University of Massachusetts Boston FIN 351 ch16

ch16Student: ___________________________________________________________________________1. The use of personal borrowing to change the overall amount of financial leverage to which an individualis exposed is called:A. homemade leverage.B. dividend recapture.C. the weighted average cost of capital.D. private debt placement.E. personal offset.2. The proposition that the value of the firm is independent of its capital structure is called:A. the capital asset pricing model.B. MM Proposition I.C. MM Proposition II.D. the law of one price.E. the efficient markets hypothesis.3. The proposition that the cost of equity is a positive linear function of capital structure is called:A. the capital asset pricing model.B. MM Proposition I.C. MM Proposition II.D. the law of one price.E. the efficient markets hypothesis.4. The tax savings of the firm derived from the deductibility of interest expense is called the:A. interest tax shield.B. depreciable basis.C. financing umbrella.D. current yield.E. tax-loss carry forward savings.5. The unlevered cost of capital is:A. the cost of capital for a firm with no equity in its capital structure.B. the cost of capital for a firm with no debt in its capital structure.C. the interest tax shield times pretax net income.D. the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure.E. equal to the profit margin for a firm with some debt in its capital structure.6. The cost of capital for a firm, R-WACC, in a zero tax environment is:A. equal to the expected earnings divided by market value of the unlevered firm.B. equal to the rate of return for that business risk class.C. equal to the overall rate of return required on the levered firm.D. is constant regardless of the amount of leverage.E. All of these.7. The firm’s capital structure refers to:A. the way a firm invests its assets.B. the amount of capital in the firm.C. the amount of dividends a firm pays.D. the mix of debt and equity used to finance the firm’s assets.E. how much cash the firm holds.8. A general rule for managers to follow is to set the firm’s capital structure such that:A. the firm’s value is minimized.B. the firm’s value is maximized.C. the firm’s bondholders are made well off.D. the firms suppliers of raw materials are satisfied.E. the firms dividend payout is maximized.9. A levered firm is a company that has:A. Accounts Payable as the only liability on the balance sheet.B. some debt in the capital structure.C. all equity in the capital structure.D. All of these.E. None of these.10. A manager should attempt to maximize the value of the firm by:A. changing the capital structure if and only if the value of the firm increases.B. changing the capital structure if and only if the value of the firm increases to the benefit of insidemanagement.C. changing the capital structure if and only if the value of the firm increases only to the benefits of thedebtholders.D.changing the capital structure if and only if the value of the firm increases although it decreases thestockholders’ value.E. changing the capital structure if and only if the value of the firm increases and stockholder wealth isconstant.11. The effect of financial leverage depends on the operating earnings of the company. Which of thefollowing is not true?A. Below the indifference or break-even point in EBIT the non-levered structure is superior.B. Financial leverage increases the slope of the EPS line.C.Above the indifference or break-even point the increase in EPS for all equity structures is less thandebt-equity structures.D.Above the indifference or break-even point the increase in EPS for all equity structures is greater thandebt-equity structures.E. The rate of return on operating assets is unaffected by leverage.12. The Modigliani-Miller Proposition I without taxes states:A. a firm cannot change the total value of its outstanding securities by changing its capital structureproportions.B. when new projects are added to the firm the firm value is the sum of the old value plus the new.C.managers can make correct corporate decisions that will satisfy all shareholders if they select projectsthat maximize value.D. the determination of value must consider the timing and risk of the cash flows.E. None of these.13. MM Proposition I without taxes is used to illustrate:A. the value of an unlevered firm equals that of a levered firm.B. that one capital structure is as good as another.C. leverage does not affect the value of the firm.D. capital structure changes have no effect on stockholders’ welfare.E. All of these.14. A key assumption of MM’s Proposition I without taxes is:A. that financial leverage increases risk.B. that individuals can borrow on their own account at rates less than the firm.C. that individuals must be able to borrow on their own account at rates equal to the firm.D. managers are acting to maximize the value of the firm.E. All of these.15. In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt rayhas a lower intercept because:A. more shares are outstanding for the same level of EBI.B. the break-even point is higher with debt.C. a fixed interest charge must be paid even at low earnings.D. the amount of interest per share has only a positive effect on the intercept.E. the higher the interest rate the greater the slope.16. In an EPS-EBI graphical relationship, the debt ray and equity ray cross. At this point the equity and debtare:A. equivalent with respect to EPS but above and below this point equity is always