Question 1

Financial risk refers to the extra risk borne by stockholders 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 2

Which of the following statements is CORRECT?

Accepted Answer

A)  The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rS). 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
C)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E) ratio. 
D)  If a company increases its debt ratio,this will typically increase the marginal costs of both debt and equity,but it still may reduce the company's WACC. 
E)  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. 
A)  The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rS). 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
C)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E) ratio. 
D)  If a company increases its debt ratio,this will typically increase the marginal costs of both debt and equity,but it still may reduce the company's WACC. 
E)  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.

Question 3

Your girlfriend plans to start a new company to make a new type of cat litter.Her father will finance the operation,but she will have to pay him back.You are helping her,and the issue now is how to finance the company,with equity only or with a mix of debt and equity.The price per unit will be $10.00 regardless of how the firm is financed.The expected fixed and variable operating costs,along with other information,are shown below.How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity,i.e. ,what is EPSL - EPSU? Do not round your intermediate calculations. $\begin{array}{lrr}&0 \% \text { Debt, U }&60 \% \text { Debt, L }\\hline
\text { Expected unit sales } & 290,000 & 290,000 \
\text { Price per unit } & \$ 10.00 & \$ 10.00 \
\text { Fixed costs } & \$ 1,000,000 & \$ 1,000,000 \
\text { Variable cost/unit } & \$ 3.50 & \$ 3.50 \
\text { Required investment } & \$ 2,500,000 & \$ 2,500,000 \
\text { Shares issued at } \$ 10 / \text { share } & 250,000 & 100,000 \
\% \text { Debt } & 0.00 \% & 60.00 \% \
\text { Debt, } \$ & \$ 0 & \$ 1,500,000 \
\text { Equity, } \$ & \$ 2,500,000 & \$ 1,000,000 \
\text { Interest rate } & \mathrm{NA} & 10.00 \% \
\text { Tax rate } & 35.00 \% & 35.00 \%
\end{array}$
?

Accepted Answer

A)  $02.48 
B)  $02.35 
C)  $03.10 
D)  $02.85 
E)  $02.60 
A)  $02.48 
B)  $02.35 
C)  $03.10 
D)  $02.85 
E)  $02.60

Question 4

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. 
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.

Question 5

Some people--including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)--have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms.

Accepted Answer

A) True 
 B)False

Question 6

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

Accepted Answer

A) True 
 B)False

Question 7

Southwest U's campus book store sells course packs for $19 each.The variable cost per pack is $12,and at current annual sales of 43,000 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)  $203,400 
B)  $277,980 
C)  $253,120 
D)  $226,000 
E)  $221,480 
A)  $203,400 
B)  $277,980 
C)  $253,120 
D)  $226,000 
E)  $221,480

Question 8

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

Question 9

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

Question 10

You plan to invest in one of two home delivery pizza companies,High and Low,that were recently founded and are about to commence operations.They are identical except for their use of debt (wd)and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate.Based on the data given below,how much higher or lower will High's expected EPS be versus that of Low,i.e. ,what is EPSHigh - EPSLow? Do not round your intermediate calculations. $\begin{array}{lclclc}\text { Applicable to Both Firms }&&\text { Firm High's Data }&&\text { Firm Low's Data }\
\text { Capital } & \$ 3,000,000 & \mathrm{w}_{\mathrm{d}} & 70 \% & \mathrm{w}_{\mathrm{d}} & 20 \% \
\text { EBIT } & \$ 565,000 & \text { Shares } & 90,000 & \text { Shares } & 240,000 \
\text { Tax rate } & 35 \% & \text { Int. rate } & 12 \% & \text { Int. rate } & 10 \%
\end{array}$
?

