your cost of equity be if the target capital
structure becomes a 50/50 mix of debt and equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #234
Type: Problems

235. Your firm has earnings before interest and taxes of

$160,000. Both the book and the market value of debt is
$300,000. Your unlevered cost of equity is 12% while
your cost of debt is 8%. The tax rate is 35%. What is
your weighted average cost of capital?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #235
Type: Problems

236. Olde Towne Industries is considering both an all equity

and a debt-equity capital structure. The all equity
capital structure would consist of 40,000 shares of
stock. The debt and equity option would consist of
25,000 shares of stock plus $300,000 of debt at an
interest rate of 8%. What is the break-even level of
earnings before interest and taxes between these two
options? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #236
Type: Problems
237. Roger's Trucking is currently an all equity firm that has
24,000 shares of stock outstanding at a market price of
$50 a share. The firm has decided to leverage its
operations by issuing $280,000 of debt at an interest
rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that Roger's is expecting? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #237
Type: Problems

238. Angela's Quilt Shop is currently an all equity firm that

has 5,000 shares of stock outstanding at a market price
of $32 a share. Company management has decided to
issue $100,000 worth of debt and use the funds to
repurchase shares of the outstanding stock. The interest
rate on the debt will be 7.5%. What are the earnings per
share at the break-even level of earnings before interest
and taxes? Ignore taxes.

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #238
Type: Problems
239. Parker & Thomas, Inc., (P&T) currently is an all equity
firm with 20,000 shares of stock outstanding at a
market price of $40 a share. The company's earnings
before interest and taxes are $50,000. The firm's
dividend payout ratio is 100%. P&T has decided to add
leverage to its financial operations by issuing $400,000
of debt at a 9% interest rate. This $400,000 will be used
to repurchase shares of stock. You own 2,500 shares of
P&T stock. You lend funds at a 9% rate of interest.
How many of your shares of stock in P&T must you
sell to offset the leverage that the firm is assuming?
Assume that you loan out all of the funds you receive
from the sale of your stock.

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #239
Type: Problems

240. You own 400 shares of Kaiser. Kaiser is currently an all

equity firm that has 12,000 shares of stock outstanding
at a market price of $50 a share. The company's
earnings before interest and taxes are $20,000. The
dividend payout ratio is 100%. Kaiser has decided to
issue $100,000 of debt at a 9% rate of interest. This
$100,000 will be used to repurchase shares of stock.
How many shares of Kaiser stock must you sell to
unlever your position if you can loan out funds at a 9%
rate of interest?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #240
Type: Problems
241. Jensen Boat Works is an all equity firm that has
340,000 shares of stock outstanding. The company is in
the process of borrowing $4 million at 8% interest to
repurchase 80,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #241
Type: Problems

242. Watson's Feed Mill is an all equity firm that has 20,000
shares of stock outstanding. The company has decided
to borrow $400,000 to buy out the shares of a family
stockholder who holds 1,200 shares. What is the total
value of this firm if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #242
Type: Problems

243. Your firm has a debt-equity ratio of .60. Your pre-tax

cost of debt is 9% and your required return on assets is
14%. What is your cost of equity if you ignore taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #243
Type: Problems
244. Hazardous Wastes, Inc. has a cost of equity of 23.2%
and a pre-tax cost of debt of 10%. The required return
on the assets is 18%. What is the firm's debt-equity
ratio based on M&M II with no taxes?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #244
Type: Problems

245. Lucky Day Campgrounds has expected earnings before

interest and taxes of $6,200, an unlevered cost of
capital of 12%, and a tax rate of 35%. The company
also has $24,000 of debt that carries an 8% coupon. The
debt is selling at par value. What is the value of this
firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #245
Type: Problems

246. Winston's Super Market is currently an all equity firm

that has 120,000 shares of stock outstanding at a market
price of $34.50 a share. The current cost of equity is
11% and the tax rate is 35%. Winston's is considering
adding $1.6 million of debt with a coupon rate of 7.5%
to the capital structure. The debt will be sold at par
value. What is the levered value of the equity?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #246
Type: Problems
247. The Coffee Shop has expected earnings before interest
and taxes of $14,600, an unlevered cost of capital of
12%, and debt with both a book and face value of
$18,000. The debt has an annual 8.25% coupon. The tax
rate is 35%. What is the value of the firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #247
Type: Problems

248. Trudy's Pizza is an unlevered firm with an after-tax net

income of $47,000. The unlevered cost of capital is
7.5% and the tax rate is 35%. What is the value of this
firm?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #248
Type: Problems

