Question 1

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 2

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 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 decreases to $10.00. 
B)  EPS stays at $12.50. 
C)  EPS increases to $30.00. 
D) EPS increases to $42.50. 
A)  EPS decreases to $10.00. 
B)  EPS stays at $12.50. 
C)  EPS increases to $30.00. 
D) EPS increases to $42.50.

Question 3

Assume a firm is financed with 30% debt on which it pays 9%. What is the expected return on equity if the expected return on assets is 14%?

Accepted Answer

A)  16.14% 
B)  17.86% 
C)  14.92% 
D) 15.50% 
A)  16.14% 
B)  17.86% 
C)  14.92% 
D) 15.50%

Question 4

An increase in a corporation's tax rate will cause:

Accepted Answer

A)  an increase in an unlevered firm's return on assets. 
B)  a decrease in a levered firm's WACC. 
C)  an increase in a levered firm's cost of debt. 
D) a decrease in an unlevered firm's cost of equity. 
A)  an increase in an unlevered firm's return on assets. 
B)  a decrease in a levered firm's WACC. 
C)  an increase in a levered firm's cost of debt. 
D) a decrease in an unlevered firm's cost of equity.

Question 5

Identify the assumptions underlying the MM proposition that a firm's value is unaffected by the firm's capital structure.

Accepted Answer

M&M Proposition I without taxes is based

Question 6

When corporate taxes are considered, how does leverage affect the WACC?

Accepted Answer

A)  An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. 
B)  Changes in leverage will affect the WACC only if the interest rate on debt changes. 
C)  Increased leverage will increase the WACC. 
D) Increased leverage will decrease the WACC. 
A)  An increase in leverage will be offset by a decrease in equity financing, thus leaving WACC unchanged. 
B)  Changes in leverage will affect the WACC only if the interest rate on debt changes. 
C)  Increased leverage will increase the WACC. 
D) Increased leverage will decrease the WACC.

Question 7

Debt may be the preferred form of external financing for many firms because:

Accepted Answer

A)  most firms already have too much equity. 
B)  tax rates on equity are lower. 
C)  debt will not adversely affect the firm's financial ratios. 
D) equity issuance is considered by investors to be a negative sign. 
A)  most firms already have too much equity. 
B)  tax rates on equity are lower. 
C)  debt will not adversely affect the firm's financial ratios. 
D) equity issuance is considered by investors to be a negative sign.

Question 8

According to pecking-order theory, managers will often choose to finance with:

Accepted Answer

A)  new equity rather than debt, due to bankruptcy costs. 
B)  debt rather than new equity, to avoid reduced share price. 
C)  debt rather than retained earnings, to lower the WACC. 
D) new equity rather than debt, to strengthen EPS. 
A)  new equity rather than debt, due to bankruptcy costs. 
B)  debt rather than new equity, to avoid reduced share price. 
C)  debt rather than retained earnings, to lower the WACC. 
D) new equity rather than debt, to strengthen EPS.

Question 9

According to the trade-off theory, capital structure is a trade-off between:

Accepted Answer

A)  tangible and intangible asset risk. 
B)  high and low target debt ratios. 
C)  tax savings and financial distress costs. 
D) tax shields and equity financing. 
A)  tangible and intangible asset risk. 
B)  high and low target debt ratios. 
C)  tax savings and financial distress costs. 
D) tax shields and equity financing.

Question 10

Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and its WACC is 14%.

Accepted Answer

A)  14% 
B)  15% 
C)  16% 
D) 17% 
A)  14% 
B)  15% 
C)  16% 
D) 17%

Question 11

What happens when firms cannot pay their creditors?

Accepted Answer

A firm that cannot meet its obligations

Question 12

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 13

A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio should be used in order to keep the WACC at 12%?

Accepted Answer

A)  0.50 
B)  0.75 
C)  0.67 
D) 0.33 
A)  0.50 
B)  0.75 
C)  0.67 
D) 0.33

Question 14

MM's proposition I states that the required rate of return on equity increases as the firm's debt-equity ratio increases.

Accepted Answer

A) True 
 B)False

Question 15

A firm's business risk depends upon:

Accepted Answer

A)  its use of debt in the capital structure. 
B)  the risk of the firm's assets and operations. 
C)  the types of debt financing utilized. 
D) the costs of financial distress. 
A)  its use of debt in the capital structure. 
B)  the risk of the firm's assets and operations. 
C)  the types of debt financing utilized. 
D) the costs of financial distress.

Question 16

Financial slack means having ready access to cash or debt financing.

Accepted Answer

A) True 
 B)False

Question 17

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 18

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

Accepted Answer

A) True 
 B)False

Question 19

If a firm's expected return on equity equals its expected return on assets, then the:

Accepted Answer

A)  expected return on debt exceeds the expected return on assets. 
B)  likelihood of financial distress is high. 
C)  firm has too much debt. 
D) firm has no debt in its capital structure. 
A)  expected return on debt exceeds the expected return on assets. 
B)  likelihood of financial distress is high. 
C)  firm has too much debt. 
D) firm has no debt in its capital structure.

Question 20

What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt?

Accepted Answer

A)  5.25% 
B)  9.75% 
C)  12.17% 
D) 20.25% 
A)  5.25% 
B)  9.75% 
C)  12.17% 
D) 20.25%

Exam 16: Debt Policy

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

Assume a firm is financed with 30% debt on which it pays 9%. What is the expected return on equity if the expected return on assets is 14%?

An increase in a corporation's tax rate will cause:

Identify the assumptions underlying the MM proposition that a firm's value is unaffected by the firm's capital structure.

When corporate taxes are considered, how does leverage affect the WACC?

Debt may be the preferred form of external financing for many firms because:

According to pecking-order theory, managers will often choose to finance with:

According to the trade-off theory, capital structure is a trade-off between:

Calculate the firm's expected return on its assets if its expected return on debt is 10%, its expected return on equity is 20%, and its WACC is 14%.

What happens when firms cannot pay their creditors?

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

A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio should be used in order to keep the WACC at 12%?

MM's proposition I states that the required rate of return on equity increases as the firm's debt-equity ratio increases.

A firm's business risk depends upon:

Financial slack means having ready access to cash or debt financing.

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

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

If a firm's expected return on equity equals its expected return on assets, then the:

What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt?

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Measuring Corporate Performance

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Using Discounted Cash-Flow Analysis to Make Investment Decisions

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Introduction to Corporate Financing

How Corporations Raise Venture Capital and Issue Securities

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