Deck 15: Capital Structure Policy

Question 1

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

Answer 1

True

Question 2

Cornucopia's liabilities and equity are shown below: What is Cornucopia's debt to value ratio?

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

Answer 2

C

Question 3

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

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

Answer 3

D

Question 4

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

Question 5

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

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

Question 6

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

A)The amount of debt that a firm uses
B)The amount of debt and preference shares that a firm uses
C)The amount of debt,preference shares,and ordinary shares that a firm uses
D)The mix of long and short-term debt used by the firm

Question 7

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 Fibonnacci's equity is $21 million.What is Fibonacci's debt ratio?

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

Question 8

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.Its Debt to Enterprise Value ratio is .5.What is the book value of Merrimac's interest-bearing debt?

A)$5.25 million
B)$10.2 million
C)$15 million
D)$20.4 million

Question 9

The interest coverage ratio measures a firm's ability to meet both interest payments and scheduled principal repayments.

Question 10

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

A)unfavourable financial leverage.
B)a sub-optimal capital structure.
C)favourable financial leverage.
D)negative financial leverage.

Question 11

Suppose we calculate an interest coverage ratio of 29 for Colgate-Palmolive.We can conclude

A)Colgate-Palmolive may experience some difficulty meeting its interest payments.
B)Colgate-Palmolive is very unlikely to have difficulty meeting its 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 12

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 Fibonnacci's equity is $21 million.What is Fibonacci's Debt to Enterprise Value ratio?

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

Question 13

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

Question 14

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

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

Question 15

How does the text distinguish between a 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

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

A)unfavourable financial leverage.
B)a sub-optimal capital structure.
C)favourable financial leverage.
D)negative financial leverage.

Question 17

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

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

Question 18

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 19

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

A)Preference shares
B)Bonds
C)Ordinary shares
D)Accounts payable
E)Retained earnings

Question 20

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.Its Debt to Enterprise Value ratio is .5.What is Merrimac's Debt Ratio?

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

Question 21

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

Question 22

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

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

Question 23

Which of the following is a reasonable conclusion from the trade-off theory of capital structure?

A)A high debt ratio will result in a maximum price of a firm's ordinary shares.
B)A firm's ordinary share 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 ordinary shares.
D)Modest levels of debt have a more favorable impact on a firm's average cost of capital and share price than no debt.

Question 24

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 25

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

Question 26

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 27

Which of the following is consistent with the trade-off 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 28

Using the original Modigliani and Miller assumptions,if a firm's cost of capital is 12% when it is all equity financed and its 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 29

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

Question 30

In its original form,the Modigliani and Miller Capital Structure Theorem

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 31

What is meant by the terms "favourable" and "unfavourable" leverage?

Question 32

An optimal capital structure is achieved

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

Question 33

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 shareholders and bondholders will decrease.
C)cash flows will increase because taxes will decrease.
D)the weighted average cost of capital will increase.

Question 34

Optimal capital structure is

A)the funding mix that will maximize the company's ordinary share 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 35

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

Question 36

The trade-off theory of capital structure suggests that if a firm moves from zero debt in its capital structure to moderate usage of debt,the result is an increase in a firm's

A)share price.
B)cost of equity.
C)dividend payout.
D)both A and C.

Question 37

An optimal capital structure is achieved

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

Question 38

The trade-off 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 39

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

A)Debt = 40%;Equity = 60%;EPS = $2.95;Share price = $26.50
B)Debt = 50%;Equity = 50%;EPS = $3.05;Share price = $28.90
C)Debt = 60%;Equity = 40%;EPS = $3.18;Share price = $31.20
D)Debt = 80%;Equity = 20%;EPS = $3.42;Share price = $30.40
E)Debt = 70%;Equity = 30%;EPS = $3.31;Share price = $30.00

Question 40

Which of the following is the most important factor that affects a firm's financing mix?

A)The amount of EPS
B)The amount of operating income
C)The number of shares that are outstanding
D)The predictability of cash flows

Question 41

The Trade-off 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 42

Investors require a higher return on ordinary share investments if a firm uses less leverage.

Question 43

The hierarchy of funding sources as applied to capital structure is derived from

A)financial distress costs.
B)the Modigliani-Miller theory.
C)preferential tax treatment of debt.
D)agency costs.

Question 44

Assume that the tax rate is 40% 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 its capital structure.

Question 45

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 46

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 47

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 48

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

Question 49

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

Question 50

The Trade-off 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 capitalisation.
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 51

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 52

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 shares at a cost of 17%.Newbury's cost of ordinary equity without selling any new shares is 16%.If Newbury's capital budget is $2.5 million,the hierarchical funding model 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 shares.
D)$1.5 million in debt and $1 million in new shares.

Question 53

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

Question 54

Capital structure theory suggests that companies may put the interests of ________ ahead of the interests of ________.

A)potential shareholders,existing shareholders
B)shareholders,bondholders
C)existing shareholders,ATO
D)There are no potential conflicts arising from the way a firm manages its capital structure.

Question 55

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 56

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

Question 57

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 shares,what would happen to the cost of equity under the original assumptions of the Modigliani and Miller Capital Structure Theorem?

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

Question 58

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

Question 59

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 ordinary share price will not be affected by the amount of debt a firm uses.
D)Too much ordinary equity increases the probability of bankruptcy.

Question 60

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)trade-off theory.
C)financial stress avoidance theory.
D)hierarchy of funding.

Question 61

The trade-off theory of capital structure recognises the tax-shield benefit of debt financing,but also recognises that the benefit is offset by costs associated with debt financing.

Question 62

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 63

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 64

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

Question 65

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 subsidise 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 66

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 67

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 68

List and briefly explain at least two important reasons why capital structures tend to differ between industries and even companies within the same industry.

Question 69

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 ordinary shares.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 share repurchase?

Question 70

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

Question 71

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

Question 72

From the table above we can conclude

A)Waltham has conservative capital structure policies.
B)Waltham has too much debt.
C)Waltham uses more leverage than the typical firm in its industry.
D)Waltham's EPS would be more sensitive than a typical firm's to changes in EBIT.

Question 73

The hierarchical funding model of capital structure indicates that firms prefer to finance investment opportunities with least expensive forms of financing first and the most expensive last.

Question 74

Which two ratios would be most helpful in managing a firm's capital structure?

A)Book Debt to Equity,Current Ratio
B)Debt to Value Ratio and Interest Coverage Ratio
C)Debt to Assets,Profit Margin
D)Payables Turnover,Return on Assets

Question 75

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 76

Adams Limited 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.

Question 77

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

Question 78

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

Question 79

Most companies differ very little in their capital structures.

Question 80

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.