Deck 15: Capital Structure Policy

Question 1

Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's equity is $6 million. Excess cash is $200,000. The market value of Merrimac's equity is $10 million. It's Debt to Enterprise Value ratio is .5. What is the book value of Merrimac's interest- bearing debt?

A) $5 .25million
B) $10.2 million
C) $15 million
D) $20.4 million

Answer 1

B

Question 2

A company whose rate of return on investments is higher than the interest rate on its debt is said to have

A) unfavorable financial leverage.
B) a sub-optimal capital structure.
C) favorable financial leverage.
D) negative financial leverage.

Answer 2

C

Question 3

The Times Interest Earned Ratio measures a firm's ability to meet both interest payments and scheduled principal repayments.

Answer 3

False

Question 4

Which of the following should be excluded from a firm's capital structure?

A) Common equity
B) Non-interest bearing debt
C) Long-term debt
D) Short-term bank notes

Question 5

Tremont Inc.'s Total Assets =$25 million. The balance sheet shows Accounts payable and accruals totaling $7 million, common stock and retained earnings total $10 million. There is no preferred stock. What is the book value of interest bearing debt?

A) $15 million
B) $7 million
C) $18 million
D) $8 million

Question 6

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value). The market value of Fibonacci's equity is $21 million. Fibonacci's debt ratio is

A) )38.
B) )23.
C) )125.
D) )24.

Question 7

Cornucopia's liabilities and equity are shown below: Cornucopia's debt ratio is

A) )48.
B) )32.
C) )21.
D) )30.

Question 8

Financial structure includes long-term and short-term sources of funds.

Question 9

Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's equity is $6 million. Excess cash is $200,000. The market value of Merrimac's equity is $10 million. It's Debt to Enterprise Value ratio is .5. What is Merrimac's Debt Ratio?

A) )75
B) )67
C) )33
D) )25

Question 10

Suppose we calculate a times interest earned ratio of 29 for Colgate-Palmolive. We can conclude

A) Colgate-Palmolive may experience some difficulty meeting it's interest payments.
B) Colgate-Palmolive is very unlikely to have difficulty meeting it's interest payments.
C) Colgate-Palmolive has $29 of operating cash flow for every dollar of interest expense.
D) Colgate-Palmolive's EBITDA is 29 times larger than its interest expense.

Question 11

A firm's capital structure consists of which of the following?

A) The amount of debt that a firm utilizes
B) The amount of debt and preferred stock that a firm utilizes
C) The amount of interest-bearing debt, preferred stock, and common stock that a firm utilizes
D) The mix of long and short-term debt used by the firm.

Question 12

The enterprise value of the firm is defined as

A) (Market Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity.
B) (Book Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity.
C) (Book Value of Interest Bearing Debt-Excess Cash) + Book Value of Equity.
D) Market Value of Interest Bearing Debt + Market Value of Equity.

Question 13

A firm's financial structure is defined by the Debt Ratio, while it's capital structure is defined by the Debt to Value ratio.

Question 14

A company that earns a rate of return on its investments lower than the interest rate on its debt is said to have

A) unfavorable financial leverage.
B) a sub-optimal capital structure.
C) favorable financial leverage.
D) negative financial leverage.

Question 15

How does the text distinguish between firm's financial structure and its capital structure?

A) Financial structure includes only interest bearing debt
B) Capital structure includes only non-interest bearing debt
C) Financial structure uses market values of equity
D) Capital structure includes only interest bearing debt

Question 16

Boylston Inc.'s total interest bearing debt is $10,000,000 on which it pays interest at the rate of 5%. Boylston's rate of return on assets is 10%. How much cash flow does leverage add to shareholders equity?

A) $(500,000) negative cash flow
B) $(1,000,000) negative cash flow.
C) $1,000,000
D) $500,000

Question 17

Cornucopia's liabilities and equity are shown below: Cornucopia's debt to enterprise value ratio is ________. Excess cash is negligible.

