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Which one of the following terms is inclusive of both direct and indirect bankruptcy costs?


A) Financial distress costs
B) Capital structure costs
C) Financial leverage
D) Homemade leverage
E) Cost of capital

F) A) and E)
G) A) and D)

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You are considering a firm under three separate scenarios: (1)no debt,taxes,or bankruptcy costs; (2)with debt and taxes but no bankruptcy costs; and (3)with debt,taxes,and bankruptcy costs.Under which one of these three scenarios will the firm have the highest value?

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When debt and taxes are added to an unle...

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Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $879,000.The current cost of equity is 18.3 percent and the tax rate is 34 percent.The company is in the process of issuing $6.2 million of 8.5 percent annual coupon bonds at par.What is the levered value of the firm?


A) $5,278,164
B) $5,541,085
C) $6,422,225
D) $6,713,185
E) $7,385,695

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

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Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $826,000 annually forever.Currently,the firm has no debt but is considering borrowing $650,000 at 6.75 percent interest.The tax rate is 34 percent and the current cost of equity is 17.2 percent.What is the value of the levered firm?


A) $3,187,271
B) $3,169,535
C) $3,307,271
D) $3,390,535
E) $3,506,418

F) B) and C)
G) B) and E)

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Cross Town Cookies is an all-equity firm with a total market value of $720,000.The firm has 150,000 shares of stock outstanding.Management is considering issuing $200,000 of debt at an interest rate of 7 percent and using the proceeds to repurchase shares.The projected earnings before interest and taxes are $58,600.What are the anticipated earnings per share if the debt is issued? Ignore taxes.


A) $0.25
B) $0.33
C) $0.38
D) $0.41
E) $0.47

F) D) and E)
G) A) and B)

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Katz is an all-equity development company that has 36,000 shares of stock outstanding at a market price of $25 a share.The firm's earnings before interest and taxes are $29,000.Katz has decided to issue $200,000 of debt at a rate of 6 percent and use the proceeds to repurchase shares.What should Leslie do if she owns 600 shares of Katz stock and wants to use homemade leverage to offset the leverage being assumed by the firm?


A) Borrow money and buy an additional 22 shares
B) Borrow money and buy an additional 133 shares
C) Sell 22 shares and loan out the proceeds
D) Sell 56 shares and loan out the proceeds
E) Sell 133 shares and loan out the proceeds

F) A) and B)
G) A) and D)

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Stevenson's Bakery is an all-equity firm that has projected perpetual earnings before interest and taxes of $138,000 a year.The cost of equity is 13.7 percent and the tax rate is 32 percent.The firm can borrow money at 6.75 percent.Currently,the firm is considering converting to a debt-equity ratio of 0.45.What is the firm's levered value?


A) $527,613
B) $689,919
C) $752,987
D) $829,507
E) $903,682

F) C) and E)
G) All of the above

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Taunton's is an all-equity firm that has 150,000 shares of stock outstanding.Neal,the financial vice president,is considering borrowing $220,000 at 8.25 percent interest to repurchase 20,000 shares.Ignoring taxes,what is the value of the firm?


A) $1,260,000
B) $1,400,000
C) $1,485,000
D) $1,520,000
E) $1,650,000

F) B) and D)
G) A) and D)

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An all-equity firm has a return on assets of 15.3 percent.The firm is considering converting to a debt-equity ratio of 0.40.The pretax cost of debt is 8.1 percent.Ignoring taxes,what will the cost of equity be if the firm switches to the levered capital structure?


A) 15.30 percent
B) 16.28 percent
C) 16.67 percent
D) 17.46 percent
E) 18.18 percent

F) B) and C)
G) B) and D)

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Which one of the following statements concerning financial leverage is correct?


A) Financial leverage increases profits and decreases losses.
B) Financial leverage has no effect on a firm's return on equity.
C) Financial leverage refers to the use of common stock.
D) Financial leverage magnifies both profits and losses.
E) Increasing financial leverage will always decrease the earnings per share.

F) All of the above
G) A) and B)

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Explain how taxes affect the value of a firm based on M&M Proposition I.

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M&M Proposition I states the value of a ...

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Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt?


A) M&M Proposition I, with taxes
B) M&M Proposition II, with taxes
C) M&M Proposition I, without taxes
D) Homemade leverage proposition
E) Static theory of capital structure

F) B) and C)
G) B) and D)

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Which one of the following is an implication of M&M Proposition II,without taxes?


A) A firm's optimal capital structure is 100 percent debt.
B) WACC is unaffected by the capital structure of a firm.
C) WACC decreases as the debt-equity ratio increases.
D) A firm's capital structure is irrelevant.
E) The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations.

F) B) and C)
G) C) and E)

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Which one of the following terms applies to the costs incurred by a firm that is trying to avoid filing for bankruptcy?


A) Indirect bankruptcy costs
B) Direct bankruptcy costs
C) Static theory cost
D) Optimal capital structure cost
E) Reorganization costs

F) B) and E)
G) All of the above

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When is a firm insolvent from an accounting perspective?


A) When the firm is unable to meet its financial obligations in a timely manner
B) When the firm's debt exceeds the value of the firm's equity
C) When the firm has a negative net worth
D) When the firm's revenues cease
E) When the market value of the firm's equity equals zero

F) A) and B)
G) D) and E)

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Explain the primary difference between a Chapter 7 bankruptcy and a Chapter 11 bankruptcy.

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A Chapter 7 bankruptcy is the ...

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Which one of the following conditions exists at the point where a firm maximizes its value?


A) The tax benefit from an additional dollar of debt is zero.
B) Financial distress costs are equal to zero.
C) The debt-equity ratio is 1.0.
D) WACC is minimized.
E) The cost of equity is minimized.

F) B) and D)
G) C) and E)

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Forbidden Fruit Extracts expects its earnings before interest and taxes to be $325,000 a year forever.Currently,the firm has no debt.The cost of equity is 16.3 percent and the tax rate is 35 percent.The company is in the process of issuing $2 million of bonds at par that carry a 6.5 percent annual coupon.What is the unlevered value of the firm?


A) $371,429
B) $431,971
C) $747,485
D) $969,325
E) $1,296,012

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

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Which one of the following statements concerning financial leverage is correct?


A) The benefits of leverage are unaffected by the amount of a firm's earnings.
B) The use of leverage will always increase a firm's earnings per share.
C) The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage.
D) Changes in the capital structure of a firm will generally change the firm's earnings per share.
E) Financial leverage is beneficial to a firm only when the firm has negative earnings.

F) C) and D)
G) B) and E)

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Which one of the following is the equity risk arising from the capital structure selected by a firm?


A) Strategic risk
B) Financial risk
C) Liquidity risk
D) Industry risk
E) Business risk

F) A) and C)
G) A) and D)

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