249. Castle Home Builders has an unlevered cost of capital

of 12%, a cost of debt of 9%, and a tax rate of 34%.
What is the target debt-equity ratio if the targeted cost
of equity is 14%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #249
Type: Problems
250. Al's Pub has debt with both a book and a market value
of $120,000. This debt has a coupon rate of 9% and
pays interest annually. The expected earnings before
interest and taxes are $42,600, the tax rate is 34%, and
the unlevered cost of capital is 11%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #250
Type: Problems

251. Deitweiler International has an unlevered cost of capital

of 10%, a tax rate of 35%, and expected earnings before
interest and taxes of $26,500. The company has
$40,000 in bonds outstanding that have a 7% coupon
and pay interest annually. The bonds are selling at par
value. What is the cost of equity?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #251
Type: Problems

252. Jefferson Electrical Supply has a cost of equity of 12%

and an unlevered cost of capital of 10.5%. The
company has $12,000 in debt that is selling at par value.
The levered value of the firm is $28,000 and the tax rate
is 34%. What is the pre-tax cost of debt?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #252
Type: Problems
253. Your firm has a pre-tax cost of debt of 8% and an
unlevered cost of capital of 12.5%. Your tax rate is 35%
and your cost of equity is 14.34%. What is your debt-
equity ratio?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #253
Type: Problems

254. Your firm has a $475,000 bond issue outstanding. These

bonds have a 7.5% coupon, pay interest semi-annually,
and have a current market price equal to 99.6% of face
value. What is the amount of the annual interest tax
shield given a tax rate of 34%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #254
Type: Problems

255. Jemison Foods has 6,500 bonds outstanding with a face

value of $1,000 each and a coupon rate of 8%. The
interest is paid semi-annually. What is the amount of
the annual interest tax shield if the tax rate is 35%?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #255
Type: Problems
256. China Importers has $267,000 of debt outstanding that
is selling at par and has a coupon rate of 9.5%. The tax
rate is 35%. What is the present value of the tax shield?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #256
Type: Problems

257. Your firm has expected earnings before interest and

taxes of $2,400. Your unlevered cost of capital is 12%
and your tax rate is 35%. You have debt with both a
book and a market value of $5,000. This debt has a 7%
coupon and pays interest annually. What is your
weighted average cost of capital?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #257
Type: Problems

258. A Mississauga firm has debt of $18,000, equity of

$42,000, a cost of debt of 7.5%, a cost of equity of
11.6%, and a tax rate of 34%. What is the firm's
weighted average cost of capital?

A.
B.
C.
D.
E.
Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #258
Type: Problems
259. Your firm has earnings before interest and taxes of
$210,000. Both the book and the market value of debt is
$500,000. Your unlevered cost of equity is 9% while
your cost of debt is 7%. The tax rate is 35%. What is
your weighted average cost of capital?

A.
B.
C.
D.
E.
Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #259
Type: Problems

260. Juno Industrial Products is debating between a

leveraged and an unleveraged capital structure. The all
equity capital structure would consist of 20,000 shares
of stock. The debt and equity option would consist of
14,000 shares of stock plus $170,000 of debt with an
interest rate of 8%. What is the break-even level of
earnings before interest and taxes between these two
options? Ignore taxes.

A.
B.
C.
D.
E.

EBIT/20,000 = [EBIT - ($170,000 × .08)]/14,000;

14,000EBIT = 20,000EBIT - $272,000,000; EBIT =
$45,333

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #260
Type: Problems
261. Lester's Meat Market is currently an all equity firm that
has 24,000 shares of stock outstanding at a market price
of $25 a share. The firm has decided to leverage its
operations by issuing $200,000 of debt at an interest
rate of 8%. This new debt will be used to repurchase
shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the
minimum level of earnings before interest and taxes
that the firm is expecting? Ignore taxes.

A.
B.
C.
D.
E.

EBIT/24,000 = [EBIT - ($200,000 × .08)]/[24,000 -

($200,000/$25)]; 16,000EBIT = 24,000EBIT -
$384,000,000; EBIT = $48,000

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #261
Type: Problems

262. The Quilt Shoppe is an all equity firm that has 2,500
shares of stock outstanding at a market price of $20 a
share. Company management has decided to issue
$10,000 worth of debt and use the funds to repurchase
shares of the outstanding stock. The interest rate on the
debt will be 8.5%. What are the earnings per share at
the break-even level of earnings before interest and
taxes? Ignore taxes.

