Question 1

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 2

A firm with a debt equity ratio of 1/2, return on assets of 15%, and return on debt of 10% will have return on equity of:

Accepted Answer

A) 15.00% 
B) 16.67% 
C) 20.00% 
D) 21.17% requity = 0.15 + 1/3(0.15 - 0.10) 
A) 15.00% 
B) 16.67% 
C) 20.00% 
D) 21.17% requity = 0.15 + 1/3(0.15 - 0.10)

Question 3

The "trade-off theory" of capital structure suggests that:

Accepted Answer

A) Firms add leverage whenever interest rates are low 
B) Firms with higher risk should use less debt 
C) Firms should use 50% debt and 50% equity 
D) Firms should use debt to overcome high par values of stock 
A) Firms add leverage whenever interest rates are low 
B) Firms with higher risk should use less debt 
C) Firms should use 50% debt and 50% equity 
D) Firms should use debt to overcome high par values of stock

Question 4

Even after relaxing the MM assumption of no taxes, it can be observed that restructuring does not affect the value of the firm.

Accepted Answer

A) True 
 B)False

Question 5

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.Assuming that individuals have the same borrowing opportunities as corporations, explain how an investor can undo the leverage that is proposed by Equity Inc.Under these conditions, what is the value of restructuring to a firm?

Accepted Answer

Since Equity Inc.will have a debt ratio

Question 6

At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the tax shield for a firm.

Accepted Answer

A) True 
 B)False

Question 7

Management's perceived signals to investors form an important component of pecking-order theory.

Accepted Answer

A) True 
 B)False

Question 8

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 70% of assets?

Accepted Answer

A) 16.14% 
B) 17.00% 
C) 19.00% 
D) 25.67% Expected return on equity = Expected return on assets + 
A) 16.14% 
B) 17.00% 
C) 19.00% 
D) 25.67% Expected return on equity = Expected return on assets +

Question 9

With a tax rate of 35%, calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, and finances 45% of assets with debt.

Accepted Answer

A) 12.83% 
B) 14.00% 
C) 14.40% 
D) 18.20% WACC =
= )65(.10)(.45) + .18(.55)
= )0293 + .099 
A) 12.83% 
B) 14.00% 
C) 14.40% 
D) 18.20% WACC =
= )65(.10)(.45) + .18(.55)
= )0293 + .099

Question 10

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 11

The optimal capital structure is met when:

Accepted Answer

A) Additional borrowing results in lower financial distress costs 
B) Additional borrowing is offset by the interest tax shield 
C) The tax savings from additional leverage is just offset by the costs of distress 
D) The present value of the tax shield is greater than the value of an all-equity financed firm 
A) Additional borrowing results in lower financial distress costs 
B) Additional borrowing is offset by the interest tax shield 
C) The tax savings from additional leverage is just offset by the costs of distress 
D) The present value of the tax shield is greater than the value of an all-equity financed firm

Question 12

A firm is currently expected to develop $2 EPS when operating income equals $4 million and interest expense equals $2 million.How low can operating income drop before EPS is reduced by half, to $1? Ignore taxes.

Accepted Answer

A) Operating income drops to $3.5 million 
B) Operating income drops to $3.0 million 
C) Operating income drops to $2.5 million 
D) Operating income drops to $2.0 million 
A) Operating income drops to $3.5 million 
B) Operating income drops to $3.0 million 
C) Operating income drops to $2.5 million 
D) Operating income drops to $2.0 million

Question 13

The present value of the costs of financial distress increases with increases in the debt ratio because the:

Accepted Answer

A) Expected return on assets increases 
B) Present value of the interest tax shield is greater 
C) Equity tax shield is depleted 
D) Probability of default and/or bankruptcy is greater 
A) Expected return on assets increases 
B) Present value of the interest tax shield is greater 
C) Equity tax shield is depleted 
D) Probability of default and/or bankruptcy is greater

Question 14

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount, i.e., $5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes, this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

Accepted Answer

A) EPS decrease to $10.00 
B) EPS decrease to $11.67 
C) EPS increase to $15.00 
D) EPS increase to $42.50 
A) EPS decrease to $10.00 
B) EPS decrease to $11.67 
C) EPS increase to $15.00 
D) EPS increase to $42.50

Question 15

A firm's capital structure is represented by its mix of:

Accepted Answer

A) Assets 
B) Liabilities and equity 
C) Assets and liabilities 
D) Assets, liabilities and equity 
A) Assets 
B) Liabilities and equity 
C) Assets and liabilities 
D) Assets, liabilities and equity

Question 16

If the value of a levered firm is $4,000,000, then the value of the same firm yet all-equity financed is:

Accepted Answer

A) $3,000,000 
B) $4,500,000 
C) $5,500,000 
D) $6,000,000 
A) $3,000,000 
B) $4,500,000 
C) $5,500,000 
D) $6,000,000

Question 17

In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the:

Accepted Answer

A) Firm uses no debt in its capital structure 
B) Firm uses no equity in its capital structure 
C) Firm uses a debt-equity ratio of 1.0 
D) Corporate tax rate approaches 100% 
A) Firm uses no debt in its capital structure 
B) Firm uses no equity in its capital structure 
C) Firm uses a debt-equity ratio of 1.0 
D) Corporate tax rate approaches 100%

Question 18

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 19

The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.

Accepted Answer

A) True 
 B)False

Question 20

What can be promised by loan covenants? What cannot be ensured by loan covenants?

Accepted Answer

The company knows that lenders will dema

Exam 16: Debt Policy

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

A firm with a debt equity ratio of 1/2, return on assets of 15%, and return on debt of 10% will have return on equity of:

The "trade-off theory" of capital structure suggests that:

Even after relaxing the MM assumption of no taxes, it can be observed that restructuring does not affect the value of the firm.

At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the tax shield for a firm.

Management's perceived signals to investors form an important component of pecking-order theory.

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt, which totals 70% of assets?

With a tax rate of 35%, calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, and finances 45% of assets with debt.

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

The optimal capital structure is met when:

A firm is currently expected to develop $2 EPS when operating income equals $4 million and interest expense equals $2 million.How low can operating income drop before EPS is reduced by half, to $1? Ignore taxes.

The present value of the costs of financial distress increases with increases in the debt ratio because the:

A firm's capital structure is represented by its mix of:

If the value of a levered firm is $4,000,000, then the value of the same firm yet all-equity financed is:

In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the:

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?

The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.

What can be promised by loan covenants? What cannot be ensured by loan covenants?

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

Payout Policy

Long-Term Financial Planning

Short-Term Financial Planning

Working Capital Management

Mergers, Acquisitions, and Corporate Control

International Financial Management

Options

Risk Management

Conclusion

What We Do and Do Not Know About Finance

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