Calculation:

 Two types of voting

 Break-even EBIT
 M&M Propositions I and II: VU ; VL ; RS ; RWACC
 Three valuation approaches: APV, FTE, and WACC
 Note that these approached can be used for capital budgeting decisions
(evaluating a project),
 and the calculation of firm value or equity value if we ignore the initial
investment.
 Estimate the discount rate of a non-scale enhancing project
 Calculate beta of levered equity, then using CAPM to calculate cost of
equity
Essay (short-answer) questions:
Chapter 15:
 Common stock and Preferred stock
 Debt and Equity
 Bond characteristics and their effect on required yield
 Different types of bonds, including International bonds
 Patterns of corporate financing
Chapter 16:
 Homemade leverage and unleverage
 Main ideas of M&M Propositions I and II under 2 cases: no corporate taxes
and with corporate taxes
Chapter 17:
 Financial distress costs (bankruptcy costs), including agency costs with three
selfish strategies
 The other four theories of capital structure (in addition to M&M theory):
everything
 How firms establish capital structure
Chapter 18:
 Compare three valuation approaches: APV, FTE, and WAC

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 Sample MCQ
1. Homemade leverage is:
A. the incurrence of debt by a corporation in order to pay dividends to shareholders.
B. the exclusive use of debt to fund a corporate expansion project.
C. the borrowing or lending of money by individual shareholders as a means of
adjusting their level of financial leverage.
D. the term used to describe the capital structure of a levered firm.

2. GPS reduced its taxes last year by $500 by increasing its interest expense by
$2000. Which of the following terms is used to describe this tax savings?
A. Current tax yield
B. tax-loss interest
C. interest tax shield
D. interest credit

3. The unlevered cost of capital refers to the cost of capital for a(n):
A. private entity.
B. all-equity firm.
C. private individual.
D. corporate shareholder.

4. The explicit costs, such as the legal expenses, associated with corporate default
are classified as _____ costs.
A. flotation
B. direct bankruptcy
C. indirect bankruptcy

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 D. unlevered

5. The costs of avoiding a bankruptcy filing by a financially distressed firm are

classified as _____ costs.
A.flotation
B.direct bankruptcy
C.indirect bankruptcy
D.financial solvency

6. By definition, which of the following costs are included in the term "financial
distress costs"?
I. direct bankruptcy costs
II. indirect bankruptcy costs
III. direct costs related to being financially distressed, but not bankrupt
IV. indirect costs related to being financially distressed, but not bankrupt
A. I only
B. III and II only
C. I and II only
D. I, II, III, and IV

7. The proposition that a firm borrows up to the point where the marginal benefit of
the interest tax shield derived from increased debt is just equal to the marginal
expense of the resulting increase in financial distress costs is called:
A. the static theory of capital structure.
B. M & M Proposition I.
C. M & M Proposition II.
D. the capital asset pricing model.

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 8. A firm should select the capital structure that:
A. produces the highest cost of capital.
B. maximizes the value of the firm.
C. minimizes taxes.
D. is fully unlevered.

9. The value of a firm is maximized when the:

A. cost of equity is maximized.
B. levered cost of capital is maximized.
C. weighted average cost of capital is minimized.
D. debt-equity ratio is minimized.

10. HPG is comparing two capital structures to determine how to best finance its
operations. The first option consists of all equity financing. The second option is
based on a debt-equity ratio of 0.45. What should HPG do if its expected earnings
before interest and taxes (EBIT) are less than the break-even level? Assume there
are no taxes.
A. select the leverage option because the debt-equity ratio is less than 0.50
B. select the leverage option since the expected EBIT is less than the break-even
level
C. select the unlevered option since the debt-equity ratio is less than 0.50
D. select the unlevered option since the expected EBIT is less than the break-
even level
E. cannot be determined from the information provided

11. You have computed the break-even point between a levered and an unlevered
capital structure. Assume there are no taxes. At the break-even level, the:

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 A. firm's earnings before interest and taxes are equal to zero.
B. firm is just earning enough to pay for the cost of the debt.
C. earnings per share for the levered option are exactly double those of the unlevered
option.
D. advantages of leverage exceed the disadvantages of leverage.

