CHAPTER 26

ANALYSIS OF CAPITAL STRUCTURE THEORY

Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.

True/False

Easy:
(26.1) Taxes and capital structure FQ Answer: a EASY
1. 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
b. False

(26.1) Taxes and capital structure FQ Answer: b EASY

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

a. True
b. False

(26.1) MM models FQ Answer: a EASY

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

a. True
b. False

(26.1) MM models FQ Answer: a EASY

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

a. True
b. False

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to a publicly accessible website, in whole or in part.
Chapter 26: Cap Structure True/False Page 1
 (26.2) Miller model FQ Answer: a EASY
5. The Miller model begins with the MM model with taxes and then adds
personal taxes.

a. True
b. False

(26.2) Miller model FQ Answer: b EASY

6. The Miller model begins with the MM model without corporate taxes and
then adds personal taxes.

a. True
b. False

(26.5) Financial leverage FQ Answer: a EASY

7. 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
b. False

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

a. True
b. False

(26.2) MM models FQ Answer: b MEDIUM

9. The MM model is the same as the Miller model, but with zero corporate
taxes.

a. True
b. False

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

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

a. True
b. False

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to a publicly accessible website, in whole or in part.

Page 2 True/False Chapter 26: Cap Structure

 (26.4) MM extension with growth FQ Answer: b MEDIUM
11. In the MM extension with growth, the appropriate discount rate for the
tax shield is the WACC.

a. True
b. False

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

12. In the MM extension with growth, the appropriate discount rate for the
tax shield is the after-tax cost of debt.

a. True
b. False

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

13. 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
b. False

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to a publicly accessible website, in whole or in part.
Chapter 26: Cap Structure True/False Page 3
 (26.5) Equity as an option FQ Answer: b MEDIUM
14. 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.

a. True
b. False

Multiple Choice: Conceptual

Medium:
(26.2) Miller model CQ Answer: b MEDIUM
15. The major contribution of the Miller model is that it demonstrates that

a. personal taxes increase the value of using corporate debt.

b. personal taxes decrease the value of using corporate debt.
c. financial distress and agency costs reduce the value of using
corporate debt.
d. equity costs increase with financial leverage.
e. debt costs increase with financial leverage.

(26.3) MM and Miller CQ Answer: d MEDIUM

16. Which of the following statements concerning capital structure theory is
NOT CORRECT?

a. The major contribution of Miller's theory is that it demonstrates that

personal taxes decrease the value of using corporate debt.
b. Under MM with zero taxes, financial leverage has no effect on a firm’s
value.
c. Under MM with corporate taxes, the value of a levered firm exceeds the
value of the unlevered firm by the product of the tax rate times the
market value dollar amount of debt.
d. Under MM with corporate taxes, rs increases with leverage, and this
increase exactly offsets the tax benefits of debt financing.
e. Under MM with corporate taxes, the effect of business risk is
automatically incorporated because rsL is a function of rsU.

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to a publicly accessible website, in whole or in part.

Page 4 Conceptual Questions Chapter 17: Cap Structure

 (26.4) MM extension with growth CQ Answer: d MEDIUM
17. Which of the following statements concerning the MM extension with growth
is NOT CORRECT?

a. The tax shields should be discounted at the unlevered cost of equity.

b. The value of a growing tax shield is greater than the value of a
constant tax shield.
c. For a given D/S, the levered cost of equity is greater than the
levered cost of equity under MM’s original (with tax) assumptions.
d. For a given D/S, the WACC is less than the WACC under MM’s original
(with tax) assumptions.
e. The total value of the firm increases with the amount of debt.

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to a publicly accessible website, in whole or in part.

Chapter 26: Cap Structure Conceptual Questions Page 5

 (26.4) MM extension with growth CQ Answer: a MEDIUM
18. 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.

b. The value of a growing tax shield is greater than the value of a
constant tax shield.
c. For a given D/S, the levered cost of equity is greater than the
levered cost of equity under MM’s original (with tax) assumptions.
d. For a given D/S, the WACC is greater than the WACC under MM’s original
(with tax) assumptions.
e. The total value of the firm increases with the amount of debt.

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

19. Which of the following statements concerning the MM extension with growth
is NOT CORRECT?

a. The tax shields should be discounted at the unlevered cost of equity.

b. The value of a growing tax shield is greater than the value of a
constant tax shield.
c. For a given D/S, the levered cost of equity is greater than the
levered cost of equity under MM’s original (with tax) assumptions.
d. For a given D/S, the WACC is greater than the WACC under MM’s original
(with tax) assumptions.
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
20. 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?

a. 11.4%
b. 12.0%
c. 12.6%
d. 13.3%
e. 14.0%

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to a publicly accessible website, in whole or in part.

