Question 1

Which one of these is not an underlying assumption of MM Proposition I?

Accepted Answer

A)  Capital markets function well. 
B)  Investors can borrow or lend on the same terms as firms. 
C)  Taxes remain at their current non-zero levels. 
D) Securities are fairly priced. 
A)  Capital markets function well. 
B)  Investors can borrow or lend on the same terms as firms. 
C)  Taxes remain at their current non-zero levels. 
D) Securities are fairly priced. C

Question 2

A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of:

Accepted Answer

A)  15.25%. 
B)  16.00%. 
C)  17.00%. 
D) 17.33%. 
A)  15.25%. 
B)  16.00%. 
C)  17.00%. 
D) 17.33%. C

Question 3

When debt is risky under MM II:

Accepted Answer

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

Question 4

The possibility of bankruptcy will do all of the following except:

Accepted Answer

A)  increase financial distress costs. 
B)  reduce the current market value of the firm. 
C)  reduce the interest rate on debt. 
D) reduce the possible payoff to stockholders. 
A)  increase financial distress costs. 
B)  reduce the current market value of the firm. 
C)  reduce the interest rate on debt. 
D) reduce the possible payoff to stockholders.

Question 5

Financial risk refers to the:

Accepted Answer

A)  risk of owning equity securities. 
B)  risk faced by equityholders of firms with debt. 
C)  general business risk of the firm. 
D) possibility that interest rates will increase. 
A)  risk of owning equity securities. 
B)  risk faced by equityholders of firms with debt. 
C)  general business risk of the firm. 
D) possibility that interest rates will increase.

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

Explain the pecking-order theory of capital structure. How might this affect the optimal capital structure for a firm?

Accepted Answer

The pecking-order theory says that firms

Question 8

The interest tax shield is equal to the:

Accepted Answer

A)  difference between the interest expense and income taxes. 
B)  amount of interest paid in a given year. 
C)  product of the interest expense and the tax rate. 
D) product of the debt principal and the interest rate on debt. 
A)  difference between the interest expense and income taxes. 
B)  amount of interest paid in a given year. 
C)  product of the interest expense and the tax rate. 
D) product of the debt principal and the interest rate on debt.

Question 9

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 . 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 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?

Accepted Answer

A)  EPS decreases to $10.00. 
B)  EPS decreases to $11.67. 
C)  EPS increases to $15.00. 
D) EPS increases to $22.50. 
A)  EPS decreases to $10.00. 
B)  EPS decreases to $11.67. 
C)  EPS increases to $15.00. 
D) EPS increases to $22.50.

Question 10

The pecking-order theory of capital structure depicts the fact that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Accepted Answer

A) True 
 B)False

Question 11

Debt usage will have an effect on:

Accepted Answer

A)  business risk. 
B)  financial risk. 
C)  operating risk. 
D) asset risk. 
A)  business risk. 
B)  financial risk. 
C)  operating risk. 
D) asset risk.

Question 12

The reason that financial leverage increases shareholder risk is that there is:

Accepted Answer

A)  more debt which increases the operating risk. 
B)  less equity to absorb the operating risk. 
C)  less business risk to be spread around. 
D) more financial risk due to reduced business risk. 
A)  more debt which increases the operating risk. 
B)  less equity to absorb the operating risk. 
C)  less business risk to be spread around. 
D) more financial risk due to reduced business risk.

Question 13

Although the value of an increase in the interest tax shield may be positive, firms are most apt to restrict borrowing if the:

Accepted Answer

A)  return on the financed project is too high. 
B)  firm's asset base is largely intangible. 
C)  firm's asset beta is zero. 
D) increased debt decreases the firm's WACC. 
A)  return on the financed project is too high. 
B)  firm's asset base is largely intangible. 
C)  firm's asset beta is zero. 
D) increased debt decreases the firm's WACC.

Question 14

According to MM, restructuring the firm will not change its overall value.

Accepted Answer

A) True 
 B)False

Question 15

The optimal capital structure occurs 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 are offset by the increased costs of distress. 
D) the present value of the tax shield exceeds the value of the 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 are offset by the increased costs of distress. 
D) the present value of the tax shield exceeds the value of the all-equity-financed firm.

Question 16

Which one of the following is a safe assumption for a firm in which the PV of the tax shield is approximately equal to the PV of the financial distress costs?

Accepted Answer

A)  The tax shield has been calculated incorrectly. 
B)  The firm is too heavily levered. 
C)  The firm has reached its optimal debt level. 
D) The firm appears to have a low risk of financial distress. 
A)  The tax shield has been calculated incorrectly. 
B)  The firm is too heavily levered. 
C)  The firm has reached its optimal debt level. 
D) The firm appears to have a low risk of financial distress.

Question 17

Discuss how agency problems can develop between shareholders and bondholders when the firm is experiencing financial distress.

Accepted Answer

Managers/owners may not have the proper

Question 18

The pecking-order theory suggests that less profitable firms borrow more because:

Accepted Answer

A)  equity issues are more expensive. 
B)  leverage is preferred over raising funds internally. 
C)  debt issues are good omens. 
D) they have insufficient internal funds. 
A)  equity issues are more expensive. 
B)  leverage is preferred over raising funds internally. 
C)  debt issues are good omens. 
D) they have insufficient internal funds.

Question 19

When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value.

Accepted Answer

A) True 
 B)False

Question 20

The benefit of an interest tax shield is captured by the equity holders.

Accepted Answer

A) True 
 B)False

Exam 16: Debt Policy

Which one of these is not an underlying assumption of MM Proposition I?

A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%, will have a return on equity of:

When debt is risky under MM II:

The possibility of bankruptcy will do all of the following except:

Financial risk refers to the:

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

Explain the pecking-order theory of capital structure. How might this affect the optimal capital structure for a firm?

The interest tax shield is equal to the:

The pecking-order theory of capital structure depicts the fact that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Debt usage will have an effect on:

The reason that financial leverage increases shareholder risk is that there is:

Although the value of an increase in the interest tax shield may be positive, firms are most apt to restrict borrowing if the:

According to MM, restructuring the firm will not change its overall value.

The optimal capital structure occurs when:

Which one of the following is a safe assumption for a firm in which the PV of the tax shield is approximately equal to the PV of the financial distress costs?

Discuss how agency problems can develop between shareholders and bondholders when the firm is experiencing financial distress.

The pecking-order theory suggests that less profitable firms borrow more because:

When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress begin to take a substantial bite out of firm value.

The benefit of an interest tax shield is captured by the equity holders.

Goals and Governance of the Corporation

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

How Corporations Raise Venture Capital and Issue Securities

Payout Policy

Long-Term Financial Planning

Short-Term Financial Planning

Working Capital Management

Mergers, Acquisitions, and Corporate Control

International Financial Management

Options

Risk Management

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