Deck 16: Debt and Payout Policy

Question 1

The benefit of an interest tax shield is captured by the equity holders.

Answer 1

True

Question 2

Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders.

Answer 2

True

Question 3

How much debt is outstanding in a firm that has calculated the present value of a perpetual tax shield to be $300,000 if the tax rate is 35% and the debt carries a 10% rate of return?

A) $300,000
B) $857,143
C) $3,000,000
D) $3,750,000

Answer 3

$857,143

Question 4

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

Question 5

A firm has an expected return on equity of 16% and an after-tax cost of debt of 8%.What debt-equity ratio should be used in order to keep the WACC at 12%?

A) .50
B) .75
C) 1.00
D) 1.50

Question 6

A firm's capital structure refers to the maturity of debt it employs.

Question 7

MM's Proposition II states that the expected return on equity increases as the firm's debt-equity ratio increases.

Question 8

In an MM world,restructuring the firm will not change its overall value.

Question 9

Proposition II of MM states that the expected return on assets increases as the debt-equity ratio increases.

Question 10

Under MM II assumptions,the expected return on equity is equal to the expected return on assets for a levered firm.

Question 11

What is the present value of the tax shields for a firm that anticipates a perpetual debt level of $10 million at an interest rate of 7% and a tax rate of 35%?(Use values in dollar.)

A) $245,000
B) $700,000
C) $3,500,000
D) $10,000,000

Question 12

At some debt-equity ratio,the costs of financial distress are expected to overcome the value of the tax shield for a firm.

Question 13

What is the amount of the annual interest tax shield for a firm with $5 million in debt that pays 10% interest if the firm is in the 40% tax bracket?(Use value in the dollar.)

A) $100,000
B) $200,000
C) $300,000
D) $400,000

Question 14

A firm has an expected return on equity of 14% and an after-tax cost of debt of 6%.What debt-equity ratio should be used in order to keep the WACC at 10%?

A) 1.00
B) 0.75
C) 0.50
D) 0.25

Question 15

Debt financing affects neither the operating risk nor the business risk of the firm.

Question 16

Financial risk is the risk to shareholders that result from debt financing.

Question 17

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket?(Use value in dollar.)

A) $126,000
B) $234,000
C) $360,000
D) $1,050,000

Question 18

The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.

Question 19

Management's perceived signals to investors form an important component of pecking-order theory.

Question 20

Even after relaxing the MM assumption of no taxes,it can be observed that restructuring does not affect the value of the firm.

Question 21

Stockholders' expected return on a stock priced at $25 per share with zero-growth dividends of $4.00 is:

A) 6.25%.
B) 13.64%.
C) 16.00%.
D) 21.00%.

Question 22

What is the maximum rate that can be paid on debt and maintain a 14% WACC with a 19% expected return on equity in a firm with a 60% debt-to-asset ratio? Ignore taxes.

A) 6.50%
B) 9.90%
C) 10.67%
D) 11.14%

Question 23

What is the expected rate of return to equity holders if the firm has a 35% tax rate,a 10% rate of interest paid on debt,a 15% WACC and a 60% debt-asset ratio?

A) 12.50%
B) 21.25%
C) 22.50%
D) 27.75%

Question 24

A firm with a debt equity ratio of 1/3,return on assets of 15%,and return on debt of 10% will have return on equity of:

A) 15.00%.
B) 16.67%.
C) 20.00%.
D) 21.17%.

Question 25

What is the return on equity for a firm with 15% return on assets,10% return on debt,and a .75 debt/equity ratio?

A) 18.75%
B) 20.00%
C) 23.75%
D) 26.25%

Question 26

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 70% of assets?

A) 16.14%
B) 17.00%
C) 19.00%
D) 25.67%

Question 27

With a tax rate of 35%,calculate the WACC for a firm that pays 10% on its debt,requires an 18% rate of return on its equity,and finances 45% of assets with debt.

