Question 1

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Accepted Answer

A) True 
 B)False

Question 2

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Accepted Answer

A) True 
 B)False

Question 3

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

Accepted Answer

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

Question 4

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Accepted Answer

A)  $164,025 
B)  $182,250 
C)  $202,500 
D)  $225,000 
E)  $247,500 
A)  $164,025 
B)  $182,250 
C)  $202,500 
D)  $225,000 
E)  $247,500

Question 5

Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

Accepted Answer

A) True 
 B)False

Question 6

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Accepted Answer

A) True 
 B)False

Question 7

Which of the following statements is CORRECT?

Accepted Answer

A)  Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. 
B)  Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. 
C)  Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC. 
D)  Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. 
E)  Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity. 
A)  Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. 
B)  Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. 
C)  Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC. 
D)  Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. 
E)  Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

Question 8

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 9

Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $25.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 75,000 units, how much higher or lower will the firm's expected EBIT be if it uses high fixed cost Machine B rather than low fixed cost Machine A, i.e., what is EBITB - EBITA?

Accepted Answer

A)  $123,019 
B)  $136,688 
C)  $151,875 
D)  $168,750 
E)  $185,625 
A)  $123,019 
B)  $136,688 
C)  $151,875 
D)  $168,750 
E)  $185,625

Question 10

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?

Accepted Answer

A)  The two companies have the same times interest earned (TI
E)  ratio. 
B)  Firm L has a lower ROA than Firm U. 
C)  Firm L has a lower ROE than Firm U. 
D)  Firm L has the higher times interest earned (TI
E)  ratio. 
E)  Firm L has a higher EBIT than Firm U. 
A)  The two companies have the same times interest earned (TI
E)  ratio. 
B)  Firm L has a lower ROA than Firm U. 
C)  Firm L has a lower ROE than Firm U. 
D)  Firm L has the higher times interest earned (TI
E)  ratio. 
E)  Firm L has a higher EBIT than Firm U.

Question 11

If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Accepted Answer

A) True 
 B)False

Question 12

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells 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 
A)  391,667 
B)  411,250 
C)  431,813 
D)  453,403 
E)  476,073

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)  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. 
B)  The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. 
C)  The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. 
D)  If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. 
E)  Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt. 
A)  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. 
B)  The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. 
C)  The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. 
D)  If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. 
E)  Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.

Question 14

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Accepted Answer

A) True 
 B)False

Question 15

Your firm 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 some of its common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

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 ROA would increase. 
E)  The company's ROE would decline. 
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 ROA would increase. 
E)  The company's ROE would decline.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. 
B)  The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. 
C)  The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. 
D)  The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. 
E)  The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC. 
A)  As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. 
B)  The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. 
C)  The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. 
D)  The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. 
E)  The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

Question 17

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Accepted Answer

A) True 
 B)False

Question 18

The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm's future prospects as its managers. That was called "symmetric information," and it is questionable. The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

Accepted Answer

A) True 
 B)False

Question 19

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the breakeven points for Machines A and B? (Hint: Find BEB - BEA)

Accepted Answer

A)  3,154 
B)  3,505 
C)  3,894 
D)  4,327 
E)  4,760 
A)  3,154 
B)  3,505 
C)  3,894 
D)  4,327 
E)  4,760

Question 20

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

Accepted Answer

A) True 
 B)False

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

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

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Which of the following statements is CORRECT?

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

Which of the following statements is CORRECT?

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Which of the following statements is CORRECT?

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds and Their Valuation

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Distributions to Shareholders: Dividends and

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

Mergers and Acquisitions

Financial Management and Stock Equilibrium

Filters

Exam 14: Capital Structure and Leverage

Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

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

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

Which of the following statements is CORRECT?

As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's breakeven point, i.e., at what unit sales volume would income equal costs?

Which of the following statements is CORRECT?

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

Which of the following statements is CORRECT?

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds and Their Valuation

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Distributions to Shareholders: Dividends and

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

Mergers and Acquisitions

Financial Management and Stock Equilibrium

Filters