Question 1

When debt is risky under MM II:

Accepted Answer

A) bond holders shift more of the risk to equity holders. 
B) equity holders shift more of the risk to bond holders. 
C) the value of the interest tax shield is at its highest. 
D) there is more overall risk in the firm. 
A) bond holders shift more of the risk to equity holders. 
B) equity holders shift more of the risk to bond holders. 
C) the value of the interest tax shield is at its highest. 
D) there is more overall risk in the firm.

Question 2

Based upon the "trade-off theory" of capital structure, what differences might you expect in the capital structure of a food producer and a defence contractor?

Accepted Answer

A) higher debt-equity ratio for food producer. 
B) higher debt-equity ratio for a defence contractor. 
C) neither firm should use debt in their structure. 
D) differences in capital structure will make no valuation differences in these firms. 
A) higher debt-equity ratio for food producer. 
B) higher debt-equity ratio for a defence contractor. 
C) neither firm should use debt in their structure. 
D) differences in capital structure will make no valuation differences in these firms.

Question 3

Under MM II assumptions, the expected return on equity is equal to the expected return on assets for a levered firm.

Accepted Answer

A) True 
 B)False

Question 4

Determine the expected return on equity for a firm with a WACC of 12%, $500,000 in 9% debt, $800,000 in equity.Both debt and equity are shown at market values, and the firm pays no taxes.How can the expected return on equity be reduced?

Accepted Answer

Recall with no taxes that the expected r

Question 5

Calculate the annual value of an interest tax shield under the assumption that a firm maintains debt at a permanent $1,000,000 level and rate of 12%.The corporate tax rate is 35%.If there is no chance of financial distress, how does the value of the firm change as a result of this debt?

Accepted Answer

Annual tax shield = debt × interest rate

Question 6

When taxes are considered, the value of a levered firm equals the value of the:

Accepted Answer

A) unlevered firm. 
B) unlevered firm plus the value of the debt. 
C) unlevered firm plus the present value of the tax shield. 
D) unlevered firm plus the value of the debt plus the value of the tax shield. 
A) unlevered firm. 
B) unlevered firm plus the value of the debt. 
C) unlevered firm plus the present value of the tax shield. 
D) unlevered firm plus the value of the debt plus the value of the tax shield.

Question 7

Firms facing financial distress may pass up positive NPV projects rather than commit new equity because:

Accepted Answer

A) they prefer to finance with debt. 
B) the benefits may be shared with the bondholders. 
C) no cash is available for dividends. 
D) there is no interest tax shield associated with equity. 
A) they prefer to finance with debt. 
B) the benefits may be shared with the bondholders. 
C) no cash is available for dividends. 
D) there is no interest tax shield associated with equity.

Question 8

What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if MM I is modified to recognize corporate taxes?

Accepted Answer

A) value increases by $35,000 
B) value increases by $100,000 
C) value increases by $350,000 
D) value increases by $700,000 
A) value increases by $35,000 
B) value increases by $100,000 
C) value increases by $350,000 
D) value increases by $700,000

Question 9

Which of the following would not be expected to change with changes in the firm's capital structure?

Accepted Answer

A) weighted-average cost of capital. 
B) expected return on equity. 
C) expected return on assets. 
D) expected earnings per share. 
A) weighted-average cost of capital. 
B) expected return on equity. 
C) expected return on assets. 
D) expected earnings per share.

Question 10

Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders.

Accepted Answer

A) True 
 B)False

Question 11

Equity Inc.is currently an all-equity financed firm.It has 10,000 shares outstanding that sell for $20 each.The firm has an operating income of $30,000 and pays no taxes.The firm contemplates a restructuring that would issue $50,000 in 8% debt, which will be used to repurchase stock.Show the value of the firm, EPS, and rate of return on the stock before and after the proposed restructuring.What changed?

Accepted Answer

@#IMG-DLM& The EPS and return on equity increased

Question 12

A firm has an expected return on equity of 15% and an after-tax cost of debt of 10%.What debt-equity ratio should be used in order to keep the WACC at 11%?

Accepted Answer

A) 1.00 
B) 2.00 
C) 3.00 
D) 4.00 
A) 1.00 
B) 2.00 
C) 3.00 
D) 4.00

Question 13

Costs of distress are greater when a large amount of __________ affect(s) the prosperity of the firm.

Accepted Answer

A) intangible assets 
B) tangible assets 
C) net working capital 
D) retained earnings 
A) intangible assets 
B) tangible assets 
C) net working capital 
D) retained earnings

Question 14

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket? (Use value in dollar.)

Accepted Answer

A) $126,000 
B) $234,000 
C) $360,000 
D) $1,050,000 
A) $126,000 
B) $234,000 
C) $360,000 
D) $1,050,000

Question 15

If the present value of the tax shield equals the present value of the costs of financial distress, then the:

Accepted Answer

A) firm is using the optimal level of debt. 
B) firm is paying too high an interest rate. 
C) firm's market value equals the value of the unlevered firm. 
D) firm should increase its use of debt. 
A) firm is using the optimal level of debt. 
B) firm is paying too high an interest rate. 
C) firm's market value equals the value of the unlevered firm. 
D) firm should increase its use of debt.

