Question 1

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 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

Barette Consulting currently has no debt in its capital structure,has $500 million of total assets,and its basic earning power is 15%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock,paying book value.If the company proceeds with the recapitalization,its operating income,total assets,and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)  The ROA would remain unchanged. 
B)  The basic earning power ratio would decline. 
C)  The basic earning power ratio would increase. 
D)  The ROE would increase. 
E)  The ROA would increase. 
A)  The ROA would remain unchanged. 
B)  The basic earning power ratio would decline. 
C)  The basic earning power ratio would increase. 
D)  The ROE would increase. 
E)  The ROA would increase.

Question 4

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

Accepted Answer

A)  HD should have a higher times interest earned (TI
E)  ratio than LD. 
B)  HD should have a higher return on equity (RO
E)  than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. 
C)  Given that BEP > rd, HD's stock price must exceed that of LD. 
D)  Given that BEP > rd, LD's stock price must exceed that of HD. 
E)  HD should have a higher return on assets (RO
A)  than LD. 
A)  HD should have a higher times interest earned (TI
E)  ratio than LD. 
B)  HD should have a higher return on equity (RO
E)  than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. 
C)  Given that BEP > rd, HD's stock price must exceed that of LD. 
D)  Given that BEP > rd, LD's stock price must exceed that of HD. 
E)  HD should have a higher return on assets (RO
A)  than LD.

Question 5

Provided a firm does not use an extreme amount of debt,financial leverage typically affects both EPS and EBIT,while operating leverage only affects EBIT.

Accepted Answer

A) True 
 B)False

Question 6

Merriwether Building has operating income of $20 million,a tax rate of 40%,and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $40 per share,and it has 2.5 million shares of stock outstanding.If it moves to a capital structure that has 40% debt and 60% equity (based on market values),its investment bankers believe its weighted average cost of capital would be 10%.What would its stock price be if it changes to the new capital structure?

Accepted Answer

A)  $40 
B)  $48 
C)  $52 
D)  $54 
E)  $60 
A)  $40 
B)  $48 
C)  $52 
D)  $54 
E)  $60

Question 7

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Accepted Answer

A) True 
 B)False

Question 8

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 9

Based on the information below for Benson Corporation,what is the optimal capital structure?

Accepted Answer

A)  Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. 
B)  Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. 
C)  Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. 
D)  Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. 
E)  Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. 
A)  Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. 
B)  Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. 
C)  Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. 
D)  Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. 
E)  Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)  Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. 
B)  Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. 
C)  Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. 
D)  Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital. 
E)  Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry. 
A)  Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. 
B)  Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels. 
C)  Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. 
D)  Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital. 
E)  Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.

Question 11

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 12

Which of these items will not generally be affected by an increase in the debt ratio?

Accepted Answer

A)  Total risk. 
B)  Financial risk. 
C)  Market risk. 
D)  The firm's beta. 
E)  Business risk. 
A)  Total risk. 
B)  Financial risk. 
C)  Market risk. 
D)  The firm's beta. 
E)  Business risk.

Question 13

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 14

Which of the following statements is CORRECT,holding other things constant?

Accepted Answer

A)  An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. 
B)  If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. 
C)  An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. 
D)  An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. 
E)  Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt. 
A)  An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. 
B)  If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. 
C)  An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. 
D)  An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. 
E)  Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

Question 15

Hernandez Corporation expects to have the following data during the coming year.What is Hernandez's expected ROE? $\begin{array}{l}
\begin{array}{lrl}
\text { Assets } & \$ 200,000 & \text { Interest rate }&8 \% \
\text { D/A } & 65 \% & \text { Tax rate } &40 \%\
\text { EBIT } & \$ 25,000 &
\end{array}\

\end{array}$

Accepted Answer

A)  12.51% 
B)  13.14% 
C)  13.80% 
D)  14.49% 
E)  15.21% 
A)  12.51% 
B)  13.14% 
C)  13.80% 
D)  14.49% 
E)  15.21%

Question 16

Firms U and L both have a basic earning power ratio of 20% 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 a before-tax cost of 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 17

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 18

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

Accepted Answer

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

Question 19

Which of the following statements is CORRECT?

Accepted Answer

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

Question 20

If debt financing is used,which of the following is CORRECT?

Accepted Answer

A)  The percentage change in net operating income will be equal to a given percentage change in net income. 
B)  The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. 
C)  The percentage change in net income will be greater than the percentage change in net operating income. 
D)  The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. 
E)  The percentage change in net operating income will be greater than a given percentage change in net income. 
A)  The percentage change in net operating income will be equal to a given percentage change in net income. 
B)  The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. 
C)  The percentage change in net income will be greater than the percentage change in net operating income. 
D)  The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. 
E)  The percentage change in net operating income will be greater than a given percentage change in net income.

Exam 15: Capital Structure Decisions

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.

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 ____.

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

Provided a firm does not use an extreme amount of debt,financial leverage typically affects both EPS and EBIT,while operating leverage only affects EBIT.

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

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.

Based on the information below for Benson Corporation,what is the optimal capital structure?

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.

Which of these items will not generally be affected by an increase in the debt ratio?

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?

Which of the following statements is CORRECT,holding other things constant?

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 40\% EBIT \ 25,000

Which of the following statements is CORRECT?

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

Which of the following statements is CORRECT?

If debt financing is used,which of the following is CORRECT?

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

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