A) 12.83%
B) 14.00%
C) 14.40%
D) 18.20%

Question 28

Calculate the firm's expected return on its assets if its expected return on debt is 10%,their expected return on equity is 20%,and its WACC is 14%.

A) 14%
B) 15%
C) 16%
D) Cannot be calculated

Question 29

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 30% of assets?

A) 16.14%
B) 17.00%
C) 19.00%
D) 25.67%

Question 30

By changing the mix of securities a firm uses for financing,the financial manager:

A) can increase the book value of the firm.
B) is changing the firm's capital structure.
C) can increase the market value of the firm.
D) is changing the firm's dividend policy.

Question 31

What is the proportion of debt financing for a firm that expects a 24% return on equity,a 16% return on assets,and a 12% return on debt? Ignore taxes.

A) 54.0%
B) 60.0%
C) 66.7%
D) 75.0%

Question 32

A firm has an expected return on equity of 15% and an after-tax cost of debt of 10%.What debt-equity ratio should be used in order to keep the WACC at 11%?

A) 1.00
B) 2.00
C) 3.00
D) 4.00

Question 33

What is the proportion of debt financing for a firm that expects a 35% return on equity,a 20% return on assets,and a 15% return on debt? Ignore taxes.

A) 15%
B) 25%
C) 75%
D) 80%

Question 34

Any financial benefit derived from the interest tax shield accrues to the:

A) Bondholders.
B) Shareholders.
C) bondholders and shareholders, equally.
D) shareholders and the federal government.

Question 35

What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt?

A) 5.25%
B) 9.75%
C) 12.17%
D) 20.25%

Question 36

A decrease in the possible range of percentage stock returns can be achieved by:

A) a decrease in the firm's financial leverage.
B) an increase in the firm's asset risk.
C) an increase in the firm's business risk.
D) a decrease in the firm's debt beta.

Question 37

A firm's capital structure is represented by its mix of:

A) Assets.
B) Debts and equity.
C) assets and liabilities.
D) assets, liabilities and equity.

Question 38

Calculate the WACC for a firm with a debt-equity ratio of .6.The debt pays 12% interest and the equity is expected to return 14%.Assume a 40% tax rate and risk-free debt.

A) 11.45%
B) 12.50%
C) 13.55%
D) 14.60%

Question 39

What is the proportion of equity financing for a firm that expects a 15% return on equity,a 10% return on assets,and an 8% return on debt? Ignore taxes.

A) 25%
B) 29%
C) 75%
D) 71%

Question 40

Those who benefit from the interest tax shield are:

A) debt holders.
B) equity holders.
C) both debt holders and equity holders.
D) only the firm's customers benefit from the interest tax shield.

Question 41

The present value of the costs of financial distress increases with increases in the debt ratio because the:

A) expected return on assets increases.
B) present value of the interest tax shield is greater.
C) equity tax shield is depleted.
D) probability of default and/or bankruptcy is greater.

Question 42

Leverage will __________ shareholders' expected return and _________ their risk.

A) increase; decrease
B) decrease; increase
C) increase; increase
D) increase; do nothing to

Question 43

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount,i.e.,$5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?(Use values in dollar.)

A) EPS decrease to $10.00
B) EPS decrease to $11.67
C) EPS increase to $15.00
D) EPS increase to $22.50

Question 44

Which of the following would not be expected to change with changes in the firm's capital structure?

A) weighted-average cost of capital.
B) expected return on equity.
C) expected return on assets.
D) expected earnings per share.

Question 45

The present value of a perpetual tax shield increases as the firm's tax rate _____ and the amount of principal _____.

A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

Question 46

MM's proposition II states that the:

A) expected return on equity increases as financial leverage increases.
B) expected return on assets decreases as expected return on debt decreases.
C) firm's capital structure is irrelevant to value determination.
D) greater the proportion of equity, the higher the expected return on debt.