Question 16

One advantage of debt financing over equity financing is:

Accepted Answer

A) tax deductible dividends. 
B) tax deductible interest. 
C) tax deductible principal repayment. 
D) tax free interest income. 
A) tax deductible dividends. 
B) tax deductible interest. 
C) tax deductible principal repayment. 
D) tax free interest income.

Question 17

A firm has a debt/equity ratio of ½.The debt pays a 6% rate of interest.The expected rate of return on equity is 12%.What would happen to the expected rate of return if the firm reduced its debt/equity ratio to 1/3?

Accepted Answer

A) rate of return would increase to 11.33% 
B) rate of return would increase to 12.50% 
C) rate of return would decrease to 10.60% 
D) rate of return would decrease to 8.33% 
A) rate of return would increase to 11.33% 
B) rate of return would increase to 12.50% 
C) rate of return would decrease to 10.60% 
D) rate of return would decrease to 8.33%

Question 18

What is the amount of the annual interest tax shield for a firm with $5 million in debt that pays 10% interest if the firm is in the 40% tax bracket? (Use value in the dollar.)

Accepted Answer

A) $100,000 
B) $200,000 
C) $300,000 
D) $400,000 
A) $100,000 
B) $200,000 
C) $300,000 
D) $400,000

Question 19

A firm has an expected return on equity of 14% and an after-tax cost of debt of 6%.What debt-equity ratio should be used in order to keep the WACC at 10%?

Accepted Answer

A) 1.00 
B) 0.75 
C) 0.50 
D) 0.25 
A) 1.00 
B) 0.75 
C) 0.50 
D) 0.25

Question 20

MM's Proposition II states that the expected return on equity increases as the firm's debt-equity ratio increases.

Accepted Answer

A) True 
 B)False

Exam 16: Debt Policy

When debt is risky under MM II:

Based upon the "trade-off theory" of capital structure, what differences might you expect in the capital structure of a food producer and a defence contractor?

Under MM II assumptions, the expected return on equity is equal to the expected return on assets for a levered firm.

Determine the expected return on equity for a firm with a WACC of 12%, $500,000 in 9% debt, $800,000 in equity.Both debt and equity are shown at market values, and the firm pays no taxes.How can the expected return on equity be reduced?

Calculate the annual value of an interest tax shield under the assumption that a firm maintains debt at a permanent $1,000,000 level and rate of 12%.The corporate tax rate is 35%.If there is no chance of financial distress, how does the value of the firm change as a result of this debt?

When taxes are considered, the value of a levered firm equals the value of the:

Firms facing financial distress may pass up positive NPV projects rather than commit new equity because:

What is the change in value for a firm with $1 million in equity, $1 million in permanent debt at a 10% interest rate, and a 35% tax rate if MM I is modified to recognize corporate taxes?

Which of the following would not be expected to change with changes in the firm's capital structure?

Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders.

A firm has an expected return on equity of 15% and an after-tax cost of debt of 10%.What debt-equity ratio should be used in order to keep the WACC at 11%?

Costs of distress are greater when a large amount of __________ affect(s) the prosperity of the firm.

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket? (Use value in dollar.)

If the present value of the tax shield equals the present value of the costs of financial distress, then the:

One advantage of debt financing over equity financing is:

A firm has a debt/equity ratio of ½.The debt pays a 6% rate of interest.The expected rate of return on equity is 12%.What would happen to the expected rate of return if the firm reduced its debt/equity ratio to 1/3?

What is the amount of the annual interest tax shield for a firm with $5 million in debt that pays 10% interest if the firm is in the 40% tax bracket? (Use value in the dollar.)

A firm has an expected return on equity of 14% and an after-tax cost of debt of 6%.What debt-equity ratio should be used in order to keep the WACC at 10%?

MM's Proposition II states that the expected return on equity increases as the firm's debt-equity ratio increases.

Goals and Governance of the Firm

Financial Markets and Institutions

Accounting and Finance

Measuring Corporate Performance

The Time Value of Money

Valuing Bonds

Valuing Stocks

Net Present Value and Other Investment Criteria

Using Discounted Cash Flow Analysis to Make Investment Decisions

Project Analysis

Introduction to Risk, Return, and the Opportunity Cost of Capital

Risk, Return, and Capital Budgeting

The Weighted-Average Cost of Capital and Company Valuation

Introduction to Corporate Financing and Governance

Venture Capital, Ipos, and Seasoned Offerings

Leasing

Payout Policy

Long-Term Financial Planning

Short-Term Financial Planning

Cash and Inventory Management

Credit Management and Collection

Mergers, Acquisitions, and Corporate Control

International Financial Management

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Risk Management

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