Question 15: Trade-off theory
Brealey and Myers discuss how much firms ought to borrow to optimize their value.
The trade-off theory considers the present value of debt tax shields and the costs of financial distress.
Which of the following is a discrepancy between empirical data and the trade-off theory?
A. Profitable firms generally have low debt ratios
B. Firms with risky assets generally have high debt ratios
C. Firms with risky assets generally have low debt ratios
D. Firms with tangible assets generally have high debt ratios
E. Firms with tangible assets generally have low debt ratios
[This scenario of capital structure and betas in perfect capital markets applies to the next two questions.]
Assume capital markets are perfect (no corporate income taxes or other imperfections) and the Miller and
Modigliani propositions hold.
At a debt-to-equity ratio of 11.1%, a firm has a debt beta of 16.1% and an equity beta of 102.4%. The firm
issues more debt and repurchases equity to bring its debt-to-equity ratio to 46.3%, where its debt beta is
32.7%.
Question 16: Beta of assets in perfect capital markets
What is the firm’s beta of assets at the debt-to-equity ratio of 50%?
A. 89.1%
B. 93.8%
C. 98.5%
D. 103.2%
E. 107.9%
Question17. Beta of equity in perfect capital markets
What is the firm’s beta of equity at the debt-to-equity ratio of 50%?
A. 103.8%
B. 109.9%
C. 116.0%
D. 122.1%
E. 128.2%
Question 1.18: Refinancing
A firm’s cost of debt capital rD depends on its debt-to-value ratio D/V as rD = 10% × (1 + D/V). The corporate
tax rate T
c = 35%. At a 20% debt-to-value ratio, the firm’s WACC is 12%.
What is the firm’s WACC at a 40% debt-to-value ratio?
A. 08.88%
B. 09.88%
C. 10.88%
D. 11.88%
E. 12.88%
Question 1.19: Value of firm with all equity financing
A firm has the following values:
! Market value of firm = 883
! Present value of tax shields = 79
! Present value of the costs of financial distress = 31
If the trade-off theory is correct, what is the value of the firm with all equity financing?
A. 773
B. 835
C. 883
D. 931
E. 993