Deck 21: Capital Structure Decisions

Question 1

Compared to non-investment grade firms, investment grade firms, in general, do not exhibit:

A)higher coverage ratios.
B)higher cash flow to debt ratios.
C)lower return on assets.
D)higher profit margin.

Answer 1

lower return on assets.

Question 2

Northwest Territories Bikini Company reported the following financial data for the year ended 2022:

The return on investment (ROI)of Northwest Territories Bikini Company is:

A)13.33%
B)30.00%
C)37.50%
D)53.33%

Answer 2

30.00%

Question 3

In 2022, Toronto Skaters earned a return on investment (ROI)of 15% and had a cost of debt of 7%.The book value of debt was $25,000 and the book value of shareholders' equity was $30,000.The firm faces a tax rate of 30%.The firm's return on equity (ROE)is:

A)19.92%
B)22.08%
C)23.42%
D)27.12%

Answer 3

23.42%

Question 4

Which of the following describes the cash flow-to-debt ratio?

A)measure of the ability of a firm to cover all debt payments, principal and interest with its cash balance
B)measure of the ability of a firm to cover interest costs with its cash balance
C)an expanded interest coverage ratio
D)measure of the cash flow available over a period of time to cover outstanding debt

Question 5

Use the following statements to answer this question:
I.The correlation between a high Altman Z score and the rating by rating agencies is positive
II.Investment-grade firms have a low yield to maturity

A)I and II are correct.
B)I and II are incorrect.
C)I is correct and II is incorrect.
D)I is incorrect and II is correct.

Question 6

Northwest Territories Bikini Company reported the following financial data for the year ended 2022.

The return on equity (ROE)of Northwest Territories Bikini Company is o:

A)13.33%
B)30.00%
C)37.50%
D)53.33%

Question 7

In order to show that capital structure is irrelevant, we need which of the following assumptions?

A)Perfect markets
B)No taxes
C)Risk-free debt
D)All of the above are critical.

Question 8

Which of the following is NOT a result of increasing debt?

A)A decrease in the financial flexibility of the firm
B)An increase in the sales breakeven point.
C)An increase in managers' flexibility to spend money.
D)An increase in the cost of borrowing.

Question 9

Fixed burden coverage ratio measures:

A)the coverage of expenses associated with debt and operating income.
B)the return on investment capital.
C)the magnitude of historical capital expenditure over the years.
D)none of the above.

Question 10

In the context of the M&M Irrelevance theorem, in the absence of taxes and bankruptcy costs, which of the following is true?

A)The total value of the firm is dependent on the firm's capital structure.
B)Investors can undo the leverage that the corporation has undertaken.
C)Adding debt to the capital structure creates value.
D)Shareholders will pay a premium for shares merely because a firm chooses to introduce financial leverage.

Question 11

Above the break-even point for earnings before interest and taxes, increased debt will ______ earnings per share.

A)decrease
B)increase
C)not change
D)Cannot be determined with the existing information

Question 12

The indifference analysis refers to the indifference of:

A)earnings with respect to two alternative financing plans.
B)sales with respect to the cost of debt.
C)cost of equity with respect to debt structure.
D)risk of bankruptcy with respect to debt structure.

Question 13

Which of the following represent limitations of indifference analysis?
I.Indifference analysis does not consider how equity investors may react to the increased risk due to increased leverage.
II.Indifference analysis fails to account for corporate taxes.
III.Indifference analysis ignores sinking fund payments.

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

Question 14

Increasing the operating or business risk of a firm will increase the variability of:

A)return on equity (ROE).
B)return on investment (ROI).
C)there is no effect on the variability of ROE and ROI.
D)both the ROE and ROI

Question 15

The M&M proof of capital structure irrelevance relies on:

A)arbitrage arguments
B)personal and corporate leverage are perfect substitutes
C)both of the above
D)neither of the above

Question 16

At the EPS indifference point, two companies would have:

A)the same sales level regardless of the number of outstanding shares.
B)the same sales level regardless of the debt to equity ratio.
C)the same EPS regardless of the number of shares.
D)the same EPS regardless of the financing scheme adopted.

Question 17

Which one of the following is an example of homemade leverage?

A)An investor borrows money to invest in a car.
B)An investor sells part of their stocks to put down a down payment on a house.
C)An investor borrows money to invest more in a company in which they own shares.
D)An investor invests in the derivatives of a firm.

Question 18

Cash flow-to-debt ratio measures:

A)the amount of dividends paid out to common shareholders.
B)the amount the cash flow available over a period to cover a firm's outstanding debt
C)the amount of income and expenditures financed with debt.
D)none of the above.

Question 19

The effect of financial leverage on ROE depends on:

A)the firm's financing strategy.
B)the dividend amount paid out.
C)the market value of the debt.
D)none of the above.

