Deck 16: Financial Leverage and Capital Structure Policy

Question 1

There appears to be some connection between operating characteristics and capital structure

Answer 1

True

Question 2

The equity beta of a firm depends on the firm's business risk and its financial policy.

Answer 2

True

Question 3

When EBIT is positive, the effect of financial leverage depends on the company's EBIT, that is,
leverage is unfavourable when EBIT is relatively high, and leverage is favourable when EBIT is
relatively low.

Answer 3

False

Question 4

When a firm is operating at its target capital structure point, shareholder value is maximized.

Question 5

All else the same, taxes and bankruptcy claims on the cash flows of the firm will tend to increase
with decreases in the debt/equity ratio?

Question 6

All else equal, higher financial leverage decreases a firm's break-even EBIT.

Question 7

Tax rate will affect the optimal level of debt for a firm.

Question 8

When a firm is operating at its target capital structure point, the debt-equity ratio is equal to 1.

Question 9

Volatility of earnings will affect the optimal level of debt for a firm.

Question 10

When EBIT is positive, increasing financial leverage increases the sensitivity of EPS and ROE to
changes in EBIT.

Question 11

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by
its capital structure, then a firm's cost of equity depends on the firm's business and financial risks.

Question 12

When a firm is operating at its target capital structure point, the total value of the firm is maximized.

Question 13

Ignoring financial distress costs, borrowing money decreases the value of the firm by increasing the
firm's tax liability.

Question 14

Nature of assets will affect the optimal level of debt for a firm.

Question 15

It appears that, capital structures vary quite a bit across differing industry groups.

Question 16

When a firm is operating at its target capital structure point, the firm's WACC is at its minimum point.

Question 17

Suppose we wish to draw a graph illustrating M&M Proposition II. Let the vertical axis represent the
cost of capital and the firm's debt-to-equity ratio represents the horizontal axis. If the line
representing the firm's WACC has a negative slope, we must be incorporating taxes into the
analysis.

Question 18

D/E ratios are significantly higher today than they were in the 1960s.

Question 19

The optimal capital structure is the mixture of debt and equity which maximizes the value of the firm
and Minimizes the firm's weighted average cost of capital.

Question 20

When EBIT is positive, high leverage decreases the returns to shareholders (as measured by ROE).

Question 21

In relation to M&M Proposition II with no taxes, the return on assets is equal to the weighted
average cost of capital.

Question 22

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the firm's
interest tax shield.

Question 23

When a firm is operating with the optimal capital structure, the weighted average cost of capital will
be at its minimal point.

Question 24

The actual value of a firm with debt is generally greater than the value of a firm without debt.

Question 25

In relation to M&M Proposition II with no taxes, financial risk determines the return on assets.

Question 26

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the firm's debt-
equity ratio.

Question 27

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the required
rate of return on the firm's assets.

Question 28

Business risk declines as the systematic risk of a firm's assets increases.

Question 29

In relation to M&M Proposition II with no taxes, the cost of equity declines when the amount of
leverage used by a firm rises.

Question 30

M&M Proposition II with no tax states that a firm's cost of equity is dependent upon the firm's cost of
debt financing.

Question 31

The actual value of a firm is equal to the value of the firm with no debt plus the present value of the
tax shield on debt minus the financial distress costs

Question 32

Financial risk is the risk associated with the use of debt financing.

Question 33

Systematic risk applies to levered firms but not to unlevered firms.

Question 34

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by
its capital structure, then the value of the firm is dependent on its capital structure.

Question 35

Business risk applies to levered firms but not to unlevered firms.

Question 36

Financial risk is wholly dependent upon the financial policy of a firm.

Question 37

Accumulated tax losses will affect the optimal level of debt for a firm.

Question 38

In relation to M&M Proposition II with no taxes, financial risk is determined by the debt-equity ratio.

Question 39

Financial risk is the risk that is inherent in a firm's operations.

Question 40

Business risk is a positive function of the systematic risk of a firm's assets.

Question 41

If the static theory of capital structure is true, then the optimal level of debt for a given firm
increases as its marginal tax rate increases and decreases as the costs of financial distress
increase.

Question 42

When taxes are factored in, debt financing creates positive value in the form of an interest tax
shield.

Question 43

When taxes are factored in, debt financing lowers a firm's cost of equity.

Question 44

The interest tax shield has no value for a firm when the firm is unlevered.

Question 45

According to the static theory of capital structure, value-maximizing financial managers will borrow
to the point where the firm's business risk is just equal to its financial risk.

