Question 1

Two operationally similar 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 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)   HD should have a higher times interest earned (TI
E)   ratio than LD.
B)   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.
C)   Given that ROIC > (1-T)  rd, HD's stock price must exceed that of LD.
D)   Given that ROIC > (1-T)  rd, LD's stock price must exceed that of HD.
E)   HD should have a higher return on assets (RO
A)   than LD.F) A) and E)
G) All of the above

Question 2

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its return on invested operating capital (ROIC)  is 14.5%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value.If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)   The ROA would remain unchanged.
B)   The ROIC would decline.
C)   The ROIC would increase.
D)   The ROE would increase.
E)   The ROA would increase.F) A) and B)
G) B) and D) D

Question 3

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Accepted Answer

A)   0.60
B)   0.63
C)   0.66
D)   0.70
E)   0.73F) A) and B)
G) A) and E)

Question 4

Morales Publishing's tax rate is 25%, its beta is 1.10, and it uses no debt.However, the CFO is considering moving to a capital structure with 30% debt and 70% equity.If 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)   1.91%
B)   2.12%
C)   2.33%
D)   2.57%
E)   2.82%F) All of the above
G) B) and E)

Question 5

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Accepted Answer

A) True 
 B)False

Question 6

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

Accepted Answer

A)   An increase in the personal tax rate.
B)   An increase in the company's operating leverage.
C)   The Federal Reserve tightens interest rates in an effort to fight inflation.
D)   The company's stock price hits a new high.
E)   An increase in the corporate tax rate.F) A) and B)
G) All of the above

Question 7

The MM model is the same as the Miller model, but with zero corporate taxes.

Accepted Answer

A) True 
 B)False

Question 8

Which of the following statements concerning capital structure theory is NOT CORRECT?

Accepted Answer

A)   Under MM with zero taxes, financial leverage has no effect on a firm's value.
B)   Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
C)   Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
D)   Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
E)   The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.F) None of the above
G) D) and E)

Question 9

Which of these items will not generally be affected by an increase in the debt ratio?

Accepted Answer

A)   Total risk.
B)   Financial risk.
C)   Market risk.
D)   The firm's beta.
E)   Business risk.F) A) and C)
G) C) and D) E

Question 10

The world-famous discounter, Fernwood Booksellers, specializes in selling paperbacks for $7 each.The variable cost per book is $5.At current annual sales of 200,000 books, the publisher is just breaking even.It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost)  and still break even?

Accepted Answer

A)   $600,000
B)   $466,667
C)   $333,333
D)   $200,000
E)   None of the aboveF) A) and E)
G) D) and E) D

Question 11

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.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?

Accepted Answer

A)   12.8%
B)   14.2%
C)   15.8%
D)   17.6%
E)   19.6%F) A) and C)
G) None of the above

Question 12

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
B)   All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.
C)   Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
D)   Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC.
E)   When a company increases its debt ratio, the costs of equity and debt both increase.Therefore, the WACC must also increase.F) A) and B)
G) A) and E)

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
B)   The capital structure that minimizes the required return on equity also maximizes the stock price.
C)   The capital structure that minimizes the WACC also maximizes the price per share of common stock.
D)   The capital structure that gives the firm the best credit rating also maximizes the stock price.
E)   The capital structure that maximizes expected EPS also maximizes the price per share of common stock.F) A) and B)
G) B) and D)

Question 15

Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.

Accepted Answer

A)   stock price.
B)   cost of equity.
C)   cost of debt.
D)   cost of preferred stock.
E)   earnings per share (EPS) .F) A) and B)
G) A) and E)

Question 16

The firm's target capital structure should be consistent with which of the following statements?

Accepted Answer

A)   Minimize the cost of debt (rd) .
B)   Obtain the highest possible bond rating.
C)   Minimize the cost of equity (rs) .
D)   Minimize the weighted average cost of capital (WAC
C)  .
E)   Maximize the earnings per share (EPS) .F) C) and E)
G) D) and E)

Question 17

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS) .Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

Accepted Answer

A)   If the plan reduces the WACC, the stock price is also likely to decline.
B)   Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
C)   If the plan does increase the EPS, the stock price will automatically increase at the same rate.
D)   Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
E)   Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.F) A) and D)
G) A) and B)

Question 18

An all-equity firm with 200,000 shares outstanding, Antwerther Inc., has $2,000,000 of EBIT, which is expected to remain constant in the future.The company pays out all of its earnings, so earnings per share (EPS)  equal dividends per shares (DPS) .Its tax rate is 25%. ​
The company is considering issuing $5,000,000 of 10.0% bonds and using the proceeds to repurchase stock.The risk-free rate is 6.5%, the market risk premium is 5.0%, and the beta is currently 0.90, but the CFO believes beta would rise to 1.10 if the recapitalization occurs.
​
Assuming that the shares can be repurchased at the price that existed prior to the recapitalization, what would the price be following the recapitalization?

Accepted Answer

A)   $70.31
B)   $74.01
C)   $77.71
D)   $81.60
E)   $85.68F) B) and D)
G) A) and D)

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)   If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage.
B)   The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
C)   If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its return on invested capital.(Assume that the repurchase has no impact on the company's operating income.) 
D)   If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.
E)   Increasing financial leverage is one way to increase a firm's return on invested capital.F) C) and D)
G) A) and D)

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)   The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
B)   The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E)   ratio.
C)   Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC.
D)   If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.
E)   The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WAC
C)  .F) B) and E)
G) B) and D)

Exam 15: Capital Structure Decisions

Correct Answer
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D

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Correct Answer
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When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Correct Answer
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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?

Correct Answer
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The MM model is the same as the Miller model, but with zero corporate taxes.

Correct Answer
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Which of the following statements concerning capital structure theory is NOT CORRECT?

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Which of these items will not generally be affected by an increase in the debt ratio?

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E

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D

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When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

Correct Answer
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Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

Correct Answer
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Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.

Correct Answer
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The firm's target capital structure should be consistent with which of the following statements?

Correct Answer
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Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

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Exam 15: Capital Structure Decisions

Correct AnswerverifiedShow Answer

Correct AnswerverifiedD

Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 25%.What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

The MM model is the same as the Miller model, but with zero corporate taxes.

Correct AnswerverifiedShow Answer

Which of the following statements concerning capital structure theory is NOT CORRECT?

Correct AnswerverifiedShow Answer

Which of these items will not generally be affected by an increase in the debt ratio?

Correct AnswerverifiedE

Correct AnswerverifiedD

Correct AnswerverifiedShow Answer

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

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 best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.

Correct AnswerverifiedShow Answer

The firm's target capital structure should be consistent with which of the following statements?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

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Which of the following statements is CORRECT?

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D

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E

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D

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