Question 20

Indifference analysis is based on the relationship between

A)debt-equity ratio and expected earnings.
B)earnings before interest and taxes and earnings per share.
C)beta and expected return.
D)after-tax earnings and earnings per share.

Question 21

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.According to M&M, the weighted average cost of capital for Whispering Pines Resort will be:

A)greater than the weighted average cost of capital for James Bay Water Park.
B)the same as the weighted average cost of capital for James Bay Water Park.
C)less than the weighted average cost of capital for James Bay Water Park.
D)insufficient information is provided to answer the question.

Question 22

In the context of the M&M Irrelevance theorem, in a world with no taxes and no bankruptcy costs,

A)the firm's value is unaffected by capital structure.
B)the firm should maximize the value of the firm by maximizing the firm's debt.
C)the firm should borrow to the point where the marginal benefits of debt equal the marginal costs.
D)the firm cannot make a decision about the optimal capital structure with the existing information.

Question 23

Which of the following statements is correct?

A)The return on equity increases as leverage increases.
B)The earnings per share decreases as leverage increases.
C)The risk of the equity remains constant as leverage increases.
D)All of the above.

Question 24

Vancouver Skaters Company (VSC)has a before-tax cost of debt of 8%, a debt/equity ratio of 3, and pays tax at the rate of 40%.The unlevered cost of equity for a firm with VSC's risk characteristics is 15%.Debt is $30,000.If VSC expects a perpetual EBIT of $20,000, then the value of the firm is:

A)$80,000
B)$92,000
C)$133,333
D)$190,476

Question 25

Poutine Cheese Co.operates in a world with zero taxes and there is no risk of financial distress.Currently the firm has a D/E ratio of 3.5, a cost of debt of 8%, and a cost of equity of 15%.Xin, a junior analyst, states that if the firm increases their use of debt their WACC should decrease.Xin is:

A)Correct because as we increase the use of debt the WACC should decrease as we are increasing our use of a cheaper source of capital (cost of debt < cost of equity).
B)Correct because according to M&M the value of the firm is unchanged as we increase the level of debt but the net income of the firm will decline (due to increased interest payments).The only way the value of the firm can remain the same is if the WACC decreases.
C)Incorrect because as we increase the use of debt we increase the riskiness of the equity and therefore the cost of equity will increase.The net effect is that the WACC remains constant.
D)Incorrect because the firm's D/E ratio is already above the firm's optimal level and any further increase in debt will result in an increase in the WACC and a decrease in firm value.

Question 26

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.What is the cost of equity for Whispering Pines Resort?

A)11.5%
B)13.25%
C)15.0%
D)18.5%

Question 27

Use the following statements to answer this question:
I.In a perfect M&M world with corporate taxes, WACC decreases linearly with the increase in debt in the company.
LI.In a perfect M&M world with corporate taxes, the slope of the WACC is proportional to debt.

A)I and II are correct.
B)I and II are incorrect.
C)I is correct and II is incorrect.
D)I is incorrect and II is correct.

Question 28

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.According to M&M, the cost of equity for Whispering Pines Resort will be:

A)greater than the cost of equity for James Bay Water Park.
B)the same as the cost of equity for James Bay Water Park.
C)less than the cost of equity for James Bay Water Park.
D)insufficient information is provided to answer the question.

Question 29

Manitoba Flat Land (MFL)Company has a perpetual EBIT of $10,000, an unlevered cost of equity of 5%, zero debt, and an income tax rate of 40%.The firm currently has 1,000 shares outstanding.MFL issues $5,000 of perpetual debt which pays interest of $500 per year and uses the proceeds of that debt issue to repurchase shares.The change in the value of the firm is:

A)no change in the value.
B)increase of $2,000.
C)increase of $3,000.
D)increase of $5,000.

Question 30

Winnipeg Skaters Company (WSC)has a before-tax cost of debt of 8%, a debt/equity ratio of 0, and pays tax at the rate of 40%.The unlevered cost of equity for a firm with WSC's risk characteristics is 15%.If WSC expects a perpetual EBIT of $20,000, then the value of the firm is:

A)$43,478
B)$80,000
C)$133,333
D)$190,476

Question 31

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 2.The cost of equity is 20%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 0 and has a cost of equity of 15%.What is the cost of debt for James Bay Water Park?

A)5.0%
B)10.0%
C)12.5%
D)17.5%

Question 32

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 3.What is the cost of equity for Whispering Pines Resort?

A)11.5%
B)12.67%
C)15.0%
D)22.0%

Question 33

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 15% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.According to M&M, the value of Whispering Pines Resort will be:

A)greater than James Bay Water Park.
B)the same as James Bay Water Park.
C)less than James Bay Water Park.
D)insufficient information is provided to answer the question.

