Question 1

MM proposition I states that a firm's value is unaffected by its:

Accepted Answer

A)  required rate of return on equity. 
B)  operating income, in the absence of taxes. 
C)  interest rate paid on debt. 
D) mixture of debt and equity. 
A)  required rate of return on equity. 
B)  operating income, in the absence of taxes. 
C)  interest rate paid on debt. 
D) mixture of debt and equity.

Question 2

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

Accepted Answer

A) True 
 B)False

Question 3

An all-equity firm as operating income of $1.5 million and EPS of $2. If you ignore taxes, and if $1 million of 20% debt were issued with the proceeds used to repurchase two-thirds of the outstanding shares of stock, then the firm's EPS would:

Accepted Answer

A)  increase to $4.80. 
B)  decrease to $3.00. 
C)  decrease to $2.60. 
D) increase to $5.20. 
A)  increase to $4.80. 
B)  decrease to $3.00. 
C)  decrease to $2.60. 
D) increase to $5.20.

Question 4

Discuss the trade-off theory of capital structure, including the determination of an optimal debt level.

Accepted Answer

The trade-off theory of capital structur

Question 5

Leverage will _____ shareholders' expected return and ______ their risk.

Accepted Answer

A)  increase; decrease 
B)  decrease; increase 
C)  increase; increase 
D) increase; do nothing to 
A)  increase; decrease 
B)  decrease; increase 
C)  increase; increase 
D) increase; do nothing to

Question 6

When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because:

Accepted Answer

A)  the firm's beta is now negative. 
B)  taxes are no longer a concern. 
C)  the interest tax shield will cover the loan costs. 
D) the lender bears all the risk. 
A)  the firm's beta is now negative. 
B)  taxes are no longer a concern. 
C)  the interest tax shield will cover the loan costs. 
D) the lender bears all the risk.

Question 7

What is the maximum rate that can be paid on debt and maintain a WACC of 14% with an expected return on equity of 19% in a firm with a debt-to-asset ratio of 60%? Ignore taxes.

Accepted Answer

A)  6.50% 
B)  9.90% 
C)  10.67% 
D) 11.14% 
A)  6.50% 
B)  9.90% 
C)  10.67% 
D) 11.14%

Question 8

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 9

Those who benefit from the interest tax shield are:

Accepted Answer

A)  debtholders. 
B)  equityholders. 
C)  both debtholders and equityholders. 
D) only the firm's customers. 
A)  debtholders. 
B)  equityholders. 
C)  both debtholders and equityholders. 
D) only the firm's customers.

Question 10

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 11

Determine the expected return on equity for a firm with a WACC of 12%, $500,000 in 9% debt, and $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 that with no taxes the expected r

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

Equity Inc., is currently an all-equity 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 14

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 15

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

Accepted Answer

A) True 
 B)False

Question 16

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity.

Accepted Answer

A) True 
 B)False

Question 17

According to MM, if individuals cannot obtain the same borrowing terms as firms, then:

Accepted Answer

A)  capital structure may be relevant. 
B)  capital structure may be irrelevant. 
C)  individuals should not invest in levered firms. 
D) firms should increase their payments to individuals. 
A)  capital structure may be relevant. 
B)  capital structure may be irrelevant. 
C)  individuals should not invest in levered firms. 
D) firms should increase their payments to individuals.

Question 18

With risky debt and MM II, the expected return on assets _____ as the debt-equity ratio _____.

Accepted Answer

A)  increases; increases 
B)  decreases; increases 
C)  increases; decreases 
D) remains constant; increases 
A)  increases; increases 
B)  decreases; increases 
C)  increases; decreases 
D) remains constant; increases

Question 19

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

Accepted Answer

A)  minimizes the financial distress costs. 
B)  maximizes the present value of the interest tax shield. 
C)  equates the present values of the interest tax shield and the financial distress costs. 
D) maximizes the after-tax cash flows that are internally generated. 
A)  minimizes the financial distress costs. 
B)  maximizes the present value of the interest tax shield. 
C)  equates the present values of the interest tax shield and the financial distress costs. 
D) maximizes the after-tax cash flows that are internally generated.

Question 20

What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio?

Accepted Answer

A)  18.75% 
B)  20.00% 
C)  23.75% 
D) 26.25% 
A)  18.75% 
B)  20.00% 
C)  23.75% 
D) 26.25%

Exam 16: Debt Policy

MM proposition I states that a firm's value is unaffected by its:

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

An all-equity firm as operating income of $1.5 million and EPS of $2. If you ignore taxes, and if $1 million of 20% debt were issued with the proceeds used to repurchase two-thirds of the outstanding shares of stock, then the firm's EPS would:

Discuss the trade-off theory of capital structure, including the determination of an optimal debt level.

Leverage will _____ shareholders' expected return and ______ their risk.

When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because:

What is the maximum rate that can be paid on debt and maintain a WACC of 14% with an expected return on equity of 19% in a firm with a debt-to-asset ratio of 60%? Ignore taxes.

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

Those who benefit from the interest tax shield are:

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, and $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?

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

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

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

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment, debt is no cheaper than equity.

According to MM, if individuals cannot obtain the same borrowing terms as firms, then:

With risky debt and MM II, the expected return on assets _____ as the debt-equity ratio _____.

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

What is the return on equity for a firm with a return on assets of 15%, a return on debt of 10%, and a 0.75 debt-equity ratio?

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

Filters

Leverage will _ shareholders' expected return and __ their risk.

With risky debt and MM II, the expected return on assets _ as the debt-equity ratio _.