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FF Qs & As Topic 7 - FeedbackForum Topic7...

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Feedback Forum  Topic 7 Capital Structure Question 1 Booster Ltd has a net operating income of $30,000 p.a. If the required rate of return of equity holders  is 10%, and the company tax rate is 34%, what is the value of Booster Ltd?   a) $340,000  b) $300,000  c) $198,000  d) $102,000  NOI = $30,000 r e  = 0.10 t = 34% total tax paid = $30,000 x 0.34 = $10,200 V = ? e r tax NOI V - = = 000 , 198 $ 10 . 0 800 , 19 $ 10 . 0 10200 $ 000 , 30 $ = = -
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Question 2 At low levels of debt, the tax deductibility of debt is greater than the costs of financial distress,  causing the companies required  rate of return to:   Financial distress costs (FDCs) – costs arising when a firm cannot meet its creditor commitments. Direct FDCs – costs directly associated with bankruptcy – e.g. legal and administration expenses. Indirect FDCs – costs associated with attempting to avoid bankruptcy Static Theory of Capital Structure  – a firm should borrow up to the point where the tax benefit from an  extra dollar of debt is exactly equal to the cost that comes from the increased probability of financial  distress. At low levels of debt, the tax deductibility benefits of debt are greater than the costs of the probability  of financial distress, meaning the firm’s required  rate of return increases. 2
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