superior.B. at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below thispoint.C. equal but away from breakeven equity is better as fewer shares are outstanding.D. at breakeven and MM Proposition II states that debt is the better choice.E. at breakeven and debt is the better choice below breakeven because small payments can be made.17. When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levelsof EBIT because:A. interest payments on the debt vary with EBIT levels.B. interest payments on the debt stay fixed, leaving less income to be distributed over less shares.C. interest payments on the debt stay fixed, leaving more income to be distributed over less shares.D. interest payments on the debt stay fixed, leaving less income to be distributed over more shares.E. interest payments on the debt stay fixed, leaving more income to be distributed over more shares.18. Financial leverage impacts the performance of the firm by:A. maintaining the same level of volatility of the firm’s EBIT.B. decreasing the volatility of the firm’s EBIT.C. decreasing the volatility of the firm’s net income.D. increasing the volatility of the firm’s net income.E. None of these.19. The increase in risk to equityholders when financial leverage is introduced is evidenced by:A. higher EPS as EBIT increases.B. a higher variability of EPS with debt than all equity.C. increased use of homemade leverage.D. equivalence value between levered and unlevered firms in the presence of taxes.E. None of these.20. The reason that MM Proposition I does not hold in the presence of corporate taxation is because:A. levered firms pay less taxes compared with identical unlevered firms.B. bondholders require higher rates of return compared with stockholders.C. earnings per share are no longer relevant with taxes.D. dividends are no longer relevant with taxes.E. All of these.21. MM Proposition I with corporate taxes states that:A. capital structure can affect firm value.B. by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.C. firm value is maximized at an all debt capital structure.D. All of these.E. None of these.22. The change in firm value in the presence of corporate taxes only is:A. positive as equityholders face a lower effective tax rate.B. positive as equityholders gain the tax shield on the debt interest.C. negative because of the increased risk of default and fewer shares outstanding.D. negative because of a reduction of equity outstanding.E. None of these.23. A firm should select the capital structure which:A. produces the highest cost of capital.B. maximizes the value of the firm.C. minimizes taxes.D. is fully unlevered.E. has no debt.24. In a world of no corporate taxes if the use of leverage does not change the value of the levered firmrelative to the unlevered firm is known as:A. MM Proposition III that the cost of stock is less than the cost of debt.B. MM Proposition I that leverage is invariant to market value.C. MM Proposition II that the cost of equity is always constant.D. MM Proposition I that the market value of the firm is invariant to the capital structure.E. MM Proposition III that there is no risk associated with leverage in a no tax world.25. Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is nowutilizing debt in its capital structure. To unlever his position, Bryan needs to:A. borrow some money and purchase additional shares of Bryco stock.B. maintain his current position as the debt of the firm did not affect his personal leverage position.C. sell some shares of Bryco stock and hold the proceeds in cash.D.sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity ratio equal tothat of the firm.E. create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.26. The capital structure chosen by a firm doesn’t really matter because of:A. taxes.B. the interest tax shield.C. the relationship between dividends and earnings per share.D. the effects of leverage on the cost of equity.E. homemade leverage.27. MM Proposition I with no tax supports the argument that:A. business risk determines the return on assets.B. the cost of equity rises as leverage rises.C. it is completely irrelevant how a firm arranges its finances.D.a firm should borrow money to the point where the tax benefit from debt is equal to the cost of theincreased probability of financial distress.E. financial risk is determined by the debt-equity ratio.28. The proposition that the value of a levered firm is equal to the value of an unlevered firm is knownas:A. MM Proposition I with no tax.B. MM Proposition II with no tax.C. MM Proposition I with tax.D. MM Proposition II with tax.E. static theory proposition.29. The concept of homemade leverage is most associated with:A. MM Proposition I with no tax.B. MM Proposition II with no tax.C. MM Proposition I with tax.D. MM Proposition II with tax.E. static theory proposition.30. Which of the following statements are correct in relation to MM Proposition II with no taxes?I. The required return on assets is equal to the weighted average cost of capital.II. Financial risk is determined by the debt-equity ratio.III. Financial risk determines the return on assets.IV. The cost of equity declines when the amount of leverage used by a firm rises.A. I and III onlyB. II and IV onlyC. I and II onlyD. III and IV onlyE. I and IV only31. MM Proposition I with taxes supports the theory that:A. there is a positive linear relationship between the amount of debt in a levered firm and its value.B. the value of a firm is inversely related to the amount of leverage used by the