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True/False

Easy:

(26.1) Taxes and capital structure FQ Answer: a EASY

i. In a world with no taxes, MM show that a firm’s capital structure does not

affect the firm’s value. However, when taxes are considered, MM show a

positive relationship between debt and value, i.e., its value rises as its

debt is increased.

a. True

ii. According to MM, in a world without taxes the optimal capital structure for a

firm is approximately 100% debt financing.

b. False

iii. MM showed that in a world with taxes, a firm’s optimal capital structure

would be almost 100% debt.

a. True

iv. MM showed that in a world without taxes, a firm’s value is not affected by

its capital structure.

a. True

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

taxes.

a. True

vi. The Miller model begins with the MM model without corporate taxes and then

adds personal taxes.

b. False

vii. 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

Medium:

(26.2) MM models FQ Answer: a MEDIUM

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

zero personal taxes.

a. True

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

b. False

x. In the MM extension with growth, the appropriate discount rate for the tax

shield is the unlevered cost of equity.

a. True

xi. In the MM extension with growth, the appropriate discount rate for the tax

shield is the WACC.

b. False

xii. In the MM extension with growth, the appropriate discount rate for the tax

shield is the after-tax cost of debt.

b. False

xiii. When a firm has risky debt, its equity can be viewed as an option on the

total value of the firm with an exercise price equal to the face value of the debt.

a. True

xiv. When a firm has risky debt, its debt can be viewed as an option on the total

value of the firm with an exercise price equal to the face value of the

equity.

b. False

Medium:

xv. The major contribution of the Miller model is that it demonstrates that

b. personal taxes decrease the value of using corporate debt.

xvi. Which of the following statements concerning capital structure theory is NOT

CORRECT?

d. Under MM with corporate taxes, rs increases with leverage, and this

increase exactly offsets the tax benefits of debt financing.

xvii. Which of the following statements concerning the MM extension with growth is

NOT CORRECT?

d. For a given D/S, the WACC is less than the WACC under MM’s original (with

tax) assumptions.

xviii. Which of the following statements concerning the MM extension with growth

is NOT CORRECT?

a. The tax shields should be discounted at the cost of debt.

xix. Which of the following statements concerning the MM extension with growth is

NOT CORRECT?

e. The total value of the firm is independent of the amount of debt it uses.

Medium:

xx. 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?

e. 14.0%

xxi. 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

5% rate, 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 would Firm L's

total value be if it had no debt?

c. $397,143

xxii. Your firm has debt worth $200,000, with a yield of 9%, and equity worth

$300,000. It is growing at a 5% rate, 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 the value of your firm’s tax shield, i.e., how much value

does the use of debt add?

b. $102,857

Multi-part:

(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%.

xxiii. What is the value of the firm according to MM with corporate taxes?

c. $587,500

e. 32.0%

xxv. Assume that the firm's gain from leverage according to the Miller model is

$126,667. If the effective personal tax rate on stock income is TS = 20%, what

is the implied personal tax rate on debt income?

e. 25.0%

(The following data apply to Problems 26 through 28. The problems MUST be kept together.)

Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax

rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in

net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar

company with no debt has a cost of equity of 11%.

xxvi. According to the MM extension with growth, what is the value of Gomez’s tax

shield?

e. $192,000

value?

c. $1,600,000

equity?

a. $1,492,000

(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.

xxix. What is the value (in millions) of Trumbull’s equity if it is viewed as an

option?

d. $313.81

xxx. What is the value (in millions) of Trumbull’s debt if its equity is viewed

as an option?

b. $186.19

e. 7.42%

xii. (26.4) MM extension with growth FQ Answer: b MEDIUM

rd: 9% rsU : 12%

T: 40% g: 5%

rd: 9% rsU : 12%

T: 40% g: 5%

Firm L has a total value of $200,000 + $300,000 = $500,000. A similar firm with no debt should have a smaller value. Here

is the calculation:

VTotal = VU + VTS, so VU = VTotal – VTS = D + S – VTS.

Value tax shelter = VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857

VU = $300,000 + $200,000 – $102,857 = $397,143

Debt: $200,000 Equity: $300,000

rd: 9% rsU: 12%

T: 40% g: 5%

VTotal = VU + VTS

Value tax shelter = VTS = rdTD/(rsU – g)

VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857

Debt: $500,000 rsU: 16%

VL = VU + TD = $437,500 + 0.3($500,000) = $587,500

First, note that the leveraged value of the firm is $587,500 as found in Problem 23. Note also that the firm has $500,000 of

debt. Therefore, the value of its equity must be $87,500. Using these data, we find the leveraged cost of equity as follows:

Ts: 20% Debt: $500,000

[1 – (0.7)(0.8)/X]$500,000 = $126,667 (1 − Ts) = 0.80

1 – 0.56/X = 0.25333 (1 − Tc) × (1 − Ts) = 0.56

0.56/X = 0.74667 Gain/Debt = 0.25333

X = 0.75000 Gain/Debt − 1 = -0.74667

1 − Td = 0.75000 X = -0.56/-0.74666 = 0.75000

Td = 25.00% X= 1 − Td

Td = 0.25000

Debt: $300,000 T: 40%

rd: 8% EBIT retained: 20%

g: 6%

= EBIT(1 – T) – EBIT(0.20)

= $200,000(0.60) – $200,000(0.20)

= $120,000 − $40,000 = $80,000

VU = FCF/(rsU – g)

= $80,000/(0.11 – 0.06)

= $1,600,000

xxviii.(26.4) MM extension with growth CQ

Answer: a MEDIUM

VTotal = VU + VTS so, VEquity = VU + VTS – Debt.

VTS = $192,000 (from above).

VU = $1,600,000 (from above).

VEquity = $1,600,000 + $192,000 – $300,000 = $1,492,000

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