Question 1

If an individual wanted to borrow with limited liability he/she should:

Accepted Answer

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 2

Which of the following is true?

Accepted Answer

A)  bD > bA > bE 
B)  bE > bA > bD 
C)  bA > bE > bD 
D)  None of the above is true

Question 3

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

Accepted Answer

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

Question 4

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

Accepted Answer

A)  Borrow $3,000 and buy 50 more shares 
B)  Continue to hold 100 shares 
C)  Sell 50 shares and purchase $3,000 debt (bonds) 
D)  None of the above

Question 5

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

Accepted Answer

A)  If the issue of debt increases the probability of bankruptcy 
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 6

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

Accepted Answer

A)  $6.00 
B)  $7.52 
C)  $7.20 
D)  None of the above

Question 7

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% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)

Accepted Answer

A)  10% 
B)  15% 
C)  8% 
D)  None of the above

Question 8

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

Accepted Answer

The answer of Briefly discuss some of the applications of...

Question 9

MM Proposition II states that:

Accepted Answer

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)  All of the above 
E)  None of the above

Question 10

State and explain MM's Proposition II.

Accepted Answer

The answer of State and explain MM's Proposition II....

Question 11

The law of conservation of value implies that:

Accepted Answer

A)  The value of 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 value of a firm's debt is unchanged when common stock is added to its capital structure 
D)  None of the above

Question 12

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.)

Accepted Answer

A)  1.5 
B)  1.1 
C)  0.3 
D)  None of the above

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

For an all equity firm,

Accepted Answer

A)  As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percent 
B)  As EBIT increases, the EPS increases by a larger percent 
C)  As EBIT increases, the EPS decreases 
D)  None of the above

Question 15

Discuss a successful example of corporations trying to add value through innovative financing.

Accepted Answer

The answer of Discuss a successful example of corporations trying...

Question 16

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

Accepted Answer

A) True 
 B)False

Question 17

The beta of the firm is equal to the weighted average of the betas on its debt and equity under the assumption of no taxes.

Accepted Answer

A) True 
 B)False

Question 18

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

Accepted Answer

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

Question 19

The "law of conservation of value" is not applicable to the mix of debt securities.

Accepted Answer

A) True 
 B)False

Question 20

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.

Accepted Answer

A) True 
 B)False

Exam 17: Does Debt Policy Matter

If an individual wanted to borrow with limited liability he/she should:

Which of the following is true?

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

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

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% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)

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

MM Proposition II states that:

State and explain MM's Proposition II.

The law of conservation of value implies that:

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.)

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

For an all equity firm,

Discuss a successful example of corporations trying to add value through innovative financing.

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

The beta of the firm is equal to the weighted average of the betas on its debt and equity under the assumption of no taxes.

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

The "law of conservation of value" is not applicable to the mix of debt securities.

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.