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Exam 26: Analysis of Capital Structure Theory

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Question 1

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(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%. -According to the MM extension with growth, what is the value of Gomez's tax shield?

A) $156,385
B) $164,616
C) $173,280
D) $182,400
E) $192,000

F) A) and B)
G) A) and C)

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Question 2

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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?

A) 16.4%
B) 18.2%
C) 20.2%
D) 22.5%
E) 25.0%

F) A) and E)
G) None of the above

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Question 3

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In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

(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%. -According to the MM extension with growth, what is Gomez's value of equity?

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.

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

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.

(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%. -According to the MM extension with growth, what is Gomez's unlevered value?

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?

(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%. -What is the value of the firm according to MM with corporate taxes?

In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

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.

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?

In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

Which of the following statements concerning capital structure theory is NOT CORRECT?

Which of the following statements concerning the MM extension with growth is NOT CORRECT?

What is the yield on Trumbull's debt?

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

MM showed that in a world without taxes, a firm's value is not affected by its capital structure.