Corporate Finance and Capital Structure Concepts Questions

Conceptual Questions 1. Homemade leverage is: the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage 2. Which one of the following states that the value of a firm is unrelated to the firm's capital structure? M&M Proposition I 3. 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? M&M Proposition II 4. Which one of the following is the equity risk that is most related to the daily operations of a firm? Business risk 5. Which one of the following is the equity risk related to a firm's capital structure policy? Financial 6. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? Interest tax shield 7. The unlevered cost of capital refers to the cost of capital for a(n): all equity firm 8. The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as direct bankruptcy costs 9. The costs incurred by a business in an effort to avoid bankruptcy are classified as indirect bankruptcy costs. 10. By definition, which of the following costs are included in the term "financial distress costs"? direct bankruptcy costs indirect bankruptcy costs direct costs related to being financially distressed, but not bankrupt indirect costs related to being financially distressed, but not bankrupt 11. 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: the static theory of capital structure 12. Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? Bankruptcy 13. A firm should select the capital structure that: maximizes the value of the firm 14. The value of a firm is maximized when the: WACC is minimized 15. The optimal capital structure has been achieved when the: debt-equity ratio results in the lowest possible weighted average cost of capital 16. AA Tours 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 AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes. select the unlevered option since the expected EBIT is less than the break-even level 17. 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: firm is just earning enough to pay for the cost of the debt 18. Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. At the break-even point, there is no advantage to debt 19. Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to: sell some shares of Quantro stock and loan out the sale proceeds. 20. Which one of the following makes the capital structure of a firm irrelevant? Homemade leverage 21. M & M Proposition I with no tax supports the argument that: d/e ratio of a firm is completely irrelevant 22. The concept of homemade leverage is most associated with: M&M proposition I w/ no tax 23. Which of the following statements are correct in relation to M & M Proposition II with no taxes? o The required return on assets is equal to the weighted average cost of capital. o Financial risk is determined by the debt-equity ratio 24. M & M Proposition II is the proposition that: a firm's cost of equity is a linear function with a slope equal to (RA - RD). 25. The business risk of a firm: has a positive relationship with the firm's cost of equity. 26. Which of the following statements related to financial risk are correct? Financial risk is the risk associated with the use of debt financing. As financial risk increases so too does the cost of equity. Financial risk is wholly dependent upon the financial policy of a firm 27. M & M Proposition I with tax supports the theory that: a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases. 28. M & M Proposition I with taxes is based on the concept that: the value of a firm increases as the firm's debt increases because of the interest tax shield. 29. M & M Proposition II with taxes: has the same general implications as M & M Proposition II without taxes. 30. The present value of the interest tax shield is expressed as: Tc x D 31. The interest tax shield has no value when a firm has a: tax rate of 0, zero debt, zero leverage 32. The interest tax shield is a key reason why: the net cost of debt to a firm is generally less than the cost of equity 33. Based on M & M Proposition II with taxes, the weighted average cost of capital: decreases as the debt-equity ratio increases. 34. Bankruptcy: transfers value from shareholders to bondholders. 