Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  A change in the personal tax rate should not affect firms' capital structure decisions. 
B)  "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. 
C)  The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. 
D)  If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. 
E)  If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. 
A)  A change in the personal tax rate should not affect firms' capital structure decisions. 
B)  "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. 
C)  The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. 
D)  If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. 
E)  If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. E

Question 2

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

Accepted Answer

A) True 
 B)False  True

Question 3

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 40%.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)  10.95% 
B)  11.91% 
C)  12.94% 
D)  14.07% 
E)  15.29% 
A)  10.95% 
B)  11.91% 
C)  12.94% 
D)  14.07% 
E)  15.29% E

Question 4

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. 
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.

Question 5

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) . 
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) .

Question 6

Morales Publishing's tax rate is 40%,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)  1.53% 
B)  1.70% 
C)  1.87% 
D)  2.05% 
E)  2.26% 
A)  1.53% 
B)  1.70% 
C)  1.87% 
D)  2.05% 
E)  2.26%

Question 7

The following information has been presented to you about the Gibson Corporation. $\begin{array}{lrlr}
\text { Total assets } & \$ 3,000 \text { million } & \text { Tax rate } & 40 \% \
\text { Operating income (EBIT) } & \$ 800 \text { million } & \text { Debt ratio } & 0 \% \
\text { Interest expense } & \$ 0 \text { million } & \text { WACC } & 10 \% \
\text { Net income } & \$ 480 \text { million } & \text { M/B ratio } & 1.00 \times \
\text { Share price } & \$ 32.00 & \text { EPS }=\text { DPS } & \$ 3.20
\end{array}$
The company has no growth opportunities (g = 0),so the company pays out all of its earnings as dividends (EPS = DPS).The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based on market values)that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%.If the company makes this change,what would be the total market value (in millions)of the firm?

Accepted Answer

A)  $3,200 
B)  $3,600 
C)  $4,000 
D)  $4,200 
E)  $4,800 
A)  $3,200 
B)  $3,600 
C)  $4,000 
D)  $4,200 
E)  $4,800

Question 8

Two operationally similar companies,HD and LD,have identical amounts of assets,operating income (EBIT),tax rates,and business risk.Company HD,however,has a much higher debt ratio than LD.Company HD's basic earning power ratio (BEP)exceeds its cost of debt (rd).Which of the following statements is CORRECT?

Accepted Answer

A)  Company HD has a higher times interest earned (TI
E)  ratio than Company LD. 
B)  Company HD has a higher return on equity (RO
E)  than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's. 
C)  The two companies have the same ROE. 
D)  Company HD's ROE would be higher if it had no debt. 
E)  Company HD has a higher return on assets (RO
A)  than Company LD. 
A)  Company HD has a higher times interest earned (TI
E)  ratio than Company LD. 
B)  Company HD has a higher return on equity (RO
E)  than Company LD, and its risk, as measured by the standard deviation of ROE, is also higher than LD's. 
C)  The two companies have the same ROE. 
D)  Company HD's ROE would be higher if it had no debt. 
E)  Company HD has a higher return on assets (RO
A)  than Company LD.

Question 9

Blueline Publishers is considering a recapitalization plan.It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock.The recapitalization would not change the company's total assets,nor would it affect the firm's basic earning power,which is currently 15%.The CFO believes that this recapitalization would reduce the WACC and increase stock price.Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

A)  The company's earnings per share would decline. 
B)  The company's cost of equity would increase. 
C)  The company's ROA would increase. 
D)  The company's ROE would decline. 
E)  The company's net income would increase. 
A)  The company's earnings per share would decline. 
B)  The company's cost of equity would increase. 
C)  The company's ROA would increase. 
D)  The company's ROE would decline. 
E)  The company's net income would increase.

Question 10

LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.The company's capital structure consists of debt and common stock.In order to estimate the cost of debt,the company has produced the following table: $\begin{array}{ccccc}
\begin{array}{c}
\text { Percent financed } \
\text { with debt }\left(\mathrm{w}_{\mathrm{d}}\right)
\end{array} & \begin{array}{c}
\text { Percent financed } \
\text { with equity }\left(\mathrm{w}_{\mathrm{c}}\right)
\end{array} & \begin{array}{c}
\text { Debt-to-equity } \
\text { ratio }(\mathrm{D} / \mathrm{S})
\end{array} & \begin{array}{c}
\text { Bond } \
\text { Rating }
\end{array} & \begin{array}{c}
\text { Before-tax } \
\text { cost of debt }
\end{array} \
\hline 0.10 & 0.90 & 0.10 / 0.90=0.11 & \text { AAA } & 7.0 \% \
0.20 & 0.80 & 0.20 / 0.80=0.25 & \text { AA } & 7.2 \
0.30 & 0.70 & 0.30 / 0.70=0.43 & \text { A } & 8.0 \
0.40 & 0.60 & 0.40 / 0.60=0.67 & \mathrm{BBB} & 8.8 \
0.50 & 0.50 & 0.50 / 0.50=1.00 & \mathrm{BB} & 9.6
\end{array}$
The company uses the CAPM to estimate its cost of common equity,rs.The risk-free rate is 5% and the market risk premium is 6%.LeCompte estimates that if it had no debt its beta would be 1.0.(Its "unlevered beta," bU,equals 1.0.)The company's tax rate,T,is 40%.
On the basis of this information,what is LeCompte's optimal capital structure,and what is the firm's cost of capital at this optimal capital structure?