12. Which of the following statements are correct in relation to M & M Proposition
II with no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I and IV only

13. In a world with taxes and financial distress, when a firm is operating with the
optimal capital structure:
I. the debt-equity ratio will also be optimal.
II. the weighted average cost of capital will be at its minimal point.
III. the required return on assets will be at its maximum point.
IV. the increased benefit from additional debt is equal to the increased bankruptcy
costs of that debt.
A. I and IV only

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 B. II and III only
C. I and II only
D. II, III, and IV only
E. I, II, and IV only

14. The optimal capital structure will tend to include more debt for firms with:
A. less taxable income.
B. the lowest marginal tax rate.
C. substantial tax shields from other sources.
D.lower probability of financial distress.

15. When graphing firm value against debt levels, the debt level that maximizes the
value of the firm is the level where:
A. the increase in the present value of distress costs from an additional dollar of debt
is greater than the increase in the present value of the debt tax shield.
B.the increase in the present value of distress costs from an additional dollar of
debt is equal to the increase in the present value of the debt tax shield.
C. the increase in the present value of distress costs from an additional dollar of debt
is less than the increase of the present value of the debt tax shield.
D. distress costs as well as debt tax shields are zero.
E. distress costs as well as debt tax shields are maximized.

16. For the corporate, when the quantity (1 - Tc)(1 - Ts) = (1 - Tb), then:
A. the firm should hold no debt.
B. the value of the levered firm is greater than the value of the
unlevered firm.

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 C.the tax shield on debt is exactly offset by higher personal taxes paid on
interest income.
D. the tax shield on debt is exactly offset by higher levels of dividends.
E. the tax shield on debt is exactly offset by higher capital gains.

17. Suppose a Miller equilibrium exists with a corporate tax rate of 30% and a
personal tax rate on income from bonds of 34%. What is the personal tax rate on
income from stocks?
A. 15%
B. 7.1%
C. 5.7%
D. 43%

18. Mad Creft's is currently an all equity firm that has 8,500 shares of stock
outstanding at a market price of $45 a share. The firm has decided to leverage its
operations by issuing $120,000 of debt at an interest rate of 9 percent. This new debt
will be used to repurchase shares of the outstanding stock. The restructuring is
expected to increase the earnings per share. What is the minimum level of earnings
before interest and taxes that the firm is expecting? Ignore taxes.
A. $34,425
B. $36,500
C. $42,000
D. $44,140
Ans: EBIT/8500 = [EBIT – (120,000*9%)]/[9000 – (120,000/$45)]=>EBIT=34,425

19. FLC is an all equity firm that has 7,000 shares of stock outstanding at a market
price of $15 a share. The firm's management has decided to issue $45,000 worth of
debt and use the funds to repurchase shares of the outstanding stock. The interest

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 rate on the debt will be 8%. What are the earnings per share at the break-even level
of earnings before interest and taxes? Ignore taxes.
A. 2.05
B. 1.65
C. 1.2
D. 1.9
Number of share repurchased = 45,000/15 = 3,000
EBIT/7000 = [EBIT – 45,000*8%]/(7,000 – 3,000) =>EBIT = 8,400
EPS = [8,400 – (45,000*8%)]/(7000 – 3000) = 1.2

20. JP has a cost of equity of 12.6% and a pre-tax cost of debt of 7%. The required
return on the assets is 11.2%. What is the firm's debt-equity ratio based on M & M
II with no taxes?
A. 0.52
B. 0.33
C. 0.24
D. 0.4
Rs =0.126 = R0 + B/S*(R0 – Rb) = 0.112 + B/S*(0.112-0.07) => B/S = 0.33

21. NP COS has expected earnings before interest and taxes of $48,900, an unlevered
cost of capital of 14.5%, and a tax rate of 34%. The company also has $8,000 of debt
that carries a 7% coupon. The debt is selling at par value. What is the value of this
firm?
A. $224,573.66
B. $223,333.33
C. $222,579.31
D. $225,299.31

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 VU = [48,900 × (1 - 0.34)]/0.145 = $222,579.31
VL = 222,579.31 + 0.34*8,000 = $225,299.31

Use the information for the question(s) below.