Question 34

In a world with corporate taxes and no bankruptcy costs,

A)the firm value is unaffected by capital structure.
B)the firm should maximize the value of the firm by maximizing the firm's debt.
C)the firm should borrow to the point just below where the marginal benefits of debt equal the marginal costs.
D)the firm cannot make a decision about its optimal capital structure with the existing information.

Question 35

James Bay Water Park operates in a world with zero taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity is 12% and the cost of debt is 5%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 0.What is the cost of equity for Whispering Pines Resort?

A)5.0%
B)8.5%
C)12.0%
D)17.0%

Question 36

What would happen to a firm that uses an excessive amount of debt in a world with no taxes?

A)The value of the firm would increase because of the increase in the assets of the firm.
B)The value of the firm would decrease because of the increase in the present value of distress costs.
C)It is completely irrelevant to the size of the firm.
D)The value of distress costs do not affect a firm in a tax-free world.

Question 37

In a world with corporate taxes and no bankruptcy costs,

A)leverage can affect firm value by an amount that is equal to the present value of the interest tax shield.
B)leverage lower the taxes of the firm and increase its total value.
C)the firm uses maximum debt.
D)all of the above

Question 38

Coco Company is financed entirely by common stock which is priced to offer a 10% rate of return.Coco has an income tax rate of 40%.If the company repurchases 40% of the stock and substitutes an equal value of debt costing 7%, what is the cost on the common stock after repurchasing?

A)10%
B)11.2%
C)12%
D)None of the above

Question 39

Use the following statements to answer this question:
I.Unlevered beta represents the systematic risk of the equity portion of the firm only.
II.The levered beta requires a linear adjustment with respect to the debt to equity ratio.

A)I and II are correct.
B)I and II are incorrect.
C)I is correct and II is incorrect.
D)I is incorrect and II is correct.

Question 40

Cayo Company is financed entirely by common stock which is priced to offer a 10% return.If the company repurchases 40% of the stock and substitutes an equal value of debt costing 7%, what is the cost on the common stock after repurchasing?

A)10%
B)18%
C)12%
D)None of the above

Question 41

Which of the following questions are related to capital structure of a firm?

A)Is the firm profitable?
B)Can the firm issue debt? Or what type of assets does the firm have?
C)How risky is the firm's underlying business?
D)All of the above.

Question 42

Which of the following is NOT a factor that can affect a firm's capital structure practices?

A)Type of assets the firm has
B)How big the firm is
C)The firm's growth rate
D)Where is the firm located

Question 43

The equity holders of a firm in financial distress have an incentive:

A)to accept risky projects that have some upside potential
B)to forego maintenance
C)a and b
D)neither a nor b as these actions will reduce the overall value of the firm.

Question 44

Which one of the following is not a bankruptcy cost?

A)The legal costs that the firm incurs in the bankruptcy process
B)The risk premium increase in the bond yield
C)The costs involved with managers hiding information from shareholders
D)The damage to the company's trademark and intangible assets

Question 45

Which one of the following theories about capital structure is based on agency cost?

A)M&M proposition I
B)Homemade leverage
C)Pecking order
D)Static trade-off

Question 46

Use the following statements to answer this question:
I.Credit rating is the number one factor mentioned by most firms in the 2006 Deutsche Bank survey.
II.Globally most firms have a target capital structure.

A)I and II are correct.
B)I and II are incorrect.
C)I is correct and II is incorrect.
D)I is incorrect and II is correct.

Question 47

The pecking order theory of capital structure suggests that firms follow which order when raising capital?

A)Internal cash flow, issue debt, issue equity
B)Internal cash flow, issue equity, issue debt
C)Issue debt, internal cash flow, issue equity
D)Issue debt, issue equity, internal cash flow

Question 48

Bankruptcy occurs when:
I.A firm fails to pay interest on debt and the creditors enforce their legal rights
II.A firm has insufficient assets to repay all the debt due in 10 years

A)I only
B)II only
C)Both I and II will cause bankruptcy
D)Neither I nor II will cause bankruptcy

Question 49

In a world with corporate taxes and bankruptcy costs,

A)the firm's value is unaffected by capital structure.
B)the firm should maximize its value by maximizing the firm's debt.
C)the firm should borrow to the point where the marginal benefits of debt equal the marginal costs.
D)the firm cannot make a decision about the optimal capital structure with the existing information.

Question 50

M&M Co.has the following characteristics: perpetual EBIT of $25,000, zero financial distress costs, unlevered cost of equity = 15%, cost of levered equity 20%, before-tax cost of debt = 10%, and the tax rate is 35%.If the value of M&M Co.is $140,000, then the D/E ratio of M&M Co.is:

A)0.2923
B)0.5473
C)1.8270
D)3.4211

Question 51

Which of the following statements is false?

