Question 1

Homemade leverage is:

Accepted Answer

A) the incurrence of debt by a corporation in order to pay dividends to shareholders. 
B) the exclusive use of debt to fund a corporate expansion project. 
C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. 
D) best defined as an increase in a firm's debt-equity ratio. 
E) the term used to describe the capital structure of a levered firm. 
A) the incurrence of debt by a corporation in order to pay dividends to shareholders. 
B) the exclusive use of debt to fund a corporate expansion project. 
C) the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. 
D) best defined as an increase in a firm's debt-equity ratio. 
E) the term used to describe the capital structure of a levered firm.

Question 2

The concept of homemade leverage is most associated with:

Accepted Answer

A) M&M Proposition I with no tax. 
B) M&M Proposition II with no tax. 
C) M&M Proposition I with tax. 
D) M&M Proposition II with tax. 
E) static theory proposition. 
A) M&M Proposition I with no tax. 
B) M&M Proposition II with no tax. 
C) M&M Proposition I with tax. 
D) M&M Proposition II with tax. 
E) static theory proposition.

Question 3

Hanover Tech is currently an all equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent and the tax rate is 36 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What is the levered value of the equity?

Accepted Answer

A) $5.209 million 
B) $5.312 million 
C) $5.436 million 
D) $6.512 million 
E) $6.708 million 
A) $5.209 million 
B) $5.312 million 
C) $5.436 million 
D) $6.512 million 
E) $6.708 million

Question 4

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization?

Accepted Answer

A) 16.30 percent 
B) 16.87 percent 
C) 17.15 percent 
D) 18.29 percent 
E) 18.86 percent 
A) 16.30 percent 
B) 16.87 percent 
C) 17.15 percent 
D) 18.29 percent 
E) 18.86 percent

Question 5

Based on the M&M propositions with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm?
 What if the analysis is based on the static theory?

Accepted Answer

Under either M&M scenario, a financial m

Question 6

Corporations in the U.S. tend to:

Accepted Answer

A) minimize taxes. 
B) underutilize debt. 
C) rely less on equity financing than they should. 
D) have relatively similar debt-equity ratios across industry lines. 
E) rely more heavily on debt than on equity as the major source of financing. 
A) minimize taxes. 
B) underutilize debt. 
C) rely less on equity financing than they should. 
D) have relatively similar debt-equity ratios across industry lines. 
E) rely more heavily on debt than on equity as the major source of financing.

Question 7

The static theory of capital structure advocates that the optimal capital structure for a firm:

Accepted Answer

A) is dependent on a constant debt-equity ratio over time. 
B) remains fixed over time. 
C) is independent of the firm's tax rate. 
D) is independent of the firm's weighted average cost of capital. 
E) equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt. 
A) is dependent on a constant debt-equity ratio over time. 
B) remains fixed over time. 
C) is independent of the firm's tax rate. 
D) is independent of the firm's weighted average cost of capital. 
E) equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

Question 8

Country Markets has an unlevered cost of capital of 12 percent, a tax rate of 38 percent, and expected earnings before interest and taxes of $15,700. The company has $11,000 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

Accepted Answer

A) 12.55 percent 
B) 13.36 percent 
C) 13.64 percent 
D) 14.07 percent 
E) 14.29 percent 
A) 12.55 percent 
B) 13.36 percent 
C) 13.64 percent 
D) 14.07 percent 
E) 14.29 percent

Question 9

Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

Accepted Answer

A) 0.26 
B) 0.33 
C) 0.37 
D) 0.43 
E) 0.45 
A) 0.26 
B) 0.33 
C) 0.37 
D) 0.43 
E) 0.45

Question 10

M&M Proposition II with taxes:

Accepted Answer

A) has the same general implications as M&M Proposition II without taxes. 
B) states that a firm's capital structure is irrelevant. 
C) supports the argument that business risk is determined by the capital structure decision. 
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases. 
E) concludes that the capital structure decision is irrelevant to the value of a firm. 
A) has the same general implications as M&M Proposition II without taxes. 
B) states that a firm's capital structure is irrelevant. 
C) supports the argument that business risk is determined by the capital structure decision. 
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases. 
E) concludes that the capital structure decision is irrelevant to the value of a firm.

Question 11

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm?

Accepted Answer

A) $245,500 
B) $247,600 
C) $251,500 
D) $264,800 
E) $271,300 
A) $245,500 
B) $247,600 
C) $251,500 
D) $264,800 
E) $271,300

Question 12

Which one of the following is a direct bankruptcy cost?

Accepted Answer

A) company CEO's time spent in bankruptcy court 
B) maintaining cash reserves 
C) maintaining a debt-equity ratio that is lower than the optimal ratio 
D) losing a key company employee 
E) paying an outside accountant fees to prepare bankruptcy reports 
A) company CEO's time spent in bankruptcy court 
B) maintaining cash reserves 
C) maintaining a debt-equity ratio that is lower than the optimal ratio 
D) losing a key company employee 
E) paying an outside accountant fees to prepare bankruptcy reports

Question 13

The Green Paddle has a cost of equity of 13.73 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?

Accepted Answer

A) 11.85 percent 
B) 12.78 percent 
C) 14.29 percent 
D) 14.46 percent 
E) 15.08 percent 
A) 11.85 percent 
B) 12.78 percent 
C) 14.29 percent 
D) 14.46 percent 
E) 15.08 percent

Question 14

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?

