Deck 16: Capital Structure

Question 1

Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?

A) $12.64 million
B) $11.35 million
C) $12.21 million
D) $13.20 million

Answer 1

$12.64 million

Question 2

Which of the following statements is FALSE?

A) The value of the firm is determined by the present value (PV) of the cash flows from its current and future investments.
B) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage.
C) As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm.
D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Answer 2

The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm.

Question 3

In general, issuing equity may not dilute the ownership of existing shareholders i?

A) the value of new shares is equal to the value of debt.
B) the firm has no debt financing.
C) the firm uses debt conservatively.
D) the new shares are sold at a fair price.

Answer 3

the new shares are sold at a fair price.

Question 4

The trade-off theory of optimal capital structure weighs the benefits of debt against the costs o?

A) financial distress.
B) input factors.
C) interest payments.
D) dividend reinvestment.

Question 5

Which of the following statements is FALSE?

A) As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero and, therefore, should not change the value of a firm.
C) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.
D) The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.

Question 6

Which of the following statements is FALSE?

A) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.
B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets.
C) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
D) The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.

Question 7

Managers should make use of the interest tax shield if the firm ha?

A) volatility in taxable income.
B) consistent dividend payments.
C) consistent taxable income.
D) low tax rates.

Question 8

By adding leverage, the returns on the firm are split between debt holders and equity holders, but equity holder risk increases because

A) interest payments can be rolled over.
B) dividends are paid first.
C) interest payments have first priority.
D) debt and equity have equal priority.

Question 9

A firm requires an investment of $20,000 and borrows $10,000 at 8%. If the return on equity is 20% and the tax rate is 30%, what is the firm's WACC?

A) 13.2%
B) 11.4%
C) 12.8%
D) 12..1%

Question 10

When a firm's investment decisions have different consequences for the value of equity and thevalue of debt, managers may take actions

A) to decrease costs of distress.
B) that benefit shareholders at the expense of debt holders.
C) to reduce fixed costs.
D) to increase debt values.

Question 11

Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an all-equity
firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12
million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend atthe same 5% rate as With. You have $5000 of your own money to invest and you plan on buying With shares. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5000 investment in Without shares?

A) $0
B) $2500
C) $4000
D) $5000

Question 12

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%,what is the firm's pretax WACC?

A) 14%
B) 12%
C) 11%
D) 13%

Question 13

The Trade-off Theory suggest?

A) differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain the differences in the use of leverage across industries.
B) there is no rational explanation for why firms choose debt levels that are too low to fully exploit the debt tax shield.
C) with higher costs of financial distress, it is optimal for the firm to choose higher leverage.
D) the firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.

Question 14

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm,it is referred to as

A) payout ratio.
B) retained earnings.
C) homemade leverage.
D) outside debt.

Question 15

One of the factors that determines the present value (PV) of financial distress costs i?

A) employee compensation.
B) probability of financial distress.
C) costs of unpaid interest arrears.
D) loss of dividend payments.

Question 16

As the level of debt increases, the tax benefits of debt increase unti?

A) tax shield benefits exceeds distress costs.
B) raw material costs exceed dividend payments.
C) employee costs exceed interest expense.
D) interest costs exceed dividend payments.

Question 17

The presence of a large amount of debt can encourage shareholders to take excessive risk becaus?

A) debt holders are risk seeking.
B) firm value increases with risk taking.
C) equity holders are risk seeking by nature.
D) the costs of failure are borne largely by debt holders.

Question 18

Which of the following statements is FALSE?

A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.
B) The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.
C) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
D) We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of capital.

Question 19

Which of the following statements is FALSE?

A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure.
B) The project's net present value (NPV) represents the value to the new investors of the firm created by the project.
C) When corporations raise funds from outside investors, they must choose which type of security to issue.
D) The most common choices are financing through equity alone and financing through a combination of debt and equity.

Question 20

A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

A) 11.4%
B) 10.1%
C) 7.8%
D) 12.3%

Question 21

Which of the following statements is FALSE?

A) One application of MM Proposition I is the useful device known as the market value balance sheet of the firm.
B) The market value balance sheet captures the idea that value is created by a firm's choice of assets and investments.
C) On the market value balance sheet the total value of all securities issued by the firm must equal the total value of the firm's assets.
D) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.

Question 22

Leverage can a firm's expected earnings per share, but does not necessarily increase the share price.

A) dilute
B) decrease
C) not change
D) increase

Question 23

Agency costs arise whe?

