ANALYSIS OF CAPITAL STRUCTURE THEORY

True/False
Easy:
(26.1) Taxes and capital structure FQ Answer: a EASY
i. In a world with no taxes, MM show that a firm’s capital structure does not
affect the firm’s value. However, when taxes are considered, MM show a
positive relationship between debt and value, i.e., its value rises as its
debt is increased.
a. True

ii. According to MM, in a world without taxes the optimal capital structure for a
firm is approximately 100% debt financing.
b. False

(26.1) MM models FQ Answer: a EASY

iii. MM showed that in a world with taxes, a firm’s optimal capital structure
would be almost 100% debt.
a. True

iv. MM showed that in a world without taxes, a firm’s value is not affected by
its capital structure.
a. True

v. The Miller model begins with the MM model with taxes and then adds personal
taxes.
a. True

vi. The Miller model begins with the MM model without corporate taxes and then
adds personal taxes.
b. False

vii. Other things held constant, an increase in financial leverage will increase a
firm's market (or systematic) risk as measured by its beta coefficient.
a. True

Medium:
(26.2) MM models FQ Answer: a MEDIUM
viii. The MM model with corporate taxes is the same as the Miller model, but with
zero personal taxes.
a. True

ix. The MM model is the same as the Miller model, but with zero corporate taxes.
b. False

(26.4) MM extension with growth FQ Answer: a MEDIUM

x. In the MM extension with growth, the appropriate discount rate for the tax
shield is the unlevered cost of equity.
a. True

xi. In the MM extension with growth, the appropriate discount rate for the tax
shield is the WACC.
b. False
xii. In the MM extension with growth, the appropriate discount rate for the tax
shield is the after-tax cost of debt.
b. False

(26.5) Equity as an option FQ Answer: a MEDIUM

xiii. When a firm has risky debt, its equity can be viewed as an option on the
total value of the firm with an exercise price equal to the face value of the debt.
a. True

xiv. When a firm has risky debt, its debt can be viewed as an option on the total
value of the firm with an exercise price equal to the face value of the
equity.
b. False

Multiple Choice: Conceptual

Medium:

(26.2) Miller model CQ Answer: b MEDIUM

xv. The major contribution of the Miller model is that it demonstrates that
b. personal taxes decrease the value of using corporate debt.

(26.3) MM and Miller CQ Answer: d MEDIUM

xvi. Which of the following statements concerning capital structure theory is NOT
CORRECT?
d. Under MM with corporate taxes, rs increases with leverage, and this
increase exactly offsets the tax benefits of debt financing.

(26.4) MM extension with growth CQ Answer: d MEDIUM

xvii. Which of the following statements concerning the MM extension with growth is
NOT CORRECT?
d. For a given D/S, the WACC is less than the WACC under MM’s original (with
tax) assumptions.

xviii. Which of the following statements concerning the MM extension with growth
is NOT CORRECT?
a. The tax shields should be discounted at the cost of debt.

xix. Which of the following statements concerning the MM extension with growth is
NOT CORRECT?
e. The total value of the firm is independent of the amount of debt it uses.

Multiple Choice: Problems

Medium:

(26.4) MM extension with growth CQ Answer: e MEDIUM

xx. Firm L has debt with a market value of $200,000 and a yield of 9%. The
firm's equity has a market value of $300,000, its earnings are growing at a
rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost
of equity of 12%. Under the MM extension with growth, what is Firm L's cost
of equity?
e. 14.0%
xxi. Firm L has debt with a market value of $200,000 and a yield of 9%. The
firm's equity has a market value of $300,000, its earnings are growing at a
5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of
equity of 12%. Under the MM extension with growth, what would Firm L's
total value be if it had no debt?
c. $397,143

xxii. Your firm has debt worth $200,000, with a yield of 9%, and equity worth
$300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar
firm with no debt has a cost of equity of 12%. Under the MM extension with
growth, what is the value of your firm’s tax shield, i.e., how much value
does the use of debt add?
b. $102,857

Multi-part:

(The following data apply to Problems 23 through 25. The problems MUST be kept together.)

The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and
a corporate tax rate of 30%. Kimberly uses $500,000 of 12.0% debt, and the cost of
equity to an unlevered firm in the same risk class is 16.0%.

(26.1) MM with tax CQ Answer: c EASY

xxiii. What is the value of the firm according to MM with corporate taxes?
c. $587,500

xxiv. What is the firm's cost of equity?

e. 32.0%

(26.2) Miller model CQ Answer: e HARD

xxv. Assume that the firm's gain from leverage according to the Miller model is
$126,667. If the effective personal tax rate on stock income is TS = 20%, what
is the implied personal tax rate on debt income?
e. 25.0%

(The following data apply to Problems 26 through 28. The problems MUST be kept together.)

Gomez computer systems has an EBIT of $200,000, a growth rate of 6%, and its tax
rate is 40%. In order to support growth, Gomez must reinvest 20% of its EBIT in
net operating assets. Gomez has $300,000 in 8% debt outstanding, and a similar
company with no debt has a cost of equity of 11%.

(26.4) MM extension with growth CQ Answer: e MEDIUM

xxvi. According to the MM extension with growth, what is the value of Gomez’s tax
shield?
e. $192,000

xxvii. According to the MM extension with growth, what is Gomez’s unlevered

value?
c. $1,600,000

xxviii. According to the MM extension with growth, what is Gomez’s value of

equity?
a. $1,492,000
(The following data apply to Problems 29 through 31. The problems MUST be kept together.)

