Question 1

Based on M&M Proposition II with taxes, the weighted average cost of capital:

Accepted Answer

A) is equal to the aftertax cost of debt. 
B) has a linear relationship with the cost of equity capital. 
C) is unaffected by the tax rate. 
D) decreases as the debt-equity ratio increases. 
E) is equal to RU * (1 - T
C) . 
A) is equal to the aftertax cost of debt. 
B) has a linear relationship with the cost of equity capital. 
C) is unaffected by the tax rate. 
D) decreases as the debt-equity ratio increases. 
E) is equal to RU * (1 - T
C) .

Question 2

Which one of the following makes the capital structure of a firm irrelevant?

Accepted Answer

A) taxes 
B) interest tax shield 
C) 100 percent dividend payout ratio 
D) debt-equity ratio that is greater than 0 but less than 1 
E) homemade leverage 
A) taxes 
B) interest tax shield 
C) 100 percent dividend payout ratio 
D) debt-equity ratio that is greater than 0 but less than 1 
E) homemade leverage

Question 3

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

Accepted Answer

A) flotation 
B) direct bankruptcy 
C) indirect bankruptcy 
D) financial solvency 
E) capital structure 
A) flotation 
B) direct bankruptcy 
C) indirect bankruptcy 
D) financial solvency 
E) capital structure

Question 4

The Corner Bakery has a debt-equity ratio of 0.54. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M&M Proposition II with no taxes?

Accepted Answer

A) 7.10 percent 
B) 8.79 percent 
C) 10.68 percent 
D) 17.56 percent 
E) 18.40 percent 
A) 7.10 percent 
B) 8.79 percent 
C) 10.68 percent 
D) 17.56 percent 
E) 18.40 percent

Question 5

A firm should select the capital structure that:

Accepted Answer

A) produces the highest cost of capital. 
B) maximizes the value of the firm. 
C) minimizes taxes. 
D) is fully unlevered. 
E) equates the value of debt with the value of equity. 
A) produces the highest cost of capital. 
B) maximizes the value of the firm. 
C) minimizes taxes. 
D) is fully unlevered. 
E) equates the value of debt with the value of equity.

Question 6

A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital?

Accepted Answer

A) 11.47 percent 
B) 11.52 percent 
C) 11.69 percent 
D) 12.23 percent 
E) 12.48 percent 
A) 11.47 percent 
B) 11.52 percent 
C) 11.69 percent 
D) 12.23 percent 
E) 12.48 percent

Question 7

The capital structure that maximizes the value of a firm also:

Accepted Answer

A) minimizes financial distress costs. 
B) minimizes the cost of capital. 
C) maximizes the present value of the tax shield on debt. 
D) maximizes the value of the debt. 
E) maximizes the value of the unlevered firm. 
A) minimizes financial distress costs. 
B) minimizes the cost of capital. 
C) maximizes the present value of the tax shield on debt. 
D) maximizes the value of the debt. 
E) maximizes the value of the unlevered firm.

Question 8

The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield?

Accepted Answer

A) $3,948.75 
B) $4,112.60 
C) $5,311.22 
D) $7,897.50 
E) $8,225.20 
A) $3,948.75 
B) $4,112.60 
C) $5,311.22 
D) $7,897.50 
E) $8,225.20

Question 9

The interest tax shield has no value when a firm has a:
I. tax rate of zero.
II. debt-equity ratio of 1.
III. zero debt.
IV. zero leverage.

Accepted Answer

A) I and III only 
B) II and IV only 
C) I, III, and IV only 
D) II, III, and IV only 
E) I, II, and IV only 
A) I and III only 
B) II and IV only 
C) I, III, and IV only 
D) II, III, and IV only 
E) I, II, and IV only

Question 10

Which of the following statements are correct in relation to M&M 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.

Accepted Answer

A) I and III only 
B) II and IV only 
C) I and II only 
D) III and IV only 
E) I and IV only 
A) I and III only 
B) II and IV only 
C) I and II only 
D) III and IV only 
E) I and IV only

Question 11

In general, the capital structures used by U.S. firms:

Accepted Answer

A) tend to overweigh debt in relation to equity. 
B) generally result in debt-equity ratios between 0.45 and 0.60. 
C) are fairly standard for all SIC codes. 
D) tend to be those which maximize the use of the firm's available tax shelters. 
E) vary significantly across industries. 
A) tend to overweigh debt in relation to equity. 
B) generally result in debt-equity ratios between 0.45 and 0.60. 
C) are fairly standard for all SIC codes. 
D) tend to be those which maximize the use of the firm's available tax shelters. 
E) vary significantly across industries.

