Deck 17: Does Debt Policy Matter

Question 1

If a firm is financed with both debt and equity, the firm's equity is known as

A)unlevered equity.
B)levered equity.
C)preferred equity.
D)None of the options are correct.

Answer 1

levered equity.

Question 2

The law of conservation of value implies that

A)the return on a firm's common stock is unchanged when debt is added to its capital structure.
B)the value of any asset is preserved regardless of the nature of the claims against it.
C)the return on a firm's debt is unchanged when common stock is added to its capital structure.
D)the value of an asset increases as debt is reduced.

Answer 2

the value of any asset is preserved regardless of the nature of the claims against it.

Question 3

The law of conservation of value implies that

A)the mix of common stock and preferred stock does not affect the value of the firm.
B)the mix of long-term and short-term debt does not affect the value of the firm.
C)the mix of secured and unsecured debt does not affect the value of the firm.
D)the mix of common stock and preferred stock does not affect the value of the firm, the mix of long-term and short-term debt does not affect the value of the firm, and the mix of secured and unsecured debt does not affect the value of the firm.

Answer 3

the mix of common stock and preferred stock does not affect the value of the firm, the mix of long-term and short-term debt does not affect the value of the firm, and the mix of secured and unsecured debt does not affect the value of the firm.

Question 4

The capital structure of the firm can be defined as

A)the firm's mix of different debt securities.
B)the firm's mix of different securities used to finance assets.
C)the market imperfection that the firm's managers can exploit.
D)the firm's mix of different debt securities, the firm's mix of different securities used to finance assets, and the market imperfection that the firm's managers can exploit.

Question 5

An investor can create the effect of leverage on his/her account by

A)buying equity of a levered firm.
B)investing in risk-free debt like T-bills.
C)borrowing on his/her own account.
D)buying equity of a levered firm and borrowing on his/her own account.

Question 6

The law of conservation of value implies that

A)the mix of senior and subordinated debt does not affect the value of the firm.
B)the mix of convertible and nonconvertible debt does not affect the value of the firm.
C)the mix of common stock and preferred stock does not affect the value of the firm.
D)the mix of senior and subordinated debt does not affect the value of the firm, the mix of convertible and nonconvertible debt does not affect the value of the firm, and the mix of common stock and preferred stock does not affect the value of the firm.

Question 7

If an individual wants to borrow with limited liability, he/she should

A)invest in the equity of an unlevered firm.
B)borrow on his/her own account.
C)invest in the equity of a levered firm.
D)invest in a risk-free asset like T-bills.

Question 8

The total market value (V) of the securities of a firm that has both debt (D) and equity (E) is

A)V = D − E
B)V = E − D
C)V = D ×E
D)V = D + E.

Question 9

An investor can undo the effect of leverage on his/her own account by

A)investing in the equity of an unlevered firm.
B)borrowing on his/her own account.
C)investing in risk-free debt like T-bills.
D)investing in the equity of an unlevered firm and investing in risk-free debt like T-bills.

Question 10

If an investor buys a portion (X) of an unlevered firm's equity, then his/her payoff is

A)(X) × (profits).
B)(X) × (interest).
C)(X) × (profits - interest).
D)(1/X) × (profits).

Question 11

A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that

A)the firm's investment policy is settled.
B)there are no taxes.
C)an issue of new debt does not affect the market value of existing debt.
D)the firm's investment policy is settled, there are no taxes, and an issue of new debt does not affect the market value of existing debt.

Question 12

Under what conditions would a policy of maximizing the value of the firm not be the same as a policy of maximizing shareholders' wealth?

A)If the issue of debt increases the financial risk of the firm's equity
B)If the firm issues debt for the first time
C)If the beta of equity is positive
D)If an issue of debt affects the market value of existing debt

Question 13

Capital structure is irrelevant if

A)capital markets are efficient.
B)each investor can borrow/lend on the same terms as the firm.
C)there are no tax benefits to debt.
D)capital markets are efficient, each investor can borrow/lend on the same terms as the firm, and there are no tax benefits to debt.