A.
B.
C.
D.
E.

Number of shares repurchased = $10,000/$20 = 500;

EBIT/2,500 = [EBIT - ($10,000 × .085)]/(2,500 - 500);
2,000EBIT = 2,500EBIT - $2,125,000; EBIT = $4,250;
EPS = [$4,250 - ($10,000 × .085)]/(2,500 - 500); EPS =
$1.70

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #262
Type: Problems
263. Abco is an all equity firm with 32,000 shares of stock
outstanding at a market price of $40 a share. The
company's earnings before interest and taxes are
$92,000. Abco has decided to add leverage to its
financial operations by issuing $220,000 of debt at a
9% rate of interest. The debt will be used to repurchase
shares of stock. You own 600 shares of Abco stock. You
also lend out funds at a 9% rate of interest. How many
shares of Abco stock must you sell to offset the
leverage that Abco is assuming? Assume you lend out
all of the funds you receive from the sale of stock.

A.
B.
C.
D.
E.

Abco interest = $220,000 × .09 = $19,800

Abco shares repurchased = $220,000/$40 = 5,500
Abco shares outstanding with debt = 32,000 - 5,500 =
26,500Abco EPS, no debt = $92,000/32,000 = $2.875
Abco EPS, with debt = ($92,000 - $19,800)/26,500 =
$2.724528
Your unlevered income from Abco = 600 × $2.875 =
$1,725
Your levered income from Abco = 600 × $2.724528 =
$1,634.7168
Abco value of stock = 26,500 × $40 = $1,060,000
Abco value of debt = $220,000
Abco total value = $1,060,000 + $220,000 =
$1,280,000
Abco weight stock = $1,060,000/$1,280,000 = .828125
Abco weight debt = $220,000/$1,280,000 = .171875
Your initial investment = 600 × $40 = $24,000
Your new stock position = .828125 × $24,000 =
$19,875
Your new number of shares = $19,875/$40 = 496.875
Your new loans = .171875 × $24,000 = $4,125
Your unlevered income = 600 × $2.875 = $1,725
Your levered income = (496.875 × $2.724528) +
($4,125 × .09) = $1,353.74985 + $371.25 = $1,725.00
Number of shares sold = 600 - 496.875 = 103.125 =
103 shares

Difficulty: Challenge
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #263
Type: Problems
264. You currently own 250 shares of Pluto, Inc. Pluto is an
all equity firm that has 36,000 shares of stock
outstanding at a market price of $25 a share. The
company's earnings before interest and taxes are
$48,000. Pluto, Inc. has decided to issue $200,000 of
debt at a 9% rate of interest. This debt will be used to
repurchase shares of stock. How many shares of Pluto,
Inc. stock must you sell to unlever your position if you
can lend out funds at a 9% rate of interest?

A.
B.
C.
D.
E.

Pluto interest = $200,000 × .09 = $18,000

Pluto shares repurchased = $200,000/$25 = 8,000
Pluto shares outstanding with debt = 36,000 - 8,000 =
28,000
Pluto EPS, no debt = $48,000/36,000 = $1.333333
Pluto EPS, with debt = ($48,000 - $18,000)/28,000 =
$1.071429
Your unlevered income from Pluto = 250 × $1.333333
= $333.333333
Your levered income from Pluto = 250 × $1.071429 =
$267.857143
Pluto value of stock = 28,000 × $25 = $700k
Pluto value of debt = $200k
Pluto total value = $700k + $200k = $900k
Pluto weight stock = $700k/$900k = .777778
Pluto weight debt = $200k/$900k = .222222Your initial
investment = 250 × $25 = $6,250
Your new stock position = .777778 × $6,250 =
$4,861.111125
Your new number of shares = $4,861.111125/$25 =
194.444445
Your new loans = .222222 × $6,250 = $1,388.88875
Your unlevered income = 250 × $1.333333 =
$333.333333
Your levered income = (194.444445 × $1.071429) +
($1,388.88875 × .09) = $208.33 + $125.00 = $333.33
Number of shares sold = 250 - 194.444445 = 55.56 =
56 shares

Difficulty: Challenge
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #264
Type: Problems
265. Clover Fields is an all equity firm with 55,000 shares of
stock outstanding at a market price of $17.50 a share.
The company has earnings before interest and taxes of
$115,500. Clover Fields decides to issue $350,000 of
debt at an 8% rate of interest. The debt will be used to
repurchase shares of the outstanding stock. Currently,
you own 800 shares of Clover Fields stock. How many
shares of this stock must you sell to unlever your
position if you can lend out funds at an 8% rate of
interest?