A) )48
B) )32
C) )21
D) )30

Question 18

The firm's optimal capital structure is the mix of financing sources that

A) minimizes the risk of financial distress.
B) maximizes after-tax earnings.
C) maximizes the total value of the firm's debt and equity.
D) maximizes favorable leverage.

Question 19

Which of the following is NOT a component of a firm's capital structure?

A) Preferred stock
B) Bonds
C) Common stock
D) Accounts payable
E) Retained earnings

Question 20

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value). Excess cash $500,000. The market value of Fibonacci's equity is $21 million. Fibonacci's Debt to Enterprise Value ratio is

A) )38.
B) )23.
C) )125.
D) )106.

Question 21

The inclusion of bankruptcy risk in firm valuation

A) acknowledges that a firm has an upper limit to debt financing.
B) causes cost of capital curve to be linear.
C) causes the cost of capital curve to be downward sloping regardless of capital structure.
D) has no consequences for practical management of capital structure policy.

Question 22

Optimal capital structure is

A) the funding mix that will maximize the company's common stock price.
B) the mix of all items that appear on the right-hand side of the company's balance sheet.
C) the mix of funds that will minimize the firm's beta.
D) the mix of securities that will maximize EPS.

Question 23

The tradeoff theory of capital structure management assumes

A) no corporate income taxes.
B) cost of equity remains constant with an increase in financial leverage.
C) firms might fail.
D) none of the above.

Question 24

Which of the following is consistent with the Tradeoff theory of capital structure?

A) The cost of capital continuously decreases as the firm's debt ratio increases.
B) The cost of capital remains constant as the firm's debt ratio increases.
C) There are no costs associated with bankruptcy.
D) There is an optimal level of debt financing.

Question 25

Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem?

A) A firm's weighted average cost of capital decreases as financial leverage is used.
B) A firm's common stock price falls as financial leverage is used.
C) A firm's weighted average cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm.
D) A firm's weighted average cost of capital increases as operating leverage is used.

Question 26

What is meant by the terms "favorable" and "unfavorable" leverage?

Question 27

A firm's excess cash can be readily determined from its balance sheet.

Question 28

An optimal capital structure is achieved

A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's break-even point is achieved.
D) when a firm's weighted average cost of capital is minimized.

Question 29

The debt ratio is usually computed using book values for both debt and equity.

Question 30

Bipolar Beverages total assets equal $360 million. The book value of Bipolar's equity is $180 million. The market value of Bipolar's equity is $ 250 million. The book value of the company's interest bearing debt is $120 million. Compute Bipolar's Debt Ratio and Debt to Value Ratio.

Question 31

The original form of the Modigliani and Miller Capital Structure Theorem

A) ignores the effect of taxes.
B) ignores the relationship between firm value and cost of capital.
C) ignores transaction costs.
D) both A and C are true.

Question 32

Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?

Question 33

The Modigliani and Miller Capital Structure Theorem, in its original form

A) uses unrealistic assumptions.
B) provided important insights into capital structure policy.
C) concludes that how a firm is financed is not important.
D) all of the above.

Question 34

Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure?

A) A high debt ratio will result in a maximum price of a firm's common stock.
B) A firm's common stock price will not be affected by the amount of debt a firm uses.
C) A low debt ratio will result in a maximum price for a firm's common stock.
D) Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

Question 35

Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and it's cost of debt is 8%, the cost of equity will be ________% when the firm is financed with equal amount of debt and equity.

A) 12%
B) 24%
C) 16%
D) cannot be determined with the information given.

Question 36

From the information below, select the optimal capital structure for Mountain High Corp.

A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50
B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90
C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20
D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40

Question 37

When the impact of taxes is considered, but the impact of financial distress is ignored, the optimal financial structure is

A) all equity.
B) an equal mix of debt and equity.
C) any mix of debt and equity. The proportions will not matter.
D) all, or nearly all, debt.

Question 38

An optimal capital structure is achieved

A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's expected stock price is maximized.
D) when a firm's break-even point is achieved.