Accepted Answer

A) $3,423,000 
B) $3,508,600 
C) $3,781,100 
D) $3,898,700 
E) $4,180,000 
A) $3,423,000 
B) $3,508,600 
C) $3,781,100 
D) $3,898,700 
E) $4,180,000

Question 15

The business risk of a firm:

Accepted Answer

A) depends on the firm's level of unsystematic risk. 
B) is inversely related to the required return on the firm's assets. 
C) is dependent upon the relative weights of the debt and equity used to finance the firm. 
D) has a positive relationship with the firm's cost of equity. 
E) has no relationship with the required return on a firm's assets according to M&M Proposition II. 
A) depends on the firm's level of unsystematic risk. 
B) is inversely related to the required return on the firm's assets. 
C) is dependent upon the relative weights of the debt and equity used to finance the firm. 
D) has a positive relationship with the firm's cost of equity. 
E) has no relationship with the required return on a firm's assets according to M&M Proposition II.

Question 16

You currently own 600 shares of JKL, Inc. JKL is an all equity firm that has 75,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $140,000. JKL has decided to issue $1 million of debt at 8 percent interest. This debt will be used to repurchase shares of stock. How many shares of JKL stock must you sell to unlever your position if you can loan out funds at 8 percent interest?

Accepted Answer

A) 120 shares 
B) 150 shares 
C) 180 shares 
D) 200 shares 
E) 250 shares 
A) 120 shares 
B) 150 shares 
C) 180 shares 
D) 200 shares 
E) 250 shares

Question 17

D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield?

Accepted Answer

A)  $504 
B)  $615 
C)  $644 
D)  $6,200 
E)  $6,720 
A)  $504 
B)  $615 
C)  $644 
D)  $6,200 
E)  $6,720

Question 18

In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down?
 After all, aren't financial managers supposed to maximize the value of a firm?

Accepted Answer

This question requires students to diffe

Question 19

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Accepted Answer

A) exceptionally high depreciation expenses 
B) very low marginal tax rate 
C) substantial tax shields from other sources 
D) low probabilities of financial distress 
E) minimal taxable income 
A) exceptionally high depreciation expenses 
B) very low marginal tax rate 
C) substantial tax shields from other sources 
D) low probabilities of financial distress 
E) minimal taxable income

Question 20

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 11 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.

Accepted Answer

A) 12.17; 12.68 
B) 12.17; 12.94 
C) 12.17; 13.33 
D) 12.29; 12.68 
E) 12.29; 13.33 
A) 12.17; 12.68 
B) 12.17; 12.94 
C) 12.17; 13.33 
D) 12.29; 12.68 
E) 12.29; 13.33

Exam 16: Financial Leverage and Capital Structure Policy

Homemade leverage is:

The concept of homemade leverage is most associated with:

Based on the M&M propositions with and without taxes, how much time should a financial manager spend analyzing the capital structure of a firm? What if the analysis is based on the static theory?

Corporations in the U.S. tend to:

The static theory of capital structure advocates that the optimal capital structure for a firm:

Jefferson & Daughter has a cost of equity of 14.6 percent and a pre-tax cost of debt of 7.8 percent. The required return on the assets is 13.2 percent. What is the firm's debt-equity ratio based on M&M II with no taxes?

M&M Proposition II with taxes:

Bright Morning Foods has expected earnings before interest and taxes of $48,600, an unlevered cost of capital of 13.2 percent, and debt with both a book and face value of $25,000. The debt has an 8.5 percent coupon. The tax rate is 34 percent. What is the value of the firm?

Which one of the following is a direct bankruptcy cost?

The Green Paddle has a cost of equity of 13.73 percent and a pre-tax cost of debt of 7.6 percent. The debt-equity ratio is 0.65 and the tax rate is 32 percent. What is Green Paddle's unlevered cost of capital?

Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. The current market value of the equity is $38 million and there are no taxes. What is EBIT?

The business risk of a firm:

D. L. Tuckers has $21,000 of debt outstanding that is selling at par and has a coupon rate of 7.5 percent. The tax rate is 32 percent. What is the present value of the tax shield?

In each of the theories of capital structure, the cost of equity increases as the amount of debt increases. So why don't financial managers use as little debt as possible to keep the cost of equity down? After all, aren't financial managers supposed to maximize the value of a firm?

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Introduction to Corporate Finance

Financial Statements, Taxes, and Cash Flow

Working With Financial Statements

Long-Term Financial Planning and Growth

Introduction to Valuation: The Time Value of Money

Discounted Cash Flow Valuation

Interest Rates and Bond Valuation

Stock Valuation

Net Present Value and Other Investment Criteria

Making Capital Investment Decisions

Project Analysis and Evaluation

Some Lessons From Capital Market History

Return, Risk, and the Security Market Line

Cost of Capital

Raising Capital

Dividends and Dividend Policy

Short-Term Finance and Planning

Cash and Liquidity Management

Credit and Inventory Management

International Corporate Finance

Behavioral Finance: Implications for Financial Management

Risk Management: An Introduction to Financial Engineering

Options and Corporate Finance

Option Valuation

Mergers and Acquisitions

Leasing

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