Sheet Industries' Market Value Balance Sheet ($ Millions) and Cost of Capital
Asset Liabilities Cost of debt: 6%
Cash 0 Debt 200 Cost of equity: 12%
Other Assets 500 Equity 300 Tc: 35%

Sheet Industries new project FCF:

Year 0 1 2 3
FCF ($100) $40 $50 $60

Assume that this new project is of average risk for Sheet and that the firm wants to
hold constant its debt to equity ratio.
22. Sheet’s Rwacc is closet to:
A. 7%
B. 7.5%
C. 9.5%
D. 8.76%
Rwacc = B/B+S *Rb*(1-Tc) + S/B+S * Rs => Rwacc = 0.0876
23. The NPV for new project is closet to:
A) $24.75
B) $26.50
C) $28.25
D) $25.69
NPV= -100 + 40/1.0876^1 + 50/1.0876^2 + 60/1.0876^3 = 25.69

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 24. Which one of the following states that the value of a firm is unrelated to the
firm's capital
structure?
A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Efficient Markets Hypothesis

25. Which one of the following states that a firm's cost of equity capital is directly
and proportionally related to the firm's capital structure?
A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Efficient Markets Hypothesis

Essay and calculation

Question 1: A company has three open seats on its board of directors. There will be
a single election to determine the winner of all open seats. As the owner of 75,000
shares of stock , you will receive one vote per share for each open seat. You decide
to cast all of your votes for a single candidate.
a. What is this type of voting called? What is the number of votes you can cast?
b. With this type of voting, suppose the company has 1.5 million shares outstanding
how many more shares must you buy to be assured of earning a seat on the board?
a) There will be a single election to determine the winner of all open seats => all
director are elected at one time, this is cumulative voting
Number of vote I can cast = 75,000*3 = 225,000
b) To assure a seat on the board, the share we need to own:
1/(N+1) * share outstanding + 1 = 1/(3+1) *1,500,000 + 1 = 375,001

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 Currenty, we have 75,000 share, so we need to buy more 375,001 – 75,000 = 300,001
share
Question 2: How does the following feature of a bond affect the required rate of
return on the bond? Explain.
a. Call provision
b. Put provision
c. Sinking fund
Phần này anh sẽ hướng dẫn làm, các bạn tự soạn văn để tránh trùng ý nha
a)Nêu định nghĩa của call provision (allow issuer to repurchase the debt security
before maturity), call provision sẽ higher risk cho bondholder vì thường nó sẽ đc
exercise khi market interest rate giảm, bondholder chưa nhận đc fully interest mà
đáng ra họ phải đc nhận => require higher return
b) Nêu định nghĩa put provision (allow the bondholder to require the issuer buy back
the bond before maturity), put provision sẽ lower risk cho bondholder vì nó thường
excercise khi market interest rate tăng, benefit cho bondholder => require lower
return
c) Nêu định nghĩa của sinking fund, những cty phát hành bond mà có sinking fund
thì sẽ lower risk cho ng mua => require lower return

Question 3: Baker Corporation expects an EBIT of $32,000 every year forever . The
company currently has no debt and its cost of equity is 14%. The corporate tax rate
is 31%
a. What is the current value of the company?
b. Suppose the company can borrow at 7%. What will the value of the company be
if it takes on debt equal to 30 percent of its unlevered value?
a) Vu = EBIT* (1-Tc)/R0 = 32,000* 0.69/14% = 157,714.29
b) Rb= 7%, B=30%Vu = 47,314.287
VL= Vu + Tc*B = 157,714.29 + 31%*47,314.287 = 172,381.719

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 Question 4:
a) Discuss the static trade-off theory and the pecking order theory of capital
structure. What are the main differences between these two theories?
Trade-off theory: There is a trade-off between the tax advantage of debt and the
costs of financial distress. There is an optimal amount of debt for any individual
firm and becomes the firm’s target debt level. Under this theory, given that a
company has not borrowed enough debt to reach its Optimal Capital structure, it
should prioritize borrowing until it maximizes its actual value.
The pecking order theory: Companies prefer financial slack so that they have a
lower need for external financing. This states that firms prefer internal financing
to external financing(debt and equity issuance). Given that their internal funds
are not enough to finance their projects, the firm should prioritize borrowing debt
to issuing equity as a last resort if it has already reached the limit of debt
borrowed.
The main difference between the two theories:
Firstly, for pecking order theory , there is no target D/E ratio whereas the trade-off
theory states that firms pursue the target (optimal) D/E ratio.