Question 46

The interest tax shield has no value for a firm when a firm elects 100% equity as its capital structure.

Question 47

When taxes are factored in, debt financing lowers a firm's weighted average cost of capital.

Question 48

Interest tax shield applies to levered firms but not to unlevered firms.

Question 49

The interest tax shield has no value for a firm when the tax rate is equal to zero.

Question 50

According to M&M Proposition II without taxes, a firm's cost of equity is a function of the required
rate of return on the firm's assets, the firm's debt/equity ratio, and the firm's cost of debt.

Question 51

The optimal capital structure is the mixture of debt and equity which maximizes the market price of
the firm's bonds.

Question 52

The interest tax shield has no value for a firm when the debt-equity ratio is exactly equal to 1.

Question 53

A sizeable increase in taxable income will tend to diminish the benefit of the interest tax shield.

Question 54

A reduction in tax rates will tend to diminish the benefit of the interest tax shield.

Question 55

The maximum value of a firm is at the point where the additional gain from leverage is just offset by
the additional financial distress cost.

Question 56

As financial risk increases so too does the cost of equity.

Question 57

A large depreciation tax deduction will tend to diminish the benefit of the interest tax shield.

Question 58

When taxes are factored in, debt financing increases the value of a firm.

Question 59

Financial risk applies to levered firms but not to unlevered firms.

Question 60

A large tax loss carry forward will tend to diminish the benefit of the interest tax shield.

Question 61

Accounting and legal fees incurred in the bankruptcy process is an indirect cost of bankruptcy.

Question 62

According to the absolute priority rule, the correct order of distribution in liquidation is:
Employee wages, Administrative expenses of the bankruptcy, Government taxes Unsecured
creditors

Question 63

It has been observed that, when firms get into financial trouble, they often find it difficult to attract
and retain high-quality employees. The additional costs incurred in this situation would be
considered direct bankruptcy costs.

Question 64

All else the same, bondholder claims on the cash flows of the firm will tend to increase with
decreases in the debt/equity ratio?

Question 65

All else the same, bankruptcy claims on the cash flows of the firm will tend to increase with
decreases in the debt/equity ratio?

Question 66

According to the absolute priority rule, the correct order of distribution in liquidation is:
Administrative expenses of the bankruptcy, Employee wages, Government taxes Unsecured
creditors.

Question 67

Joe's BBQ Grill has $21,000 of debt outstanding that is selling at par and has a coupon rate of 6.5%. The tax rate is 35%. What is the present value of the tax shield?

A) $478
B) $790
C) $1,365
D) $4,780
E) $7,350

Question 68

Foregone profitable projects due to debt restrictions is an indirect cost of bankruptcy.

Question 69

When a firm is operating with the optimal capital structure, the debt-equity ratio will also be optimal.

Question 70

When a firm is operating with the optimal capital structure, the increased benefit from additional
debt is equal to the increased bankruptcy costs of that debt.

Question 71

Loss created by sale of assets which was required to improve liquidity is an indirect cost of
bankruptcy.

Question 72

A firm has a tax rate of 35%, an unlevered rate of return of 14%, total debt of $1,000, and an EBIT of $300.00. What is the unlevered value of the firm?

A) $27
B) $393
C) $1,027
D) $1,393
E) $2,143

Question 73

When a firm files for bankruptcy, the firm often must hire appraisers to determine the fair value of
the firm's assets. This is an example of a direct cost of bankruptcy.

Question 74

When a firm is operating with the optimal capital structure, the required return on assets will be at
its maximum point.

Question 75

Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a financially
distressed firm.

Question 76

Loss of key employees is an indirect cost of bankruptcy.

Question 77

Direct bankruptcy costs are those costs that are directly associated with bankruptcy, such as legal
and administrative costs.

Question 78

In order to avoid bankruptcy, management sometimes seeks to work with creditors. One method of
restructuring debt involves composition, which involves a reduction in the amount of the payment
to be made.

Question 79

An unlevered firm has a cost of capital of 16% and earnings before interest and taxes of $225,000. A levered firm with the same operations and assets has both a book value and a face value of debt
Of $850,000 with an 8% annual coupon. The applicable tax rate is 34%. What is the value of the
Levered firm?

A) $928,125
B) $1,110,125
C) $1,178,125
D) $1,217,125
E) $1,778,125

Question 80

The actual firm value is equal to the M&M Proposition I with tax value minus the financial distress
costs.