Disclaimer: this exam from the past will resemble only in format as what

the upcoming exam looks like. It has been modified to reflect mainly the
materials that are related to our course. However, it does NOT suggest this
old exam will show exactly the same length, difficulty level of, as well as
the emphases and weights on the contents and materials that we have
covered so far for the current exam. Even though it has been edited, this
exam might not cover some of the current course materials as the course is
constantly updated.
Name: _______________________
Section (please circle):

5108

5109

5111

Instructions:
1. Please write your name in the space provided on this page, and circle your
section.
2. The exam is closed book and closed notes.
3. You have two hours to do the exam. There are 100 total points; points per
question are indicated below. Allocate your time carefully.
4. For multiple choice questions, circle the answer that best answers the
questions. Circle only one answer for each question. No partial credit is
given on multiple choice questions or T and F questions, so you do not need to
show your work on these questions.
5. For the rest of the exam, your grade will be based only on work in this exam
book. Show your work and explain any additional assumptions you
make; you will not get full credit for your answer unless you do so. If
you need additional space, please continue on the back of the page and
indicate clearly that you are doing so. It is important to avoid mistakes,
especially ones that lead to glaringly wrong answers, so check your work
carefully.

1) You are preparing a valuation for Acrobatics Corp. Based on the firms most
recent statement, the firm has debt of $1,000 and free cash flow of $2,250. The
firm is stable and the constant, nominal growth rate is 7%. The firms current
stock price is $3 with 1,000 shares outstanding. Additionally, the firm has an
equity beta of 1.2 and a cost of debt of 10%. Assume that the expected return on
the market is 14%, the risk free rate is 5%, and the tax rate is 30%. Carry all
percentages to 2 decimal places, for example, 11.25% is not rounded to 11%.
a. Calculate each of the following:
i. The firms cost of equity

ii. The portion of the cost of equity attributable to the firms operating
risk.

iii. The portion of the cost of equity attributable to the firms financial
risk.

iv. The firms Weighted Average Cost of Capital

b. Acrobatics Corp. is considering altering their capital structure and issues

$500 of stock and uses the proceeds to reduce debt by $500. Further,
assume that the stock will be issued at the current market price of $3 and
the stock price did not change. Additionally, assume that the change in
leverage would have no impact on the firms risk of default. Ignoring
agency problems (i.e. considering only the impact of taxes and default),
calculate each of the following:
i. The firms cost of equity

ii. The firms Weighted Average Cost of Capital

2) ABC Inc. has a debt to equity ratio of 0.2. The firm recently repurchased a large
amount of stock and financed the stock repurchase by issuing debt. This resulted
in the debt to equity ratio increasing to 0.4. For each of the following scenarios,

state the impact of this change in leverage by circling either increase, decrease,
or unchanged.
a) If we consider a world with no taxes, no default risk, no agency problems
and homogeneous information, state what will happen to the firms
i)

Cost of Equity increase decrease unchanged

ii) Weighted Average Cost of Capital increase decrease unchanged

iii) Value increase decrease unchanged
iv) Free Cash Flow increase decrease unchanged
b) If we consider a world with taxes and default risk but no other market
imperfections and we know that the firms optimal leverage ratio is 0.2, state
what will happen to the firms
iii. Cost of Equity increase decrease unchanged
iv. Weighted Average Cost of Capital increase decrease unchanged
v. Value increase decrease unchanged
vi. Free Cash Flow increase decrease unchanged

3) Cash Cow Corp is a stable firm with few growth prospects. Its current assets in
place generate high free cash flow. Explain why this firm may benefit from debt.
4) Modigliani and Miller show that in a world without market imperfections (referred
to in class as a perfect world) capital structure does not matter. Thus, the value
of a levered firm is equal to the value of an unlevered firm as long as everything
else about the two firms are the same. However, our world is not a perfect world.
List 3 of Modigliani and Millers assumptions and briefly explain why debt
impacts value if the assumption is not made.
5) The market value of United Frypan Company is $160 (total firm value). Its book
values are below and the market value of debt equals the book value of debt.
Assume that Modigliani and Millers theory with corporate taxes holds (i.e.
consider only the influence of corporate taxes). There is no growth and the $40 of
debt is expected to be permanent (i.e they will not borrow or repay this debt).
Also, assume a 40% corporate tax rate. (20 points)
Net Working Capital
Fixed Assets
Total

$ 20
80
$100

Debt
Equity
Total

$ 40
60
$100

a) Calculate how much of the firms market value is accounted for by the debtgenerated corporate tax shield? Show the value of the unlevered firm.
b) Assume that in part a, you determined that debt adds $20 of value to the firm
and that the unlevered firm is worth $140. Calculate the market value of