Question 47

Debt may be the preferred form of external financing for many firms because:

A) most firms already have too much equity.
B) tax rates on equity are lower.
C) debt will not adversely affect the firm's financial ratios.
D) equity issuance is considered by investors to be a negative sign.

Question 48

An increase in a firm's financial leverage will:

A) increase the variability in earnings per share.
B) reduce the operating risk of the firm.
C) increase the value of the firm in a non-MM world.
D) increase the WACC.

Question 49

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

A) firm uses no debt in its capital structure.
B) firm uses no equity in its capital structure.
C) firm uses a debt-equity ratio of 1.0.
D) corporate tax rate approaches 100%.

Question 50

According to pecking-order theory,managers will often choose to finance with:

A) new equity rather than debt, due to bankruptcy costs.
B) debt rather than new equity, to avoid reduced share price.
C) debt rather than retained earnings, to lower the WACC.
D) new equity rather than debt, to strengthen EPS.

Question 51

Financial risk refers to the:

A) risk of owning equity securities.
B) risk faced by equity holders when debt is used.
C) general business risk of the firm.
D) possibility that interest rates will increase.

Question 52

The pecking-order theory suggests that less profitable firms borrow more because:

A) equity issues are more expensive.
B) leverage is preferred over raising funds internally.
C) debt issues are good omens.
D) they have insufficient internal funds.

Question 53

What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the stock if operating income equals $1.5 million and EPS were $2 when the firm was all equity financed? Ignore taxes.(Use values in dollar.)

A) EPS increase to $2.60
B) EPS increase to $3.00
C) EPS increase to $4.80
D) EPS increase to $5.20

Question 54

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount,i.e.,$5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

A) EPS decrease to $10.00
B) EPS decrease to $11.67
C) EPS increase to $15.00
D) EPS increase to $42.50

Question 55

If a firm's expected return on equity equals its expected return on assets,then the:

A) expected return on debt exceeds the expected return on assets.
B) likelihood of financial distress is high.
C) firm has too much debt.
D) firm has no debt in its capital structure.

Question 56

If the present value of the tax shield equals the present value of the costs of financial distress,then the:

A) firm is using the optimal level of debt.
B) firm is paying too high an interest rate.
C) firm's market value equals the value of the unlevered firm.
D) firm should increase its use of debt.

Question 57

The stability of a firm's operating income is the focus of:

A) financial leverage.
B) weighted-average cost of capital.
C) capital structure.
D) business risk.

Question 58

The "trade-off theory" of capital structure suggests that:

A) Firms add leverage whenever interest rates are low.
B) Firms with higher risk should use less debt.
C) Firms should use 50% debt and 50% equity.
D) Firms should use debt to overcome high par values of stock.

Question 59

A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if operating income increases to $2.0 million?

A) EPS will increase to $15.63.
B) EPS will increase to $16.67.
C) EPS will increase to $17.50.
D) EPS will increase to $20.00.

Question 60

The pecking-order theory of capital structure suggests the following order of financing:

A) internal financing, debt issue, equity issue.
B) internal financing, equity issue, debt issue.
C) debt issue, equity issue, internal financing.
D) equity issue, internal financing, debt issue.

Question 61

The reason that financial leverage increases shareholder risk is that there is:

A) more debt which increases the operating risk.
B) less equity to absorb the operating risk.
C) less business risk to be spread around.
D) more financial risk due to reduced business risk.

Question 62

When a corporation issues permanent debt,the value of all its securities:

A) increases by the present value of the tax shield.
B) decreases by the present value of the tax shield.
C) increases by the annual interest tax shield.
D) decreases by the annual interest tax shield.

Question 63

When corporate taxes and the cost of financial distress are taken into consideration,the market value of a firm equals the value of all-equity financed _____ the PV of the tax shield _____ the PV costs of financial distress.

A) Plus; plus
B) Minus; plus
C) Plus; minus
D) Minus; minus

Question 64

What is meant by investors being able "to undo" the effects of corporate restructuring?