Accepted Answer

A)  wc = 0.9; wd = 0.1; WACC = 14.96% 
B)  wc = 0.8; wd = 0.2; WACC = 10.96% 
C)  wc = 0.7; wd = 0.3; WACC = 7.83% 
D)  wc = 0.6; wd = 0.4; WACC = 10.15% 
E)  wc = 0.5; wd = 0.5; WACC = 10.18% 
A)  wc = 0.9; wd = 0.1; WACC = 14.96% 
B)  wc = 0.8; wd = 0.2; WACC = 10.96% 
C)  wc = 0.7; wd = 0.3; WACC = 7.83% 
D)  wc = 0.6; wd = 0.4; WACC = 10.15% 
E)  wc = 0.5; wd = 0.5; WACC = 10.18%

Question 11

If Miller and Modigliani had incorporated the costs of bankruptcy into their model,it is unlikely that they would have concluded that 100% debt financing is optimal.

Accepted Answer

A) True 
 B)False

Question 12

Two firms,although they operate in different industries,have the same expected earnings per share and the same standard deviation of expected EPS.Thus,the two firms must have the same business risk.

Accepted Answer

A) True 
 B)False

Question 13

Companies HD and LD have identical tax rates,total assets,and basic earning power ratios,and their basic earning power exceeds their before-tax cost of debt,rd.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 lower ROA than Company LD. 
B)  Company HD has a lower ROE than Company LD. 
C)  The two companies have the same ROA. 
D)  The two companies have the same ROE. 
E)  Company HD has a higher net income than Company LD. 
A)  Company HD has a lower ROA than Company LD. 
B)  Company HD has a lower ROE than Company LD. 
C)  The two companies have the same ROA. 
D)  The two companies have the same ROE. 
E)  Company HD has a higher net income than Company LD.

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. 
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.

Question 15

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. 
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.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
B)  A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. 
C)  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. 
D)  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 financing. 
E)  In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. 
A)  There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. 
B)  A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. 
C)  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. 
D)  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 financing. 
E)  In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Question 17

Which of the following would increase the likelihood that a company would increase its 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)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
D)  The company's stock price hits a new low. 
E)  An increase in costs incurred when filing for bankruptcy. 
A)  An increase in the corporate tax rate. 
B)  An increase in the personal tax rate. 
C)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
D)  The company's stock price hits a new low. 
E)  An increase in costs incurred when filing for bankruptcy.

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 40%. 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)  $65.77 
B)  $69.23 
C)  $72.69 
D)  $76.33 
E)  $80.14 
A)  $65.77 
B)  $69.23 
C)  $72.69 
D)  $76.33 
E)  $80.14

Question 19

A firm's capital structure does not affect its calculated free cash flows,because FCF reflects only operating cash flows.

Accepted Answer

A) True 
 B)False

Question 20

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Accepted Answer

A) True 
 B)False

Exam 15: Capital Structure Decisions

Which of the following statements is CORRECT?

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

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

Which of the following statements is CORRECT?

If Miller and Modigliani had incorporated the costs of bankruptcy into their model,it is unlikely that they would have concluded that 100% debt financing is optimal.

Two firms,although they operate in different industries,have the same expected earnings per share and the same standard deviation of expected EPS.Thus,the two firms must have the same business risk.

Companies HD and LD have identical tax rates,total assets,and basic earning power ratios,and their basic earning power exceeds their before-tax cost of debt,rd.However,Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following would increase the likelihood that a company would increase its debt ratio,other things held constant?

A firm's capital structure does not affect its calculated free cash flows,because FCF reflects only operating cash flows.

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

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

Valuation of Stocks and Corporations

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

Agency Conflicts and 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

Extension 18 A: Rights Offerings

Lease Financing

Hybrid Financing: Preferred Stock, warrants, and Convertibles

Dynamic Capital Structures

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

Filters

Companies HD and LD have identical tax rates,total assets,and basic earning power ratios,and their basic earning power exceeds their before-tax cost of debt,r_d.However,Company HD has a higher debt ratio and thus more interest expense than Company LD.Which of the following statements is CORRECT?