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Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?


A) 18.2%
B) 20.2%
C) 22.5%
D) 25.0%

Correct Answer

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Ang Enterprises has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Ang's beta be if it used no debt, i.e., what is its unlevered beta?


A) 0.67
B) 0.71
C) 0.75
D) 0.79

Correct Answer

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Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm 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 basic earning power, 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?


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

Correct Answer

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Which of the following statements is correct?


A) Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
B) Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
C) 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.
D) 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.

Correct Answer

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Suppose a firm increases the operating leverage used to produce a given quantity of output, what will it normally lead to?


A) a decrease in the standard deviation of its expected EBIT
B) a decrease in its business risk
C) a decrease in the variability of its expected EPS
D) a reduction in its fixed assets turnover ratio

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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.

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MM shows that in a world without taxes, a firm's value is not affected by its capital structure.

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Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?


A) demand variability
B) input price variability
C) the extent to which operating costs are fixed
D) the extent to which interest rates on the firm's debt fluctuate

Correct Answer

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A firm with a debt-to-equity ratio (D/E) of 0.5, return on assets of 18%, and return on debt of 12% will have a return on equity of which of the following?


A) 15.00%
B) 16.67%
C) 20.00%
D) 21.17%

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A firm's financial risk has identifiable market risk and diversifiable risk components.

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The Miller model begins with the MM model with taxes and then adds personal taxes.

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Which of the following is likely to happen in the MM model with a high risk of bankruptcy?


A) almost 100% debt financing
B) valuable projects are foregone to preserve cash
C) wasteful expenditures are often found
D) management buys back shares from the open market

Correct Answer

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Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

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The presence of personal taxes completely eliminates the benefits of debt financing.

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Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?


A) an increase in the corporate tax rate
B) an increase in the personal tax rate
C) an increase in the company's operating leverage
D) the company's stock price hitting a new high

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?


A) an increase in costs incurred when filing for bankruptcy
B) an increase in the corporate tax rate
C) an increase in the personal tax rate
D) the company's stock price hitting a new low

Correct Answer

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Based on the information below, what is Ezzel Enterprises' optimal capital structure?


A) Debt = 40%; Equity = 60%; EPS = $2.95; Common share price = $26.50
B) Debt = 50%; Equity = 50%; EPS = $3.05; Common share price = $28.90
C) Debt = 60%; Equity = 40%; EPS = $3.18; Common share price = $31.20
D) Debt = 80%; Equity = 20%; EPS = $3.42; Common share price = $30.40

Correct Answer

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


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

Correct Answer

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According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

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