Question 1

Which of the following statements is CORRECT, holding other things constant?

Accepted Answer

A)   Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
B)   An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
C)   If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
D)   An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
E)   An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.F) A) and E)
G) C) and D)

Question 2

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation)  of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sale price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT) ?

Accepted Answer

A)   12,600
B)   14,000
C)   15,400
D)   16,940
E)   18,634F) A) and B)
G) A) and C)

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A)   A firm's business risk is determined solely by the financial characteristics of its industry.
B)   The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.
C)   One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.
D)   A firm's financial risk can be minimized by diversification.
E)   The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.F) B) and D)
G) A) and E)

Question 4

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged)  is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?

Accepted Answer

A)   0.71
B)   0.75
C)   0.79
D)   0.83
E)   0.87F) A) and D)
G) C) and D) E

Question 5

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions) (WACC - g) Oper. income (EBIT) New cost of equity (rs) Interest rate (rd)  8.00%

Accepted Answer

A)   $2,982
B)   $3,314
C)   $3,682
D)   $4,091
E)   $4,545F) A) and E)
G) A) and B)

Question 6

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Accepted Answer

A) True 
 B)False

Question 7

Companies HD and LD have the same total assets, operating income (EBIT) , tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP)  ratios exceed their cost of debt (rd) . Which of the following statements is CORRECT?

Accepted Answer

A)   HD should have a higher return on assets (RO
A)   than LD.
B)   HD should have a higher times interest earned (TI
E)   ratio than LD.
C)   HD should have a higher return on equity (RO
E)   than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
D)   Given that BEP > rd, HD's stock price must exceed that of LD.
E)   Given that BEP > rd, LD's stock price must exceed that of HD.F) A) and D)
G) C) and E)

Question 8

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, 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 higher net income than Company LD.
B)   Company HD has a lower ROA than Company LD.
C)   Company HD has a lower ROE than Company LD.
D)   The two companies have the same ROA.
E)   The two companies have the same ROE.F) B) and C)
G) B) and E)

Question 9

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A) True 
 B)False  True

Question 11

Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Accepted Answer

A) True 
 B)False

Question 12

Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? New Debt/Assets 55% Orig. cost of equity, rs 10.0%
New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%

Accepted Answer

A)   2.74%
B)   3.01%
C)   3.32%
D)   3.65%
E)   4.01%F) A) and D)
G) All of the above

Question 13

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

Accepted Answer

A) True 
 B)False

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)   Increasing its use of financial leverage is one way to increase a firm's basic earning power (BEP) .
B)   If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
C)   The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
D)   If a company were to issue debt and use the money to repurchase common stock, this would reduce its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) 
E)   If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.F) B) and D)
G) B) and C)

Question 15

Which of the following statements best describes the optimal capital structure?

Accepted Answer

A)   The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS) .
B)   The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.
C)   The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity.
D)   The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt.
E)   The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.F) B) and C)
G) A) and E)

Question 16

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

Accepted Answer

A) True 
 B)False

Question 17

Based on the information below, what is the firm's optimal capital structure?

Accepted Answer

A)   Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
B)   Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
C)   Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
D)   Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
E)   Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.F) None of the above
G) A) and E)

Question 18

Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)   The ROA would increase.
B)   The ROA would remain unchanged.
C)   The basic earning power ratio would decline.
D)   The basic earning power ratio would increase.
E)   The ROE would increase.F) A) and C)
G) C) and E)

Question 19

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are

Accepted Answer

A) True 
 B)False  True

Question 20

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Accepted Answer

A)   The costs associated with filing for bankruptcy increase.
B)   The corporate tax rate is increased.
C)   The personal tax rate is increased.
D)   The Federal Reserve tightens interest rates in an effort to fight inflation.
E)   The company's stock price hits a new low.F) C) and E)
G) A) and B)

Exam 14: Capital Structure and Leverage

Which of the following statements is CORRECT, holding other things constant?

Correct Answer
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Correct Answer
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Which of the following statements is CORRECT?

Correct Answer
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El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?

Correct Answer
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E

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions) (WACC - g) Oper. income (EBIT) New cost of equity (rs) Interest rate (rd) 8.00%

Correct Answer
verified

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Correct Answer
verified

Companies HD and LD have the same total assets, operating income (EBIT) , tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd) . Which of the following statements is CORRECT?

Correct Answer
verified

Correct Answer
verified

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Correct Answer
verified

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

Correct Answer
verified
True

Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Correct Answer
verified

Correct Answer
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The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.

Correct Answer
verified

Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements best describes the optimal capital structure?

Correct Answer
verified

Correct Answer
verified

Based on the information below, what is the firm's optimal capital structure?

Correct Answer
verified

Correct Answer
verified

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are

Correct Answer
verified
True

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Correct Answer
verified

Exam 14: Capital Structure and Leverage

Which of the following statements is CORRECT, holding other things constant?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?

Correct AnswerverifiedE

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions) (WACC - g) Oper. income (EBIT) New cost of equity (rs) Interest rate (rd) 8.00%

Correct AnswerverifiedShow Answer

A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.

Correct AnswerverifiedShow Answer

Companies HD and LD have the same total assets, operating income (EBIT) , tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd) . Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedTrue

Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Which of the following statements best describes the optimal capital structure?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Based on the information below, what is the firm's optimal capital structure?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are

Correct AnswerverifiedTrue

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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E

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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True

Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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Correct Answer
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True

Correct Answer
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