UFs equity if the firm borrows an additional $30 and uses the proceeds to
repurchase stock?
c) Again, assume that in part a, you determined that debt adds $20 of value to
the firm and that the unlevered firm is worth $140. Now suppose that
Congress passes a law eliminating the deductibility of interest for tax
purposes after a grace period of five years (i.e. the firm can deduct interest
from taxable income for 2 more years). Assuming everything else equal, the
firm has the capital structure from part a, and an 8% cost of debt; calculate
the new value of the firm.
6) The following three questions relate to the costs and benefit of debt discussed in
class and how they impact firms in specific situations.
a) State if the following statement is True or False and briefly explain your
answer. A company can incur costs of financial distress without ever going
bankrupt, filing chapter 11, or hiring anyone to assist in legal or administrative
procedures associated with these possible events.
b) Assume that the corporate tax laws are set up such that companies cannot
carry losses forward or back; thus, the firm pays taxes on positive taxable
income and pays nothing (nor receives benefit) for losses. If a company has
earnings before interest (expense), taxes and depreciation (EBITD) of $100,
interest expense of $150, total debt of $15,000 (with a 10% interest rate) and
depreciation expense of $115. Calculate the benefit to the corporate interest
tax shield assuming the corporate tax rate is 30%.
7) ABC Corp. has debt to equity ratio of 0.3 using the market value of equity and
book value of debt. Using the book value of equity, the firms debt to equity ratio
is 0.5. The firm has cost of equity of 14% and a cost of debt of 10%.
a) Assume that the corporate tax rate is 30%. Calculate the required return
investors demand because of the business risk of the firm (i.e. the portion of
the return on equity associated with the business risk). Calculate the
required return associated with the financial risk of the firm.
b) Assume that the firm issues debt and uses the proceeds to repurchase stock
and its new debt to equity ratio is 0.5 using the market value of equity and
book value of debt. Using the book value of equity, the firms debt to equity
ratio is 0.6. The corporate tax rate remains 30%. Calculate the firms WACC,
assuming that the cost of debt does not change with the increased leverage?
8) Assume that the WACC incorporating all costs and benefits of debt for
Abracadabra Inc. is 15%, the cost of capital for the firm if it had no debt is 16%,
the nominal free cashflow expected next year is $10,000, and that the free
cashflow will grow at 9% forever. Also, assume that the entire $10,000 is
considered risky cashflow and that the tax rate is 30%. Further, Abracadabra has
$50,000 in debt, pays $5,000 in interest expense each year, and has a stock price
of $5 per share at year-end and 25,000 shares outstanding. (10 points)
a. Calculate the value of the levered firm.

b. Calculate the value of the unlevered firm.

c. Calculate the value of leverage to Abracadabra. Show what portion of
this value is due to the debt tax shield.
9) According to the theory of optimal capital structure, there are many costs and
benefits to debt. Firms weigh these costs and benefits to determine their optimal
capital structure. State five costs or benefits of debt and if this will increase or
decrease a firms optimal leverage ratio. If it cannot be determined, put it
depends.
The following dividend questions is not applicable to FALL 2002:
10) If the marginal investor as a tax rate of 33% and a company has announced a
dividend of $3.00:
a) The price of stock should decrease by $2.00 immediately after
record.
b) The price of stock should decrease by $2.00 immediately after the
date.
c) The price of stock should decrease by $4.48 immediately after
record.
d) The price of stock should decrease by $4.48 immediately after
date.
e) Both b & c.

the date of
ex-dividend
the date of
ex-dividend

11) Which of the following statement concerning dividends is not true?

a) Dividends are relevant.
b) Dividend policy is argued to be irrelevant.
c) Firms should never give up positive NPV projects to increase a dividend.
d) A key assumption in the dividend irrelevance proposition is that the firms
investment policy is set ahead of time and is not altered by the dividend.
e) None of the above.
12) In the presence of personal taxes the MM irrelevance proposition does not hold
because:
a) Managers have an incentive to seek alternative uses for these funds.
b) Personal taxes always increase the value of dividends.
c) Personal taxes reduce the value of diviends but are not sufficient to eliminate
all dividends.
d) a) and b)
e) a) and c)
13) If dividends are taxed at higher rates than are capital gains, then high dividend
payout stocks should sell at lower prices, everything else equal, compared to low
dividend paying stocks. One implication of this is that investors in ( ) tax brackets
will tend to prefer high dividend payout stocks.
a) Very high
b) Slightly highers than average
c) Average
d) Slightly lower than average
e) Zero

Exam Solutions
1)