A) conflicts of interest exist between stakeholders.
B) input costs are higher than interest costs.
C) interest costs exceed dividend payments.
D) there are high labour costs.

Question 24

A firm requires an investment of $30,000 and will return $35,000 after 1 year. If the firm borrows $20,000 at 10% what is the return on levered equity?

A) 43%
B) 39%
C) 37%
D) 30%

Question 25

The optimal capital structure depends o?

A) firm specific risks
B) systematic risks
C) market imperfections
D) capital market factors

Question 26

A firm has a market value of assets of $50,000. It borrows $10,000 at 3%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A) 18%
B) 16%
C) 19%
D) 17%

Question 27

Use next year's Cash Flow Forecast for Blank Company to answer the following questions:
$\begin{array} { | l | l | } \hline \text { Demand } & \text { Cash Flow } \\\hline \text { Weak } & \$ 25,000 \\\hline \text { Expected } & \$ 35,000 \\\hline \text { Strong } & \$ 45,000 \\\hline\end{array}$

-Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the expected return to equity holders?

A) 8.0%
B) 9.33%
C) 11.6%
D) 30.0%

Question 28

Which of the following statements is FALSE?

A) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged.
B) With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is unlevered.
C) Although debt has a lower cost of capital than equity, leverage does not lower a firm's WACC.
D) With no debt, the WACC is equal to the unlevered equity cost of capital.

Question 29

The probability of financial distress depends on th?

A) likelihood of asset growth.
B) likelihood of dividend payments.
C) likelihood that a firm will be unable to meet its debt commitments.
D) chance that a firm's raw material costs will increase.

Question 30

Aside from the direct costs of bankruptcy, a firm may also incur other indirect costs such a?

A) loss of interest receipts.
B) increase in raw material costs.
C) loss of dividend receipts.
D) loss of customers and loss of suppliers.

Question 31

Suppose a project financed via an issue of debt requires five annual interest payments of $20 million each year. If the tax rate is 30% and the cost of debt is 5%, what is the value of the interest rate tax shield?

A) $32.35 million
B) $22.67 million
C) $22.25 million
D) $25.98 million

Question 32

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to
repurchase shares from its investors and has already announced the share repurchase plan. Currently Luther is an all-equity
firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
Assume that in addition to 1.25 billion ordinary shares outstanding, Luther has share options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?

A) 1.2 billion
B) 1.1 billion
C) 0.75 billion
D) 1.0 billion

Question 33

Which of the following statements is FALSE?

A) The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets.
B) When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered, however, its asset beta will change to reflect the effect of the capital structure change on its risk.
C) The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage.
D) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.

Question 34

The relative proportions of debt, equity, and other securities that a firm has outstanding constitute
its

A) leverage.
B) capital structure.
C) retained earnings.
D) paid out capital.

Question 35

A firm will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 11%, what is the levered value of the firm with perfect capital markets?

A) $19,820
B) $18,182
C) $20,000
D) more information needed

Question 36

Firms in industries such as real estate tend to have distress costs because of a large proportion of tangible assets.

A) high
B) varying
C) unexpected
D) low

Question 37

Which of the following statements is FALSE?

A) Since the WACC does not change with the use of leverage, the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does
Not depend on its financing choices.
B) Holding cash has the opposite effect of leverage on risk and return.
C) Even if the firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.
D) We use the market value of the firms' net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets.

Question 38

Market timing means that managers may sell when they believe the shares are overvalued and rely on when the shares are undervalued.

A) new shares, debt
B) debt, debt
C) debt, shares
D) debt, preference shares

Question 39

The under-investment problem refers to the problem that equity holders prefer not to invest in positive-NPV projects in highly levered firms because

A) future investments are contingent on debt financing.
B) most of the gains from the investment accrue to debt holders.
C) projects are contingent on equity financing.
D) gains are evenly shared between all stakeholders.

Question 40

A project will give a one-time cash flow of $20,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets?

A) $18,182
B) $19,000
C) $20,000
D) more information needed

Question 41

A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows $5,000 at 7% what is the return on levered equity?

A) 45%
B) 41%
C) 39%
D) 43%

Question 42

Managerial entrenchment means that managers and run the firm for their own best interests.

A) are overseen by debt holders
B) are well compensated
C) are overseen by equity holders
D) may face little threat of being fired

Question 43

Investment cash flows are independent of financing choices in ?