Trumbull, Inc., has total value (debt plus equity) of $500 million and $200
million face value of 1-year zero coupon debt. The volatility () of Trumbull’s
total value is 0.60, and the risk-free rate is 5%. Assume that N(d1) = 0.9720 and
N(d2) = 0.9050.

(26.5) Equity as an option CQ Answer: d MEDIUM

xxix. What is the value (in millions) of Trumbull’s equity if it is viewed as an
option?
d. $313.81

xxx. What is the value (in millions) of Trumbull’s debt if its equity is viewed
as an option?
b. $186.19

xxxi. What is the yield on Trumbull’s debt?

e. 7.42%
xii. (26.4) MM extension with growth FQ Answer: b MEDIUM

xiii. (26.5) Equity as an option FQ Answer: a MEDIUM

xiv. (26.5) Equity as an option FQ Answer: b MEDIUM

xv. (26.2) Miller model CQ Answer: b MEDIUM

xvi. (26.3) MM and Miller CQ Answer: d MEDIUM

xvii. (26.4) MM extension with growth CQ Answer: d MEDIUM

xviii.(26.4) MM extension with growth CQ Answer: a MEDIUM

xix. (26.4) MM extension with growth CQ Answer: e MEDIUM

xx. (26.4) MM extension with growth CQ Answer: e MEDIUM

Debt: $200,000 Equity: $300,000

rd: 9% rsU : 12%
T: 40% g: 5%

rsL = rsU + (rsU – rd)(D/S) = 12% + (12% – 9%)($200,000/$300,000) = 14.0%

xxi. (26.4) MM extension with growth CQ Answer: c MEDIUM

Debt: $200,000 Equity: $300,000

rd: 9% rsU : 12%
T: 40% g: 5%

Firm L has a total value of $200,000 + $300,000 = $500,000. A similar firm with no debt should have a smaller value. Here
is the calculation:
VTotal = VU + VTS, so VU = VTotal – VTS = D + S – VTS.
Value tax shelter = VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857
VU = $300,000 + $200,000 – $102,857 = $397,143

xxii. (26.4) MM extension with growth CQ Answer: b MEDIUM

 Debt: $200,000 Equity: $300,000
rd: 9% rsU: 12%
T: 40% g: 5%

VTotal = VU + VTS
Value tax shelter = VTS = rdTD/(rsU – g)
VTS = rdTD/(rsU – g) = 0.09(0.40)($200,000)/(0.12 – 0.05) = $102,857

xxiii.(26.1) MM with tax CQ Answer: c EASY

EBIT: $100,000 rd: 12% Tc: 30%

Debt: $500,000 rsU: 16%

VU = EBIT(1 – T)/rsU = $100,000(0.7)/0.16 = $437,500

VL = VU + TD = $437,500 + 0.3($500,000) = $587,500

xxiv. (26.1) MM with tax CQ Answer: e EASY

First, note that the leveraged value of the firm is $587,500 as found in Problem 23. Note also that the firm has $500,000 of
debt. Therefore, the value of its equity must be $87,500. Using these data, we find the leveraged cost of equity as follows:

rsL = rsU + (rsU – rd)(1 – T)(D/S) = 16% + (16% – 12%)(0.7)($500,000/$87,500) = 32.0%

xxv. (26.2) Miller model CQ Answer: e HARD

Tc: 30% Gain from leverage: $126,667

Ts: 20% Debt: $500,000

[1 – (1 – Tc)(1 – Ts)/(1 – Td)]D = $126,667 (1 − Tc) = 0.70

[1 – (0.7)(0.8)/X]$500,000 = $126,667 (1 − Ts) = 0.80
1 – 0.56/X = 0.25333 (1 − Tc) × (1 − Ts) = 0.56
0.56/X = 0.74667 Gain/Debt = 0.25333
X = 0.75000 Gain/Debt − 1 = -0.74667
1 − Td = 0.75000 X = -0.56/-0.74666 = 0.75000
Td = 25.00% X= 1 − Td
Td = 0.25000

xxvi. (26.4) MM extension with growth CQ Answer: e MEDIUM

EBIT: $200,000 rsU: 11%

Debt: $300,000 T: 40%
rd: 8% EBIT retained: 20%
g: 6%

VTS = rdTD/(rsU – g) = 0.08(0.40)($300,000)/(0.11 – 0.06) = $192,000

xxvii.(26.4) MM extension with growth CQ Answer: c MEDIUM

FCF = NOPAT – Net investment in operating assets

= EBIT(1 – T) – EBIT(0.20)
= $200,000(0.60) – $200,000(0.20)
= $120,000 − $40,000 = $80,000

VU = FCF/(rsU – g)
= $80,000/(0.11 – 0.06)
= $1,600,000
xxviii.(26.4) MM extension with growth CQ

Answer: a MEDIUM

VEquity = VTotal – Debt.

VTotal = VU + VTS so, VEquity = VU + VTS – Debt.
VTS = $192,000 (from above).
VU = $1,600,000 (from above).
VEquity = $1,600,000 + $192,000 – $300,000 = $1,492,000