Question 1

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

Accepted Answer

A)  An increase in the corporate tax rate. 
B)  An increase in the personal tax rate. 
C)  An increase in the company's operating leverage. 
D)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
E)  The company's stock price hits a new high. 
A)  An increase in the corporate tax rate. 
B)  An increase in the personal tax rate. 
C)  An increase in the company's operating leverage. 
D)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
E)  The company's stock price hits a new high. A

Question 2

If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.

Accepted Answer

A) True 
 B)False  True

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)  The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs). 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
C)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E)  ratio. 
D)  If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC. 
E)  If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. 
A)  The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs). 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
C)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E)  ratio. 
D)  If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC. 
E)  If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. D

Question 4

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Accepted Answer

A)  The costs associated with filing for bankruptcy increase. 
B)  The corporate tax rate is increased. 
C)  The personal tax rate is increased. 
D)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
E)  The company's stock price hits a new low. 
A)  The costs associated with filing for bankruptcy increase. 
B)  The corporate tax rate is increased. 
C)  The personal tax rate is increased. 
D)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
E)  The company's stock price hits a new low.

Question 6

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

Accepted Answer

A)  normally leads to an increase in its fixed assets turnover ratio. 
B)  normally leads to a decrease in its business risk. 
C)  normally leads to a decrease in the standard deviation of its expected EBIT. 
D)  normally leads to a decrease in the variability of its expected EPS. 
E)  normally leads to a reduction in its fixed assets turnover ratio. 
A)  normally leads to an increase in its fixed assets turnover ratio. 
B)  normally leads to a decrease in its business risk. 
C)  normally leads to a decrease in the standard deviation of its expected EBIT. 
D)  normally leads to a decrease in the variability of its expected EPS. 
E)  normally leads to a reduction in its fixed assets turnover ratio.

Question 7

Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU?

Accepted Answer

A)  $0.54 
B)  $0.60 
C)  $0.67 
D)  $0.75 
E)  $0.83 
A)  $0.54 
B)  $0.60 
C)  $0.67 
D)  $0.75 
E)  $0.83

Question 8

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

Accepted Answer

A) True 
 B)False

Question 9

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Accepted Answer

A) True 
 B)False

Question 10

Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 40.0% debt (wd)Risk-free rate, rRF 6.00% Tax rate, T 40% Market risk premium, RPM 4.00% Current wd 0% Current beta, bU 1.15 Target wd 40%

Accepted Answer

A)  1.66% 
B)  1.84% 
C)  2.02% 
D)  2.23% 
E)  2.45% 
A)  1.66% 
B)  1.84% 
C)  2.02% 
D)  2.23% 
E)  2.45%

Question 11

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

Accepted Answer

A) True 
 B)False

Question 12

If a firm borrows money, it is using financial leverage.

Accepted Answer

A) True 
 B)False

Question 13

Gator Fabrics Inc. currently has zero debt . It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew?

Accepted Answer

A)  2.74% 
B)  3.01% 
C)  3.32% 
D)  3.65% 
E)  4.01% 
A)  2.74% 
B)  3.01% 
C)  3.32% 
D)  3.65% 
E)  4.01%

Question 14

The firm's target capital structure should do which of the following?

Accepted Answer

A)  Maximize the earnings per share (EPS). 
B)  Minimize the cost of debt (rd). 
C)  Obtain the highest possible bond rating. 
D)  Minimize the cost of equity (rs). 
E)  Minimize the weighted average cost of capital (WAC
C) . 
A)  Maximize the earnings per share (EPS). 
B)  Minimize the cost of debt (rd). 
C)  Obtain the highest possible bond rating. 
D)  Minimize the cost of equity (rs). 
E)  Minimize the weighted average cost of capital (WAC
C) .

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)  A firm's business risk is determined solely by the financial characteristics of its industry. 
B)  The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control. 
C)  One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy. 
D)  A firm's financial risk can be minimized by diversification. 
E)  The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk. 
A)  A firm's business risk is determined solely by the financial characteristics of its industry. 
B)  The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control. 
C)  One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy. 
D)  A firm's financial risk can be minimized by diversification. 
E)  The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

Question 16

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. 
B)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
C)  A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. 
D)  If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. 
E)  Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity. 
A)  In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. 
B)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
C)  A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. 
D)  If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. 
E)  Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

Question 18

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Accepted Answer

A) True 
 B)False

Question 19

You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU?

Accepted Answer

A)  5.85% 
B)  6.14% 
C)  6.45% 
D)  6.77% 
E)  7.11% 
A)  5.85% 
B)  6.14% 
C)  6.45% 
D)  6.77% 
E)  7.11%

Question 20

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

Accepted Answer

A) True 
 B)False

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.

Which of the following statements is CORRECT?

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 40.0% debt (wd)Risk-free rate, rRF 6.00% Tax rate, T 40% Market risk premium, RPM 4.00% Current wd 0% Current beta, bU 1.15 Target wd 40%

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

If a firm borrows money, it is using financial leverage.

The firm's target capital structure should do which of the following?

Which of the following statements is CORRECT?

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Which of the following statements is CORRECT?

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

Overview

Financial Markets

Financial Statements

Statement Analysis

Time Value of Money

Forecasting

Interest Rates

Risk and Return

Bonds

Stocks

Cost of Capital

Capital Budgeting Mc Problems

Cash Flow and Risk

Real Options

Dividends

Working Capital

Derivatives

Multinational

Hybrid Financing

Mergers

Filters

Exam 15: Capital Structure

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.

Which of the following statements is CORRECT?

Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this

Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 40.0% debt (wd)Risk-free rate, rRF 6.00% Tax rate, T 40% Market risk premium, RPM 4.00% Current wd 0% Current beta, bU 1.15 Target wd 40%

Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

If a firm borrows money, it is using financial leverage.

The firm's target capital structure should do which of the following?

Which of the following statements is CORRECT?

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Which of the following statements is CORRECT?

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

Overview

Financial Markets

Financial Statements

Statement Analysis

Time Value of Money

Forecasting

Interest Rates

Risk and Return

Bonds

Stocks

Cost of Capital

Capital Budgeting Mc Problems

Cash Flow and Risk

Real Options

Dividends

Working Capital

Derivatives

Multinational

Hybrid Financing

Mergers

Filters