A) market with frictions.
B) firm with leverage.
C) perfect capital market.
D) setting with frictions in investment returns.

Question 44

Suppose a project financed via an issue of debt requires six annual interest payments of $20 million each year. If the tax rate is 30% and the cost of debt is 8%, what is the value of the interest rate tax shield?

A) $32.64 million
B) $23.20 million
C) $31.35 million
D) $27.74 million

Question 45

$$X = \frac { E } { E + D } r _ { E } + \frac { D } { E + D } r _ { D }$$ can be used to calculate all of the following EXCEPT:

A) the unlevered cost of equity
B) the cost of capital for the firm's assets
C) the levered cost of equity
D) the weighted average cost of capital

Question 46

Use next year's Cash Flow Forecast for Blank Company to answer the following questions:
$\begin{array} { | l | l | } \hline \text { Demand } & \text { Cash Flow } \\\hline \text { Weak } & \$ 25,000 \\\hline \text { Expected } & \$ 35,000 \\\hline \text { Strong } & \$ 45,000 \\\hline\end{array}$

-Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is weak?

A) -58.6%
B) -37.5%
C) -35.3%
D) 8.0%

Question 47

Issuing debt provides incentives for managers to run the firm efficiently becaus?

A) shareholders prefer to decline new projects to save cash, even if their NPVs are positive.
B) ownership may remain more concentrated, improving monitoring of management.
C) debt increases the funds available to managers to run the firm.
D) managers may take actions that benefit shareholders but harm creditors and lower the value of the firm.

Question 48

In a setting where there is no risk that a firm will default, leverag?

A) increases
B) decreases
C) does not change
D) cannot say for sure

Question 49

Use next year's Cash Flow Forecast for Blank Company to answer the following questions:
$\begin{array} { | l | l | } \hline \text { Demand } & \text { Cash Flow } \\\hline \text { Weak } & \$ 25,000 \\\hline \text { Expected } & \$ 35,000 \\\hline \text { Strong } & \$ 45,000 \\\hline\end{array}$

-Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is strong?

A) 28.6%
B) 8.0%
C) 54.0%
D) 38.0%

Question 50

A firm requires an investment of $30,000 and borrows $20,000 at 7%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

A) 10.4%
B) 9.13%
C) 8.91%
D) 8.27%

Question 51

Managers should conside?

A) internal equity
B) long-term debt
C) retained earnings
D) short-term debt

Question 52

Which of the following statements is FALSE?

A) When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalisation.
B) By choosing positive-NPV projects that are worth more than their initial investment, the firm can enhance its value.
C) MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
D) The choice of capital structure does not change the value of the firm if the cash flows generated by the firm's assets are assumed to remain constant.

Question 53

The A in the equation above represent?

A) the market value of the firm's assets.
B) the value of the firm's equity.
C) the value of the firm's debt.
D) the value of the firm's unlevered equity.

Question 54

Which of the following do firms consider in the choice of securities issued?

A) whether the chosen security will have a fair price in the market
B) the transactions costs of the chosen security
C) the tax consequences of the chosen security
D) All of the above are considered.

Question 55

Asymmetric information implies that may have better information about a firm's cash flows than other stakeholders.

A) debt holders
B) creditors
C) suppliers
D) managers

Question 56

Use next year's Cash Flow Forecast for Blank Company to answer the following questions:
$\begin{array} { | l | l | } \hline \text { Demand } & \text { Cash Flow } \\\hline \text { Weak } & \$ 25,000 \\\hline \text { Expected } & \$ 35,000 \\\hline \text { Strong } & \$ 45,000 \\\hline\end{array}$

-Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. What is the value of the company?

A) $32,407.40
B) $41,666.67
C) $23,148.15
D) cannot be determined with the information given

Question 57

Which of the following statements is FALSE?

A) By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity.
B) The levered equity return equals the unlevered return, plus an extra "kick" due to leverage.
C) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.
D) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

Question 58

MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market value of the generated by its assets.

A) earnings after interest
B) earnings after taxes
C) cash flows after taxes
D) free cash flows

Question 59

The E in the equation above represent?

A) the value of the firm's debt.
B) the market value of the firm's assets.
C) the value of the firm's equity.
D) the value of the firm's unlevered equity.

Question 60

The pecking order hypothesis states that managers will have a preference to fund investment by using , followed by , and will issue as a last resort.

A) debt, retained earnings, equity
B) retained earnings, equity, debt
C) retained earnings, debt, equity
D) debt, equity, retained earnings

Question 61

The U in the equation above represent?