A.
B.
C.
D.
E.

Clover Fields interest = $350,000 × .08 = $28,000

Clover Fields shares repurchased = $350,000/$17.50 =
20,000
Clover Fields shares outstanding with debt = 55,000 -
20,000 = 35,000
Clover Fields EPS, no debt = $115,500/55,000 = $2.10
Clover Fields EPS, with debt = ($115,500 -
$28,000)/35,000 = $2.50
Your unlevered income from Clover Fields = 800 ×
$2.10 = $1,680
Your levered income from Clover Fields = 800 × $2.50
= $2,000
Clover Fields value of stock = 35,000 × $17.50 =
$612,500
Clover Fields value of debt = $350k
Clover Fields total value = $612,500 + $350k =
$962,500
Clover Fields weight stock = $612,500/$962,500
= .636364
Clover Fields weight debt = $350k/$962,500 = .363636
Your initial investment = 800 × $17.50 = $14,000
Your new stock position = .636364 × $14,000 =
$8,909.09
Your new number of shares = $8,909.09/$17.50 =
509.090857
Your new loans = .363636 × $14,000 = $5,090.9096
Your unlevered income = 800 × $.2.10 = $1,680
Your levered income = (509.090857 × $2.50) +
($5090.9096 × .08) = $1,272.73 + $407.27 = $1,680
Number of shares sold = 800 - 509.090857 = 290.91 =
291 shares

Difficulty: Challenge
 Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #265
Type: Problems

266. United Landscaping is an all equity firm that has

140,000 shares of stock outstanding. The company is in
the process of borrowing $1.2 million at 8% interest to
repurchase 30,000 shares of the outstanding stock.
What is the value of this firm if you ignore taxes?

A.
B.
C.
D.
E.

Firm value = 140,000 × ($1.2m/30,000) = $5.6m

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #266
Type: Problems

267. Frontier Markets is an all equity firm that has 35,000

shares of stock outstanding. The company has decided
to borrow the $35,000 that is needed to repurchase
1,000 shares of stock from the estate of a deceased
shareholder. What is the total value of Frontier Markets
if you ignore taxes?

A.
B.
C.
D.
E.

Firm value = 35,000 × ($35,000/1,000) = $1.225m

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #267
Type: Problems
268. You own 20% of Holiday Travels, 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 $800,000 to
purchase your 500 shares of stock. What is the total
value of Holiday Travels Inc. if you ignore taxes?

A.
B.
C.
D.
E.

Firm value = $800,000/.20 = $4m

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #268
Type: Problems

269. Marshall's has a debt-equity ratio of .60. The pre-tax

cost of debt is 9.1% and the required return on assets is
14%. What is the cost of equity if you ignore taxes?

A.
B.
C.
D.
E.

Re = .14 + (.14 - .091) × .60 = .1694 = 16.94%

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #269
Type: Problems
270. Thompson Feed has a cost of equity of 11.9% and a
pre-tax cost of debt of 9%. The required return on the
assets is 11%. What is the firm's debt-equity ratio based
on M&M II with no taxes?

A.
B.
C.
D.
E.

.119 = .11 + (.11 - .09) × D/E; D/E = .45

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #270
Type: Problems

271. Lizzie's Kitchen has a debt-equity ratio of .60. The

firm's required return on assets is 11% and its cost of
equity is 14.7%. What is the pre-tax cost of debt based
on M&M II with no taxes?

A.
B.
C.
D.
E.

.147 = .11 + (.11 - Rd) × .60; Rd = .0483 = 4.83%

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #271
Type: Problems
272. Victoria Dry Goods has expected earnings before
interest and taxes of $14,600, an unlevered cost of
capital of 15%, and a tax rate of 35%. The company
also has $3,500 of debt that carries a 6% coupon. The
debt is selling at par value. What is the value of this
firm?

A.
B.
C.
D.
E.

VU = [$14,600 × (1 - .35)]/.15 = $63,266.67; VL =

$63,266.67 + (.35 × $3,500) = $64,491.67 = $64,492

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #272
Type: Problems

273. Hanover Tech is currently an all equity firm that has

130,000 shares of stock outstanding with a market price
of $36 a share. The current cost of equity is 14% and
the tax rate is 35%. The firm is considering adding $1.5
million of debt with a coupon rate of 7% to its capital
structure. The debt will be sold at par value. What is the
levered value of the equity?

A.
B.
C.
D.
E.

VL = (130,000 × $36) + (.35 × $1.5m) = $4.68m

+ .525m = $5.205m; VE = $5.205m - $1.5m = $3.705m

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #273
Type: Problems
274. Back Woods Coffee has expected earnings before
interest and taxes of $34,500, an unlevered cost of
capital of 14%, and debt with both a book and face
value of $20,000. The debt has an annual 7% coupon.
The tax rate is 35%. What is the value of the firm?

A.
B.
C.
D.
E.

VU = [$34,500 × (1 - .35)]/.14 = $160,178.57; VL =

$160,178.57 + (.35 × $20,000) = $167,179

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #274
Type: Problems

275. Swedish Imports is an unlevered firm with an after-tax

net income of $79,000. The unlevered cost of capital is
12% and the tax rate is 35%. What is the value of this
firm?