Question 39

When the impact of taxes is considered, as the firm takes on more debt

A) there will be no change in total cash flows.
B) both taxes and total cash flow to stockholders and bondholders will decrease.
C) cash flows will increase because taxes will decrease.
D) the weighted average cost of capital will increase.

Question 40

Debt ratios and debt to enterprise value ratios differ widely from one industry to another.

Question 41

The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as

A) the Modigliani and Miller Proposition.
B) tradeoff theory.
C) financial stress avoidance theory.
D) pecking order theory.

Question 42

The Tradeoff Theory of capital structure theory indicates that

A) the tax shield on debt positively affects firm value, indicating that there is some benefit to financial leverage as opposed to an all-equity capitalization.
B) the higher the firm's financial leverage, the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts, which could ultimately lead to firm failure.
C) there is a range of capital structures, rather than a single capital structure, that is optimal.
D) all of the above.

Question 43

The inclusion of bankruptcy costs and taxes in firm valuation

A) causes the cost of capital curve to be umbrella shaped.
B) is consistent with a saucer-shaped cost of capital curve.
C) is consistent with a cost of capital curve that slopes downward
D) causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

Question 44

The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

Question 45

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one. If Madison Co. increases debt from 10% of its capital structure to 40%, cash flows to investors will

A) decrease.
B) remain the same.
C) increase.
D) A firm's cash flows are independent of it's capital structure.

Question 46

Given the existence of taxes and bankruptcy costs, the optimal capital structure is 100% debt.

Question 47

Newbury Inc. has retained $2 million in earnings this year. It can borrow up to $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%. Newbury's cost of common equity without selling any new stock is 16%. If Newbury's capital budget is $2.5 million, pecking order theory says management will use

A) $1.5 million in debt and $1 million in retained earnings.
B) $2 million in retained earnings and $0.5 million in debt.
C) $833,333 each from retained earnings, new debt and new stock.
D) $1.5 million in debt and $1 million in new stock.

Question 48

Investors require a higher return on common stock investments if a firm uses less leverage.

Question 49

Which of the following is a conclusion of agency theory?

A) Managers may accept excessive financial risks to increase the returns to shareholders.
B) Managers tend to avoid high-risk, high-return investments that may jeopardize their positions if successful.
C) Managers will always use the least expensive source of funds to finance investments.
D) Managers will tend to put the stockholders interests before their own security and ambitions.

Question 50

What is being traded off in tradeoff theory?

A) tax savings from interest and financial distress costs.
B) cost of equity and cost of debt.
C) dividend payments and interest payments.
D) EBIT and EPS.

Question 51

Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs?

A) Increased usage of financial leverage will increase a firm's weighted average cost of capital indefinitely.
B) Increased usage of financial leverage will lower a firm's weighted average cost of capital indefinitely.
C) Increased usage of financial leverage will not affect a firm's weighted average cost of capital.
D) Increased usage of operating leverage will increase a firm's weighted average cost of capital indefinitely.

Question 52

The pecking order theory of capital structure is derived from

A) expectations theory.
B) the Modigliani-Miller theory.
C) liquidity preference theory.
D) agency theory.

Question 53

If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?

A) The tax shield effect of debt will result in a lower cost of equity.
B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
C) A firm's common stock price will not be affected by the amount of debt a firm uses.
D) Too much common equity increases the probability of bankruptcy.

Question 54

The Tradeoff Theory view of capital structure management says that the cost of capital curve is

A) a straight line.
B) v-shaped.
C) s-shaped.
D) saucer-shaped.

Question 55

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

A) It would remain at 16%.
B) t would rise to 22%.
C) It would fall to 11%.
D) It would fall to 13%.

Question 56

Which of the following is part of a firm's financial structure but NOT a component of its capital structure?

A) Retained earnings
B) Mortgage bonds
C) Accounts payable
D) Both A and C

Question 57

Lowell Corporation and Lawrence Corporation each have EBIT of $4 million. Lowell has no debt and no interest expense; Lawrence has $2 million in debt at a before-tax rate of 8%. The tax rate is 40%. How much cash does each firm return to its investors.