A)With zero taxes and zero bankruptcy costs, the value of the firm is independent of its debt-equity ratio.
B)With taxes and zero bankruptcy costs, the value of the firm reaches a maximum and then declines as the debt-equity ratio increases.
C)With taxes and bankruptcy costs, the value of the firm reaches a maximum and then declines as the debt-equity ratio increases.
D)With taxes and bankruptcy costs, the value of the firm is independent of its debt-equity ratio.

Question 52

Financial distress has an impact on the value of the firm by increasing:

A)the level of risk aversion of the investors toward the debt of the firm.
B)its instability.
C)the probability that it may occur.
D)all of the above

Question 53

According to the 2006 Deutsche Bank survey, rank the following reasons for capital structure:
I.Credit rating
II.Ability to manage earnings per share
III.Transaction costs
IV.Tax shield

A)I, II, IV, III
B)II, I, III, IV
C)I, IV, III, II
D)IV, III, II, I

Question 54

Which of the following statements is correct?

A)The firm should finance using retained earnings, then debt, and, finally common equity.
B)The firm should finance using debt, then retained earnings, and, finally common equity.
C)The firm should finance using common equity, then retained earnings, and finally debt.
D)The firm should finance using retained earnings, then preferred shares, then debt and finally common equity.

Question 55

In a world with corporate and personal taxes, and no bankruptcy costs,

A)a firm's value is unaffected by capital structure.
B)a firm should maximize its value by maximizing its debt.
C)a firm should borrow to the point where the marginal benefits of debt equal the marginal costs.
D)there are usually gains to the firm value associated with the use of debt, however the gains are not as large as those predicted by M&M's corporate tax model.

Question 56

Direct costs of bankruptcy do not include:

A)loss of tax losses.
B)accounting and legal fees.
C)asset liquidation.
D)agency costs.

Question 57

According to the static trade-off model of capital structure, in a world with taxes, firms have an incentive:

A)to issue debt as this will always reduce the weighted average cost of capital.
B)to issue debt until the benefits from the tax savings equals the costs of financial distress.
C)to issue less debt to reduce the costs of financial distress
D)to maximize the amount of debt.

Question 58

Which region has the biggest percentage of firms pursuing a target capital structure according to 2006 Deutsche Bank survey?

A)North America
B)Germany
C)Latin America
D)None of the above

Question 59

Which of the following is not an example of an agency problem?

A)Firms are not as levered as shareholders would like them to be, due to fears of insolvency and possible bankruptcy.
B)Managers have discretion over whether or not to take on risky projects.
C)Managers can maintain control over a greater free cash flow by avoiding debt in their firm's capital structures.
D)Investors do not have perfect information about the value of their investments.

Question 60

James Bay Water Park operates in a world with 15% taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity to James Bay Water Park is 20% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.What is the cost of equity for Whispering Pines Resort?

A)25.52%
B)11.20%
C)13.40%
D)14.49%

Question 61

A firm's capital structure is made up of 200,000 common shares and $1,000,000 debt at 12% interest.The company's tax rate is 50%.An additional $500,000 has to be raised, and the following financing alternatives are available:
Option 1: Common shares: The company can sell additional shares at $10 a share.Hence, 50,000 new shares would have to be issued.
Option 2: Debt: Debt can be issued at 12%, requiring interest payments of $60,000.
Compute EPS as a function of EBIT for both alternatives and derive the break-even point.

Question 62

In a world with corporate taxes, no personal taxes and no risk of bankruptcy, what is a firm's ideal capital structure?

Question 63

Explain the concept of M&M's homemade leverage and why it is not equivalent to a firm's debt.

Question 64

There are two companies, U and L, which are identical in every respect, except that U is financed entirely through common equity and L has $100,000 in debt at an interest rate of 16%.Both companies achieve annual net operating earnings of $45,000.Assume perfect markets and information, with no taxes and no bankruptcy costs.If the market capitalizes firm U at a rate of 10%, and the total market value of L is $500,000, is there an arbitrage opportunity available, and if so, what is the net gain?

Question 65

Explain the importance of debt in minimizing the agency cost problem between the managers and the shareholders.

Question 66

Briefly explain the trade-off theory of capital structure.

Question 67

Compare and contrast the responsibility of the board of directors (BOD)of a solvent Canadian firm and one that is insolvent.

Question 68

The management of Maritime Fisheries Company has just announced that they will be issuing shares to finance a positive net present value (NPV)project.Briefly discuss the likely impact this action will have on the current share.

Question 69

If the personal tax rate on dividends (T_D)equals the tax rate on interest income (T_P),

A)there is no tax advantage to using debt.
B)there is a tax advantage to using debt.
C)there is a tax disadvantage to using debt.
D)none of the above