A.
B.
C.
D.
E.

VU = $79,000/.12 = $658,333

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #275
Type: Problems
276. An unlevered firm has a cost of capital of 16% and
earnings before interest and taxes of $225,000. A
levered firm with the same operations and assets has
both a book value and a face value of debt of $850,000
with an 8% annual coupon. The applicable tax rate is
34%. What is the value of the levered firm?

A.
B.
C.
D.
E.

VU = [$225,000 × (1 - .34)]/.16 = $928,125; VL =

$928,125 + (.34 × $850k) = $1,217,125

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #276
Type: Problems

277. Salem Mills has an unlevered cost of capital of 14%, a

cost of debt of 9%, and a tax rate of 34%. What is the
target debt-equity ratio if the targeted cost of equity is
16.5%?

A.
B.
C.
D.
E.

.165 = .14 + (.14 - .09) × D/E × (1 - .34); .025

= .033D/E; D/E = .76

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #277
Type: Problems
278. The Fabric Mill has debt with both a face and a market
value of $6,500. This debt has a coupon rate of 8% and
pays interest annually. The expected earnings before
interest and taxes are $1,400, the tax rate is 35%, and
the unlevered cost of capital is 14%. What is the firm's
cost of equity?

A.
B.
C.
D.
E.

VU = [EBIT × (1 - Tc)]/RU = [$1,400 × (1 - .35)]/.14 =

$6,500
VL = VU + (Tc × D) = $6,500 + (.35 × $6,500) = $8,775
VL - VD = VE = $8,775 - $6,500 = $2,275
RE = RU + (RU - RD) × D/E × (1 - TC) = .14 + [(.14 - .08)
× ($6,500/$2,275) × (1 - .35)] = 25.14%

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #278
Type: Problems

279. Uptown Appliances has an unlevered cost of capital of

14%, a tax rate of 35%, and expected earnings before
interest and taxes of $8,200. The company has $15,000
in bonds outstanding that have a 7.5% coupon and pay
interest annually. The bonds are selling at par value.
What is the cost of equity?

A.
B.
C.
D.
E.

VU = [EBIT × (1 - Tc)]/RU = [$8,200 × (1 - .35)]/.14 =

$38,071.43
VL = VU + (Tc × D) = $38,071.43 + (.35 × $15,000) =
$43,321.43
VL - VD = VE = $43,321.43 - $15,000 = $28,321.43
RE = RU + (RU - RD) × D/E × (1 - TC) = .14 + [(.14
- .075) × ($15,000/$28,321.43) × (1 - .35)] = 16.24%

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #279
Type: Problems
280. The Pizza Palace has a cost of equity of 14.4% and an
unlevered cost of capital of 10%. The company has
$18,000 in debt that is selling at par value. The levered
value of the firm is $32,000 and the tax rate is 35%.
What is the pre-tax cost of debt?

A.
B.
C.
D.
E.

.144 = .10 + (.10 - RD) × [$18,000/($32,000 - $18,000)]

× (1 - .35); .044 = .083571 - .835714RD; RD = 4.73%

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #280
Type: Problems

281. The Rose Bush has a cost of equity of 14.5% and a pre-
tax cost of debt of 9%. The debt-equity ratio is .70 and
the tax rate is .35. What is The Rose Bush's unlevered
cost of capital?

A.
B.
C.
D.
E.

.145 = RU + (RU - .09) × .70 × (1 - .35); .18595 =

1.455RU; RU = 12.78%

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #281
Type: Problems
282. Glover Tools has a pre-tax cost of debt of 9% and an
unlevered cost of capital of 13.5%. The firm's tax rate is
34% and the cost of equity is 15%. What is the firm's
debt-equity ratio?

A.
B.
C.
D.
E.

.15 = .135 + (.135 - .09) × D/E × (1 - .34); .015

= .0297D/E; D/E =.51

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #282
Type: Problems

283. Prescription Express has a debt-equity ratio of .70. The

pre-tax cost of debt is 8.5% while the unlevered cost of
capital is 15%. What is the cost of equity if the tax rate
is 35%?

A.
B.
C.
D.
E.

RE = .15 + (.15 - .085) × .70 × (1 - .35) = 17.96%

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #283
Type: Problems
284. Webb Street Books has a $130,000 bond issue
outstanding. These bonds have an 8% coupon, pay
interest semiannually, and have a current market price
equal to 101.5% of face value. The tax rate is 35%.
What is the amount of the annual interest tax shield?

