Capital Structure: Basic Concepts

What is the primary conclusion of the pie model of capital structure regarding the goal of management?

J. J. Sprint Company, an unlevered firm, has a market value of $1,000 and 100 shares of stock. It plans to borrow $500 and pay it out as a dividend. If, after this restructuring, the firm's value increases to $1,250, what is the net gain to the original stockholders?

Trans Am Corporation is currently an all-equity firm with assets of $8,000 and 400 shares outstanding. If the company has earnings of $400 during a recession, what is its Earnings Per Share (EPS)?

Trans Am Corporation is considering issuing $4,000 of debt at a 10 percent interest rate. If the company proceeds with this plan and experiences an expansion where earnings before interest (EBI) are $2,000, what will be the Earnings Per Share (EPS)?

At what level of Earnings Before Interest (EBI) do the unlevered and levered capital structures for Trans Am Corporation produce the same Earnings Per Share (EPS)?

What is the concept of 'homemade leverage' as described by Modigliani and Miller?

What does Modigliani-Miller Proposition I state in a world without corporate taxes?

According to MM Proposition II (no taxes), what is the relationship between the expected return on equity and leverage?

An all-equity firm has a cost of capital (R0) of 15 percent. It is considering a capital structure with a debt-to-equity ratio (B/S) of 1. The cost of debt (Rb) is 10 percent. According to MM Proposition II (no taxes), what is the firm's new cost of equity (Rs)?

In a world with no corporate taxes, what happens to a firm's weighted average cost of capital (WACC) as it increases leverage?

What is the primary reason that debt provides a tax advantage in the U.S. tax system?

Water Products Company has expected EBIT of $1,000,000 and a corporate tax rate of 35 percent. If the company takes on $4,000,000 of debt with a 10 percent interest rate, what is the annual tax shield from this debt?

According to MM Proposition I with corporate taxes, what is the value of a levered firm (VL)?

Divided Airlines is an unlevered firm with expected EBIT of $153.85 and a cost of equity (R0) of 20 percent. The corporate tax rate is 35 percent. If the firm takes on $200 of debt, what is the new value of the firm (VL)?

In a world with corporate taxes, what happens to the weighted average cost of capital (WACC) as a firm increases its leverage?

What is the key insight of the MM 'pie model' of capital structure?

In the Trans Am example, if an investor wants to replicate the payoff of buying 100 shares of the levered equity, what action must she take using the unlevered firm's stock?

According to the MM Proposition II (no taxes) formula, Rs = R0 + (B/S)(R0 - Rb), the cost of equity (Rs) rises as the debt-to-equity ratio (B/S) increases. What must be true for this relationship to hold?

In a world with corporate taxes, what is the present value of the tax shield for a firm with $1 million in perpetual debt, a cost of debt (Rb) of 10 percent, and a corporate tax rate (tC) of 35 percent?

Why does a market value balance sheet differ from an accountant's balance sheet?

Luteran Motors, an all-equity firm with 10 million shares, has a market value of $100 million. It announces it will issue $4 million in equity to fund a new plant with an NPV of $6 million. What is the stock price immediately after the announcement?

In the MM world with no taxes, why is the overall cost of capital (WACC) invariant to leverage?

A firm with a corporate tax rate of 35 percent has an unlevered cost of capital (R0) of 20 percent and a cost of debt (Rb) of 10 percent. If it adopts a debt-to-equity ratio (B/S) of 2/3, what is its new cost of equity (Rs) according to MM Proposition II with taxes?

Divided Airlines has a levered cost of equity (Rs) of 23.51 percent, a cost of debt (Rb) of 10 percent, a tax rate of 35 percent, and a capital structure of $200 debt and $370 equity. What is its Weighted Average Cost of Capital (WACC)?

What does the MM theory, when corporate taxes are considered, imply about the optimal capital structure for a firm?

In the J.J. Sprint example, why should managers choose the capital structure that maximizes the total firm value?

How does increasing financial leverage affect the Return on Equity (ROE) for a firm like Trans Am?

What is the key assumption of the Modigliani-Miller theory that allows for the concept of homemade leverage to work perfectly?

In the MM model with corporate taxes, if the unlevered cost of capital R0 is 15 percent, the cost of debt Rb is 10 percent, and the tax rate is 40 percent, what is the WACC for a firm with a debt-to-equity ratio of 1?

A key difference between the MM propositions with and without taxes is the effect of leverage on the firm's WACC. Without taxes, WACC is constant. With corporate taxes, how does the WACC behave as leverage increases?