Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)   There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
B)   A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
C)   If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
D)   Suppose a firm has less than its optimal amount of debt.Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing.
E)   In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Question 2

Serendipity Inc.is re-evaluating its debt level.Its current capital structure consists of 80% debt and 20% common equity, its beta is 1.60, and its tax rate is 25%.However, the CFO thinks the company has too much debt, and he is considering moving to a capital structure with 40% debt and 60% equity.The risk-free rate is 5.0% and the market risk premium is 6.0%.By how much would the capital structure shift change the firm's cost of equity?

Accepted Answer

A)   −5.40%
B)   −6.00%
C)   −6.60%
D)   −7.26%
E)   −7.99%

Question 3

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Accepted Answer

A) True 
 B)False

Question 4

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Accepted Answer

A) True 
 B)False

Question 5

If debt financing is used, which of the following is CORRECT?

Accepted Answer

A)   The percentage change in net operating income will be equal to a given percentage change in net income.
B)   The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
C)   The percentage change in net income will be greater than the percentage change in net operating income.
D)   The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
E)   The percentage change in net operating income will be greater than a given percentage change in net income.

Question 6

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Accepted Answer

A) True 
 B)False

Question 7

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Accepted Answer

A) True 
 B)False

Question 8

Eccles Inccorporated
Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
-Refer to the data for Eccles Incorporated.What is the firm's cost of equity according to MM with corporate taxes?

Accepted Answer

A)   21.0%
B)   23.3%
C)   25.9%
D)   28.8%
E)   32.0%

Question 9

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Accepted Answer

A)   normally lead to a decrease in its business risk.
B)   normally lead to a decrease in the standard deviation of its expected EBIT.
C)   normally lead to a decrease in the variability of its expected EPS.
D)   normally lead to a reduction in its fixed assets turnover ratio.
E)   normally lead to an increase in its fixed assets turnover ratio.

Question 11

Blueline Publishers is considering a recapitalization plan.It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock.The recapitalization would not change the company's total assets, nor would it affect the firm's return on invested capital (ROIC) , which is currently 15%.The CFO believes that this recapitalization would reduce the WACC and increase stock price.Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

A)   The company's earnings per share would decline.
B)   The company's cost of equity would increase.
C)   The company's ROA would increase.
D)   The company's ROE would decline.
E)   The company's net income would increase.

Question 12

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

Accepted Answer

A)   The costs that would be incurred in the event of bankruptcy increase.
B)   Management believes that the firm's stock has become overvalued.
C)   Its degree of operating leverage increases.
D)   The corporate tax rate increases.
E)   Its sales become less stable over time.

Question 13

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit.What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

Accepted Answer

A)   391,667
B)   411,250
C)   431,813
D)   453,403
E)   476,073

Question 14

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Accepted Answer

A)   An increase in the corporate tax rate.
B)   An increase in the personal tax rate.
C)   The Federal Reserve tightens interest rates in an effort to fight inflation.
D)   The company's stock price hits a new low.
E)   An increase in costs incurred when filing for bankruptcy.

Question 15

Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT) , tax rates, and business risk.Company HD, however, has a much higher debt ratio than LD.Company HD's return on invested capital (ROIC)  exceeds its after-tax cost of debt, (1-T)  rd.Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a higher times interest earned (TI
E)   ratio than Company LD.
B)   Company HD has a higher return on equity (RO
E)   than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's.
C)   The two companies have the same ROE.
D)   Company HD's ROE would be higher if it had no debt.
E)   Company HD has a higher return on assets (RO
A)   than Company LD.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
B)   The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
C)   If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
D)   Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.
E)   A firm can use retained earnings without paying a flotation cost.Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.

Question 17

Whenever a firm borrows money, it is using financial leverage.

Accepted Answer

A) True 
 B)False

Question 18

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC) , and their ROIC exceeds their after-tax cost of debt, (1-T)  rd.However, Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

Accepted Answer

A)   Company HD has a lower ROA than Company LD.
B)   Company HD has a lower ROE than Company LD.
C)   The two companies have the same ROA.
D)   The two companies have the same ROE.
E)   Company HD has a higher net income than Company LD.

Question 19

Merriwether Building has operating income of $20 million, a tax rate of 25%, and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $27 per share, and it has 5 million shares of stock outstanding.If it moves to a capital structure that has 40% debt and 60% equity (based on market values) , its investment bankers believe its weighted average cost of capital would be 10%.What would its stock price be if it changes to the new capital structure?

Accepted Answer

A)   $28
B)   $30
C)   $33
D)   $35
E)   $40

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)   Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
B)   Drug companies (prescription, not illegal!)  generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
C)   Wide variations in capital structures exist both between industries and among individual firms within given industries.These differences are caused by differing business risks and also managerial attitudes.
D)   Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.
E)   Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.

Exam 15: Capital Structure Decisions

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Correct Answer
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Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC) , and their ROIC exceeds their after-tax cost of debt, (1-T) r_d.However, Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

Correct Answer
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As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Correct Answer
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Correct Answer
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If debt financing is used, which of the following is CORRECT?

Correct Answer
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Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Correct Answer
verified

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Correct Answer
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Correct Answer
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Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Correct Answer
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Whenever a firm borrows money, it is using financial leverage.

Correct Answer
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Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit.What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

Correct Answer
verified

Exam 15: Capital Structure Decisions

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Correct AnswerverifiedShow Answer

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC) , and their ROIC exceeds their after-tax cost of debt, (1-T) rd.However, Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

If debt financing is used, which of the following is CORRECT?

Correct AnswerverifiedShow Answer

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Correct AnswerverifiedShow Answer

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

Whenever a firm borrows money, it is using financial leverage.

Correct AnswerverifiedShow Answer

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000, its variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit.What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

Correct AnswerverifiedShow Answer

Correct Answer
verified

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC) , and their ROIC exceeds their after-tax cost of debt, (1-T) r_d.However, Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

Correct Answer
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