Deck 16: Debt Policy

Question 1

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

Answer 1

New equity is issued and the proceeds repay debt

Question 2

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

A)Repay their portion of the firm's debt
B)Only purchase securities in unlevered firms
C)Will pay more for unlevered shares
D)Borrow in their name and replicate the effects of restructuring

Answer 2

Borrow in their name and replicate the effects of restructuring

Question 3

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

Answer 3

Risk faced by equity holders when debt is used

Question 4

Ignoring taxes, a firm's weighted-average cost of capital is equal to:

A)Its expected return on assets
B)Its expected return on equity
C)The sum of expected return on equity and expected return on debt
D)Its expected return on assets times the debt-equity ratio

Question 5

When taxes are considered, the value of a levered firm equals the value of the:

A)Unlevered firm
B)Unlevered firm plus the value of the debt
C)Unlevered firm plus the present value of the tax shield
D)Unlevered firm plus the value of the debt plus the value of the tax shield

Question 6

Under the assumptions necessary for MM I, if investors can borrow or lend at the same terms as the firm, they will:

A)Invest in debt only and ignore equity investments
B)Not be willing to pay more for a restructured firm
C)Require a higher rate of return on equity
D)Accept a lower rate of return on equity

Question 7

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 8

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 9

When taxes are ignored, which of the following can be used to calculate the weighted-average cost of capital?

A)Ratio of expected operating income to book value of all securities
B)The expected return on equity times the debt-equity ratio
C)Ratio of expected operating income to market value of all securities
D)The required return on equity plus the required return on debt

Question 10

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?

A)$126,000
B)$234,000
C)$360,000
D)$1,050,000 Interest tax shield = interest expense x tax rate
= $360,000 x .35

Question 11

According to MM II, as a firm's debt-to-equity ratio decreases:

A)Its financial risk increases
B)Its operating risk increases
C)The required rate of return on equity increases
D)The required rate of return on equity decreases

Question 12

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%?

A)$245,000
B)$700,000
C)$3,500,000
D)$10,000,000 PV tax shield =

Question 13

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% .24 = .16 +

Question 14

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% Expected return on equity = Expected return on assets +

Question 15

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 16

An implicit cost of adding debt to the capital structure is that it:

A)Adds interest expense to the operating statement
B)Increases the required return on equity
C)Reduces the expected return on assets
D)Decreases the firm's beta

Question 17

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% Expected return on equity = Expected return on assets +

Question 18

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)?

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 19

When debt is risky under MM II:

A)Bond holders shift more of the risk to equity holders
B)Equity holders shift more of the risk to bond holders
C)The value of the interest tax shield is at its highest
D)There is more overall risk in the firm

Question 20

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 21

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% WACC =
= )65(.10)(.45) + .18(.55)
= )0293 + .099

Question 22

Restructuring a firm involves changing the:

A)Mix of liabilities and equity
B)Dividend payout ratio
C)Managerial personnel
D)Interest rate on debt

Question 23

When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because:

A)The firm's beta is now negative
B)Taxes are no longer a concern
C)The interest tax shield will cover the loan costs
D)The lender bears all the risk

Question 24

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 25

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 26

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% After-tax cost of debt = (1-T_c)r_debt
= .65 x .15

Question 27

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 28

What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if MM I is modified to recognize corporate taxes?

A)Value increases by $35,000
B)Value increases by $100,000
C)Value increases by $350,000
D)Value increases by $700,000 PV of interest tax shield = T_c x D
= )35 x $1,000,000
= $350,000
Value of levered firm = value of all-equity financed + present value of tax shield

Question 29

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 30

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 31

Although the value of an additional interest tax shield may be positive, firms may restrict borrowing if:

A)The returns on the project are too high
B)Their asset base is largely intangible
C)Their asset beta is zero
D)The borrowing increases their WACC

Question 32

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 33

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 34

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 35

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% r_equity = r_assets +

Question 36

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 37

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 Let x = debt/asset ratio.Then
)12 = .08x + (1-x).16
= )08x + .16 - .16x
)08x/.08 = .04/.08
X = .50

Question 38

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.