1) You are preparing a valuation for Acrobatics Corp. Based on the firms most
recent statement, the firm has debt of $1,000 and free cash flow of $2,250. The firm
is stable and the constant, nominal growth rate is 7%. The firms current stock price
is $3 with 1,000 shares outstanding. Additionally, the firm has an equity beta of 1.2
and a cost of debt of 10%. Assume that the expected return on the market is 14%,
the risk free rate is 5%, and the tax rate is 30%. Carry all percentages to 2 decimal
places, for example, 11.25% is not rounded to 11%.
a. Calculate each of the following:
i)

The firms cost of equity

5+1.2(14-5)=15.8%

ii) The portion of the cost of equity attributable to the firms operating risk.
15.8 = R(U)+(R(U)-10)1/3(1-.3)
R(U) = 14.70%

iii) The portion of the cost of equity attributable to the firms financial risk.
15.8-14.70=1.10%

iv) The firms Weighted Average Cost of Capital

WACC=15.8(3/4)+10(1/4)(1-.3)=13.6
f)

Acrobatics Corp. is considering altering their capital structure and issues $500
of stock and uses the proceeds to reduce debt by $500. Further, assume that
the stock will be issued at the current market price of $3 and the stock price
did not change. Additionally, assume that the change in leverage would have
no impact on the firms risk of default. Ignoring agency problems (i.e.
considering only the impact of taxes and default), calculate each of the
following:
i)

The firms cost of equity

14.7+(14.7-10)5/35(1-.3)=15.17

ii) The firms Weighted Average Cost of Capital

WACC=15.17(3500/4000)+10(500/4000)(1-.3)=14.15

2) ABC Inc. has a debt to equity ratio of 0.2. The firm recently repurchased a large
amount of stock and financed the stock repurchase by issuing debt. This resulted in
the debt to equity ratio increasing to 0.4. For each of the following scenarios, state
the impact of this change in leverage by circling either increase, decrease, or
unchanged.
)a If we consider a world with no taxes, no default risk, no agency problems and
homogeneous information, state what will happen to the firms
)i Cost of Equity increase decrease unchanged
)ii Weighted Average Cost of Capital increase decrease unchanged
)iii Value increase decrease unchanged
)iv Free Cash Flow increase decrease unchanged
)b If we consider a world with taxes and default risk but no other market
imperfections and we know that the firms optimal leverage ratio is 0.2, state
what will happen to the firms
)i Cost of Equity increase decrease unchanged
)ii Weighted Average Cost of Capital increase decrease unchanged
)iii Value increase decrease unchanged
)iv Free Cash Flow increase decrease unchanged

3) Cash Cow Corp is a stable firm with few growth prospects. Its current assets in
place generate high free cash flow. Explain why this firm may benefit from debt.
Like all firms this firm will benefit from the debt tax shield. It
will also benefit because the debt will reduce the excess cash
flow and act as a monitor. Thus, the managers cannot waste
the excess funds.
4) Modigliani and Miller show that in a world without market imperfections (referred
to in class as a perfect world) capital structure does not matter. Thus, the value of a
levered firm is equal to the value of an unlevered firm as long as everything else
about the two firms is the same. However, our world is not a perfect world. List 3 of
Modigliani and Millers assumptions and briefly explain why debt impacts value if
the assumption is not made.
)a No agency problems if DH and SH have unaligned incentives debt is not
preferred because SH may not take all + NPV projects due to risk-shifting; if
mangers and SH have unaligned incentives debt is preferred because in
monitors mangers and limits excess cash flow.

)b No default risk if firms can go bankrupt, more debt increases the probability
and thus firm value is reduced by expected costs times the probability of
bankruptcy.
)c No taxes Corporate taxes shields income and increase firm value (personal
taxes may alter this).
)d MM also assumed homogeneous information, though we did not discuss in
class the implications of relaxing this assumption.
5) The market value of United Frypan Company is $160 (total firm value). Its book
values are below and the market value of debt equals the book value of debt.
Assume that Modigliani and Millers theory with corporate taxes holds (i.e. consider
only the influence of corporate taxes). There is no growth and the $40 of debt is
expected to be permanent (i.e they will not borrow or repay this debt). Also, assume
a 40% corporate tax rate.
Net Working Capital
Fixed Assets
Total