A.
B.
C.
D.
E.

Annual interest tax shield = $130,000 × .08 × .35 =

$3,640

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #284
Type: Problems

285. Sam's Men's Wear has 2,500 bonds outstanding with a

face value of $1,000 each and a coupon rate of 7.5%.
The interest is paid semi-annually. What is the amount
of the annual interest tax shield if the tax rate is 34%?

A.
B.
C.
D.
E.

Annual interest tax shield = 2,500 × $1,000 × .075 × .34

= $63,750

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #285
Type: Problems
286. Joe's BBQ Grill has $21,000 of debt outstanding that is
selling at par and has a coupon rate of 6.5%. The tax
rate is 35%. What is the present value of the tax shield?

A.
B.
C.
D.
E.

Present value of the tax shield = .35 × $21,000 = $7,350

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #286
Type: Problems

287. Berkley's has expected earnings before interest and

taxes of $3,800. Its unlevered cost of capital is 14.5%
and its tax rate is 35%. Berkley's has debt with both a
book and a face value of $2,200. This debt has a 7.5%
coupon and pays interest annually. What is the firm's
weighted average cost of capital?

A.
B.
C.
D.
E.

VU = [$3,800 × (1 - .35)]/.145 = $17,034.48

VL = $17,034.48 + (.35 × $2,200) = $17,804.48
VE = VL - VD = $17,804.48 - $2,200 = $15,604.48
RE = .145 + (.145 - .075) × ($2,200/$15,604.48) × (1
- .35) = .1514148
WACC = [($15,604.48/$17,804.48) × .1514148] +
[($2,200/$17,804.48) × .075 × (1 - .35)] = 13.87%

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #287
Type: Problems
288. A firm has debt of $8,000, a leveraged value of
$18,800, a cost of debt of 8.75%, a cost of equity of
13%, and a tax rate of 35%. What is the firm's weighted
average cost of capital?

A.
B.
C.
D.
E.

WACC = {[($18,800 - $8,000)/$18,800] × .13} +

($8,000/$18,800) × .0875 × (1 - .35) = 9.89%

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #288
Type: Problems

289. Exley's Farms has a debt-equity ratio of .75. The cost of

equity is 15% and the after-tax cost of debt is 5.4%.
What will the firm's cost of equity be if the debt-equity
ratio is revised to .60?

A.
B.
C.
D.
E.

WACC = [(1.0/1.75) × .15] + [(.75/1.75) × .054]

= .108857; .108857 = [(1.0/1.60) × RE] + (.60/1.60)
× .054; RE = 14.18%

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #289
Type: Problems
290. Thompson & Jones has earnings before interest and
taxes of $149,000. Both the book and the market value
of debt is $265,000. The unlevered cost of equity is
13.5% while the pre-tax cost of debt is 9%. The tax rate
is 34%. What is Thompson & Jones' weighted average
cost of capital?

A.
B.
C.
D.
E.

VU = [$149,000 × (1 - .34)]/.135 = $728,444.44

VL = $728,444.44 + (.34 × $265k) = $818,544.44
VE = VL - VD = $818,544.44 - $265k = $553,544.44
RE = .135 + (.135 - .09) × ($265k/$553,544.44) × (1
- .34) = .149218
WACC = [($553,544.44/$818,544.44) × .149218] +
[($265k/$818,544.44) × .09 × (1 - .34)] = 12.01%

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #290
Type: Problems
291. Janess Corporation is an all equity firm with 500,000
shares outstanding. It is considering changing its capital
structure to include debt. If it does, its shares will
reduce to 375,000 and it will incur interest of $200,000.
Given this information, calculate the indifference
EBIT.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #291
Type: Problems
292. Klassen Corporation is an all equity firm with 170,000
shares outstanding. It is considering changing its capital
structure to include debt. If it does, its shares will
reduce to 90,000 and it will incur interest of $100,000.
Given this information, calculate the indifference
EBIT.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #292
Type: Problems
293. Lombardo Company had net income of $70,000 and
interest expense of $10,000. If the corporate tax rate
was 30%, determine its Degree of Financial Leverage
(DFL).

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #293
Type: Problems
294. Manchu company had net income of $140,000 and
interest expense of $30,000. If the corporate tax rate
was 30%, determine its Degree of Financial Leverage
(DFL).

