FIN3101 Corporate Finance Practice Questions 3 Topic: Capital Structure

1. Explain whether the following statement is true in a Modigliani-Miller world with taxes: If a firm issues equity to repay some of its debt, the price per share of the firm’s stock will fall because the shares are less risky. 2. With its current leverage, Singmart will have net income (net of interest) next year of $3million. If Singmart’s tax rate is 20% and it pays 8% interest on its debt, how much additional debt can Singmart issue this year and still receive the full benefit of the interest tax shield next year? 3. United has no debt. It has a market value of $160 million and a cost of equity capital of 10%. There is news that it plans to raise $40 million in debt and pay the proceeds to shareholders as a special cash dividend. The cost of debt capital is 6%. a) Assume no taxes and a Modigliani-Miller world. What is the value of United after the change in leverage? What are the cost of equity and the overall cost of capital after the change in leverage? b) Assume a corporate tax of 30% and a Modigliani-Miller world. What is the value of United after the change in leverage? What are the cost of equity and the overall cost of capital after the change in leverage? 4. MacKenzie Corporation currently has 10 million shares of stock outstanding at a price of $40 per share. The company would like to raise money and has announced a rights issue. The company plans to require five rights to purchase one share at a price of $40 per share. Assume perfect capital markets. a) Assuming the rights issue is successful, how much money will it raise? b) What will the share price be after the rights issue? Suppose instead that the firm changes the plan so that each right gives the holder the right to purchase one share at $8 per share. c). How much money will the new plan raise? d). What will the share price be after the rights issue? e). Which plan is more likely to raise the full amount of capital? f). Who gains from the rights issue in the first plan? In the second plan? 5. An unlevered firm has a market value of $7million. It is contemplating issuing $4m of 10% coupon bonds (permanent debt). The firm has a corporate tax rate of 30% and has estimated that the tax rates for its investors are 20% on stock income and 25% on bond income. a) If only corporate taxes exist, what is the total value of the firm and the gain from leverage? FIN3101 Page 1

b) With both corporate and personal taxes. what is the gain from leverage and the total value of the firm? c) Why is the gain from leverage lower in (b)? FIN3101 Page 2 .

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