Secondly, in pecking order profitable firms use less debt, whereas the trade-off
theory states that profitable firms use more debt.

Finally, for Pecking order theory, companies like financial slack (large free cash
flow) so that they have less need for external financing , whereas the trade-off theory
states that firms don’t like too much free cash flow, so they borrow more debt to
reduce free cash flow to limit the opportunities of managers pursuing wasteful
activities and avoid the agency costs of free cash flow).

b)Global Production (GP) is a large conglomerate thinking of entering the smart

alarm business, where it plans to finance a project with a debt-to-value ratio of 20
percent. GP expects to borrow for its smart alarm venture at an interest rate of 10%.
There is currently one firm in the smart alarm industry, American Smart Alarm
(ASA). This ASA firm is financed with 25 percent debt and 75 percent equity. The
beta of ASA’s equity is 1.5. ASA has a borrowing interest rate of 9%. The corporate
tax rate for both firms is 35%. The market risk premium is 8%, and the risk-free rate

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 is 5%. What is the appropriate discount rate (RWACC) for GP to use for its smart
alarm venture?
ASA firm:
Beta equity of ASA= 1.5 = [1 + D/E*(1-Tc)] * Beta unlevered => Beta unlevered =
1.5/[1+25%/75% * (1-31%)] = 1.219521
Debt to value ratio of GP = 0.2 => Equity to value ratio of GP= 0.8 =>D/E= 1/4
Beta equity of GP = [1 + D/E*(1-Tc)] * Beta unlevered = [ 1+ 1/4 * (1-31%)]*
1.219521 = 1.42988
Rs = 5% + 1.42988*8% = 0.164390
Rwacc = E/V *Rs + D/V*Rb* (1-Tc) = 0.164390*0.8 + 0.2*0.1*(1 − 31%) =
0.145312
Question 5: Mercer Inc. has a debt-to-equity ratio of 0.40. The required return on
the company’s unlevered equity is 12%, and the pretax cost of the firm’s debt is 8%.
Sales revenue for the company is expected to remain stable indefinitely at last year’s
level of $18,500,000 . Variable costs (including SG & A expenses) are 65 percent of
sales. The corporate tax rate is 31%. The company distributes all its earnings as
dividends at the end of each year.
a. If the company were financed entirely by equity, how much would it be worth?
b. What is the required return on the company’s levered equity?
c. Use the weighted average cost of capital (WACC) approach to calculate the value
of the company. What is the value of the company’s equity? What is the value of the
company’s debt?
d. Use the flow to equity (FTE) approach to calculate the value of the company’s
equity (Hint: use the value of debt calculated in part c to calculate interest expense).
a) B/S=0.4, R0=12%, Rb=8% , Tc=31%
Sale revenue: 18,500,000
Variable cost: (12,025,000) = 65%*18,500,000
EBIT: 6,475,000
The company finance entirely by equity => R0=Rwacc = 12%

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 Vu= EBIT*(1-Tc)/Rwacc = 37,231,250
b)Rs = R0 + B/S*(1-Tc)*(R0-Rb) = 0.13104
c)B/S=0.4 => B/V = 2/7 , S/V=5/7
Rwacc = Rs*S/V + Rb*B/V*(1-Tc) = 13.1%*5/7 + 8%* 2/7 *0.69 = 0.1093
The value of the company = EBIT*(1-Tc)/Rwacc = 6,475,000*0.69/0.1093 =
40,876,029.28
The value of the company debt = value of company * B/V = 40,876,029.28* 2/7 =
11,678,865.51
The value of company equity =40,876,029.28 * 5/7= 29,197,163.77
d) Sale revenue: 18,500,000
Variable cost: (12,025,000) = 65%*18,500,000
EBIT: 6,475,000
Interest: (934,309.24) =11,678,865.51 *8%
EBT: 5,540,690.76
Tax expense: (1,717,614.136)
Net income(LCF): 3,823076.624
The value of the company = LCF/Rs =3,823076.624 / 0.13104 = 29,174,882.66

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