Deck 16: Debt Policy

Question 1

According to MM,debt restructuring will not change the firm's overall value.

Answer 1

True

Question 2

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

Answer 2

True

Question 3

Even after relaxing the MM assumption of no taxes,restructuring should not affect the value of the firm.

Answer 3

False

Question 4

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

Question 5

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

Question 6

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

Question 7

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

Question 8

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 9

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

Question 10

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

Question 11

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.

Question 12

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

Question 13

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

Question 14

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

Question 15

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

Question 16

As long as investors can borrow or lend on their own account on the same terms as the firm,they will not pay extra for firm leverage.

Question 17

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

Question 18

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

Question 19

According to MM's proposition II the expected return on equity is equal to the expected return on assets for a levered firm.

Question 20

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

Question 21

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.If the firm does not pay tax,what will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt?

A) EPS decreases by 33.3% to $10.00.
B) EPS decreases by 6.7% to $11.67.
C) EPS increases by 20% to $15.00.
D) EPS increases by 80% to $22.50.

Question 22

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 23

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 24

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 25

When debt is risky:

A) bondholders shift some of the firm risk to equityholders.
B) equityholders shift some of the firm 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 26

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

Question 27

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

Question 28

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 an MM world.
D) increase the WACC.

Question 29

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 30

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.If the firm does not pay tax,what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt?

A) EPS decreases by 33.3% to $10.00.
B) EPS stays at $12.50.
C) EPS increases by 140% to $30.00.
D) EPS increases by 240% to $42.50.

Question 31

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 by 33.3% to $2.0 million?

A) EPS increases by 25% to $15.63.
B) EPS increases by 33.3% to $16.67.
C) EPS increases by 40% to $17.50.
D) EPS increases by 60% to $20.00.

Question 32

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

Question 33

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

Question 34

According to MM Proposition 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 35

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

Question 36

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 37

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

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

Question 38

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

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

Question 39

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

Question 40

Fluctuations in a firm's operating income represent:

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

Question 41

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 42

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 43

According to the 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 a fall in the share price.
C) debt rather than retained earnings, to lower the WACC.
D) new equity rather than debt, to strengthen EPS.

Question 44

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 most of the risk.

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

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 47

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

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

Question 48

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 49

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 50

A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%.What debt-equity ratio produces a WACC of 12%?

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

Question 51

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 52

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 53

If the present value of the interest tax shield on debt equals the present value of the costs of financial distress,then the trade-off theory implies that 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 54

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 55

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 incremental interest tax shield and the incremental financial distress costs.
D) maximizes the after-tax cash flows that are internally generated.

Question 56

Firms are more likely 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 57

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 are shared with the bondholders.
C) no cash is available for dividends.
D) there is no interest tax shield associated with equity.

Question 58

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 59

The present value of the costs of financial distress increases as the debt ratio increases 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 is greater.

Question 60

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 the maximum amount of debt in its capital structure.
C) firm uses a debt-equity ratio of 1.0.
D) corporate tax rate approaches 100%.

Question 61

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

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

Question 62

With risky debt and MM's Proposition 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 63

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

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

Question 64

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 65

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 66

A firm has a WACC of 14%,an expected return on equity of 19%,and a debt-to-asset ratio of 60%.If the firm does not pay tax,what is the interest rate on the debt?

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

Question 67

According to MM,leverage may increase expected earnings per share but still leave the share price unchanged because:

A) the firm's operating risk decreases.
B) the number of shares is decreased.
C) the required return on equity increases.
D) the firm is less risky.

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

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.

Question 70

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 71

A firm increases its debt ratio from 50% to 60%.In the absence of taxes,an investor can offset the change in capital structure by:

A) selling part of her holding and buying debt.
B) borrowing money and investing it in the firm's equity.
C) holding a diversified portfolio.
D) switching her investment to convertible bonds.

Question 72

When a firm pays tax,MM's Proposition I no longer holds,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) interest tax shield.
D) higher operating income from lower dividends.

Question 73

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 74

In the absence of taxes,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 75

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 76

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 77

An all-equity firm has 1 million shares outstanding with a market value of $10 million.It does not pay tax and has an operating income of $1.5 million.If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock,then the firm's EPS:

A) increasesby 20% to $1.80.
B) decreasesby 40%to $0.9.
C) decreases by 20% to $1.20.
D) increasesby 8.3% to $1.63.

Question 78

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 79

How much debt is outstanding if the present value of a perpetual tax shield is $300,000,the tax rate is 35% and the interest rate on the debt is 10%?

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

Question 80

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.