Accepted Answer

A)  $01.16 
B)  $00.67 
C)  $01.07 
D)  $00.80 
E)  $00.89 
A)  $01.16 
B)  $00.67 
C)  $01.07 
D)  $00.80 
E)  $00.89

Question 11

As a consultant to First Responder Inc. ,you have obtained the following data (dollars in millions).The company plans to pay out all of its earnings as dividends,hence g = 0.Also,no net new investment in operating capital is needed because growth is zero.The CFO believes that a move from zero debt to 80.0% debt would cause the cost of equity to increase from 10.0% to 12.0%,and the interest rate on the new debt would be 9.0%.What would the firm's total market value be if it makes this change? Hints: Find the FCF,which is equal to NOPAT = EBIT(1 - T)because no new operating capital is needed,and then divide by (WACC - g).Do not round your intermediate calculations. $\begin{array}{lrlr}
\text { Oper income (EBIT) } & \$ 800 & \text { Tax rate } & 40.0 \% \
\text { New cost of equity }\left(\mathrm{r}_{\mathrm{s}}\right) & 12.00 \% & \text { New wd } & 80.0 \% \
\text { Interest rate }\left(\mathrm{r}_{\mathrm{d}}\right) & 9.00 \% & &
\end{array}$
?

Accepted Answer

A)  $7,143 
B)  $8,000 
C)  $7,357 
D)  $5,357 
E)  $5,929 
A)  $7,143 
B)  $8,000 
C)  $7,357 
D)  $5,357 
E)  $5,929

Question 12

Your uncle is considering investing in a new company that will produce high quality stereo speakers.The sales price would be set at 1.70 times the variable cost per unit;the variable cost per unit is estimated to be $75.00;and fixed costs are estimated at $1,170,000.What sales volume would be required to break even,i.e. ,to have EBIT = zero?

Accepted Answer

A)  23,400 
B)  25,851 
C)  18,051 
D)  17,160 
E)  22,286 
A)  23,400 
B)  25,851 
C)  18,051 
D)  17,160 
E)  22,286

Question 13

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 14

Companies HD and LD have identical tax rates,total assets,total investor-supplied capital,and returns on investors' capital (ROIC),and their ROICs exceed their after-tax costs of debt,rd(1 - T).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. 
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.

Question 15

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 16

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 17

Which of the following statements is CORRECT?

Accepted Answer

A)  In general,a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. 
B)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
C)  A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk,assuming all else equal. 
D)  If a firm's after-tax cost of equity exceeds its after-tax cost of debt,it can always reduce its WACC by increasing its use of debt. 
E)  Suppose a firm has less than its optimal amount of debt.Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity. 
A)  In general,a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. 
B)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
C)  A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk,assuming all else equal. 
D)  If a firm's after-tax cost of equity exceeds its after-tax cost of debt,it can always reduce its WACC by increasing its use of debt. 
E)  Suppose a firm has less than its optimal amount of debt.Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

Question 18

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 19

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 20

Which of the following statements is CORRECT?

Accepted Answer

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

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

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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

Southwest U's campus book store sells course packs for $19 each.The variable cost per pack is $12,and at current annual sales of 43,000 packs,the store earns $75,000 before taxes on course packs.How much are the fixed costs of producing the course packs?

Which of the following events is likely to encourage a company to raise its target debt ratio,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.

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

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.

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

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.

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.

Which of the following statements is CORRECT?

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements,cash Flow and Taxes

Analysis of Financial Statements

Time Value of Money

Interest Rates

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 Share Repurchases

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

Filters

Exam 14: Capital Structure and Leverage

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

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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

Southwest U's campus book store sells course packs for $19 each.The variable cost per pack is $12,and at current annual sales of 43,000 packs,the store earns $75,000 before taxes on course packs.How much are the fixed costs of producing the course packs?

Which of the following events is likely to encourage a company to raise its target debt ratio,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.

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

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.

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

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.

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.

Which of the following statements is CORRECT?

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements,cash Flow and Taxes

Analysis of Financial Statements

Time Value of Money

Interest Rates

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 Share Repurchases

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

Filters