1. 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. $27 B. $393 C. $1,027 D. $1,393 E. $2,143
300(1-0.35)/0.14 = 1393
2. 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. $928,125 B. $1,110,125 C. $1,178,125 D. $1,217,125 E. $1,778,125
225000(1-0.34)/0.16=928125
928125+850000(0.34)=1217125
3. 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. $478 B. $790 C. $1,365 D. $4,780 E. $7,350
21000x0.35=7350
4. 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.
Number of shares repurchased = $50,000/$12.5 = 4,000. EBIT/15000= [EBIT - ($50,000 x .09)]/(15000 -4000) = 16875
EPS = [($16875 - ($50,000 x .09)]/11000 = 1.125
A. $1.005 B. $1.125 C. $1.175 D. $1.200 E. $1.250
5. 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. $1.207 million B. $1.225 million C. $1.250 million D. $1.350 million E. $1.375
million
35000x(35000/1000)=1225000
6. 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. $.72 B. $.76 C. $1.54 D. $1.60 E. $1.72
7. 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.
Number of shares repurchased = $10,000/$20 = 500. EBIT/2500 = [EBIT - ($10,000 x .085)]/(2500 -500) = 4250
EPS = [($4250 - ($10,000 x .085)] / 2000 = 1.7
A. $1.63 B. $1.70 C. $1.82 D. $1.88 E. $1.94
8. 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?
40000 x 2.12 + 360000 x 0.09=117200
A. $84,800 B. $91,600 C. $102,300 D. $117,200 E. $119,70
9. 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. $12,064 B. $12,087 C. $12,113 D. $23,418 E. $23,513
Text475000 x 0.075 x 0.34 = 12113
10. NLEV 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.
What is the value of UNLEV's equity after the restructuring?
A. $11,792 B. $12,600 C. $12,819 D. $13,592 E. $16,461
(4000 x (1 - 0.34) / 0.15) - (8800 x (1-0.34)) = 11792
Answers for the MCQs
1. D
2. D
3. E
4. B
5. B
6. D
7. B
8. D
9. C
10. A
True/False
1. M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the firm's
cost of debt financing.
TRUE
2. In relation to M&M Proposition II with no taxes, the cost of equity declines when the amount
of leverage used by a firm rises.
FALSE
3. M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the firm's
interest tax shield.
FALSE
4. M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the
required rate of return on the firm's assets.
TRUE
5. In relation to M&M Proposition II with no taxes, the return on assets is equal to the weighted
average cost of capital.
TRUE
6. Business risk declines as the systematic risk of a firm's assets increases.
FALSE
7. The interest tax shield has no value for a firm when the tax rate is equal to zero.
TRUE
8. The interest tax shield has no value for a firm when the firm is unlevered.
TRUE
9. When taxes are factored in, debt financing lowers a firm's cost of equity.
FALSE