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# Value of firm if it borrows funds to repurchase shares

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M.G. Movers can borrow at 7.5 percent. The firm currently has no debt, and the cost of equity is 16 percent. The current value of the firm is \$540,000. What will the value be if the firm borrows \$160,000 and uses the proceeds to repurchase shares? The corporate tax rate is 34 percent.

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Value of a levered firm = Value unlevered + PV of interest tax ...

#### Solution Summary

The solution explains how to determine the value of firm if it borrows funds to repurchase shares

\$2.19

## Multiple Choice Questions: optimal capital structure, financial leverage, debt-equity ratio, financial risk, bankruptcy, M&M Proposition I, M&M Proposition II, static theory of capital structure, EPS, break-even level of earnings before interest and taxes, dividend income, cost of equity, tax shield, levered value of the firm, value of the unlevered firm, cost of debt

Question 21
21. A firm's optimal capital structure:
d. is the debt-equity ratio that results in the lowest possible weighted average cost of capital.
a. is generally a mix of 40 percent debt and 60 percent equity.
e. is found by locating the mix of debt and equity which causes the earnings per share to equal exactly \$1.
b. exists when the debt-equity ratio is .50.
c. is the debt-equity ratio that exists at the point where the firm's weighted after tax cost of debt is minimized.

Question 22
22. Which one of the following statements concerning financial leverage is correct?
c. If a firm employs financial leverage, the shareholders will be exposed to greater risk.
b. A firm employing leverage will always have a higher earnings per share than a firm which does not employ leverage.
e. Financial leverage is always beneficial to a firm when the interest rate on the debt is less than 10 percent.
a. The benefits of leverage are unaffected by changes in a firm's earnings before interest and taxes.
d. The earnings per share remain constant even when an all-equity firm switches to a debt-equity ratio of .4.

Question 23
23. Less Debt, Inc., just revised its capital structure such that the firm's debt-equity ratio decreased from .80 to .40. Those individual investors who prefer the old capital structure:
e. can replicate that structure by reducing their debt and doubling their investment in the firm.
a. should sell half of their equity holdings and invest in cash.
c. should loan out funds equivalent to the amount invested in Less Debt.
b. should sell half of their equity holdings and loan out the net proceeds of the sale.
d. can replicate that structure by increasing their use of homemade leverage.

Question 24
24. M&M Proposition I, without taxes, states that:
c. firms should borrow to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress.
e. financial risk is determined by the debt-equity ratio.
b. the weighted average cost of capital is constant.
a. the cost of equity rises when financial leverage rises.
d. it is completely irrelevant how a firm arranges its finances.

Question 25
25. According to M&M Proposition II, without taxes, the cost of equity depends on the firm's: (I. earnings before interest and taxes; II. cost of debt; III. debt-equity ratio; IV. required rate of return on its assets)
d. I, III, and IV only
a. I and II only
c. I, II, and IV only
b. II, III, and IV only
e. I, II, III, and IV

Question 26
26. Financial risk:
c. increases as the left-hand side of a firm's balance sheet changes.
d. increases as a firm's debt-equity ratio increases.
b. increases as the risk of a firm's new projects increases.
a. determines the required return on a firm's assets.
e. represents the entire increase in a firm's systematic risk.

Question 27
27. Which of the following statements correctly relate to M&M Proposition I, with taxes? (I. Debt financing is advantageous to a firm; II. The value of a firm unlevered is greater than the value levered; III. The weighted average cost of capital (WACC) is constant; IV. The financial structure of a firm is completely irrelevant)
b. III only
a. I only
e. I, III, and IV only
d. I and II only
c. III and IV only

Question 28
28. The maximum firm value, according to the static theory of capital structure, occurs at a point where the:
a. value of a levered firm initially begins to exceed that of an unlevered firm.
e. value of the firm equalizes the costs of financial distress with the present value of the tax shield on debt.
c. value of the firm is equal to the value defined by M&M Proposition I, with tax.
b. financial distress costs are equal to zero.
d. value of the firm, as defined by M&M Proposition I, with tax, is exactly equal to the value of the firm, as defined by M&M Proposition I, without tax.

Question 29
29. Which of the following are correct assumptions based on the static theory of capital structure? (I. There is a direct relationship between the amount of benefit a firm realizes from leverage and the amount of the annual depreciation expense; II. There is an inverse relationship between the amount that a firm should borrow and the volatility of its earnings before interest and taxes (EBIT); III. The costs of financial distress are unrelated to a firm's assets; IV. The higher a firm's tax rate, the greater the firm's incentive to borrow)
a. I and II only
d. II and IV only
c. II and III only
b. I and III only
e. I and II only

Question 30
30. Which one of the following statements is true concerning a bankruptcy?
a. A Chapter 7 bankruptcy is a reorganization.
b. A federal judge has the authority to deny a Chapter 11 bankruptcy petition filed by a firm.
e. New equity securities must be issued if a firm undergoes a Chapter 11 bankruptcy.
c. The absolute priority rule must be followed in both Chapter 7 and Chapter 11 bankruptcies.
d. Only a firm can file a bankruptcy petition.