A) Investors repay their portion of the firm's debt.
B) Investors only purchase securities in unlevered firms.
C) Investors will pay more for unlevered shares.
D) Investors borrow in their name and replicate the effects of restructuring.

Question 65

A decrease of debt in the capital structure tends to reduce a firm's EPS when the firm:

A) faces high interest rates.
B) faces strong growth in business conditions.
C) pays taxes.
D) does not reinvest its earnings.

Question 66

Firms facing financial distress may pass up positive NPV projects rather than commit new equity because:

A) they prefer to finance with debt.
B) the benefits may be shared with the bondholders.
C) no cash is available for dividends.
D) there is no interest tax shield associated with equity.

Question 67

Restructuring a firm involves changing the:

A) mix of debts and equity.
B) dividend payout ratio.
C) managerial personnel.
D) interest rate on debt.

Question 68

With the inclusion of taxes,MM I is incorrect and the capital structure of the firm can be important due to:

A) lower tax rates on dividends than on debt.
B) higher tax rates on retained earnings than on debt.
C) lower tax liability due to interest deductibility.
D) higher operating income from less dividends.

Question 69

MM Proposition I states that a firm's value is unaffected by its:

A) required rate of return on equity.
B) operating income, in the absence of taxes.
C) interest rate paid on debt.
D) mixture of debt and equity.

Question 70

As a firm's debt/equity ratio approaches zero,the firm's expected return on equity approaches:

A) the expected return on debt.
B) the expected return on assets.
C) its maximum.
D) zero.

Question 71

Costs of distress are greater when a large amount of __________ affect(s)the prosperity of the firm.

A) intangible assets
B) tangible assets
C) net working capital
D) retained earnings

Question 72

With risky debt and MM II,the expected return on assets _____ as the debt-equity ratio _____.

A) increases; increases
B) decreases; increases
C) increases; decreases
D) is constant; increases

Question 73

Which of the following is an example of restructuring the firm?

A) dividends are increased from $1 to $2 per share.
B) a new investment increases the firm's business risk.
C) new equity is issued and the proceeds repay debt.
D) a new board of directors is elected to the firm.

Question 74

A firm is currently expected to develop $2 EPS when operating income equals $4 million and interest expense equals $2 million.How low can operating income drop before EPS is reduced by half,to $1? Ignore taxes.

A) operating income drops to $3.5 million.
B) operating income drops to $3.0 million.
C) operating income drops to $2.5 million.
D) operating income drops to $2.0 million.

Question 75

Debt usage will have an effect on:

A) business risk.
B) financial risk.
C) operating risk.
D) asset risk.

Question 76

When corporate taxes are considered,how does leverage affect the WACC?

A) an increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged.
B) changes in leverage will affect the WACC only if the interest rate on debt changes.
C) increased leverage will increase the WACC.
D) increased leverage will decrease the WACC.

Question 77

Based upon the "trade-off theory" of capital structure,what differences might you expect in the capital structure of a food producer and a defence contractor?

A) higher debt-equity ratio for food producer.
B) higher debt-equity ratio for defence contractor.
C) neither firm should use debt in their structure.
D) differences in capital structure will make no valuation differences in these firms.

Question 78

If the value of a levered firm is $4,000,000,then the value of the same firm yet all-equity financed is:

A) Less than $4,000,000
B) Less than $4,500,000
C) Less than $5,500,000
D) Less than $6,000,000

Question 79

According to MM,if individuals cannot obtain the same borrowing terms as firms,then:

A) capital structure may be relevant.
B) capital structure may be irrelevant.
C) individuals should not invest in levered firms.
D) firms should increase their payments to individuals.

Question 80

The interest tax shield is equal to the:

A) difference between interest expense and income taxes.
B) amount of interest paid in a given year.
C) product of the interest expense and the tax rate.
D) product of the debt principal and the interest rate on debt.