$ 20
80
$100

Debt
Equity
Total

$ 40
60
$100

)a Calculate how much of the firms market value is accounted for by the debtgenerated corporate tax shield? Show the value of the unlevered firm.
Value of tax shield = 40*.4=16
Value of unlevered firm = 160-16=144
)b Assume that in part a, you determined that debt adds $20 of value to the firm
and that the unlevered firm is worth $140. Calculate the market value of
UFs equity if the firm borrows an additional $30 and uses the proceeds to
repurchase stock?
Value of Tax Shield = (30+40).4=28
V of the levered firm =140+28=168
Value of equity =168-70=98 (where 70 is the amount of debt the firm)
Or
Value of Tax Shield = 20+(30).4=32
V of the levered firm =140+32=172
Value of equity =172-70=102 (where 70 is the amount of debt the
firm)
)c Again, assume that in part a, you determined that debt adds $20 of value to
the firm and that the unlevered firm is worth $140. Now suppose that
Congress passes a law eliminating the deductibility of interest for tax
purposes after a grace period of five years (i.e. the firm can deduct interest
from taxable income for 2 more years). Assuming everything else equal, the
firm has the capital structure from part a, and an 8% cost of debt; calculate
the new value of the firm.
Using the equation Debt * the tax rate is appropriate if the tax shield is
a perpetuity. Here the tax shield provides benefit for only 2 years. So,
you must calculate the interest tax shield and discount it for year 1 and
2.

V(L)=140 + (40*.08*.4)/1.08+(40*.08*.4)/1.082 =142

6) The following three questions relate to the costs and benefit of debt discussed in
class and how they impact firms in specific situations.
)a State if the following statement is True or False and briefly explain your
answer. A company can incur costs of financial distress without ever going
bankrupt, filing chapter 11, or hiring anyone to assist in legal or administrative
procedures associated with these possible events.
True. A firm can incur indirect cost of bankruptcy without filing for
bankruptcy.
)b Assume that the corporate tax laws are set up such that companies cannot
carry losses forward or back; thus, the firm pays taxes on positive taxable
income and pays nothing (nor receives benefit) for losses. If a company has
earnings before interest (expense), taxes and depreciation (EBITD) of $100,
interest expense of $150, total debt of $15,000 (with a 10% interest rate) and
depreciation expense of $115. Calculate the benefit to the corporate interest
tax shield assuming the corporate tax rate is 30%.
Taxable income before interest = 100-115<0, so no income to shield
after depreciation tax shield. This illustrates the impact of non-debt
tax shields on the interest tax shield.
7) ABC Corp. has debt to equity ratio of 0.3 using the market value of equity and
book value of debt. Using the book value of equity, the firms debt to equity ratio is
0.5. The firm has cost of equity of 14% and a cost of debt of 10%.
)a Assume that the corporate tax rate is 30%. Calculate the required return
investors demand because of the business risk of the firm (i.e. the portion of
the return on equity associated with the business risk). Calculate the
required return associated with the financial risk of the firm.
BR=The return on the unlevered firm (I would also accept WACC as the
measure of business risk)
R(E)=.14=R(U)+(R(U)-.10).3*.7
R(U) =13.31%
FR=the portion of the R(E) after the plus sign
=.3(.1331-.10)(1-.3)=0.701%
)b Assume that the firm issues debt and uses the proceeds to repurchase stock
and its new debt to equity ratio is 0.5 using the market value of equity and
book value of debt. Using the book value of equity, the firms debt to equity
ratio is 0.6. The corporate tax rate remains 30%. Calculate the firms WACC,
assuming that the cost of debt does not change with the increased leverage?
You must unlever and relever R(E) to use in WACC. R(U) is in a.
Re-lever to get new R(E):
R(E)=.1331+(.1331-.10).5(.7)=14.46%
WACC=.1446(10/15)+.10(5/15).7=11.97%

8) Assume that the WACC incorporating all costs and benefits of debt for Abracadabra
Inc. is 15%, the cost of capital for the firm if it had no debt is 16%, the nominal free
cashflow expected next year is $10,000, and that the free cashflow will grow at 9%
forever. Also, assume that the entire $10,000 is considered risky cashflow and that
the tax rate is 30%. Further, Abracadabra has $50,000 in debt, pays $5,000 in
interest expense each year, and has a stock price of $5 per share at year-end and
25,000 shares outstanding.
a. Calculate the value of the levered firm.
10,000/(.15-.09)=166,667
b. Calculate the value of the unlevered firm.
10,000/(.16-.09)=142,857
c. Calculate the value of leverage to Abracadabra. Show what portion of
this value is due to the debt tax shield.
166,667-142,857=23,810
Tax shield=50,000*.3=15,000 (63%)
9) According to the theory of optimal capital structure, there are many costs and
benefits to debt. Firms weigh these costs and benefits to determine their optimal
capital structure. State five costs or benefits of debt and if this will increase or
decrease a firms optimal leverage ratio. If it cannot be determined, put it depends.
1. Corp taxes, increase
2. Personal taxes, depends
3. Bankruptcy cost, decrease
4. Risk-shifting (shareholder-debtholder agency costs), decrease
10) b.

5. Monitoring (shareholder-manager agency costs), increase

11) e.
12) e.
13) e.

10