1. Company A is trying to determine its optimal capital structure. The firm is currently all-equity financed and has a total market value of $10 million. Company A plans to keep the total value of capital the same by using the proceeds from new debt financing to repurchase outstanding shares of common stock. The firm is in the 40% tax bracket. The estimated present value of bankruptcy cost is $6 million and the probability of bankrutpcy is as follows:
Prob. of Bankruptcy @ $2 million of debt = 0.00%
Prob. of Bankruptcy @ $3 million of debt = 5.00%
Prob. of Bankruptcy @ $4 million of debt = 10.00%
Prob. of Bankruptcy @ $5 million of debt = 20.00%
Prob. of Bankruptcy @ $6 million of debt = 30.00%
Prob. of Bankruptcy @ $7 million of debt = 40.00%
Prob. of Bankruptcy @ $8 million of debt = 50.00%
Prob. of Bankruptcy @ $9 million of debt = 60.00%
Based upon the trade-off theory, what is the value of Company A at its optimal capital structure?
A. $10,600,000
B. $10,800,000
C. $10,900,000
D. $11,000,000
E. $11,200,000
2. According to the Modigliani-Miller theorem, which of the following would have to be true in order for capital structure to have no impact upon firm value?
I. Taxes have an impact upon the firm's earnings
II. The risk of defaulting on debt is nonexistent
III. There are no transaction costs of moving from one capital structure to another
A. I only
B. I and II only
C. I and III only
D. II and III only
E. I, II, and III
3. In what ways might a firm seek to benefit its stockholders at the expense of its existing bondholders?
I. By accepting riskier investment projects
II. By paying lower dividends to shareholders
III. By increasing the firm's financial leverage
A. I only
B. I and II only
C. I and III only
D. II and III only
E. I, II, and III