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 39

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 40

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

A)Assets
B)Liabilities and equity
C)Assets and liabilities
D)Assets, liabilities and equity

Question 41

A decrease in the possible range of %age 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 42

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% WACC = r_debt + r_equity
14% = r_debt(.60) + 19%(.40)
14% = .6r_debt + 7.6%

Question 43

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 44

Which of the following is a safe assumption for a firm in which the PV of the tax shield is approximately equal to the costs of financial distress?

A)The tax shield has been calculated incorrectly
B)The firm is too heavily levered financially
C)The firm has reached its optimal debt level
D)The firm appears to have low risk of financial distress

Question 45

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

Question 46

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 47

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 48

Which of the following lists presents the order of financing from most preferred to least preferred according to the pecking order theory?

A)Debt issue, stock issue, internally generated funds
B)Internally generated funds, debt issue, stock issue
C)Stock issue, internally generated funds, debt issue
D)Internally generated funds, stock issue, debt issue

Question 49

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 50

What is the expected rate of return to equityholders 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 51

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

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

Question 52

According to MM, an increase in expected earnings per share can leave the share price unchanged if the:

A)Firm's operating risk decreases
B)Number of shares is decreased
C)Required return on equity increases
D)Firm has no financial leverage

Question 53

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 54

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 55

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 56

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 57

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 PV tax shield =
$300,000 =
30,000 = 28.5714D

Question 58

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 59

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 60

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 61

Which of the following statements is true regarding the trade-off theory:

A)Target debt ratios are similar among firms in the same industry
B)Riskier firms tend to rely mostly on debt financing
C)Riskier firms should have high target debt ratios
D)Less risky firms ought to have a greater amount of debt financing

Question 62

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

A)$3,000,000
B)$4,500,000
C)$5,500,000
D)$6,000,000

Question 63

The possibility of bankruptcy will do all of the following except:

A)Increase financial distress costs
B)Reduce the current market value of the firm
C)Reduce the interest rate on debt
D)Reduce the possible payoff to stockholders

Question 64

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 65

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

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

Question 66

Which of the following statements is false regarding MM's proposition I:

A)Firm value is unaffected by its capital structure
B)It is also called the debt irrelevance proposition
C)Shareholders should care about the firm's debt policy
D)After restructuring, the firm's value should be the same as it was prior to restructuring

Question 67

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 68

Debt usage will have an effect on:

A)Business risk
B)Financial risk
C)Operating risk
D)Asset risk

Question 69

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 70

According to the trade-off theory, the capital structure is a trade-off between:

A)Tangible and intangible asset risk
B)High and low target debt ratios
C)Tax savings and financial distress costs
D)Tax shields and equity financing

Question 71

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 72

One advantage of debt financing over equity financing is:

A)Tax deductible dividends
B)Tax deductible interest
C)Tax deductible principal repayment
D)Tax free interest income

Question 73

According to MM II, if the expected return on assets decreases, what happens to the expected return on equity?

A)Depends on the firm's capital structure
B)Decreases
C)Remains constant
D)Increases

Question 74

The WACC is used to value:

A)Projects with any risk
B)Projects with the same risk as the firm's current business
C)Projects with the same risk as the firm's debt
D)Projects with the same risk as the firm's equity

Question 75

As the debt to equity ratio decreases when debt is not risk free:

A)Debt holders demand a higher expected return
B)Debt holders demand a lower expected return
C)The expected return on equity increases
D)The expected return on assets increases

Question 76

A firm with a debt equity ratio of 1/2, 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% r_equity = 0.15 + 1/3(0.15 - 0.10)

Question 77

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 78

The optimal capital structure is met when:

A)Additional borrowing results in lower financial distress costs
B)Additional borrowing is offset by the interest tax shield
C)The tax savings from additional leverage is just offset by the costs of distress
D)The present value of the tax shield is greater than the value of an all-equity financed firm

Question 79

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 80

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