Page 6 Problems Chapter 26: Cap Structure

 (26.4) MM extension with growth CQ Answer: c MEDIUM
21. 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?

a. $358,421
b. $377,286
c. $397,143
d. $417,000
e. $437,850

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

22. 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?

a. $92,571
b. $102,857
c. $113,143
d. $124,457
e. $136,903

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

23. What is the value of the firm according to MM with corporate taxes?

a. $475,875
b. $528,750
c. $587,500
d. $646,250
e. $710,875

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to a publicly accessible website, in whole or in part.

Chapter 26: Cap Structure Problems Page 7

 (26.1) MM with tax CQ Answer: e EASY
24. What is the firm's cost of equity?

a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%

(26.2) Miller model CQ Answer: e HARD

25. 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?

a. 16.4%
b. 18.2%
c. 20.2%
d. 22.5%
e. 25.0%

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to a publicly accessible website, in whole or in part.

Page 8 Problems Chapter 26: Cap Structure

 (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

26. According to the MM extension with growth, what is the value of Gomez’s
tax shield?

a. $156,385
b. $164,616
c. $173,280
d. $182,400
e. $192,000

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

27. According to the MM extension with growth, what is Gomez’s unlevered
value?

a. $1,296,000
b. $1,440,000
c. $1,600,000
d. $1,760,000
e. $1,936,000

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

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

a. $1,492,000
b. $1,529,300
c. $1,567,533
d. $1,606,721
e. $1,646,889

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to a publicly accessible website, in whole or in part.

Chapter 26: Cap Structure Problems Page 9

 (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

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

a. $228.77
b. $254.19
c. $282.43
d. $313.81
e. $345.19

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

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

a. $167.57
b. $186.19
c. $204.81
d. $225.29
e. $247.82

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

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

a. 6.04%
b. 6.36%
c. 6.70%
d. 7.05%
e. 7.42%

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to a publicly accessible website, in whole or in part.

Page 10 Problems Chapter 26: Cap Structure

 CHAPTER 26
ANSWERS AND SOLUTIONS
1. (26.1) Taxes and capital structure FQ Answer: a EASY

2. (26.1) Taxes and capital structure FQ Answer: b EASY

3. (26.1) MM models FQ Answer: a EASY

4. (26.1) MM models FQ Answer: a EASY

5. (26.2) Miller model FQ Answer: a EASY

6. (26.2) Miller model FQ Answer: b EASY

7. (26.5) Financial leverage FQ Answer: a EASY

8. (26.2) MM models FQ Answer: a MEDIUM

9. (26.2) MM models FQ Answer: b MEDIUM

10. (26.4) MM extension with growth FQ Answer: a MEDIUM

11. (26.4) MM extension with growth FQ Answer: b MEDIUM

12. (26.4) MM extension with growth FQ Answer: b MEDIUM

13. (26.5) Equity as an option FQ Answer: a MEDIUM

14. (26.5) Equity as an option FQ Answer: b MEDIUM

15. (26.2) Miller model CQ Answer: b MEDIUM

16. (26.3) MM and Miller CQ Answer: d MEDIUM

17. (26.4) MM extension with growth CQ Answer: d MEDIUM

18. (26.4) MM extension with growth CQ Answer: a MEDIUM

19. (26.4) MM extension with growth CQ Answer: e MEDIUM

20. (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%

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to a publicly accessible website, in whole or in part.

Chapter 26: Cap Structure Answers Page 11

21. (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

22. (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

23. (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

24. (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%

25. (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

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to a publicly accessible website, in whole or in part.

Page 12 Answers Chapter 26: Cap Structure

26. (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

27. (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

28. (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

29. (26.5) Equity as an option CQ Answer: d MEDIUM

Total value = P = $500.0 d1 = 1.910485

Debt = X = $200.0 N(d1) = 0.9720
Volatility () = 0.6 d2 = 1.310485
rRF = 5% N(d2) = 0.9050

Vs = PN(d1) – Xe-RFtN(d2)
= $500(0.9720) – $200e-0.05(1)(0.9050)
= $485.98 − $172.17
= $313.81

30. (26.5) Equity as an option CQ Answer: b MEDIUM

VDebt = VTotal – VEquity = $500 – $313.81 = $186.19

31. (26.5) Equity as an option CQ Answer: e MEDIUM

Yield = [(Face Value/Price)1/Maturity] – 1.0 = [$200/$186.19]1 – 1.0 = 7.42%

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to a publicly accessible website, in whole or in part.

Chapter 26: Cap Structure Answers Page 13