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #294
Type: Problems
295. Bodmore Corporation's EBIT and EPS in the previous
year were $525,000 and $3.23. This year EBIT and EPS
were $750,000 and $5.26. Given this information,
calculate the company's DFL.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #295
Type: Problems
296. Due to a prolonged economic downturn, Keely
Corporation's EBIT and EPS in the previous year were
$225,000 and $1.35. This year EBIT and EPS were
$35,000 and $0.70. Given this information, calculate
the company's DFL.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #296
Type: Problems
297. Calculate the company's cost of equity given the
following information: return on assets 7.0%; return on
debt 3.25%; 25% debt; 75% equity.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #297
Type: Problems
298. Calculate the company's cost of equity given the
following information: return on assets 10.50%; return
on debt 8.75%; total debt $995,000; total equity
$1,520,000.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #298
Type: Problems
299. Calculate the company's cost of equity given the
following information: return on assets 13.25%; return
on debt 8.25%; total debt $525,000; total equity
$775,000.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #299
Type: Problems
300. Calculate the company's cost of equity given the
following information: return on assets 10.5%; return
on debt 8.75%; total debt $995,000; total equity
$1,520,000. Tax rate 40%.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #300
Type: Problems
301. Calculate the company's cost of equity given the
following information: return on assets 6.75%; return
on debt 4.5%; total debt $200,000; total equity
$800,000. Tax rate 35%.

A.
B.
C.
D.
E.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #301
Type: Problems

302. Explain homemade leverage and why it matters.

Homemade leverage is the ability of investors to alter

their own financial leverage to achieve a desired capital
structure no matter the firm's capital structure choice. If
investors can use homemade leverage to create
additional leverage or to undo existing leverage of the
firm at their discretion, then the actual capital structure
decision of the firm itself becomes irrelevant.

Difficulty: Intermediate
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #302
Type: Essay
303. Given that rational investors are risk averse, the cost of
debt will generally be lower than the cost of equity;
however, M&M Proposition I states that replacing
equity with debt will not change the value of the firm.
Explain.

The student is asked to demonstrate his/her

understanding of the basic M&M model. The astute
student will recognize that, in terms of logical
consistency, M&M is "bulletproof"; i.e., given the
assumptions, you will arrive at M&M's conclusions --
period. Second, no one believes that the Case I model
accurately describes reality; rather, it provides a
jumping off point from which we can readily assess the
importance of market "imperfections" such as taxes,
bankruptcy costs, etc. One would hope that the
responses to this question reflect these aspects of the
issue, as well as the basic mechanics involved.

Difficulty: Challenge
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #303
Type: Essay

304. Describe some of the sources of business risk and

financial risk. Do financial decision makers have the
ability to "trade off" one type of risk for the other?

Students should intuitively recognize that some of the

observed variation in capital structures across
industries, for example, reflect differences in the nature
of the industries themselves; i.e., business risk.
Similarly, intuition would suggest that firms with large
capital requirements and stable cash flows (e.g., electric
utilities) are more likely to be willing to raise funds via
large amounts of borrowing. Alternatively, firms with
lower tangible asset needs and highly uncertain cash
flows (e.g., small software companies) are more likely
to employ equity.

Difficulty: Challenge
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #304
Type: Essay
305. 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 minimize
shareholder costs)?

This question requires students to differentiate between

the cost of equity and the weighted average cost of
capital. In fact, it gets to the essence of capital structure
theory: the firm trades off higher equity costs for lower
debt costs. The shareholders benefit (to a point,
according to the static theory) because their investment
in the firm is leveraged, enhancing the return on their
investment. Thus, even though the cost of equity rises,
the overall cost of capital declines (again, up to a point
according to the static theory) and firm value rises.

Difficulty: Challenge
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #305
Type: Essay

306. According to the capital structure theories we

examined, a firm benefits by having debt since the
interest expense is deductible for tax purposes, creating
an interest tax shield. The interest tax shield, on the
other hand, increases in value the higher the coupon
rate on the debt and the higher the tax rate. Ignoring
financial distress costs, shouldn't the firm then choose
to pay as high a coupon rate as possible?

This odd question challenges the students to

differentiate between tax benefits and after-tax costs.
The interest tax shield measures the benefits of having
debt, but ignores the cost side. What matters to the firm
is the WACC, which is minimized by adding low-cost
debt to the mix. As debt costs rise, the after-tax cost of
debt rises, the WACC rises, and the benefits of debt
decline.

Difficulty: Challenge
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #306
Type: Essay
307. In a world of corporate taxes only, show that the WACC
can be written as WACC = RU × [1 - TC × (D/V)].

The student will need to use the M&M propositions to

derive the WACC. The student should begin with:

RE = RU + (RU - RD) × D/E × (1 - TC)

RA = RE × E/V + RD × D/V × (1 - TC) = WACC
From there, substituting RE into the RA equation leads
to the final answer.

Difficulty: Challenge
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #307
Type: Essay

308. Is there an easily identifiable debt/equity ratio that will

maximize the value of a firm? Why or why not?

