Fundamentals of Corporate Finance
11th Edition
ISBN: 9780077861704
Author: Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Bradford D Jordan Professor
Publisher: McGraw-Hill Education
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Chapter 16, Problem 20QP
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QUESTION
Generally speaking, the cost of debt is cheaper than the cost of equity. Does it imply that a firm should increase its debt-to-equity ratio to as high as possible such that its corporate cost of capital can be minimized?
Question 13
According to MM propositions, at what debt-equity ratio the cost of equity should be the lowest?
Zero if there is no tax and indefinitely large if a non-zero tax rate is applied.
O Infinitely large
Zero if there is no tax and 1 if a non-zero tax rate is applied.
Zero
6
P10.4
Unlevering the Equity Cost of Capital-Low Leverage & High Leverage Companies: Below, we show
the information for two potential comparable companies. Calculate the unlevered cost of capital based on the
following assumptions. Neither company expects its free cash flows to grow.
Income tax rate for interest (TINT).
Value of debt
Value of preferred stock.
Value of equity
Maturity of debt (years)
Debt cost of capital.
Preferred stock cost of capital.
Equity cost of capital.
Low Leverage
Company
High Leverage
Company
35.0%
$ 4,000
$ 1,000
$15,000
45.0%
$45,000
$
0
Perpetual
$ 5,000
Perpetual
5.0%
8.0%
6.0%
11.8%
28.0%
a.
b.
C.
Assume that interest is tax deductible and that the discount rate for all interest tax shields is the unlevered
cost of capital.
Assume that interest is tax deductible and that the discount rate for all interest tax shields is the cost of debt.
Assume that interest is tax deductible but that the company refinances its debt at the end of each year
(annual…
Chapter 16 Solutions
Fundamentals of Corporate Finance
Ch. 16.1 - Why should financial managers choose the capital...Ch. 16.1 - What is the relationship between the WACC and the...Ch. 16.1 - What is an optimal capital structure?Ch. 16.2 - Prob. 16.2ACQCh. 16.2 - Prob. 16.2BCQCh. 16.2 - Prob. 16.2CCQCh. 16.3 - What does MM Proposition I state?Ch. 16.3 - What are the three determinants of a firms cost of...Ch. 16.3 - Prob. 16.3CCQCh. 16.4 - What is the relationship between the value of an...
Ch. 16.4 - If we consider only the effect of taxes, what is...Ch. 16.5 - Prob. 16.5ACQCh. 16.5 - What are indirect bankruptcy costs?Ch. 16.6 - Can you describe the trade-off that defines the...Ch. 16.6 - What are the important factors in making capital...Ch. 16.7 - Prob. 16.7ACQCh. 16.7 - What is the difference between a marketed claim...Ch. 16.7 - What does the extended pie model say about the...Ch. 16.8 - Prob. 16.8ACQCh. 16.8 - Why might firms prefer not to issue new equity?Ch. 16.8 - Prob. 16.8CCQCh. 16.9 - Do U.S. corporations rely heavily on debt...Ch. 16.9 - What regularities do we observe in capital...Ch. 16.10 - Prob. 16.10ACQCh. 16.10 - Prob. 16.10BCQCh. 16 - Maximizing what will maximize shareholder value?Ch. 16 - What is most closely related to a firms use of...Ch. 16 - Give an example of a direct cost of bankruptcy.Ch. 16 - Prob. 16.7CTFCh. 16 - Prob. 1CRCTCh. 16 - Prob. 2CRCTCh. 16 - Optimal Capital Structure [LO1] Is there an easily...Ch. 16 - Observed Capital Structures [LO1] Refer to the...Ch. 16 - Financial Leverage [LO1] Why is the use of debt...Ch. 16 - Homemade Leverage [LO1] What is homemade leverage?Ch. 16 - Prob. 7CRCTCh. 16 - Prob. 8CRCTCh. 16 - Prob. 9CRCTCh. 16 - Prob. 10CRCTCh. 16 - Prob. 1QPCh. 16 - Prob. 2QPCh. 16 - Prob. 3QPCh. 16 - Prob. 4QPCh. 16 - MM and Stock Value [LO1] In Problem 4, use MM...Ch. 16 - Prob. 6QPCh. 16 - Prob. 7QPCh. 16 - Prob. 8QPCh. 16 - Homemade Leverage and WACC [LO1] ABC Co. and XYZ...Ch. 16 - Prob. 10QPCh. 16 - MM and Taxes [LO2] In the previous question,...Ch. 16 - Calculating WACC [LO1] Twice Shy Industries has a...Ch. 16 - Calculating WACC [LO1] Braxton Corp. has no debt...Ch. 16 - MM and Taxes [LO2] Meyer Co. expects its EBIT to...Ch. 16 - Prob. 15QPCh. 16 - MM [LO2] Tool Manufacturing has an expected EBIT...Ch. 16 - Prob. 17QPCh. 16 - Homemade Leverage [LO1] The Day Company and the...Ch. 16 - Weighted Average Cost of Capital [LO1] In a world...Ch. 16 - Cost of Equity and Leverage [LO1] Assuming a world...Ch. 16 - Business and Financial Risk [LO1] Assume a firms...Ch. 16 - Stockholder Risk [LO1] Suppose a firms business...Ch. 16 - Prob. 1MCh. 16 - Prob. 2MCh. 16 - Prob. 3MCh. 16 - Stephenson Real Estate Recapitalization Stephenson...Ch. 16 - Stephenson Real Estate Recapitalization Stephenson...