Question 12

North Side, Inc. has no debt outstanding and a total market value of $175,000. Earnings before interest and taxes, EBIT, are projected to be $16,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 35 percent higher. If there is a recession, then EBIT will be 70 percent lower. North Side is considering a $70,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. North Side has a tax rate of 34 percent. If the economy expands strongly, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

A) 38.80 percent 
B) 45.26 percent 
C) 50.45 percent 
D) 53.92 percent 
E) 61.07 percent 
A) 38.80 percent 
B) 45.26 percent 
C) 50.45 percent 
D) 53.92 percent 
E) 61.07 percent

Question 13

Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio?

Accepted Answer

A) 0.72 
B) 0.76 
C) 0.79 
D) 0.82 
E) 0.87 
A) 0.72 
B) 0.76 
C) 0.79 
D) 0.82 
E) 0.87

Question 14

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

Accepted Answer

A) $2.5 million 
B) $4.0 million 
C) $5.0 million 
D) $5.5 million 
E) $6.0 million 
A) $2.5 million 
B) $4.0 million 
C) $5.0 million 
D) $5.5 million 
E) $6.0 million

Question 15

A business firm ceases to exist as a going concern as a result of which one of the following?

Accepted Answer

A) divestiture 
B) share repurchase 
C) liquidation 
D) reorganization 
E) capital restructuring 
A) divestiture 
B) share repurchase 
C) liquidation 
D) reorganization 
E) capital restructuring

Question 16

Kelso Electric is debating between a leveraged and an unleveraged capital structure. The all equity capital structure would consist of 40,000 shares of stock. The debt and equity option would consist of 25,000 shares of stock plus $280,000 of debt with an interest rate of 7 percent. What is the break-even level of earnings before interest and taxes between these two options? Ignore taxes.

Accepted Answer

A) $42,208 
B) $44,141 
C) $46,333 
D) $49,667 
E) $52,267 
A) $42,208 
B) $44,141 
C) $46,333 
D) $49,667 
E) $52,267

Question 17

Georga's Restaurants has 4,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent?

Accepted Answer

A) $137,362.50 
B) $162,411.90 
C) $187,750.00 
D) $210,420.00 
E) $233,887.50 
A) $137,362.50 
B) $162,411.90 
C) $187,750.00 
D) $210,420.00 
E) $233,887.50

Question 18

East Side, Inc. has no debt outstanding and a total market value of $136,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. East Side is considering a $54,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. If the economy enters a recession, EPS will change by ____ percent as compared to a normal economy, assuming that the firm recapitalizes.

Accepted Answer

A) -70.97 percent 
B) -63.15 percent 
C) -58.08 percent 
D) -42.29 percent 
E) -38.87 percent 
A) -70.97 percent 
B) -63.15 percent 
C) -58.08 percent 
D) -42.29 percent 
E) -38.87 percent

Question 19

The interest tax shield is a key reason why:

Accepted Answer

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. 
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.

Question 20

M&M Proposition I with no tax supports the argument that:

Accepted Answer

A) business risk determines the return on assets. 
B) the cost of equity rises as leverage rises. 
C) the debt-equity ratio of a firm is completely irrelevant. 
D) a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. 
E) homemade leverage is irrelevant. 
A) business risk determines the return on assets. 
B) the cost of equity rises as leverage rises. 
C) the debt-equity ratio of a firm is completely irrelevant. 
D) a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. 
E) homemade leverage is irrelevant.

Exam 16: Financial Leverage and Capital Structure Policy

Based on M&M Proposition II with taxes, the weighted average cost of capital:

Which one of the following makes the capital structure of a firm irrelevant?

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

The Corner Bakery has a debt-equity ratio of 0.54. The firm's required return on assets is 14.2 percent and its cost of equity is 16.1 percent. What is the pre-tax cost of debt based on M&M Proposition II with no taxes?

A firm should select the capital structure that:

A firm has debt of $12,000, a leveraged value of $26,400, a pre-tax cost of debt of 9.20 percent, a cost of equity of 17.6 percent, and a tax rate of 37 percent. What is the firm's weighted average cost of capital?

The capital structure that maximizes the value of a firm also:

The June Bug has a $270,000 bond issue outstanding. These bonds have a 7.5 percent coupon, pay interest semiannually, and have a current market price equal to 98.6 percent of face value. The tax rate is 39 percent. What is the amount of the annual interest tax shield?

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

In general, the capital structures used by U.S. firms:

Bob's Warehouse has a pre-tax cost of debt of 8.4 percent and an unlevered cost of capital of 14.6 percent. The firm's tax rate is 37 percent and the cost of equity is 18 percent. What is the firm's debt-equity ratio?

Pewter & Glass is an all equity firm that has 80,000 shares of stock outstanding. The company is in the process of borrowing $600,000 at 9 percent interest to repurchase 12,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?

A business firm ceases to exist as a going concern as a result of which one of the following?

Georga's Restaurants has 4,500 bonds outstanding with a face value of $1,000 each and a coupon rate of 8.25 percent. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 37 percent?

The interest tax shield is a key reason why:

M&M Proposition I with no tax supports the argument that:

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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