Deck 16: Debt Policy

Question 1

According to MM, restructuring the firm will not change its overall value.

Answer 1

True

Question 2

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

Answer 2

False

Question 3

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity.

Answer 3

True

Question 4

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones.

Question 5

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

Question 6

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

Question 7

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

Question 8

MM's proposition I states that the required rate of return on equity increases as the firm's debt-equity ratio increases.

Question 9

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

Question 10

Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy.

Question 11

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

Question 12

When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating.

Question 13

The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them.

Question 14

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

Question 15

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure.

Question 16

Debt finance does not affect the operating risk but it does add financial risk.

Question 17

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

Question 18

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

Question 19

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate.

Question 20

MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure.

Question 21

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 22

Assume a firm is financed with 30% debt on which it pays 9%. What is the expected return on equity if the expected return on assets is 14%?

A) 16.14%
B) 17.86%
C) 14.92%
D)15.50%

Question 23

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 increases to $15.63.
B) EPS increases to $16.67.
C) EPS increases to $17.50.
D)EPS increases to $20.00.

Question 24

When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value.

Question 25

Financial slack means having ready access to cash or debt financing.

Question 26

According to MM II, as a firm's debt-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 27

Which one of these is not an underlying assumption of MM Proposition I?

A) Capital markets function well.
B) Investors can borrow or lend on the same terms as firms.
C) Taxes remain at their current non-zero levels.
D)Securities are fairly priced.

Question 28

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 . 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 decreases to $10.00.
B) EPS stays at $12.50.
C) EPS increases to $30.00.
D)EPS increases to $42.50.

Question 29

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

Question 30

The pecking-order theory of capital structure depicts the fact that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Question 31

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 32

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

Question 33

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

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

Question 34

Financial risk refers to the:

A) risk of owning equity securities.
B) risk faced by equityholders of firms with debt.
C) general business risk of the firm.
D)possibility that interest rates will increase.

Question 35

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

Question 36

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

Question 37

An increase in a firm's financial leverage will:

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

Question 38

Assume a firm is financed with 60% debt on which it pays 7%. What is the expected return on equity if the expected return on assets is 12%?

A) 16.14%
B) 20.30%
C) 19.50%
D)21.67%

Question 39

When debt is risky under MM II:

A) bondholders shift more risk to equityholders.
B) equityholders shift more risk to bondholders.
C) the value of the interest tax shield is at its highest.
D)there is more overall risk in the firm.

Question 40

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 . 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 decreases to $10.00.
B) EPS decreases to $11.67.
C) EPS increases to $15.00.
D)EPS increases to $22.50.

Question 41

Restructuring a firm involves changing the:

A) mix of liabilities and equity.
B) dividend payout policy.
C) managerial personnel.
D)types of production equipment utilized.

Question 42

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 43

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

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

Question 44

What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio?

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

Question 45

MM Proposition I without taxes states that:

A) firms should be all-equity financed to maximize shareholder value.
B) shareholders are unaffected by the debt policy of the firm.
C) shareholders are indifferent to a firm's value.
D)shareholders prefer to invest in all-equity firms.

Question 46

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 47

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 48

A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio should be used in order to keep the WACC at 12%?

A) 0.50
B) 0.75
C) 0.67
D)0.33

Question 49

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 50

A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%?

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

Question 51

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 52

If the present value of the interest 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 its book value.
D)firm should increase its use of debt.

Question 53

Although the value of an increase in the interest tax shield may be positive, firms are most apt to restrict borrowing if the:

A) return on the financed project is too high.
B) firm's asset base is largely intangible.
C) firm's asset beta is zero.
D)increased debt decreases the firm's WACC.

Question 54

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

Question 55

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 56

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 57

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 58

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

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

Question 59

Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital structure.

A) $35,000
B) $70,000
C) $350,000
D)$700,000

Question 60

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

A) minimizes the financial distress costs.
B) maximizes the present value of the interest tax shield.
C) equates the present values of the interest tax shield and the financial distress costs.
D)maximizes the after-tax cash flows that are internally generated.

Question 61

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

Question 62

A firm currently has operating income of $4 million, interest expense of $2 million, and EPS of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore taxes.

A) $3.5 million
B) $3.0 million
C) $2.5 million
D)$2.0 million

Question 63

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 64

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 65

A firm's business risk depends upon:

A) its use of debt in the capital structure.
B) the risk of the firm's assets and operations.
C) the types of debt financing utilized.
D)the costs of financial distress.

Question 66

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 67

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

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

Question 68

The interest tax shield is equal to the:

A) difference between the 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 69

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

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

Question 70

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 71

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 72

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

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 lower dividends.

Question 73

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 74

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)remains constant; increases

Question 75

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 76

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

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

Question 77

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 78

An all-equity firm as operating income of $1.5 million and EPS of $2. If you ignore taxes, and if $1 million of 20% debt were issued with the proceeds used to repurchase two-thirds of the outstanding shares of stock, then the firm's EPS would:

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

Question 79

Which one 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 80

MM's proposition II without taxes 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 the firm's overall value.
D)greater the proportion of equity, the higher the expected return on debt.