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Exam 26: Analysis of Capital Structure Theory

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Question 21

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Which of the following statements concerning the MM extension with growth is NOT CORRECT?

A) The tax shields should be discounted at the unlevered cost of equity.
B) The value of a growing tax shield is greater than the value of a constant tax shield.
C) For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
D) For a given D/S, the WACC is less than the WACC under MM's original (with tax) assumptions.
E) The total value of the firm increases with the amount of debt.

F) B) and D)
G) None of the above

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Question 22

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Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

A) True
B) False

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Question 23

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(The following data apply to Problems 29 through 31. The problems MUST be kept together.) Trumbull, Inc., has total value (debt plus equity) of $500 million and $200 million face value of 1-year zero coupon debt. The volatility () of Trumbull's total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and N(d2) = 0.9050. -What is the value (in millions) of Trumbull's equity if it is viewed as an option?

Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L's cost of equity?

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

The MM model is the same as the Miller model, but with zero corporate taxes.

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

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

(The following data apply to Problems 23 through 25. The problems MUST be kept together.) The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -What is the firm's cost of equity?

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

What is the value (in millions) of Trumbull's debt if its equity is viewed as an option?