Question

2. As a firm's debt/equity ratio approaches zero, the firm's expected return on equity approaches:

1. the expected return on assets.

2. its maximum.

3. zero.

4. the expected return on debt.

3. The Boat Company has a capital structure of 30 percent riskless debt and 70 percent equity. The assumed tax rate is 23 percent. If the asset beta is .9, what is the equity beta?

1. .63

2. 1.20

3. .41

4. 1.26

5. 1.49

4. Reena Industries has $138,000 of perpetual debt outstanding that is selling at par and has a coupon rate of 7 percent. If the tax rate is 21 percent, what is the present value of the tax shield on debt?

1. $31,010

2. $3,284

3. $28,412

4. $28,980

5. $2,029

5. In a world with taxes and financial distress, when a firm is operating with the optimal capital structure:

(I) the debt-equity ratio will also be optimal.

(II) the weighted average cost of capital will be at its minimal point.

(III) the required return on assets will be at its maximum point.

(IV) the increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

1. II, III, and IV only

2. I, II, and IV only

3. I and II only

4. I and IV only

5. II and III only

6. Which of the following would be indicative of inefficient markets?

1. Immediate and accurate response

2. Delayed response

3. Overreaction with reversion and delayed response

4. Overreaction and reversion

5. Immediate and accurate response with a zero NPV

Answer 1

Note: As per answering guidelines, only the first four parts can be answered.

Solution:-

(2)

Cost of debt is lower than the cost of equity. Due to this, when debt is introduced in capital structure, it reduces the overall cost of capital and increases the return on equity. However, when debt becomes zero, equity is the only capital sources left in the business and thus all assets are financed through equity, which means that return on equity becomes equal to the return on assets.

Therefore, the correct option is option 1.

(3)

Asset beta= equity beta / [1+(1-tax rate)*debt equity ratio]

0.9= Equity beta/ [1+(1-23%)*(3/7)]

Equity beta= 1.2

Therefore, the correct option is option 2

(4)

Present value of tax shield on debt= $138,000*7%*21%= $2,029

Therefore, the correct option is the last option.

(5)

In an optimal capital structure, the company's ratio of debt and equity is optimal which minimises the overall cost of capital.

However, the company's required return on assets is not dependent on optimal capital structure and is rather dependent on investors' perceptions of the business risk.

Also, the increased benefit from additional debt in an optimal capital structure is not achieved at the cost of increased bankruptcy risk.

Therefore, based on above the correct statements are the first and second statements and the correct option is option three.