Question 1

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones.

Accepted Answer

A) True 
 B)False

Question 2

According to MM II, as a firm's debt-equity ratio decreases:

Accepted Answer

A)  its financial risk increases. 
B)  its operating risk increases. 
C)  the required rate of return on equity increases. 
D) the required rate of return on equity decreases. 
A)  its financial risk increases. 
B)  its operating risk increases. 
C)  the required rate of return on equity increases. 
D) the required rate of return on equity decreases.

Question 3

A 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 operating income increases to $2.0 million?

Accepted Answer

A)  EPS increases to $15.63. 
B)  EPS increases to $16.67. 
C)  EPS increases to $17.50. 
D) EPS increases to $20.00. 
A)  EPS increases to $15.63. 
B)  EPS increases to $16.67. 
C)  EPS increases to $17.50. 
D) EPS increases to $20.00.

Question 4

The stability of a firm's operating income is the focus of:

Accepted Answer

A)  financial leverage. 
B)  the weighted-average cost of capital. 
C)  capital structure. 
D) business risk. 
A)  financial leverage. 
B)  the weighted-average cost of capital. 
C)  capital structure. 
D) business risk.

Question 5

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate.

Accepted Answer

A) True 
 B)False

Question 6

If the present value of the interest tax shield equals the present value of the costs of financial distress, then the:

Accepted Answer

A)  firm is using the optimal level of debt. 
B)  firm is paying too high an interest rate. 
C)  firm's market value equals its book value. 
D) firm should increase its use of debt. 
A)  firm is using the optimal level of debt. 
B)  firm is paying too high an interest rate. 
C)  firm's market value equals its book value. 
D) firm should increase its use of debt.

Question 7

Which one of the following statements is false regarding MM's proposition I?

Accepted Answer

A)  Firm value is unaffected by the firm's capital structure. 
B)  Proposition I is also called the debt-irrelevance proposition. 
C)  Shareholders should care about the firm's debt policy. 
D) After restructuring, the firm's value should be the same as it was prior to restructuring. 
A)  Firm value is unaffected by the firm's capital structure. 
B)  Proposition I is also called the debt-irrelevance proposition. 
C)  Shareholders should care about the firm's debt policy. 
D) After restructuring, the firm's value should be the same as it was prior to restructuring.

Question 8

When a corporation issues permanent debt, the value of all its securities:

Accepted Answer

A)  increases by the present value of the tax shield. 
B)  decreases by the present value of the tax shield. 
C)  increases by the annual interest tax shield. 
D) decreases by the annual interest tax shield. 
A)  increases by the present value of the tax shield. 
B)  decreases by the present value of the tax shield. 
C)  increases by the annual interest tax shield. 
D) decreases by the annual interest tax shield.

Question 9

As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches:

Accepted Answer

A)  the expected return on debt. 
B)  the expected return on assets. 
C)  its maximum. 
D) zero. 
A)  the expected return on debt. 
B)  the expected return on assets. 
C)  its maximum. 
D) zero.

Question 10

Which one of these statements correctly applies to an unlevered firm that pays no taxes?

Accepted Answer

A)  The return on equity exceeds the WACC. 
B)  The return on assets equals the return on equity and also equals WACC. 
C)  The return on assets equals the return on equity and exceeds WACC. 
D) The return on equity equals WACC and exceeds the return on assets. 
A)  The return on equity exceeds the WACC. 
B)  The return on assets equals the return on equity and also equals WACC. 
C)  The return on assets equals the return on equity and exceeds WACC. 
D) The return on equity equals WACC and exceeds the return on assets.

Question 11

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

Accepted Answer

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

Question 12

Which one of the following would not be expected to change with changes in the firm's capital structure?

Accepted Answer

A)  Weighted-average cost of capital 
B)  Expected return on equity 
C)  Expected return on assets 
D) Expected earnings per share 
A)  Weighted-average cost of capital 
B)  Expected return on equity 
C)  Expected return on assets 
D) Expected earnings per share

Question 13

What is the expected rate of return to equityholders if the firm has a tax rate of 35%, an interest rate on debt of 10%, a WACC of 15%, and a debt-asset ratio of 60%?

Accepted Answer

A)  12.50% 
B)  21.25% 
C)  22.50% 
D) 27.75% 
A)  12.50% 
B)  21.25% 
C)  22.50% 
D) 27.75%

Question 14

MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases.

Accepted Answer

A) True 
 B)False

Question 15

The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them.

Accepted Answer

A) True 
 B)False

Question 16

An increase in a firm's financial leverage will:

Accepted Answer

A)  increase the variability in earnings per share. 
B)  always reduce the operating risk of the firm. 
C)  increase the value of the firm in a non-MM world. 
D) increase the WACC. 
A)  increase the variability in earnings per share. 
B)  always reduce the operating risk of the firm. 
C)  increase the value of the firm in a non-MM world. 
D) increase the WACC.

Question 17

Any financial benefit derived from the interest tax shield accrues to the:

Accepted Answer

A)  bondholders. 
B)  shareholders. 
C)  bondholders and shareholders, equally. 
D) shareholders and the federal government. 
A)  bondholders. 
B)  shareholders. 
C)  bondholders and shareholders, equally. 
D) shareholders and the federal government.

Question 18

Restructuring a firm involves changing the:

Accepted Answer

A)  mix of liabilities and equity. 
B)  dividend payout policy. 
C)  managerial personnel. 
D) types of production equipment utilized. 
A)  mix of liabilities and equity. 
B)  dividend payout policy. 
C)  managerial personnel. 
D) types of production equipment utilized.

Question 19

MM Proposition I without taxes states that:

Accepted Answer

A)  firms should be all-equity financed to maximize shareholder value. 
B)  shareholders are unaffected by the debt policy of the firm. 
C)  shareholders are indifferent to a firm's value. 
D) shareholders prefer to invest in all-equity firms. 
A)  firms should be all-equity financed to maximize shareholder value. 
B)  shareholders are unaffected by the debt policy of the firm. 
C)  shareholders are indifferent to a firm's value. 
D) shareholders prefer to invest in all-equity firms.

Question 20

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. 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

@#IMG-DLM& Since Equity Inc., will have a debt rat

Exam 16: Debt Policy

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones.

According to MM II, as a firm's debt-equity ratio decreases:

A 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 operating income increases to $2.0 million?

The stability of a firm's operating income is the focus of:

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate.

If the present value of the interest tax shield equals the present value of the costs of financial distress, then the:

Which one of the following statements is false regarding MM's proposition I?

When a corporation issues permanent debt, the value of all its securities:

As a firm's debt-equity ratio approaches zero, the firm's expected return on equity approaches:

Which one of these statements correctly applies to an unlevered firm that pays no taxes?

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

Which one of the following would not be expected to change with changes in the firm's capital structure?

What is the expected rate of return to equityholders if the firm has a tax rate of 35%, an interest rate on debt of 10%, a WACC of 15%, and a debt-asset ratio of 60%?

MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases.

The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them.

An increase in a firm's financial leverage will:

Any financial benefit derived from the interest tax shield accrues to the:

Restructuring a firm involves changing the:

MM Proposition I without taxes states that:

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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