Question 31
31. Donaldsen International is an all-equity firm with a total market value of \$120,000. The firm has 10,000 shares of stock outstanding. Management is considering issuing \$50,000 of debt at an interest rate of 6.5 percent and using the proceeds on a stock repurchase. It is expected that the company will have earnings before interest and taxes (EBIT) of \$22,000 if the economy is normal, \$12,000 if it is in recession, and \$30,000 if the economy booms. Ignore taxes. The earnings per share (EPS) will decrease by ____ if the economy goes into a recession rather than being normal as it is currently. Assume that the firm maintains its all-equity status.
e. 54.5 percent
a. 39.4 percent
d. 45.5 percent
b. 41.6 percent
c. 42.0 percent

Question 32
32. Blue & Co. is an all-equity firm with a total market value of \$230,000. The firm has 25,000 shares of stock outstanding. Management is considering issuing \$100,000 of debt at an interest rate of 7 percent and using the proceeds to repurchase shares. Management estimates that the economy will be fairly normal and thus the firm's earnings before interest and taxes (EBIT) will be \$60,000. Ignore taxes. What is the anticipated earnings per share (EPS) if the debt is issued?
b. \$3.46
a. \$3.20
c. \$3.54
e. \$3.82
d. \$3.75

Question 33
33. Master Cylinders has 15,000 shares of stock outstanding and no debt as the original founder of the firm did not approve of debt financing. The new CEO is considering issuing \$250,000 of debt and using the proceeds to retire 5,000 shares of stock. The interest rate on debt is 7.5 percent. What is the break-even level of earnings before interest and taxes (EBIT) between these two capital structure options?
e. \$59,250
a. \$38,500
c. \$56,250
b. \$47,750
d. \$58,500

Question 34
34. Deltona, USA is a development company that currently is financed with 100 percent equity. There are 15,000 shares outstanding at a market price of \$50 a share. The dividend payout ratio is 100 percent. Deltona has earnings before interest and taxes (EBIT) of \$60,000. Ignore taxes. The firm has decided to issue \$250,000 of debt at a rate of 7 percent and use the proceeds to repurchase shares. Scott owns 100 shares of Deltona and decided to continue holding them. Once Deltona issued the debt, Scott's total annual dividend income:
d. increased from \$400 to \$425.
c. decreased from \$300 to \$200.
e. remained constant.
b. increased from \$100 to \$200.
a. decreased from \$400 to \$200.

Question 35
35. Day 'n Nite currently has 25,000 shares of stock outstanding and no debt. The price per share is \$20. The firm is considering borrowing funds at 8 percent interest and using the proceeds to repurchase 5,000 shares of stock. Ignore taxes. How much is the firm borrowing?
b. \$140,000
e. \$185,000
a. \$100,000
c. \$165,000
d. \$180,000

Question 36
36. Jennifer's Boutique has a pre-tax cost of debt of 9 percent and a return on assets of 14 percent. The debt-equity ratio is .75. Ignore taxes. What is the cost of equity?
a. 7.25 percent
d. 17.75 percent
b. 12.00 percent
e. 18.25 percent
c. 16.67 percent

Question 37
37. The Smith Co. has a \$10 million bond issue outstanding with a coupon rate of 6 percent. The tax rate is 35 percent. What is the present value of the tax shield?
e. \$3.65 million
a. \$3.50 million
d. \$3.62 million
b. \$3.53 million
c. \$3.57 million

Question 38
38. Trade International is an all-equity firm that has projected earnings before interest and taxes of \$497,000 forever. The current cost of equity is 16 percent and the tax rate is 34 percent. The company is in the process of issuing \$1.5 million of bonds at par that carry a 6 percent annual coupon. What is the levered value of the firm?
a. \$2,112,003
d. \$2,448,009
b. \$2,113,609
c. \$2,424,024
e. \$2,560,125

Question 39
39. Uncle Pete's is an all-equity firm with a current cost of equity of 18 percent. The estimated earnings before interest and taxes is \$204,000 annually forever. Currently, the firm has no debt but is in the process of borrowing \$500,000 at 9 percent interest. The tax rate is 34 percent. What is the value of the unlevered firm?
d. \$723,150
c. \$654,900
e. \$748,000
a. \$609,900
b. \$630,850

Question 40
40. A firm has a weighted average cost of capital of 8.59 percent, and a cost of equity of 11 percent. The debt-equity ratio is .65. There are no taxes. What is the firm's cost of debt?
e. 5.90 percent
b. 5.01 percent
c. 5.23 percent
a. 4.88 percent
d. 5.68 percent

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