Practice Questions 4: Final
FIN 3701B
Note: This set of questions is for your practice, and you don’t need to submit a
report.
1. Explain homemade leverage and why it matters.
2. A firm should always select the capital structure that:
a. produces the highest cost of capital.
b. maximizes the value of the firm.
c. minimizes taxes.
d. maximizes current dividends.
e. has no debt.
3. Max Iger Designs has a debt-equity ratio of .68. The firm's required return on assets is 11.7
percent and its levered cost of equity is 15.54 percent. What is the pretax cost of debt based
on MM Proposition II with no taxes?
4. Stevenson's Bakery is an all-equity firm that has projected perpetual EBIT of $147,000 per
year. The cost of equity is 10.7 percent and the tax rate is 39 percent. The firm can borrow
perpetual debt at 5.9 percent. Currently, the firm is considering taking on debt equal to 57
percent of its unlevered value. What is the firm's levered value?
5. Assume O’Connell Enterprises is indifferent between issuing equity and issuing debt. The
corporate tax rate is 21 percent and dividends are taxed at the personal level at 20 percent.
What is the personal tax on interest income?
6. Houston Homes has outstanding debt of $78 that is due in one year. Given the financial distress
costs, debtholders will receive only $62 if the firm does well and $24 if it does poorly. The
probability that the firm will do well is 75 percent and the probability that it will do poorly is 25
percent. Assuming a discount rate of 9.6 percent, what is the current value of the debt?
7. Green Thumb Nursery has 36,000 shares outstanding at a market price of $63.23 per share.
The earnings per share are $3.23. The firm has total assets of $328,000 and total liabilities of
$190,000. Today, the firm announced a share repurchase for $83,000 of its stock. What is the
earnings per share after the repurchase?
8. A firm has a market value equal to its book value. Currently, the firm has excess cash of $900
and other assets of $5,100. Equity is worth $6,000. The firm has 600 shares of stock
outstanding and net income of $700. What will the new earnings per share be if the firm uses
its excess cash to complete a stock repurchase?
9. Murphy's, Incorporated, has 31,950 shares of stock outstanding with a par value of $1 per
share. The market value is $10 per share. The balance sheet shows $87,850 in the capital in
excess of par account, $31,950 in the common stock account, and $147,950 in the retained
earnings account. The firm just announced a stock dividend of 14 percent. What will the market
price per share be after the dividend?
10. Principal is acquiring Secondary Companies for $38,000 in cash. Principal has 4,500 shares
of stock outstanding at a market price of $31 per share. Secondary has 1,600 shares of stock
outstanding at a market price of $22 per share. Neither firm has any debt. The net present
value of the acquisition is $2,400. What is the price per share of Principal after the acquisition?
11. Firm K is planning on merging with Firm L. Firm K currently has 5,500 shares of stock
outstanding at a market price of $28 per share. Firm L has 500 shares outstanding at a price
of $16 per share. The merger will create $600 of synergy. Firm K plans to offer a sufficient
number of its shares to acquire Firm L at an acquisition cost of $8,200. How many total shares
will be outstanding in the merged firm?
12. Western has a market value of $950 with 50 shares outstanding and a price per share of $19.
Eastern has a market value of $3,000 with 120 shares outstanding and a price per share of
$25. Eastern is acquiring Western by exchanging 40 of its shares for all 50 of Western's shares.
What is the cost of the merger to Eastern's stockholders if the merger creates $200 of synergy?
13. A firm may want to divest itself of some of its assets for all the following reasons except to:
a. raise cash.
b. eliminate unprofitable operations.
Practice Questions 4: Final
c. eliminate some recently acquired assets.
d. cash in on profitable operations.
e. eliminate some synergy.
FIN 3701B
Practice Questions 4: Final
FIN 3701B
ANSWERS
1. Reference: Capital Structure II slides, textbook Chapter 16
Homemade leverage is the ability of investors to alter their own financial leverage to achieve a desired
capital structure no matter what a firm’s capital structure might be. If investors can, at their discretion, use
homemade leverage to create additional leverage or to undo any existing leverage of the firm then the
actual capital structure decision of the firm itself becomes irrelevant. Cost of equity increases as the debtequity ratio increases. This increase in equity cost is just sufficient to offset the increased risk, allowing
WACC to remain constant. This is MM Proposition II with no corporate taxes
2. Reference: Capital Structure II slides, textbook Chapter 16
b
3. Reference: Capital Structure II slides, textbook Chapter 16
RS =.1554=.117+.68(.117− RB)
RB = .0605, or 6.05%
4. Reference: Capital Structure II slides, textbook Chapter 16
VU = $147,000(1 − .39)/.107
VU = $838,037
VL = $838,037 + .39(.57)($838,037)
VL = $1,024,333
5. Reference: Capital Structure III slides, textbook Chapter 17
(1 − TB) = (1 − TC)(1 − TS)
(1 − TB) = (1 − .21)(1 − .20)
TB = .37, or 37%
6. Reference: Capital Structure III slides, textbook Chapter 17
Debt value = [.75($62) + .25($24)]/1.096
Debt value = $47.90
7. Reference: Dividend Policy slides, textbook Chapter 19
Shares after repurchase = 36,000 − ($83,000/$63.23)
Shares after repurchase = 34,687.33 shares
New EPS = ($3.23 × 36,000)/34,687.33
New EPS = $3.35
Practice Questions 4: Final
8. Reference: Dividend Policy slides, textbook Chapter 19
Market value per share = Book value per share = $6,000/600 shares
Market value per share = $10
Number of shares repurchased = $900/$10 per share
Number of shares repurchased = 90 shares
Number of shares outstanding after the repurchase = 600 − 90
Number of shares outstanding after the repurchase = 510 shares
EPS after repurchase = $700 / 510 shares
EPS after repurchase = $1.37
9. Reference: Dividend Policy slides, textbook Chapter 19
Total market value = 31,950 shares × $10 per share
Total market value = $319,500
New number of shares outstanding = 31,950(1 + .14)
New number of shares outstanding = 36,423 shares
New market price per share = $319,500/36,423 shares
New market price per share = $8.77
10. Reference: M&A slides, textbook Chapter 29
Price per share = [4,500($31) + $2,400]/4,500
Price per share = $31.53
11. Reference: M&A slides, textbook Chapter 29
Post-merger value = 5,500($28) + 500($16) + $600
Post-merger value = $162,600
α($162,600) = $8,200
α = .0504
α = New shares/(New shares + Old shares)
.0504 = New shares/(5,500 + New shares)
New shares = 292
Post-merger total shares = 5,500 + 292
Post-merger total shares = 5,792
12. Reference: M&A slides, textbook Chapter 29
Combined firm value = $950 + 3,000 + 200
Combined firm value = $4,150
FIN 3701B
Practice Questions 4: Final
Total new shares = 120 + 40
Total new shares = 160
Western shareholders’ ownership = 40/160
Western shareholders’ ownership = .25
Western shareholders’ value = Cost to Eastern’s shareholders = .25($4,150)
Cost to Eastern’s shareholders = $1,037.50
13. Reference: M&A slides, textbook Chapter 29
e
FIN 3701B