Chapter 17 - Capital Structure: Limits to the Use of Debt
53. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?
Corporate tax rate: 34%
Personal tax rate on income from bonds: 20% Personal tax rate on income from stocks: 50% A. $-0.050 B. $-0.188 C. $0.367 D. $0.588
E. None of the above
[1 - ((1 - .34)(1 - .5))/(1 - .2)] = 1 - .4125 = $0.5875
Difficulty level: Challenge
Topic: ADDED VALUE OF LEVERAGE WITH TAXES Type: PROBLEMS
54. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?
Corporate tax rate: 34%
Personal tax rate on income from bonds: 20% Personal tax rate on income from stocks: 30% A. $-0.050 B. $0.006 C. $0.246 D. $0.340 E. $0.423
[1 - ((1 - Tc)(1 - Ts)/(1 - Tb))]B = [1 - ((.66)(.7)/.8)]B = $0.4225
Difficulty level: Challenge
Topic: ADDED VALUE OF LEVERAGE WITH TAXES Type: PROBLEMS
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Chapter 17 - Capital Structure: Limits to the Use of Debt
55. Given the following information, leverage will add how much value to the unlevered firm per dollar of debt?
Corporate tax rate: 30%
Personal tax rate on income from bonds: 20% Personal tax rate on income from stocks: 0% A. $0.125 B. $0.472 C. $0.528 D. $0.825
E. None of the above
[1 - ((1 - Tc)(1 - Ts)/(1 - Tb))]B = [1 - ((.70)(1)/(1 - .2)]B = .125B ; $0.125
Difficulty level: Challenge
Topic: ADDED VALUE OF LEVERAGE WITH TAXES Type: PROBLEMS
56. Holly Berry Incorporated will earn $40 in one year if it does well. The debtholders are promised payments of $25 in one year if the firm does well. If the firm does poorly, expected earnings in one year will be $20 and the repayment will be $15 because of the dead weight cost of bankruptcy. The probability of the firm performing poorly or well is 50%. If bondholders are fully aware of these costs what will they pay for the debt? The interest rate on the bonds is 8%. A. $18.52 B. $30.00 C. $32.55 D. $35.75 E. $37.04
[0.5($25) + 0.5 ($15)]/1.08 = $18.52
Difficulty level: Medium Topic: VALUE OF DEBT Type: PROBLEMS
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Chapter 17 - Capital Structure: Limits to the Use of Debt
57. Holly Berry Incorporated debtholders are promised payments of $25 if the firm does well, but will receive only $20 if the firm does poorly. Bondholders are willing to pay $15. The promised return to the bondholders is approximately: A. 5.65% B. 45.65% C. 50.00% D. 66.67% E. 100.00%
($25/$15) -1 = .6667 = 66.67%
Difficulty level: Medium
Topic: RETURN TO BOND HOLDERS Type: PROBLEMS
58. An investment is available that pays a tax-free 7%. The corporate tax rate is 40%. Ignoring risk, what is the pre-tax return on taxable bonds? A. 4.20% B. 7.00% C. 7.47% D. 11.67%
E. None of the above
Rb = .07/(1 - .4) = .07/.6 = .1167 = 11.67%
Difficulty level: Medium
Topic: PRE-TAX RETURN ON BONDS Type: PROBLEMS
Essay Questions
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Chapter 17 - Capital Structure: Limits to the Use of Debt
59. What are the advantages of a prepackaged bankruptcy for a firm? What are the disadvantages?
A prepack allows a firm to minimize its stay in bankruptcy court and should allow the firm to minimize its bankruptcy costs as well. In either case, management is freed up to spend time on more productive tasks such as operating the firm. The negative side of a prepack is a little more difficult to discern. Astute students will recognize that prepacks take time to negotiate, that is, they may save time during bankruptcy, but they are likely to take more time up front than a straight bankruptcy filing. Furthermore, it is also likely that the firm must give creditors a better deal in order to get them to sign on to the bankruptcy agreement. Should this be the case, the firm may actually get better terms from its creditors by going through with a full bankruptcy process.
Topic: PREPACKAGED BANKRUPTCY Type: ESSAYS
60. Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
Students should explain that in a world with taxes, transaction costs, and financial distress costs, there are both benefits and costs to higher debt loads, and there is no way to target exactly what the ideal capital structure should be.
Topic: CAPITAL STRUCTURE THEORY Type: ESSAYS
61. Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to \
Students should intuitively recognize that some of the observed variations in capital structures across industries reflect the differences in the nature of the industries themselves i.e., business risk. Similarly, intuition would suggest that firms with large capital requirements and stable cash flows (e.g., electric utilities) are more likely to be willing to raise funds via large amounts of borrowing. Alternatively, firms with lower tangible asset needs and highly uncertain cash flows (e.g., small software companies) are more likely to employ equity.
Topic: BUSINESS AND FINANCIAL RISK Type: ESSAYS
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