A) Lowell $2,400,000, Lawrence $2,144,000
B) Lowell $2,400,000, Lawrence $2,240,000
C) Lowell $2,400,000, Lawrence $2,464,000
D) Lowell $2,400,000, Lawrence $2,304,000

Question 58

The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital

A) first falls with moderate levels of leverage and then increases as a firm's leverage becomes high.
B) does not change with leverage.
C) increases proportionately with increases in leverage.
D) increases with moderate amounts of leverage and then falls.

Question 59

With taxes, but in the absence of financial distress costs, the optimal capital structure would be

A) 100% equity.
B) 50% debt, 50% equity.
C) 100% debt.
D) completely insensitive to the mix of debt and equity.

Question 60

Other things the same, the use of debt financing reduces the firm's total tax bill, resulting in a higher total market value.

Question 61

Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

Question 62

In which countries would you expect companies to have the lowest leverage ratios?

A) Countries with very high tax rates.
B) Countries that tend to subsidize key industries and protect them from failure.
C) Countries where creditors have very strong legal protection.
D) Countries where the market value of companies is high compared to their book values.

Question 63

The trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes that the benefit may at some point be offset by costs associated with financial distress.

Question 64

Which of the following factors favors the use of more debt in a company's financial structure?

A) High levels of taxable income
B) Low levels of taxable income
C) The business is basically risky with unpredictable cash flows.
D) Risk of bankruptcy would make customers reluctant to buy the company's products.

Question 65

The pecking order theory of capital structure indicates that firms prefer to finance investment opportunities with least expensive forms of financing first and the most expensive last.

Question 66

Which industry would you expect to have the highest Debt to Asset ratios?

A) Business oriented software
B) Electric utilities
C) Communications equipment
D) Retail clothing

Question 67

Companies faced with higher tax burdens are likely to use more debt.

Question 68

Which of the following is a good reason for a company to have higher than average debt ratios?

A) The company's cash flows are difficult to predict.
B) The company generates little taxable income.
C) Customer support is an important aspect of the company's business.
D) The company faces high marginal tax rates.

Question 69

At the beginning of the financial crisis of 2008, excessive debt caused serious problems in the ________ industry.

A) computer
B) pharmaceuticals
C) utilities
D) financial

Question 70

The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of the debt and the firm's marginal tax rate.

Question 71

Top management's desire to avoid the scrutiny that comes with higher levels of debt may influence the capital structures of some firms.

Question 72

Cheshire Corporation is now financed 100% with equity. The cost of equity is 15%. Cheshire is considering a proposal to borrow enough money at 7% to buy back half of its common stock. It would then be financed 50% with debt and 50% with equity. Assume that this does not affect the cost of equity. Cheshire's tax rate is 40%. What is Cheshire's cost of capital without and with the stock repurchase?

Question 73

There is abundant evidence that most companies operate at or near their optimal capital structures.

Question 74

In the original version of the Modigliani and Miller capital structure theorem, as a firm increases the amount of debt in its capital structure, the cost of equity will rise but the cost of capital will remain the same.

Question 75

The objective of capital structure management is to maximize the market value of the firm's equity.

Question 76

Under what conditions are shareholders likely to incur agency costs when managers make capital budgeting decisions?

Question 77

Conservative balance sheets may be advantageous for companies that have long-term relationships with their customers.

Question 78

U. S. companies differ very little in their capital structures.

Question 79

Agency costs occur when managers choose the easiest form of financing over the value maximizing capital structure.

Question 80

Adams Inc. expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Bellingham Inc. also expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Adams is financed entirely with equity while Bellingham is financed 50% with debt at 10%. Adams has $200 million in equity; Bellingham is financed with $100 million of debt and $100 million of equity. The tax rate is 30%. Both firms pay out all available earnings as dividends. If there is a recession, compare dividends and total distributions to investors for each company.