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- The optimal capital structure: a. Maximizes the value of equity but not the tax shield associated with debtb. Minimizes the tax shield associated with debtc. Maximizes the value of the company but not necessarily the tax shield associated with debtd. Maximizes the value of the company and the tax shield associated with debtarrow_forwardM&M Proposition II, without taxes, puts forth that, Multiple Choice the capital structure of a company has no effect on that company's value. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. O a company's cost of equity is a linear function with a slope equal to (RA - Rpl- the cost of equity is equivalent to the required rate of return on assets. the size of the pie does not depend on how the pie is sliced.arrow_forward41) Balancing the advantages and disadvantages of using debt and equity when determining a firm’s optimal capital structure is referred to as: Question 41 options: Tax theory Trade off theory Signaling theory Pecking order theory1arrow_forward
- 14. 1.4 All of the following are sustainable methods businesses can use to raise capital (funding) except for ________. A. borrowing from lenders B. selling ownership shares C. profitable operations D. tax refundsarrow_forwardChapter 9 Homework Questions 1.What do we mean by financial structure? 2. What accounts in the statement of financial position are taken into consideration to calculate the cost of financing? 3. What is the meaning of economic value added (EVA)? What does it measure? Why is it important? 4. What is the purpose of calculating the cost of capital? 5. Differentiate between debt financing and common share financiarrow_forwardQUESTION 13 Which of the following statements is correct? O A. The tax benefit from using debt financing reduces a firm's risk O B. The lower the level of a firm's debt, the higher the firm's leverage O C. The lower the level of a firm's debt, the higher the firm's equity multiplier O D. The lower the level of a firm's debt, the lower the firm's equity multiplierarrow_forward
- 15-2 Which of the following real-world factors favour a high dividend payout? taxes flotation costs debt covenant desire for current income uncertainty resolution Select one: a. I and II only b. II and III only c. I, II, and III only d. III, IV, and V only e. I, IV, and V onlyarrow_forwardAccording to MM propositions, at what debt-equity ratio the cost of equity should be lowest? Zero if there is no tax and indefinitely large if a non-zero tax rate is applied. Infinitely large Zero if there is no tax and 1 if a non-zero tax rate is applied. Zeroarrow_forward34. The concept of optimum capital structure is based on the assumption that the prudent use of debt can lower the firm's overall cost of capital True or False 35. The cost of common equity is the most difficult concept to measure True or False 36 The optimum capital structure is the one that? 37. Preferred stock is considered as debt to the extent that preferred dividends are a tax-deductible expense True or False 38. The net cash flows from an investment project 39 Beta may be used to classify stocks into which of the two following categories? 40. The capital budgeting process must follow an ideally prescribed order because there are many steps and elements in the whole process of planning capital expenditures. True or False 41. The nominal rate of interest equals the effective rate of interest only if interest is compounded semiannually True or False 42. Efficient capital markets exist when security prices reflect all available information and market prices adjust slowly to new…arrow_forward
- Which of the following statements is most likely correct? 0.000 I. II. III. The higher the cost of equity and debt, the higher the cost of capital (WACC), with all else constant. The higher the cost of capital (WACC), the lower the value of the company, with all else constant. A lower corporate tax rate will incentivize firms to issue more debt than equity to reduce the cost of capital (WACC), with all else constant. I only Il only I and III I and IIarrow_forwardQ ) If the corporate income tax rate were to increase, then the use of debt will become more desirable in terms of increasing ROE. (All else equal.) a - True b - Falsearrow_forward11.Explain why a firm needs to understand their allocation of debtfinancing to equity (the amount the owner used to fund thebusiness). Discuss how this allocation can impact their Total DebtRatio. Can having too much debt bring down profit margins? Why orWhy Not?arrow_forward
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