Question 1

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 30% of assets?

Accepted Answer

A)  16.14% 
B)  17.00% 
C)  19.00% 
D)  25.67% 
A)  16.14% 
B)  17.00% 
C)  19.00% 
D)  25.67%

Question 2

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 3

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

Accepted Answer

A) True 
 B)False

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

When large firms file for bankruptcy,they usually do so under an arrangement called:

Accepted Answer

A)  Chapter 9. 
B)  Chapter 11. 
C)  Chapter 13. 
D)  Chapter 14. 
A)  Chapter 9. 
B)  Chapter 11. 
C)  Chapter 13. 
D)  Chapter 14.

Question 6

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 7

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 8

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 9

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

Accepted Answer

A) True 
 B)False

Question 10

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

Accepted Answer

A) True 
 B)False

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

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 decrease to $10.00. 
B)  EPS decrease to $11.67. 
C)  EPS increase to $15.00. 
D)  EPS increase to $22.50. 
A)  EPS decrease to $10.00. 
B)  EPS decrease to $11.67. 
C)  EPS increase to $15.00. 
D)  EPS increase to $22.50.

Question 13

Debt financing does not affect the operating risk but it does add financial risk.For example,when there is only half the equity to absorb the same amount of operating risk,risk per share must double.

Accepted Answer

A) True 
 B)False

Question 14

What can be promised by loan covenants? What cannot be ensured by loan covenants?

Accepted Answer

The company knows that lenders will dema

Question 15

Equity,Inc.is currently an all-equity-financed 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 16

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%

Question 17

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 18

A firm has an expected return on equity of 16% and an after-tax cost of debt of 8%.What debt-equity ratio should be used in order to keep the WACC at 12%?

Accepted Answer

A)  .50 
B)  .75 
C)  1.00 
D)  1.50 
A)  .50 
B)  .75 
C)  1.00 
D)  1.50

Question 19

Is there a rule for finding optimal capital structure?

Accepted Answer

There are no simple answers for capital

Question 20

Compared to other countries,the U.S.bankruptcy system is debtor-friendly.

Accepted Answer

A) True 
 B)False

Exam 16: Debt Policy

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 30% of assets?

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

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

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

When large firms file for bankruptcy,they usually do so under an arrangement called:

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

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

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

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

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

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?

Debt financing does not affect the operating risk but it does add financial risk.For example,when there is only half the equity to absorb the same amount of operating risk,risk per share must double.

What can be promised by loan covenants? What cannot be ensured by loan covenants?

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

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

A firm has an expected return on equity of 16% and an after-tax cost of debt of 8%.What debt-equity ratio should be used in order to keep the WACC at 12%?

Is there a rule for finding optimal capital structure?

Compared to other countries,the U.S.bankruptcy system is debtor-friendly.

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