Question 14

For a levered firm,

A)as earnings before interest and taxes (EBIT) increases, earnings per share (EPS) increases by the same percentage.
B)as EBIT increases, EPS increases by a larger percentage.
C)as EBIT increases, EPS decreases by the same percentage.
D)as EBIT increases, EPS decreases by a larger percentage.

Question 15

When a firm has no debt, then such a firm is known as a(n)

A)unlevered firm.
B)levered firm.
C)all-equity firm.
D)unlevered firm and an all-equity firm.

Question 16

If an investor buys a portion (X) of both the debt and equity of a levered firm, then his/her payoff is

A)(X) × (profits).
B)(X) × (interest).
C)(X) × (profits - interest).
D)None of the options are correct.

Question 17

Value additivity works for

A)combining assets.
B)splitting up of assets.
C)combining assets and splitting up of assets.
D)combining assets, splitting up of assets, and the mix of debt securities issued by the firm.

Question 18

Modigliani and Miller's Proposition I states that

A)the market value of any firm is independent of its capital structure.
B)the market value of a firm's debt is independent of its capital structure.
C)the market value of a firm's common stock is independent of its capital structure.
D)None of the options are correct.

Question 19

If an investor buys a portion (X) of the equity of a levered firm, then his/her payoff is

A)(X) × (profits).
B)(X) × (interest).
C)(X) × (profits - interest).
D)(1/X) × (profits - interest).

Question 20

If firm U is unlevered and firm L is levered, then which of the following is true?

A)V_U = E_U only.
B)V_U = E_U and V_L = E_L + D_L.
C)V_U = E_U, V_L = E_L + D_L, and V_L = E_U + D_L.
D)V_L = E_U + D_L only.

Question 21

According to an EPS-operating income graph, such as Figure 17.1, EPS is higher when expected operating income is

A)less than the break-even income.
B)greater than the break-even income.
C)equal to the break-even income.
D)not able to be determined.

Question 22

A firm has zero debt in its capital structure.Its overall cost of capital is 10 percent.The firm is considering a new capital structure with 60 percent debt.The interest rate on the debt would be 8 percent.Assuming there are no taxes, its cost of equity capital with the new capital structure would be

A)8 percent.
B)16 percent.
C)13 percent.
D)10 percent.

Question 23

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return.The stock price is $60 and the earnings per share are $12.The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent.Suppose that, before refinancing, an investor owned 100 shares of Learn and Earn common stock.What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?

A)Borrow $3,000 and buy 50 more shares.
B)Continue to hold 100 shares.
C)Sell 50 shares and purchase $3,000 of 8 percent debt (bonds).
D)Sell 8 percent of his stock and invest in bonds.

Question 24

The cost of capital for a firm, r_WACC, in a tax-free environment is

A)equal to the market value weighted average of the return on equity and the return on debt.
B)equal to r_A, the rate of return for that business risk class.
C)equal to the overall rate of return required on the levered firm.
D)equal to the market value weighted average of the return on equity and the return on debt; equal to r_A, the rate of return for that business risk class; and equal to the overall rate of return required on the levered firm.

Question 25

When comparing levered vs.unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt

A)vary with EBIT levels.
B)stay fixed, leaving less income to be distributed over fewer shares.
C)stay fixed, leaving less income to be distributed over more shares.
D)stay fixed, leaving more income to be distributed over fewer shares.

Question 26

For an all-equity firm,

A)as earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percentage.
B)as EBIT increases, the EPS increases by a larger percentage.
C)as EBIT increases, the EPS decreases at the same rate.
D)as EBIT increases, the EPS decreases by a larger percentage.

Question 27

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return.If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?

A)32 percent
B)28 percent
C)20 percent
D)14 percent

Question 28

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E) is equal to

A)r_E = r_A.
B)r_E = r_A + (D/E) × [r_A - r_D].
C)r_E = r_A + (D/(D + E)) × [r_A - r_D].
D)None of the options are correct.

Question 29

In an EPS-operating income graph, such as Figure 17.1, the slope of the line is steeper when the debt ratio is higher.The debt line has a negative intercept because

A)the break-even point is higher with debt.
B)a fixed interest charge must be paid even at low earnings.
C)the amount of interest per share has only a positive effect on the intercept.
D)the higher the interest rate, the greater the slope.

