Question 1

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 2

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

Question 3

Which of the following statements is CORRECT?

Accepted Answer

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

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

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. 
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 6

Hernandez Corporation expects to have the following data during the coming year.What is Hernandez's expected ROE? $\begin{array}{lc}
\text { Assets } & \$ 200,000 \text { Interest rate }&8\% \
\text { D/A } & 65 \% \text { Tax rate } &25\%\
\text { EB IT } & \$ 25,000
\end{array}$

Accepted Answer

A)  15.64% 
B)  16.43% 
C)  17.25% 
D)  18.11% 
E)  19.01% 
A)  15.64% 
B)  16.43% 
C)  17.25% 
D)  18.11% 
E)  19.01%

Question 7

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% 
A)  1.91% 
B)  2.12% 
C)  2.33% 
D)  2.57% 
E)  2.82%

Question 8

The major contribution of the Miller model is that it demonstrates that

Accepted Answer

A)  personal taxes decrease the value of using corporate debt. 
B)  financial distress and agency costs reduce the value of using corporate debt. 
C)  equity costs increase with financial leverage. 
D)  debt costs increase with financial leverage. 
E)  personal taxes increase the value of using corporate debt. 
A)  personal taxes decrease the value of using corporate debt. 
B)  financial distress and agency costs reduce the value of using corporate debt. 
C)  equity costs increase with financial leverage. 
D)  debt costs increase with financial leverage. 
E)  personal taxes increase the value of using corporate debt.

Question 9

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

Accepted Answer

A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability. 
A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability.

Question 10

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

Accepted Answer

A) True 
 B)False

Question 11

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Accepted Answer

A) True 
 B)False

Question 12

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now, Cartwright has a capital structure that consists of 20% debt and 80% equity, based on market values.(Its D/S ratio is 0.25.) The risk-free rate is 6% and the market risk premium, rM − rRF, is 5%.Currently the company's cost of equity, which is based on the CAPM, is 12% and its tax rate is 25%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Accepted Answer

A)  13.00% 
B)  13.65% 
C)  14.84% 
D)  15.58% 
E)  16.00% 
A)  13.00% 
B)  13.65% 
C)  14.84% 
D)  15.58% 
E)  16.00%

Question 13

VanMannen Foundations, Inc.(VF)
VanMannen Foundations, Inc.(VF) is a zero-growth company that currently has zero debt, and it has the data shown below.
 $\begin{array}{lr}
\text { EBIT }= & \$ 80,000 \
\text { Growth }= & 0 \% \
\text { Orig cost of equity, } \mathrm{r}_{\mathrm{s}}= & 10.0 \% \
\text { No. of shares }= & 10,000 \
\text { Price per share } & \$ 60.00 \
\text { Tax rate }= & 25 \%
\end{array}$ ​
-Refer to the data for VanMannen Foundations, Inc.(VF).Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt.This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations.Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase.What is the stock price per share immediately after issuing the debt but prior to the repurchase? $\begin{array}{llr}
\text { Debt } / \text { Value }= & 40 \% \text { Value of new debt }= & \$ 280,702 \
\text { Equity } / \text { Value }= & 60 \% \mathrm{New} \text { W } \mathrm{ACC}= & 8.55 \%
\end{array}$

Accepted Answer

A)  $66.67 
B)  $70.18 
C)  $73.68 
D)  $77.37 
E)  $81.24 
A)  $66.67 
B)  $70.18 
C)  $73.68 
D)  $77.37 
E)  $81.24

Question 14

Wilson Dover Inc.
The total value (debt plus equity) of Wilson Dover Inc.is $500 million and the face value of its 1-year coupon debt is $200 million.The volatility (σ) of Wilson Dover's total value is 0.60, and the risk-free rate is 5%.Assume that N(dS1U1B11S1U1B0) = 0.9720 and N(dS1U1B12S1U1B0) = 0.9050.
​
-Refer to the data for Wilson Dover Inc.What is the value (in millions) of Wilson Dover's debt if its equity is viewed as an option?

Accepted Answer

A)  $167.57 
B)  $186.19 
C)  $204.81 
D)  $225.29 
E)  $247.82 
A)  $167.57 
B)  $186.19 
C)  $204.81 
D)  $225.29 
E)  $247.82

Question 15

Pennewell Publishing Inc.(PP)
Pennewell Publishing Inc.(PP) is a zero growth company.It currently has zero debt and its earnings before interest and taxes (EBIT) are $80,000.PP's current cost of equity is 10%, and its tax rate is 25%.The firm has 10,000 shares of common stock outstanding selling at a price per share of $48.00.
-Refer to the data for Pennewell Publishing Inc.(PP).Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity.This results in a weighted average cost of capital equal to 9.125% and a new value of operations of $657,534.Assume PP raises $230,137 in new debt and purchases T-bills to hold until it makes the stock repurchase.PP then sells the T-bills and uses the proceeds to repurchase stock.How many shares remain after the repurchase, and what is the stock price per share immediately after the repurchase? Remaining Shares; P Post

Accepted Answer

A)  7,500; $86.18 
B)  7,000; $74.26 
C)  6,500; $65.75 
D)  6,649; $63.48 
E)  6,959; $58.03 
A)  7,500; $86.18 
B)  7,000; $74.26 
C)  6,500; $65.75 
D)  6,649; $63.48 
E)  6,959; $58.03

Question 16

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

Question 17

Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets.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 an after-tax cost of 4.8%.Both firms have positive net income.Which of the following statements is CORRECT?

Accepted Answer

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

Question 18

Which of the following statements is CORRECT?

Accepted Answer

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

Question 19

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)  0.73 
A)  0.60 
B)  0.63 
C)  0.66 
D)  0.70 
E)  0.73

Question 20

Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 25%.Currently, the cost of equity, rs, is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)

Accepted Answer

A)  11.50% 
B)  12.50% 
C)  13.58% 
D)  14.77% 
E)  16.05% 
A)  11.50% 
B)  12.50% 
C)  13.58% 
D)  14.77% 
E)  16.05%

Exam 15: Capital Structure Decisions

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.

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 ____.

Which of the following statements is CORRECT?

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

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?

Hernandez Corporation expects to have the following data during the coming year.What is Hernandez's expected ROE? Assets \ 200,000 Interest rate 8\% D/A 65\% Tax rate 25\% EB IT \ 25,000

The major contribution of the Miller model is that it demonstrates that

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

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Which of the following statements is CORRECT?

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?

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Risk and Return

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Corporate Valuation and Financial Planning

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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