35. Which one of the following is a direct bankruptcy cost? paying an outside accountant fees to prepare bankruptcy reports 36. If a firm has the optimal amount of debt, then the: value of the levered firm will exceed the value of the firm if it were unlevered. 37. Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm? low probabilities of financial distress 38. The capital structure that maximizes the value of a firm also: minimizes cost of capital 39. The optimal capital structure: will vary over time as taxes and market conditions change. 40. The static theory of capital structure advocates that the optimal capital structure for a firm: equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt 41. The basic lesson of M & M Theory is that the value of a firm is dependent upon: the total cash flow of the firm 42. Which form of financing do firms prefer to use first according to the pecking-order theory? Internal funds 43. Which of the following are correct according to pecking-order theory? Firms stockpile internally generated cash. There is an inverse relationship between a firm's profit level and its debt level. A firm's capital structure is dictated by its need for external financing. 44. Corporations in the US tend to: underutilize debt Mathematical Questions 45. Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes EBIT/40,000 = [EBIT - ($280,000 × 0.07)]/25,000; EBIT = $52,267 46. Holly's is currently an all equity firm that has 9,000 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 9.5 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 EBIT/9,000 = [EBIT - ($120,000 × 0.095)]/[9,000 - ($120,000/$45)]; EBIT = $38,475 47. Sewer's Paradise is an all equity firm that has 5,000 shares of stock outstanding at a market price of $15 a share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes. Number of shares repurchased = $30,000/$15 = 2,000 EBIT/5,000 = [EBIT - ($30,000 × .0.10)]/(5,000 - 2,000); EBIT = $7,500 EPS = [$7,500 - ($30,000 × 0.10)]/(5,000 - 2,000); EPS = $1.50 48. Miller's Dry Goods is an all equity firm with 48,000 shares of stock outstanding at a market price of $50 a share. The company's earnings before interest and taxes are $128,000. Miller's has decided to add leverage to its financial operations by issuing $250,000 of debt at 8 percent interest. The debt will be used to repurchase shares of stock. You own 400 shares of Miller's stock. You also loan out funds at 8 percent interest. How many shares of Miller's stock must you sell to offset the leverage that Miller's is assuming? Assume you loan out all of the funds you receive from the sale of stock. Ignore taxes. Miller's interest = $250,000 × 0.08 = $20,000 Miller's shares repurchased = $250,000/$50 = 5,000 Miller's shares outstanding with debt = 48,000 - 5,000 = 43,000 Miller's EPS, no debt = $128,000/48,000 = $2.666667 Miller's EPS, with debt = ($128,000 - $20,000)/43,000 = $2.511628 Miller's value of stock = 43,000 × $50 = $2,150,000 Miller's value of debt = $250,000 Miller's total value = $2,150,000 + $250,000 = $2,400,000 Miller's weight stock = $2,150,000/$2,400,000 = 0.895833 Miller's weight debt = $250,000/$2,400,000 = 0.104167 Your initial investment = 400 × $50 = $20,000 Your new stock position = 0.895833 × $20,000 = $17,916.67 Your new number of shares = $17,916.67/$50 = 358.3333 Number of shares sold = 400 - 358.3333 = 41.67 shares Check: Your new loans = 0.104167 × $20,000 = $2,083.33 Your total unlevered income = 400 × $2.666667 = $1,066.67 Your total levered income = (358.3333 × $2.511628) + ($2,083.33 × 0.08) = $11,066.67 49. You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to un-lever your position if you can loan out funds at 8 percent interest? JKL interest = $1m × 0.08 = $80,000 JKL shares repurchased = $1m/$40 = 25,000 JKL shares outstanding with debt = 75,000 - 25,000 = 50,000 JKL EPS, no debt = $140,000/75,000 = $1.866667 JKL EPS, with debt = ($140,000 - $80,000)/50,000 = $1.20 JKL value of stock = 50,000 × $40 = $2m JKL value of debt = $1m JKL total value = $2m + $1m = $3m JKL weight stock = $2m/$3m = 2/3 JKL weight debt = $1m/$3m = 1/3 Your initial investment = 600 × $40 = $24,000 Your new stock position = 2/3($24,000) = $16,000 Your new number of shares = $16,000/$40 = 400 Number of shares sold = 600 - 400 = 200 shares Check: Your new loans = 1/3($24,000) = $8,000 Your unlevered income = 600 × $1.866667 = $1,120 Your levered income = (400 × $1.20) + ($8,000 × 0.08) = $1,120 50. Naylor's is an all equity firm with 60,000 shares of stock outstanding at a market price of $50 a share. The company has earnings before interest and taxes of $102,000. Naylor's has decided to issue $750,000 of debt at 7.5 percent. The debt will be used to repurchase shares of the outstanding stock. Currently, you own 500 shares of Naylor's stock. How many shares of Naylor's stock will you continue to own if you unlever this position? Assume you can loan out funds at 7.5 percent interest. Ignore taxes. Naylor's interest = $825,000 × 0.075 = $61,875 Naylor's shares repurchased = $825,000/$50 = 16,500 Naylor's shares outstanding with debt = 60,000 - 16,500 = 43,500 Naylor's EPS, no debt = $102,000/60,000 = $1.70 Naylor's EPS, with debt = ($102,000 - $61,875)/43,500 = $.9224138 Naylor's value of stock = 43,500 × $50 = $2,175,000 Naylor's value of debt = $825,000 Naylor's total value = $2,175,000 + $825,000 = $3,000,000 Naylor's weight stock = $2,175,000/$3,000,000 = 0.725 Naylor's weight debt = $825,000/$3,000,000 = 0.275 Your initial investment = 500 × $50 = $25,000 Your new stock position = 0.725 × $25,000 = $18,125 Your new number of shares = $18,125/$50 = 362.5 shares Check: Your new loans = 0.275 × $25,000 = $6,875 Your unlevered income = 500 × $1.70 = $850 Your levered income = (362.5 × $0.9224138) + ($6,875 × 0.075) = $850 51. Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? Firm value = 80,000 × ($600,000/12,000) = $4 million 52. The Jean Outlet is an all equity firm that has 146,000 shares of stock outstanding. The company has decided to borrow the $1.1 million to repurchase 7,500 shares of its stock from the estate of a deceased shareholder. What is the total value of the firm if you ignore taxes? Firm value = 152,000 × ($1.1m/7,500) = $22,293,333 53. Stacy owns 38 percent of The Town Centre. She has decided to retire and wants to sell all of her shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $650,000 to purchase her shares of stock. What is the total market value of The Town Centre? Ignore taxes Firm value = $650,000/0.38 = $1,710,526 54. Winter's Toyland has a debt-equity ratio of 0.65. The pre-tax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. What is the cost of equity if you ignore taxes? RE = 0.161 + (0.161 - 0.087) × 0.65 = 20.91% 55. Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M & M II with no taxes? RE = 0.146 = 0.132 + (0.132 - 0.078) × D/E; D/E = 0.26 56. The Corner Bakery has a debt-equity ratio of 0.62. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M & M Proposition II with no taxes? RE = 0.161 = 0.142 + (0.142 - Rd) × 0.62; Rd = 11.14% 57. L.A. Clothing has expected earnings before interest and taxes of $48,900, an unlevered cost of capital of 14.5 percent, and a tax rate of 34 percent. The company also has $8,000 of debt that carries a 7 percent coupon. The debt is selling at par value. What is the value of this firm? VU = [$48,900 × (1 - 0.34)]/0.145 = $222,579.31 VL = $222,579.31 + 0.34 ($8,000) = $225,299.31 58. Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity? VL = (320,000 × $19) + (0.34 × $1.2m) = $6.488m VE = $6.488m - $1.2m = $5.288m 59. Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm? VU = [$48,600 × (1 - 0.34)]/0.132 = $243,000 VL = $243,000 + (0.34 × $25,000) = $251,500 60. Exports Unlimited is an unlevered firm with an aftertax net income of $52,300. The unlevered cost of capital is 14.1 percent and the tax rate is 36 percent. What is the value of this firm? VU = $52,300/0.141 = $370,922 61. An unlevered firm has a cost of capital of 17.5 percent and earnings before interest and taxes of $327,500. A levered firm with the same operations and assets has both a book value and a face value of debt of $650,000 with a 7.5 percent annual coupon. The applicable tax rate is 38 percent. What is the value of the levered firm? VU = [$327,500 × (1 - 0.38)]/0.175 = $1,160,285.71 VL = $1,160,285.71 + 0.38($650k) = $1,407,286 62. Down Bedding has an unlevered cost of capital of 14 percent, a cost of debt of 7.8 percent, and a tax rate of 32 percent. What is the target debt-equity ratio if the targeted cost of equity is 15.51 percent? RE = 0.1551 = 0.14 + (0.14 - 0.078) × D/E × (1 - 0.32); D/E = 0.358 63. Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity? VU = [$2,100 × (1 - 0.30)]/0.117 = $12,564.10 VL = $12,564.10 + (0.30 × $12,000) = $16,164.10 VE = $16,164.10 - $12,000 = $4,164.10 RE = 0.117 + [(0.117 - 0.06) × ($12,000/$4,164.10) × (1 - 0.30)] = 23.20% 64. Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $12,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity? VU = [$15,700 × (1 - 0.38)]/0.12 = $81,116.67 VL = $81,116.67 + (0.38 × $12,000) = $85,676.67 VE = $85,676.67 - $12,000 = $73,676.67 RE = 0.12 + [(0.12 - 0.06) × ($12,000/$73,676.67) × (1 - 0.38)] = 12.61% 65. The Pizza Palace has a cost of equity of 15.3 percent and an unlevered cost of capital of 11.8 percent. The company has $22,000 in debt that is selling at par value. The levered value of the firm is $41,000 and the tax rate is 34 percent. What is the pre-tax cost of debt? RE = 0.153 = 0.118 + (0.118 - RD) × [$22,000/($41,000 - $22,000)] × (1 - 0.34); RD = 7.22 % 66. The Green Paddle has a cost of equity of 12.1 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital? RE = 0.121 = RU + (RU - 0.076) × 0.65 × (1 - 0.32); RU = 10.72 percent 67. Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio? RE = 0.18 = 0.146 + (0.146 - 0.084) × D/E × (1 - 0.37); D/E = 0.87 68. Douglass & Frank has a debt-equity ratio of 0.35. The pre-tax cost of debt is 8.2 percent while the unlevered cost of capital is 13.3 percent. What is the cost of equity if the tax rate is 39 percent? RE = 0.133 + (0.133 - 0.082) × 0.35 × (1 - 0.39) = 14.39% 69. The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield? Annual interest tax shield = $270,000 × 0.075 × 0.39 = $7,897.50 70. Georga's Restaurants has 5,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent? Annual interest tax shield = 5,000 × $1,000 × 0.0825 × 0.37 = $152,625.00 71. D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield? Present value of the tax shield = 0.32 × $21,000 = $6,720 72. Jemisen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital? VU = [$6,200 × (1 - 0.34)]/0.14 = $29,228.57 VL = $29,228.57 + (0.34 × $2,500) = $30,078.57 VE = $30,078.57 - $2,500 = $27,578.57 RE = 0.14 + (0.14 - 0.09) × ($2,500/$27,578.57) × (1 - 0.34) = 0.142991 WACC = [($27,578.57/$30,078.57) × 0. 142991] + [($2,500/$30,078.57) × 0.09 × (1 - 0.34)] = 13.60% 73. A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital? WACC = {[($26,400 - $12,000)/$26,400] × 0.176} + [($12,000/$26,400) × 0.092 × (1 - 0.37)] = 12.23% 74. Young's Home Supply has a debt-equity ratio of 0.80. The cost of equity is 14.5 percent and the after-tax cost of debt is 4.9 percent. What will the firm's cost of equity be if the debt-equity ratio is revised to 0.70? WACC = [(1.0/1.8) × 0.145] + [(0.8/1.8) × 0.049] = 0.102333; WACC = 0.102333 = [(1.0/1.70) × RE] + [(0.70/1.70) × 0.049; RE = 13.97 percent 75. Percy's Wholesale Supply has earnings before interest and taxes of $106,000. Both the book and the market value of debt is $170,000. The unlevered cost of equity is 15.5 percent while the pre-tax cost of debt is 8.6 percent. The tax rate is 38 percent. What is the firm's weighted average cost of capital? VU = [$106,000 × (1 - 0.38)]/0.155 = $424,000 VL = $424,000 + (0.38 × $170,000) = $488,600 VE = $488,600 - $170,000 = $318,600 RE = 0.155 + (0.155 - 0.086) × ($170,000/$318,600) × (1 - 0.38) = 0.177827 WACC = [($318,600/$488,600) × 0.177827] + [($170,000/$488,600) × 0.086 × (1 - 0.38)] = 13.45% 76. East Side, Inc. has no debt outstanding and a total market value of $136,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes. Share price = $136,000/2,000 = $68 Shares repurchased = $54,000/$68 = 794.117647 Annual interest = $54,000 × 0.05 = $2,700 EPSNormal = ($12,000 - $2,700)/(2,000 - 794.117647) = $7.712195 EPSRecession = {[$12,000 × (1 - 0.55)] - $2,700}/(2,000 - 794.117647) = $2.239024 Percentage change = ($2.239024 - $7.712195)/$7.712195 = -70.97 percent 77. Galaxy Products is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Galaxy would have 178,500 shares of stock outstanding. Under Plan II, there would be 71,400 shares of stock outstanding and $1.79 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. What is the breakeven EBIT? EBIT/178,500 = [EBIT - 0.10($1,790,000)]/71,400; EBIT = $298,333.33 78. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent ABC: RE = RA = $58,400/$480,000 = 12.17 percent XYZ: RE = 0.1217 + (0.1217 - 0.09) x (1) = 15.33 percent Note: ABC: Equity = $480,000 XYZ: Equity = $240,000; Debt = $480,000 - $240,000 = $240,000; D/E = 1 79. Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT? V = $38,000,000 = EBIT/0.11; EBIT = $4,180,000 80. The SLG Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $31 million and the corporate tax rate is 34 percent. What is EBIT? VU = $31,000,000 = EBIT (1 - 0.34)/0.11; EBIT = $5,166,667 81. W.V. Trees, Inc. has a debt-equity ratio of 1.4. Its WACC is 10 percent, and its cost of debt is 9 percent. The corporate tax rate is 33 percent. What is the firm's unlevered cost of equity capital? WACC = 0.10 = (1/2.4) RE + (1.4/2.4) (0.09) (1 - 0.33); RE = 0.15558 RE = 0.15558 = RU + (RU - 0.09)(1.4)(1 - 0.33); RU = 12.38% 82. New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has no debt, and its cost of equity is 15 percent. The firm can borrow at 8 percent and the corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent debt? VU = $7,000 (1 - 0.34)/0.15 = $30,800.00 VL = $30,800.00 + 0.34 (0.50) ($30,800.00) = $36,036.00 Note: When levered, the value of debt is equal to one-half of the unlevered value of the firm Essay Questions 1. Based on the M & M propositions with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory? Under either M & M scenario, a financial manager should not spend time analyzing the firm's capital structure. With no taxes, capital structure is irrelevant. With taxes, M & M says a firm will maximize its value by using 100 percent debt. In both cases, the manager has nothing to decide. With the static theory, however, the manager must determine the optimal amount of debt and equity by analyzing the tradeoff between the benefits of the interest tax shield versus the financial distress costs. Finding the optimal capital structure is challenging in this case 2. Pete is the CFO of Dexter International. He would like to increase the debt-equity ratio of the firm but is concerned that the firm's shareholders may not be willing to accept additional financial leverage. Pete has come to you for advice. What is your recommendation? The capital structure of the firm is irrelevant to the shareholders because they can use homemade leverage to adjust their exposure to financial leverage to whatever level they prefer. Thus, Pete can increase the debt-equity ratio of the firm if he feels it is in the best interest of the firm to do so. 3. In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm? This question requires students to differentiate between the cost of equity and the weighted average cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades off higher equity costs for lower debt costs. The shareholders benefit (to a point, according to the static theory) because their investment in the firm is leveraged, enhancing the return on their investment. Thus, even though the cost of equity rises, the overall cost of capital declines (again, up to a point according to the static theory) and firm value rises. 4. Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective. The bankruptcy process is a legal proceeding that either liquidates or reorganizes a firm. Under either situation, legal, accounting, and other administrative fees are incurred. These fees, which are frequently quite substantial, must be paid out of the assets of the firm, thereby reducing the value remaining for the creditors and shareholders. In addition, the bankruptcy process generally transfers value from the shareholders to the creditors based on the absolute priority rule.