A) the value of the firm's unlevered equity.
B) the value of the firm's debt.
C) the value of the firm's equity.
D) the market value of the firm's assets.

Question 62

Which of the following equations would NOT be appropriate to use in a firm with risky debt?

A) $\beta _ { U } = \frac { E } { E + D } \beta _ { E } + \frac { D } { E + D } \beta _ { D }$
B) $\beta U = \beta _ { E ^ { + } } \frac { D } { E } \left( \beta U - \beta _ { D } \right)$
C) $\beta _ { E } = \beta U + \frac { D } { E } \left( \beta _ { U } - \beta _ { D } \right)$
D) $\beta _ { E } = \beta U + \frac { D } { E } \beta U$

Question 63

Which of the following statements is FALSE?

A) We can calculate the cost of capital of the firm's assets by computing the weighted average of the firm's equity and debt cost of capital, which we refer to as the firm's weighted average
Cost of capital.
B) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its equity cost of capital as the cost of capital for the project.
C) When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project's free cash flow.
D) The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were unlevered.

Question 64

A firm has a market value of assets of $50,000. It borrows $10,000 at 7%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A) 18%
B) 16%
C) 17%
D) 19%

Question 65

Equity in a firm with debt is calle?

A) unlevered equity.
B) levered equity.
C) risk-free equity.
D) risky equity.

Question 66

Use next year's Cash Flow Forecast for Blank Company to answer the following questions:
$\begin{array} { | l | l | } \hline \text { Demand } & \text { Cash Flow } \\\hline \text { Weak } & \$ 25,000 \\\hline \text { Expected } & \$ 35,000 \\\hline \text { Strong } & \$ 45,000 \\\hline\end{array}$

-Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company uses no leverage, what is the expected return to equity holders?

A) 30.0%
B) 9.33%
C) 11.6%
D) 8.0%

Question 67

Managers should not change the capital structure unless it departs significantly from the optimal level because such a change would

A) change incentives of stakeholders.
B) reduce dividends.
C) incur transactions costs.
D) increase fixed costs.

Question 68

It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm because

A) leverage changes the unlevered cost of equity.
B) leverage increases the risk of the equity of the firm.
C) cost of debt decreases in this setting.
D) leverage decreases the risk of equity of the firm.

Question 69

A project will give a one-time cash flow of $25,000 after one year. If the project risk requires a return of 12%, what is the levered value of the firm with perfect capital markets?

A) $22,000
B) $22,321
C) $19,882
D) more information needed

Question 70

A firm has a market value of assets of $50,000. It borrows $10,000 at 5%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A) 20.6%
B) 17.5%
C) 18.5%
D) 19.2%

Question 71

The use of leverage as a way to signal information to investors is known as the signaling theory of debt.

A) random
B) good
C) bad
D) none of the above

Question 72

Which of the following is NOT one of Modigliani and Miller's conditions for a perfect capital market?

A) Investors and firms can trade the same set of securities at competitive market prices equal to the present value (PV) of their future cash flows.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm's financing decisions do not change the cash flows generated by its investments, nor do they reveal new information about them.
D) All investors hold the efficient portfolio of assets.

Question 73

Differences in the magnitude of financial distress costs and volatility of cash flows across industries do not impact the choice of leverage.

Question 74

A firm requires an investment of $20,000 and borrows $10,000 at 8%. If the return on equity is 20%, what is the firm's pretax WACC?

A) 15%
B) 17%
C) 14%
D) 16%

Question 75

A firm'?

A) asset
B) debt-to-value
C) debt-to-equity
D) liability

Question 76

Even if two firms operate in the same industry, they may prefer different choices of debt-equity ratios.

Question 77

A firm requires an investment of $20,000 and will return $25,000 after one year. If the firm borrows $10,000 at 7% what is the return on levered equity?

A) 37%
B) 39%
C) 43%
D) 29%

Question 78

A financial manager makes a choice of the amount and source of capital based on how the choice will impact

A) debt-equity ratio.
B) firm value.
C) earnings per share.
D) debt value.

Question 79

A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy includ?

A) taxes.
B) raw material costs.
C) dividend payments.
D) costs of hiring legal experts, appraisers, and auctioneers.

Question 80

A firm requires an investment of $40,000 and borrows $10,000 at 8%. If the return on equity is 20%, what is the firm's pretax WACC?

A) 15%
B) 16%
C) 14%
D) 17%