Question 1

Which one of these actions generally occurs first in a bankruptcy reorganization?

Accepted Answer

A)  Filing proofs of claim 
B)  Dividing creditors into classes 
C)  Confirming the reorganization plan 
D)  Distributing cash, property, and securities to creditors 
E)  Submitting a reorganization plan

Question 2

Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to:

Accepted Answer

A)  borrow some money and purchase additional shares of QRT stock. 
B)  maintain her current equity position as the debt of the firm does not affect her personally. 
C)  sell 36 percent of her shares of QRT stock and hold the proceeds in cash. 
D)  sell 36 percent of her shares of QRT stock and loan out the sale proceeds. 
E)  create a personal debt-equity ratio of .36.

Question 3

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?

Accepted Answer

A)  Static theory of capital structure 
B)  M&M Proposition I 
C)  M&M Proposition II 
D)  Homemade leverage 
E)  Pecking-order theory

Question 4

Bruce & Co. expects its EBIT to be $165,000 every year forever. The company currently has no debt but can borrow at 8.6 percent while its cost of equity is 14.7 percent. The tax rate is 21 percent. The company is planning to borrow $55,000 and use the loan proceeds to repurchase shares. What will be the WACC after recapitalization?

Accepted Answer

A)  14.57 percent 
B)  15.07 percent 
C)  14.51 percent 
D)  14.11 percent 
E)  14.58 percent

Question 5

The business risk of a company:

Accepted Answer

A)  depends on the company's level of unsystematic risk. 
B)  is inversely related to the required return on the company's assets. 
C)  is dependent upon the relative weights of the debt and equity used to finance the company. 
D)  has a positive relationship with the company's cost of equity. 
E)  has no relationship with the required return on a company's assets according to M&M theory.

Question 6

Which one of the following is the equity risk related to capital structure policy?

Accepted Answer

A)  Market risk 
B)  Systematic risk 
C)  Static risk 
D)  Business risk 
E)  Financial risk

Question 7

Johnson Tire Distributors has debt with both a face and a market value of $35,000. This debt has a coupon rate of 6.6 percent and pays interest annually. The expected earnings before interest and taxes are $8,300, the tax rate is 21 percent, and the unlevered cost of capital is 10.9 percent. What is the cost of equity?

Accepted Answer

A)  12.46 percent 
B)  12.87 percent 
C)  14.56 percent 
D)  13.59 percent 
E)  15.14 percent

Question 8

Which one of the following is the equity risk that is most related to the daily operations of a firm?

Accepted Answer

A)  Market risk 
B)  Systematic risk 
C)  Extrinsic risk 
D)  Business risk 
E)  Financial risk

Question 9

Auto Care has a pretax cost of debt of 8.3 percent and an unlevered cost of capital of 13.7 percent. The total tax rate is 23 percent and the cost of equity is 15.6 percent. What is the debt-equity ratio?

Accepted Answer

A)  .47 
B)  .61 
C)  .53 
D)  .42 
E)  .46

Question 10

Lester's has expected earnings before interest and taxes of $74,800, an unlevered cost of capital of 11.6 percent, and debt with both a book and face value of $84,000. The debt has a coupon rate of 6.35 percent and the tax rate is 24 percent. What is the value of this company?

Accepted Answer

A)  $403,136 
B)  $347,600 
C)  $510,229 
D)  $387,094 
E)  $428,507

Question 11

Which one of the following is a direct cost of bankruptcy?

Accepted Answer

A)  Bypassing a positive NPV project to avoid additional debt 
B)  Investing in cash reserves 
C)  Maintaining a debt-equity ratio that is lower than the optimal ratio 
D)  Losing a key company employee 
E)  Paying an outside accountant to prepare bankruptcy reports

Question 12

Jamison's has expected earnings before interest and taxes of $11,900. Its unlevered cost of capital is 12.8 percent and its tax rate is 21 percent. The company has debt with both a book and a face value of $12,500. This debt has a coupon rate of 7.6 percent and pays interest annually. What is the weighted average cost of capital?

Accepted Answer

A)  12.48 percent 
B)  12.36 percent 
C)  12.87 percent 
D)  11.38 percent 
E)  12.09 percent

Question 13

The capital structure that maximizes the value of a company also:

Accepted Answer

A)  minimizes financial distress costs. 
B)  minimizes the cost of capital. 
C)  maximizes the present value of the tax shield on debt. 
D)  maximizes the value of the debt. 
E)  maximizes the present value of the bankruptcy costs.

Question 14

A company is technically insolvent when:

Accepted Answer

A)  it has a negative book value. 
B)  its total debt exceeds its total equity. 
C)  it is unable to meet its financial obligations. 
D)  it files for bankruptcy protection. 
E)  the market value of its stock is less than its book value.

Question 15

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the:

Accepted Answer

A)  company is earning just enough to pay for the cost of the debt. 
B)  company's earnings before interest and taxes are equal to zero. 
C)  earnings per share for the levered option are exactly double those of the unlevered option. 
D)  advantages of leverage exceed the disadvantages of leverage. 
E)  company has a debt-equity ratio of .50.

Question 16

Holly's is currently an all-equity firm that has 7,200 shares of stock outstanding at a market price of $41 a share. The firm has decided to leverage its operations by issuing $60,000 of debt at an interest rate of 7.6 percent. This new debt will be used to repurchase shares of the outstanding stock. The restructuring is expected to increase the earnings per share. What is the minimum level of earnings before interest and taxes that the firm is expecting? Ignore taxes.

Accepted Answer

A)  $22,435 
B)  $19,516 
C)  $26,400 
D)  $17,141 
E)  $25,020

Question 17

Lamont Corp. is debt-free and has a weighted average cost of capital of 12.7 percent. The current market value of the equity is $2.3 million and there are no taxes. According to M&M Proposition I, what will be the value of the company if it changes to a debt-equity ratio of .85?

Accepted Answer

A)  $18,110,236 
B)  $1,955,000 
C)  $15,393,701 
D)  $2,705,882 
E)  $2,300,000

Question 18

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.

Accepted Answer

A)  At the break-even point, there is no advantage to debt. 
B)  The earnings per share will equal zero when EBIT is zero for a levered firm. 
C)  The advantages of leverage are inversely related to the level of EBIT. 
D)  The use of leverage at any level of EBIT increases the EPS. 
E)  EPS are more sensitive to changes in EBIT when a firm is unlevered.

Question 19

With the exception of a few industries, most corporations in the U.S. tend to:

Accepted Answer

A)  minimize taxes. 
B)  underutilize debt. 
C)  rely equally on debt and equity. 
D)  have relatively similar debt-equity ratios across industry lines. 
E)  rely more heavily on debt than on equity.

Question 20

The optimal capital structure of a company:

Accepted Answer

A)  minimizes the company's tax payments. 
B)  maximizes the value of that company's marketed claims. 
C)  minimizes both the marketed and nonmarketed claims against that company. 
D)  eliminates all nonmarketed claims against that company. 
E)  equates the company's marketed and nonmarketed claims.

Exam 16: Financial Leverage and Capital Structure Policy