Question 30

The effect of financial leverage on the performance of the firm depends on the

A)expected rate of return on equity.
B)firm's level of operating income.
C)current market value of the debt.
D)rate of dividend growth.

Question 31

Wealth and Health Company is financed entirely by common stock that is priced to offer a 15 percent expected return.The common stock price is $40/share.The earnings per share (EPS) is expected to be $6.If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

A)$6
B)$7.52
C)$7.20
D)$6.90

Question 32

A firm has a debt-to-equity ratio of 0.50.Its cost of debt is 10 percent.Its overall cost of capital is 14 percent.What is its cost of equity if there are no taxes?

A)13 percent
B)16 percent
C)15 percent
D)18 percent

Question 33

Health and Wealth Company is financed entirely by common stock that is priced to offer a 15 percent expected return.If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing? (Ignore taxes.)

A)18 percent
B)21 percent
C)15 percent
D)10.5 percent

Question 34

An EPS-operating income graph, such as Figure 17.1, shows the

A)greater risk associated with debt financing, which is evidenced by a greater slope.
B)the break-even point where EPS of two different debt ratios are equal.
C)the minimum operating income needed to pay the interest for a given level of debt.
D)greater risk associated with debt financing, which is evidenced by a greater slope, the break-even point where EPS of two different debt ratios are equal, and the minimum operating income needed to pay the interest for a given level of debt.

Question 35

MM Proposition II states that

A)the expected return on equity is positively related to leverage.
B)the required return on equity is a linear function of the firm's debt to equity ratio.
C)the risk to equity increases with leverage.
D)the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage.

Question 36

A firm is unlevered and has a cost of equity capital of 9 percent.What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent.(Assume no taxes.)

A)15 percent
B)16 percent
C)14.5 percent
D)13 percent

Question 37

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return.The stock price is $60 and the earnings per share are $12.If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?

A)$12
B)$19.20
C)$24
D)$15.60

Question 38

A firm has a debt-to-equity ratio of 1.Its levered cost of equity is 16 percent, and its cost of debt is 8 percent.If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

A)8 percent
B)10 percent
C)12 percent
D)14 percent

Question 39

A firm has a debt-to-equity ratio of 1.If it had no debt, its cost of equity would be 12 percent.Its cost of debt is 9 percent.What is its cost of equity if there are no taxes?

A)21 percent
B)18 percent
C)15 percent
D)16 percent

Question 40

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E) equals

A)b_E = b_A..
B)b_E = b_A + (D/E) × [b_A - b_D].
C)b_E = b_A + (D/(D + E)) × [b_A - b_D].
D)None of the options are correct.

Question 41

The equity beta of a levered firm is 1.2.The beta of debt is 0.2.The firm's market value debt to equity ratio is 0.5.What is the asset beta if the tax rate is zero?

A)1.20
B)0.73
C)0.20
D)0.87

Question 42

Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; r_D = 6%; r_E = 12%; and T_C = 30%.Calculate the after-tax weighted average cost of capital (WACC):

A)10.5 percent
B)15 percent
C)10.05 percent
D)9.45 percent

Question 43

The asset beta of a levered firm is 1.1.The beta of debt is 0.3.If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

A)1.50
B)1.10
C)0.30
D)0.15

Question 44

A firm's return on assets is 12 percent and the cost of the firm's debt is 7 percent.Given a 0.7 debt-equity-ratio, what is the levered cost of equity? Assume that there are no taxes.

A)7 percent
B)12 percent
C)13.6 percent
D)15.5 percent

Question 45

The beta of an all-equity firm is 1.2.Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing.What is the equity beta of the levered firm? The beta of debt is 0.2.(Assume no taxes.)

A)1.2
B)2.2
C)2.4
D)1.7

Question 46

If MM?s Proposition I holds, minimizing the weighted average cost of capital (WACC) is the same as maximizing the

A)market value of the firm.
B)book value of the firm.
C)profits of the firm.
D)liquidating value of the firm.

Question 47

Which of the following is true?

