Question 1

According to MM Proposition 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 2

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 3

A firm has a WACC of 14%,an expected return on equity of 19%,and a debt-to-asset ratio of 60%.If the firm does not pay tax,what is the interest rate on the debt?

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 4

When a corporation issues permanent debt,its value:

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 5

MM's proposition II without taxes states that the:

Accepted Answer

A)  expected return on equity increases as financial leverage increases. 
B)  expected return on assets decreases as expected return on debt decreases. 
C)  firm's capital structure is irrelevant to the firm's overall value. 
D)  greater the proportion of equity, the higher the expected return on debt. 
A)  expected return on equity increases as financial leverage increases. 
B)  expected return on assets decreases as expected return on debt decreases. 
C)  firm's capital structure is irrelevant to the firm's overall value. 
D)  greater the proportion of equity, the higher the expected return on debt.

Question 6

If the present value of the interest tax shield on debt equals the present value of the costs of financial distress,then the trade-off theory implies that 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

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 8

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.If the firm does not pay tax,what will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt?

Accepted Answer

A)  EPS decreases by 33.3% to $10.00. 
B)  EPS decreases by 6.7% to $11.67. 
C)  EPS increases by 20% to $15.00. 
D)  EPS increases by 80% to $22.50. 
A)  EPS decreases by 33.3% to $10.00. 
B)  EPS decreases by 6.7% to $11.67. 
C)  EPS increases by 20% to $15.00. 
D)  EPS increases by 80% to $22.50.

Question 9

Which of the following pair of firms do you think should be more highly levered: A taxpaying company,or a company with large tax loss carry-forwards?

Accepted Answer

The taxpay

Question 10

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 11

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

Accepted Answer

A) True 
 B)False

Question 12

A firm currently has operating income of $4 million,interest expense of $2 million,and EPS of $2.How low can operating income drop before EPS are reduced by half,to $1? Ignore taxes.

Accepted Answer

A)  $3.5 million 
B)  $3.0 million 
C)  $2.5 million 
D)  $2.0 million 
A)  $3.5 million 
B)  $3.0 million 
C)  $2.5 million 
D)  $2.0 million

Question 13

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 14

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 15

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

Accepted Answer

A) True 
 B)False

Question 16

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

Accepted Answer

A) True 
 B)False

Question 17

The possibility of bankruptcy will do all of the following except:

Accepted Answer

A)  increase financial distress costs. 
B)  reduce the current market value of the firm. 
C)  reduce the interest rate on debt. 
D)  reduce the possible payoff to stockholders. 
A)  increase financial distress costs. 
B)  reduce the current market value of the firm. 
C)  reduce the interest rate on debt. 
D)  reduce the possible payoff to stockholders.

Question 18

An all-equity firm has 1 million shares outstanding with a market value of $10 million.It does not pay tax and has an operating income of $1.5 million.If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock,then the firm's EPS:

Accepted Answer

A)  increasesby 20% to $1.80. 
B)  decreasesby 40%to $0.9. 
C)  decreases by 20% to $1.20. 
D)  increasesby 8.3% to $1.63. 
A)  increasesby 20% to $1.80. 
B)  decreasesby 40%to $0.9. 
C)  decreases by 20% to $1.20. 
D)  increasesby 8.3% to $1.63.

Question 19

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 20

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.

Exam 16: Debt Policy

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

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

A firm has a WACC of 14%,an expected return on equity of 19%,and a debt-to-asset ratio of 60%.If the firm does not pay tax,what is the interest rate on the debt?

When a corporation issues permanent debt,its value:

MM's proposition II without taxes states that the:

If the present value of the interest tax shield on debt equals the present value of the costs of financial distress,then the trade-off theory implies that the:

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

Which of the following pair of firms do you think should be more highly levered: A taxpaying company,or a company with large tax loss carry-forwards?

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.

A firm currently has operating income of $4 million,interest expense of $2 million,and EPS of $2.How low can operating income drop before EPS are reduced by half,to $1? Ignore taxes.

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.

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.

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

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

The possibility of bankruptcy will do all of the following except:

An all-equity firm has 1 million shares outstanding with a market value of $10 million.It does not pay tax and has an operating income of $1.5 million.If $2 million of 10% debt is issued and the proceeds used to repurchase shares of stock,then the firm's EPS:

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

MM Proposition I without taxes states that:

Goals and Governance of the Firm

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 and Governance

Venture Capital, IPOs, and Seasoned Offerings

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