Students should explain that in a world with taxes,

transaction costs, and financial distress costs, there are
both benefits and costs to higher debt loads, and there is
no way to target exactly what the ideal capital structure
should be.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #308
Type: Essay
309. Based on M&M without taxes and with taxes, how
much time should a financial manager spend analyzing
the capital structure of their firm? How about based on
the static theory?

Under either M&M scenario, the financial manager

should invest no time in analyzing the firm's capital
structure. With no taxes, capital structure is irrelevant.
With taxes, M&M says a firm will maximize its value
by using 100% debt. In both cases, the manager has
nothing to decide. With the static theory, however, the
manager decides the optimal amount of debt and equity
by analyzing the tradeoff between the benefits of the
interest tax shield versus financial distress costs.
Ultimately, finding the optimal capital structure is
challenging in this case.

Difficulty: Challenge
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #309
Type: Essay

310. Draw the following two graphs, one above the other: In
the top graph, plot firm value on the vertical axis and
total debt on the horizontal. Use the graph to illustrate
the value of a firm under M&M without taxes, M&M
with taxes, and the static theory of capital structure. On
the lower graph, plot the WACC on the vertical axis and
the debt/equity ratio on the horizontal axis. Use the
graph to illustrate the value of the firm's WACC under
M&M without taxes, M&M with taxes, and the static
theory. Briefly explain what the two graphs tell us about
firm value and its cost of capital under the three
different theories.

The student should replicate and explain Figure 16.8

from the text.

Difficulty: Challenge
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #310
Type: Essay
311. Differentiate between (A) business failure, (B) legal
bankruptcy, (C) technical insolvency, and (D)
accounting insolvency.

This a straightforward question requiring the student to

know and understand the terminology in section 16.9.

Difficulty: Intermediate
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #311
Type: Essay

312. What are the advantages for a firm using a pre-

packaged bankruptcy? Disadvantages?

A prepack allows a firm to minimize its stay in

bankruptcy court, and should allow the firm to
minimize its bankruptcy costs as well. In either case,
management is freed up to spend time on more
productive tasks, such as operating the firm. The
negative side of a prepack is a little more difficult to
discern. Astute students will recognize that prepacks
take time to negotiate, that is, they may save time
during bankruptcy, but they likely take more time up
front than a straight bankruptcy filing. Furthermore, it is
also likely that the firm must give creditors a better deal
in order to get them to sign on to the bankruptcy
agreement. If so, the firm may actually get better terms
from its creditors by going through with a full
bankruptcy process.

Difficulty: Challenge
Learning Objective: 16-03 The essentials of the bankruptcy process.
Ross - Chapter 16 #312
Type: Essay
313. Explain why the optimal capital structure is one that
maximizes the value of marketed claims and minimizes
the value of nonmarketed claims.

Marketed claims are claims the bondholders and

shareholders have on a firm. Nonmarketed claims
include taxes, bankruptcy costs, and other similar items.
The optimal capital structure should ensure full
payment of debt in a timely manner and provide the
maximum return for shareholders. Nonmarketed claims
reduce the return to shareholders and thus, should be
minimized.

Difficulty: Intermediate
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #313
Type: Essay

314. Using the variables of total debt and firm value, draw a
graph contrasting M&M Proposition I with taxes with
M&M Proposition I without taxes. Explain the
difference between these two propositions.

Students should duplicate Figure 16.4 from the

textbook. M&M Proposition I without taxes states that
the value of an unlevered firm is equal to the value of a
levered firm. M&M Proposition I with taxes states that
the value of a levered firm is equal to the value of an
unlevered firm plus the present value of the interest tax
shield. The difference between the two propositions is
the present value of the interest tax shield.

Difficulty: Basic
Learning Objective: 16-01 The effect of financial leverage on firm value and cost of capital.
Ross - Chapter 16 #314
Type: Essay
315. Using the cost of capital and the debt-equity ratio,
illustrate how the cost of capital for an unlevered firm
varies from the weighted average cost of capital of a
levered firm.

Students should duplicate Figure 16.5 from the

textbook. The unlevered cost of capital is constant. The
weighted average cost of capital declines as the debt-
equity ratio rises from zero.

Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #315
Type: Essay

316. Using a graph of firm value against total debt, explain

how M&M Proposition I with taxes differs from the
static theory of capital structure.

Students should duplicate the graph in Figure 16.6 from

the textbook. M&M Proposition I with taxes depicts the
value of a firm as a linear function with an upward
slope. The value of the firm according to the static
theory is dome-shaped such that the value rises up to a
point and thereafter if the debt level rises, the value of
the firm declines.

Difficulty: Basic
Learning Objective: 16-02 The impact of taxes and bankruptcy on capital structure choice.
Ross - Chapter 16 #316
Type: Essay
Chapter 16 Financial Leverage and Capital Structure Policy
Summary