Question 1

Is financial slack always valuable?

Accepted Answer

Increasing levels of financial slack may

Question 2

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

Accepted Answer

A)  12.83% 
B)  14.00% 
C)  14.40% 
D) 18.20% 
A)  12.83% 
B)  14.00% 
C)  14.40% 
D) 18.20%

Question 3

Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy.

Accepted Answer

A) True 
 B)False

Question 4

How much debt is outstanding in a firm that has calculated the present value of a perpetual tax shield to be $300,000 if the tax rate is 35% and the debt carries a 10% rate of return?

Accepted Answer

A)  $300,000 
B)  $857,143 
C)  $3,000,000 
D) $3,750,000 
A)  $300,000 
B)  $857,143 
C)  $3,000,000 
D) $3,750,000

Question 5

One advantage of debt financing over equity financing is the:

Accepted Answer

A)  tax-deductible dividends. 
B)  tax-deductible interest. 
C)  tax-deductible principal repayment. 
D) tax-free interest income. 
A)  tax-deductible dividends. 
B)  tax-deductible interest. 
C)  tax-deductible principal repayment. 
D) tax-free interest income.

Question 6

Which one of the following lists presents the order of financing from most preferred to least preferred according to the pecking-order theory?

Accepted Answer

A)  Debt issue, stock issue, internally generated funds 
B)  Internally generated funds, debt issue, stock issue 
C)  Stock issue, internally generated funds, debt issue 
D) Internally generated funds, stock issue, debt issue 
A)  Debt issue, stock issue, internally generated funds 
B)  Internally generated funds, debt issue, stock issue 
C)  Stock issue, internally generated funds, debt issue 
D) Internally generated funds, stock issue, debt issue

Question 7

Under MM II assumptions, the expected return on equity is equal to the expected return on assets for a levered firm.

Accepted Answer

A) True 
 B)False

Question 8

Show how leverage increases financial risk by calculating the EPS and return on shares for a firm with $1 million in 10% debt. The firm also has 50,000 shares outstanding that sell for $40 each. Three states of the economy are possible: a slump under which the firm would have operating income of $150,000, a normal state under which the firm will earn $420,000, and a boom under which the firm will earn $600,000. The firm pays no taxes.

Accepted Answer

The answer of Show how leverage increases financial risk by...

Question 9

What is the goal of the capital structure decision? What is the financial manager trying to achieve with this goal?

Accepted Answer

The goal is to maximize the overall mark

Question 10

Is there a rule for finding optimal capital structure?

Accepted Answer

There are no simple answers for capital

Question 11

Calculate the WACC for a firm with a debt-equity ratio of 1.5. The debt pays 10% interest and the equity is expected to return 16%. Assume a 35% tax rate and risk-free debt.

Accepted Answer

If D/E = 1.5, then debt = 60%

Question 12

A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%?

Accepted Answer

A)  $245,000 
B)  $700,000 
C)  $3,500,000 
D) $10,000,000 
A)  $245,000 
B)  $700,000 
C)  $3,500,000 
D) $10,000,000

Question 13

How do corporate income taxes modify MM's leverage irrelevance proposition?
D. Future interest tax shields are usually valued by discounting at the borrowing rate rdebt. In the special case of permanent debt,
PV tax shield = Tc(rdebt × D)/rdebt = TcD

Accepted Answer

Debt interest is a tax-deductible expens

Question 14

Debt finance does not affect the operating risk but it does add financial risk.

Accepted Answer

A) True 
 B)False

Question 15

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket?

Accepted Answer

A)  $126,000 
B)  $234,000 
C)  $360,000 
D) $1,050,000 
A)  $126,000 
B)  $234,000 
C)  $360,000 
D) $1,050,000

Question 16

According to MM, an increase in expected earnings per share can leave the share price unchanged if the:

Accepted Answer

A)  firm's operating risk decreases. 
B)  number of shares is decreased. 
C)  required return on equity increases. 
D) firm has no financial leverage. 
A)  firm's operating risk decreases. 
B)  number of shares is decreased. 
C)  required return on equity increases. 
D) firm has no financial leverage.

Question 17

Financial risk is the risk to shareholders that results from debt financing.

Accepted Answer

A) True 
 B)False

Question 18

Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital structure.

Accepted Answer

A)  $35,000 
B)  $70,000 
C)  $350,000 
D) $700,000 
A)  $35,000 
B)  $70,000 
C)  $350,000 
D) $700,000

Question 19

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure.

Accepted Answer

A) True 
 B)False

Question 20

Debt financing affects neither the business risk nor the financial risk of the firm.

Accepted Answer

A) True 
 B)False

Exam 16: Debt Policy

Is financial slack always valuable?

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

Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy.

How much debt is outstanding in a firm that has calculated the present value of a perpetual tax shield to be $300,000 if the tax rate is 35% and the debt carries a 10% rate of return?

One advantage of debt financing over equity financing is the:

Which one of the following lists presents the order of financing from most preferred to least preferred according to the pecking-order theory?

Under MM II assumptions, the expected return on equity is equal to the expected return on assets for a levered firm.

What is the goal of the capital structure decision? What is the financial manager trying to achieve with this goal?

Is there a rule for finding optimal capital structure?

Calculate the WACC for a firm with a debt-equity ratio of 1.5. The debt pays 10% interest and the equity is expected to return 16%. Assume a 35% tax rate and risk-free debt.

A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the tax rate is 35%?

How do corporate income taxes modify MM's leverage irrelevance proposition? D. Future interest tax shields are usually valued by discounting at the borrowing rate rdebt. In the special case of permanent debt, PV tax shield = Tc(rdebt × D)/rdebt = TcD

Debt finance does not affect the operating risk but it does add financial risk.

What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in the 35% tax bracket?

According to MM, an increase in expected earnings per share can leave the share price unchanged if the:

Financial risk is the risk to shareholders that results from debt financing.

Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital structure.

When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure.

Debt financing affects neither the business risk nor the financial risk of the firm.

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

How do corporate income taxes modify MM's leverage irrelevance proposition? D. Future interest tax shields are usually valued by discounting at the borrowing rate r_debt. In the special case of permanent debt, PV tax shield = T_c(r_debt × D)/r_debt = T_cD