Question 1

Why does MM Proposition I,without taxes,not hold in the presence of corporate taxation?

Accepted Answer

A) Bondholders require higher rates of return when their interest payments are taxed. 
B) Dividends are no longer relevant when taxes are introduced. 
C) A levered firm will pay less tax than the identical firm unlevered. 
D) The cost of equity increases with leverage. 
E) The pretax cost of debt increases when taxes are considered.

Question 2

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios?

Accepted Answer

A) 0.0 
B) 0.1 
C) 0.5 
D) 0.7 
E) 0.9

Question 3

A levered firm has a pretax cost of debt of 6.8 percent and an unlevered cost of capital of 13.4 percent.The tax rate is 34 percent,and the cost of equity is 16.06 percent.What is the debt-equity ratio?

Accepted Answer

A) 0.57 
B) 0.45 
C) 0.51 
D) 0.47 
E) 0.61

Question 4

When selecting a capital structure,managers should aim to maximize the

Accepted Answer

A) tax deductions that are available to the company. 
B) value of the firm for its managers and employees. 
C) size of the firm. 
D) value of the firm for its shareholders. 
E) growth rate of the company.

Question 5

Assume you are reviewing a graph depicting earnings per share (EPS)on the vertical axis and earnings before interest (EBI)on the horizontal axis.Data points for both a levered and an unlevered firm are displayed.Given this,which statement accurately describes this graph?

Accepted Answer

A) The unlevered firm has a greater reaction to a change in EBI than does the levered firm. 
B) The levered firm consistently has higher EPS than the unlevered firm. 
C) Both the levered and unlevered firms have zero EPS when EBI is zero. 
D) Debt becomes a greater disadvantage to a firm as EBI increases. 
E) When earnings exceed the breakeven point,the levered firm has the higher EPS.

Question 6

The Grist Mill has no debt,a total market value of $319,200,and 24,000 shares of stock outstanding.The firm has expected EBIT of $21,000 if the economy is normal and $24,000 if the economy booms.The firm is considering a bond issue of $79,800 with an attached interest rate of 5.9 percent.The bond proceeds will be used to repurchase shares.The tax rate is 35 percent.What is the percentage increase in EPS if the economy booms rather than be normal?

Accepted Answer

A) 18.78% 
B) 18.67% 
C) 19.34% 
D) 18.41% 
E) 19.29%

Question 7

MM Proposition I,with tax,supports the theory that

Accepted Answer

A) the value of an unlevered firm is equal to the value of a levered firm plus the interest tax shield. 
B) the value of a firm is inversely related to the amount of leverage used by the firm. 
C) there is a positive linear relationship between the debt-to-equity ratio and firm value. 
D) a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. 
E) a firm's weighted average cost of capital increases as the debt-equity ratio of the firm increases.

Question 8

Baker Breads has $428,000 of debt outstanding that is selling at par and has a coupon rate of 6.25 percent.The tax rate is 34 percent.What is the present value of the tax shield?

Accepted Answer

A) $9,095 
B) $10,459 
C) $52,760 
D) $145,520 
E) $147,600

Question 9

When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt

Accepted Answer

A) increase as EBIT increases. 
B) stay fixed,leaving more income to be distributed over fewer shares. 
C) stay fixed,leaving less income to be distributed over fewer shares. 
D) stay fixed,leaving less income to be distributed over more shares. 
E) decrease as EBIT increases.

Question 10

Travel Express has a debt-equity ratio of 0.42.The pretax cost of debt is 7.1 percent while the unlevered cost of capital is 13.6 percent.What is the cost of equity if the tax rate is 34 percent?

Accepted Answer

A) 17.52% 
B) 13.78% 
C) 15.40% 
D) 17.83% 
E) 14.30%

Question 11

A firm's capital structure refers to the

Accepted Answer

A) division of a firm's assets into current and fixed assets. 
B) amount shareholders have invested into the firm. 
C) types of fixed assets owned by the firm. 
D) mix of debt and equity used to finance the firm's assets. 
E) amount of cash and cash equivalents held by a firm.

Question 12

Which one of these presents the idea that the cost of equity is a positive linear function of capital structure?

Accepted Answer

A) MM Proposition I,without taxes 
B) MM Proposition II,without taxes 
C) Capital asset pricing model 
D) MM Proposition I,with taxes 
E) Homemade leverage

Question 13

Managers should select the capital structure that

Accepted Answer

A) maximizes the value of the firm. 
B) has no debt. 
C) is fully levered. 
D) minimizes taxes. 
E) produces the highest current level of net income.

Question 14

Leisure Vacations is an unlevered firm with aftertax net income of $57,980,a cost of capital of 13.2 percent,and a tax rate of 35 percent.What is the value of this firm?

Accepted Answer

A) $285,507.58 
B) $318,906.15 
C) $401,008.47 
D) $439,242.42 
E) $368,511.12

Question 15

Which one of these statements is correct?

Accepted Answer

A) Firms across all industries in the U.S.tend to have similar debt-to-equity ratios. 
B) The banking industry tends to have the lowest debt-to-equity ratio of any United States industry. 
C) Financial leverage lowers risk to equity holders. 
D) MM Propositions ignore bankruptcy costs. 
E) MM Propositions,without taxes,illustrate that a firm's overall cost of capital is affected by leverage.

Question 16

The use of leverage by a firm

Accepted Answer

A) increases the variability of EBIT. 
B) replaces all use of homemade leverage. 
C) increases shareholder risk. 
D) affects EBIT more than net income. 
E) increases EPS at low levels of income.

Question 17

The Studio is currently an all-equity firm that has 68,000 shares of stock outstanding with a market price of $36.80 a share.The current cost of equity is 11.7 percent,and the tax rate is 35 percent.The firm is considering adding $750,000 of debt with a coupon rate of 5.8 percent to its capital structure.The debt will be sold at par value.What is the levered value of the equity?

Accepted Answer

A) $2,014,900 
B) $3,035,500 
C) $1,785,000 
D) $2,005,200 
E) $1,806,400

Question 18

Simpson's is an all-equity firm that has 400,000 shares of stock outstanding.The company is in the process of borrowing $1.5 million at 5 percent interest to repurchase 30,000 of the firm's outstanding shares.Ignore taxes.What will be the market value of equity after the repurchase?

Accepted Answer

A) $20.0 million 
B) $19.2 million 
C) $18.5 million 
D) $19.8 million 
E) $18.9 million

Question 19

R0 is defined as the

Accepted Answer

A) cost of capital for an unlevered firm. 
B) pretax cost of debt. 
C) cost of capital in a risk-free world without taxes. 
D) cost of capital for a fully levered firm. 
E) aftertax cost of debt.

Question 20

Wilt's has a debt-equity ratio of 0.48,a pretax cost of debt of 7.3 percent,and an unlevered cost of capital of 14.1 percent.What is its levered cost of equity if there are no taxes or other imperfections?

Accepted Answer

A) 19.65% 
B) 15.55% 
C) 18.20% 
D) 17.36% 
E) 16.45%

Exam 14: Capital Structure: Basic Concepts