firm.C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest taxshield.D. a firm’s cost of capital is the same regardless of the mix of debt and equity used by the firm.E. a firm’s weighted average cost of capital increases as the debt-equity ratio of the firm rises.32. MM Proposition I with taxes is based on the concept that:A. the optimal capital structure is the one that is totally financed with equity.B. the capital structure of the firm does not matter because investors can use homemade leverage.C. the firm is better off with debt based on the weighted average cost of capital.D. the value of the firm increases as total debt increases because of the interest tax shield.E. the cost of equity increases as the debt-equity ratio of a firm increases.33. MM Proposition II with taxes:A. has the same general implications as MM Proposition II without taxes.B. reveals how the interest tax shield relates to the value of a firm.C. supports the argument that business risk is determined by the capital structure employed by a firm.D. supports the argument that the cost of equity decreases as the debt-equity ratio increases.E. reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.34. MM Proposition II is the proposition that:A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm.B. the cost of equity depends on the return on debt, the debt-equity ratio and the tax rate.C. a firm’s cost of equity capital is a positive linear function of the firm’s capital structure.D. the cost of equity is equivalent to the required return on the total assets of a firm.E. supports the argument that the size of the pie does not depend on how the pie is sliced.35. The interest tax shield has no value for a firm when:I. the tax rate is equal to zero.II. the debt-equity ratio is exactly equal to 1.III. the firm is unlevered.IV. a firm elects 100% equity as its capital structure.A. I and III onlyB. II and IV onlyC. I, III, and IV onlyD. II, III, and IV onlyE. I, II, and IV only36. The interest tax shield is a key reason why:A. the required rate of return on assets rises when debt is added to the capital structure.B. the value of an unlevered firm is equal to the value of a levered firm.C. the net cost of debt to a firm is generally less than the cost of equity.D. the cost of debt is equal to the cost of equity for a levered firm.E. firms prefer equity financing over debt financing.37. Which of the following will tend to diminish the benefit of the interest tax shield given a progressive taxrate structure?I. A reduction in tax ratesII. A large tax loss carryforwardIII. A large depreciation tax deductionIV. A sizeable increase in taxable incomeA. I and II onlyB. I and III onlyC. II and III onlyD. I, II, and III onlyE. I, II, III, and IV38. Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The companyis in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstandingstock. What is the value of this firm if you ignore taxes?A. $20.0 millionB. $20.8 millionC. $21.0 millionD. $21.2 millionE. $21.3 million39. Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding. The companyhas decided to borrow $1 million to buy out the shares of a deceased stockholder who holds 2,500 shares.What is the total value of this firm if you ignore taxes?A. $15.5 millionB. $15.6 millionC. $16.0 millionD. $16.8 millionE. $17.2 million40. You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in thisclosely held, all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million topurchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes?A. $4.8 millionB. $5.1 millionC. $5.4 millionD. $5.7 millionE. $6.0 million41. Your firm has a debt-equity ratio of .75. Your pre-tax cost of debt is 8.5% and your required return onassets is 15%. What is your cost of equity if you ignore taxes?A. 11.25%B. 12.21%C. 16.67%D. 19.88%E. 21.38%42. Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on theassets is 11%. What is the firm’s debt-equity ratio based on MM Proposition II with no taxes?A. .60B. .64C. .72D. .75E. .8043. The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm’s required return on assets is 12%and its cost of equity is 15.68%. What is the pre-tax cost of debt based on MM Proposition II with notaxes?A. 6.76%B. 7.00%C. 7.25%D. 7.40%E. 7.50%44. The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered costof capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon.The debt is selling at par value. What is the value of this firm?A. $9,900B. $10,852C. $11,748D. $12,054E. $12,70045. Gail’s Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with amarket price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail is consideringadding $1 million of debt with a coupon rate of 8% to her capital structure. The debt will be sold at parvalue. What is the levered value of the equity?A. $2.4 millionB. $2.7 millionC. $3.3 millionD. $3.7 millionE. $3.9 million46. The Montana Hills Co. has expected earnings before interest and taxes of $8,100, an unlevered cost ofcapital of 11%, and debt with both a book and face value of $12,000. The debt has an annual 8% coupon.The tax rate is 34%. What is the value of the firm?A. $48,600B. $50,000C. $52,680D. $56,667E. $60,60047. Joe’s Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000. The unleveredcost of capital is 10% and the tax rate is 34%. What is the value of this firm?A. $567,600B. $781,818C. $860,000D. $946,000E. $1,152,40048. An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000.A levered firm with the same operations and assets has both a book value and a face value of debt of$700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm?A. $696,429B. $907,679C. $941,429D. $1,184,929E. $1,396,42949. The Spartan Co. has an unlevered cost of capital of 11%, a cost of debt of 8%, and a tax rate of 35%.What is the target debt-equity ratio if the targeted cost of equity is 12%?A. .44B. .49C. .51D. .56E. .6250. Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7%and pays interest annually. The expected earnings before interest and taxes is $1,200, the tax rate is 34%,and the unlevered cost of capital is 12%. What is the firm’s cost of equity?A. 13.25%B. 13.89%C. 13.92%D. 14.14%E. 14.25%51. Anderson’s Furniture Outlet has an unlevered cost of capital of 10%, a tax rate of 34%, and expectedearnings before interest and taxes of $1,600. The company has $3,000 in bonds outstanding that have an8% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?A. 8.67%B. 9.34%C. 9.72%D. 9.99%E. 10.46%52. Aspen’s Distributors has a cost of equity of 13.84% and an unlevered cost of capital of 12%. Thecompany has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and thetax rate is 34%. What is the pre-tax cost of debt?A. 7.92%B. 8.10%C. 8.16%D. 8.84%E. 9.00%53. Rosita’s has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio is .60 andthe tax rate is .34. What is Rosita’s unlevered cost of capital?A. 8.83%B. 12.30%C. 13.97%D. 14.08%E. 14.60%54. Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your tax rate is 35%and your cost of equity is 15.26%. What is your debt-equity ratio?A. .43B. .49C. .51D. .54E. .5855. Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while the unleveredcost of capital is 14%. What is the cost of equity if the tax rate is 34%?A. 7.52%B. 8.78%C. 15.98%D. 16.83%E. 17.30%56. Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon, pay interestsemiannually, and have a current market price equal to 103% of face value. What is the amount of theannual interest tax shield given a tax rate of 35%?A. $6,125B. $6,309C. $9,500D. $17,500E. $18,02557. Jasmine’s Boutique has 2,000 bonds outstanding with a face value of $1,000 each and a coupon rate of9%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rateis 34%?A. $58,500B. $60,100C. $60,750D. $61,200E. $62,25058. Juanita’s Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%.The tax rate is 34%. What is the present value of the tax shield?A. $2,823B. $2,887C. $4,080D. $4,500E. $4,63359. A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost ofequity of 12%, and a tax rate of 34%. What is the firm’s weighted average cost of capital?A. 7.29%B. 7.94%C. 8.87%D. 10.40%E. 11.05%60. A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering anew capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are notaxes or other imperfections, its cost of equity capital with the new capital structure would be _____.A. 9%B. 10%C. 13%D. 14%E. None of these.61. A firm has a debt-to-equity ratio of .60. Its cost of debt is 8%. Its overall cost of capital is 12%. What isits cost of equity if there are no taxes or other imperfections?A. 10.0%B. 13.5%C. 14.4%D. 18.0%E. None of these.62. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If there are notaxes or other imperfections, what would be its cost of equity if the debt-to-equity ratio were 0?A. 8%B. 10%C. 12%D. 14%E. 16%63. A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost ofdebt is 10%. What is its cost of equity if there are no taxes or other imperfections?A. 10%B. 15%C. 18%D. 21%E. None of these.64. If a firm is unlevered and has a cost of equity capital of 12%, what would the cost of equity be if its debtequityratio became 2? The expected cost of debt is 8%.A. 14.0%B. 14.67%C. 16.0%D. 20.0%E. None of these.65. A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is considering a newcapital structure with 40% debt. The interest rate on the debt would be 4%. Assuming that the corporatetax rate is 34%, what would the cost of equity capital with the new capital structure be?A. 10.3%B. 11.0%C. 11.2%D. 13.9%E. None of these.66. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporatetax rate is 25%, what would the cost of equity be if the debt-to-equity ratio were 0?A. 11.11%B. 12.57%C. 13.33%D. 16.00%E. None of these.67. A firm has a debt-to-equity ratio of .5. Its cost of equity is 22%, and its cost of debt is 16%. If thecorporate tax rate is .40, what would the cost of equity be if the debt-to-equity ratio were 0?A. 14.00%B. 20.61%C. 21.07%D. 22.00%E. None of these.68. A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 14%. Its cost ofdebt is 10%. What is its cost of equity if the corporate tax rate is 50%?A. 14.0%B. 16.0%C. 17.5%D. 21.0%E. None of these.69. What is the cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratioof 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 10%.A. 17.4%B. 18.4%C. 19.6%D. 21.4%E. None of these.70. A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its cost of debtis 7%. What is its cost of equity if the corporate tax rate is 50%?A. 7.73%B. 10.00%C. 10.75%D. 12.50%E. None of these.71. Lyme Home has 3,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8%. Theinterest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 30%?A. $52,000B. $60,000C. $62,500D. $68,000E. $72,00072. Reena Industries has $10,000 of debt outstanding that is selling at par and has a coupon rate of 7%. Thetax rate is 34%. What is the present value of the tax shield?A. $2,800B. $3,000C. $3,400D. $3,800E. $7.00073. A firm has debt of $7,000, equity of $12,000, a leveraged value of $8,900, a cost of debt of 7%, a cost ofequity of 14%, and a tax rate of 30%. What is the firm’s weighted average cost of capital?A. 8.45%B. 9.90%C. 10.65%D. 12.50%E. 14.00%74. You own 30% of Westcoast, Inc. You have decided to retire and want to sell your shares in this closelyheld, all equity firm. The other shareholders have agreed to have the firm borrow $2 million to purchaseyour 2,000 shares of stock. What is the total value of this firm today if you ignore taxes?A. $4.58 millionB. $5.08 millionC. $5.40 millionD. $5.76 millionE. $6.67 million75. Your firm has a debt-equity ratio of .60. Your pre-tax cost of debt is 6.0% and your required return onassets is 12%. What is your cost of equity if you ignore taxes?A. 9.00%B. 12.00%C. 14.50%D. 15.60%E. 16.10%76. Longmont Inc. has a cost of equity of 12% and a pre-tax cost of debt of 6%. The required return on theassets is 10%. What is the firm’s debt-equity ratio based on MM Proposition II with no taxes?A. .45B. .50C. .55D. .60E. .6577. Alexandria’s Dance Studio is currently an all equity firm that has 60,000 shares of stock outstanding witha market price of $24 a share. The current cost of equity is 11% and the tax rate is 40%. Alexandria isconsidering adding $2 million of debt with a coupon rate of 7% to her capital structure. The debt will besold at par value. What is the levered value of the equity?A. $.12 millionB. $.24 millionC. $1.12 millionD. $2.24 millionE. $2.84 million78. Boutelle Homes has 4,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 7%.The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is40%?A. $58,000B. $60,000C. $72,000D. $98,000E. $112,00079. A firm has debt of $90,000, equity of $140,000, a leveraged value of $100,000, a cost of debt of 6%, acost of equity of 12%, and a tax rate of 40%. What is the firm’s weighted average cost of capital?A. 8.15%B. 8.40%C. 8.70%D. 9.30%E. None of these80. Based on MM with taxes and without taxes, how much time should a financial manager spend analyzingthe capital structure of his firm? What if the analysis is based on the static theory?81. Explain homemade leverage and why it matters.82. In each of the theories of capital structure the cost of equity rises as the amount of debt increases. So whydon’t financial managers use as little debt as possible to keep the cost of equity down? After all, isn’t thegoal of the firm to maximize share value and minimize shareholder costs?83. Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 ofdebt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is anillusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicateMike’s payout from firm L.Given a level of operating income of $2,500, show the specific strategy that Mike has in mind.84. Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 ofdebt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is anillusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicateMike’s payout from firm L.After seeing Steve’s analysis, Mike tells Steve that while his analysis looks good on paper, Steve willnever be able to borrow at 8%, but would have to pay a more realistic rate of 12%. If Mike is right, whatwill Steve’s payout be?85. Consider two firms, U and L, both with $50,000 in assets. Firm U is unlevered, and firm L has $20,000 ofdebt that pays 8% interest. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding.Mike owns 20% of firm L and believes that leverage works in his favor. Steve tells Mike that this is anillusion, and that with the possibility of borrowing on his own account at 8% interest, he can replicateMike’s payout from firm L.Suppose the tax authorities allow firms to deduct their interest expense from operating income. Both firmU and firm L are in the 34% tax bracket. Show what happens to the market value of both firms if the debtheld by firm L is permanent. Assume MM with taxes.86. The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whetherincluding debt in its capital structure would increase its value. The current cost of equity is 12%. Underconsideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase$300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding andeffective marginal tax bracket is zero. What will Nantucket’s new WACC be?87. The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whetherincluding debt in its capital structure would increase its value. The current of cost of equity is 12%. Underconsideration is issuing $300,000 in new debt with an 8% interest rate. Nantucket would repurchase$300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding andits effective marginal tax bracket is 34%. What will Nantucket’s new WACC be?88. The weighted average cost of capital is invariant to the use of leverage under MM conditions of no taxes.Graph the relationship of the weighted average cost of capital and leverage; be sure to include the cost ofequity and debt. Explain why this relationship holds.89. According the MM with taxes, the value of the firm is maximized by taking on as much debt as possible.Show graphically how adding debt can increase value through the overall cost of capital. Explain howand under what conditions this impacts the cost of capital and translates into firm value.90. Discuss Modigliani and Miller’s Propositions I and II in a world without taxes. List the basic assumptions,results, and intuition of the model.91. Discuss Modigliani and Miller’s Propositions I and II in a world with taxes. List the basic assumptions,results, and intuition of the model.