A)b_D > b_A > b_E
B)b_E > b_A > b_D
C)b_A > b_E > b_D
D)b_A > b_D > b_E

Question 48

According to the graph of WACC for Union Pacific, which of the following is (are) true?

A)The cost of equity is an increasing function of the debt-equity ratio.
B)The cost of equity is an increasing function of the debt-equity ratio, and the cost of debt is an increasing function of the debt-equity ratio.
C)The weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.
D)The cost of equity is an increasing function of the debt-equity ratio, the cost of debt is an increasing function of the debt-equity ratio, and the weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.

Question 49

If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by

A)equity beta = 1 + [(beta of assets)/(debt-equity ratio)].
B)equity beta = (1 - debt-equity ratio)(beta of assets).
C)equity beta = (1 + debt-equity ratio)(beta of assets).
D)equity beta = 1 + (debt-equity ratio/ beta of assets).

Question 50

Generally, which of the following is true? (b = beta)

A)b_D < b_A < b_E
B)b_E < b_A < b_D
C)b_A < b_E < b_D
D)b_A < b_D < b_E

Question 51

The principle of value additivity holds for the aggregation of assets but does not apply to the division of assets.

Question 52

The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity.The cost of debt is 5 percent and the cost of equity is 10 percent.Calculate the weighted average cost of capital.(Assume no taxes.)

A)10 percent
B)15 percent
C)8 percent
D)7 percent

Question 53

Generally, which of the following is true?

A)r_D > r_A > r_E
B)r_E > r_D > r_A
C)r_E > r_A > r_D
D)r_A > r_E > r_D

Question 54

The M&M Company is financed by $10 million in debt (market value) and $40 million in equity (market value).The cost of debt is 10 percent and the cost of equity is 20 percent.Calculate the weighted average cost of capital, assuming no taxes.

A)18 percent
B)20 percent
C)10 percent
D)12 percent

Question 55

The after-tax weighted average cost of capital (WACC) is given by (corporate tax rate = T_C):

A)WACC = (r_D)(D/V) + (r_E)(E/V)
B)WACC = (r_D)(D/V) +[(r_E )(E/V)/(1 - T_C)]
C)WACC = [(r_D)(D/V) + (r_E)(E/V)]/(1 - T_C)
D)WACC = (r_D)(1 - T_C)(D/V) + (r_E)(E/V)

Question 56

The law of conservation of value does not apply to the mix of a firm's debt securities.

Question 57

The firm's mix of securities used to finance its assets is called the firm's capital structure.

Question 58

A firm's equity beta is 1.2 and its debt is risk free.Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)

A)0.7
B)1
C)1.2
D)0

Question 59

Generally, which of the following is true?

A)r_E < r_D < r_A
B)r_D < r_A < r_E
C)r_E < r_A < r_D
D)r_D < r_E < r_A

Question 60

Modigliani and Miller Proposition I states that the market value of any firm is independent of its capital structure.

Question 61

Briefly describe the traditionalists' position on capital structure.

Question 62

Briefly discuss some of the applications of the law of conservation of value.

Question 63

A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes.

Question 64

Describe the break-even point, as displayed on an EPS-operating income graph.

Question 65

Financial leverage increases the expected return and risk of the shareholder.

Question 66

Modigliani and Miller Proposition II states that the rate of return required by shareholders increases steadily as the firm's debt-equity ratio increases.

Question 67

State the law of conservation of value.

Question 68

According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure.

Question 69

The firm's debt beta is usually approximately 1.

Question 70

Explain the concept of value additivity.
B.The same idea holds when assets are divided.

Question 71

According to Modigliani and Miller Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged.

Question 72

The firm's asset beta is usually higher than the firm's equity beta.

Question 73

What circumstances violate M&M's Proposition I? Briefly discuss.

Question 74

According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.

Question 75

Briefly explain how changes in the debt-equity ratio change the firm's equity beta.

Question 76

Explain why, as a function of the debt-equity ratio, the cost of debt graph is concave at high levels of debt.

Question 77

Investors require higher returns on levered equity than on equivalent unlevered equity.

Question 78

MM's Proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the unmet needs of such a clientele.

Question 79

According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases.

Question 80

State and explain M&M's Proposition II.