Question 1

A firm with a debt-equity ratio of 0.5,a return on assets of 14%,and a return on debt of 8%,will have a return on equity of:

Accepted Answer

A)  15.25%. 
B)  16.00%. 
C)  17.00%. 
D)  17.33%. 
A)  15.25%. 
B)  16.00%. 
C)  17.00%. 
D)  17.33%.

Question 2

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 $3,750,000 of shares and substitutes an equal amount of debt?

Accepted Answer

A)  EPS decreases by 33.3% to $10.00. 
B)  EPS stays at $12.50. 
C)  EPS increases by 140% to $30.00. 
D)  EPS increases by 240% to $42.50. 
A)  EPS decreases by 33.3% to $10.00. 
B)  EPS stays at $12.50. 
C)  EPS increases by 140% to $30.00. 
D)  EPS increases by 240% to $42.50.

Question 3

The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Accepted Answer

A) True 
 B)False

Question 4

Which one of the following statements is true regarding the trade-off theory?

Accepted Answer

A)  Highly profitable firms should have low debt ratios. 
B)  All firms should have the same target debt-equity ratio. 
C)  Riskier firms should have high target debt ratios. 
D)  Less risky firms ought to have a greater amount of debt financing. 
A)  Highly profitable firms should have low debt ratios. 
B)  All firms should have the same target debt-equity ratio. 
C)  Riskier firms should have high target debt ratios. 
D)  Less risky firms ought to have a greater amount of debt financing.

Question 5

Assume a firm is financed with 60% debt on which it pays interest of 7%.What is the expected return on equity if the expected return on assets is 12%? Ignore taxes.

Accepted Answer

A)  16.14% 
B)  20.30% 
C)  19.50% 
D)  21.67% 
A)  16.14% 
B)  20.30% 
C)  19.50% 
D)  21.67%

Question 6

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

Accepted Answer

A)  minimizes the financial distress costs. 
B)  maximizes the present value of the interest tax shield. 
C)  equates the present values of the incremental interest tax shield and the incremental financial distress costs. 
D)  maximizes the after-tax cash flows that are internally generated. 
A)  minimizes the financial distress costs. 
B)  maximizes the present value of the interest tax shield. 
C)  equates the present values of the incremental interest tax shield and the incremental financial distress costs. 
D)  maximizes the after-tax cash flows that are internally generated.

Question 7

Calculate the WACC for a firm that pays 10% on its debt,requires an 18% rate of return on its equity,finances 45% of the market value of its 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 8

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Accepted Answer

A)  firm uses no debt in its capital structure. 
B)  firm uses the maximum amount of debt in its capital structure. 
C)  firm uses a debt-equity ratio of 1.0. 
D)  corporate tax rate approaches 100%. 
A)  firm uses no debt in its capital structure. 
B)  firm uses the maximum amount of debt in its capital structure. 
C)  firm uses a debt-equity ratio of 1.0. 
D)  corporate tax rate approaches 100%.

Question 9

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 10

Which one of the following statements is false according to 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 11

According to the trade-off theory,if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs,then the:

Accepted Answer

A)  tax shield has been calculated incorrectly. 
B)  firm is too heavily levered. 
C)  firm has reached its optimal debt level. 
D)  firm appears to have a low risk of financial distress. 
A)  tax shield has been calculated incorrectly. 
B)  firm is too heavily levered. 
C)  firm has reached its optimal debt level. 
D)  firm appears to have a low risk of financial distress.

Question 12

Leverage will _____ shareholders' expected return and ______ their risk.

Accepted Answer

A)  increase; decrease 
B)  decrease; increase 
C)  increase; increase 
D)  increase; do nothing to 
A)  increase; decrease 
B)  decrease; increase 
C)  increase; increase 
D)  increase; do nothing to

Question 13

An implicit cost of adding debt to the capital structure is that it:

Accepted Answer

A)  adds interest expense to the operating statement. 
B)  increases the required return on equity. 
C)  reduces the expected return on assets. 
D)  decreases the firm's beta. 
A)  adds interest expense to the operating statement. 
B)  increases the required return on equity. 
C)  reduces the expected return on assets. 
D)  decreases the firm's beta.

Question 14

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 15

The pecking-order theory suggests that less profitable firms borrow more because:

Accepted Answer

A)  equity issues are more expensive. 
B)  leverage is preferred over raising funds internally. 
C)  debt issues are good omens. 
D)  they have insufficient internal funds. 
A)  equity issues are more expensive. 
B)  leverage is preferred over raising funds internally. 
C)  debt issues are good omens. 
D)  they have insufficient internal funds.

Question 16

The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____.

Accepted Answer

A)  increases; increases 
B)  increases; decreases 
C)  decreases; decreases 
D)  decreases; increases 
A)  increases; increases 
B)  increases; decreases 
C)  decreases; decreases 
D)  decreases; increases

Question 17

Costs of financial distress are greater when a firm increases its:

Accepted Answer

A)  intangible assets as a percentage of total assets. 
B)  tangible assets as a percentage of total assets. 
C)  net working capital. 
D)  retained earnings. 
A)  intangible assets as a percentage of total assets. 
B)  tangible assets as a percentage of total assets. 
C)  net working capital. 
D)  retained earnings.

Question 18

Financial risk refers to the:

Accepted Answer

A)  risk of owning equity securities. 
B)  risk faced by equityholders of firms with debt. 
C)  general business risk of the firm. 
D)  possibility that interest rates will increase. 
A)  risk of owning equity securities. 
B)  risk faced by equityholders of firms with debt. 
C)  general business risk of the firm. 
D)  possibility that interest rates will increase.

Question 19

Debt usage will have an effect on:

Accepted Answer

A)  business risk. 
B)  financial risk. 
C)  operating risk. 
D)  asset risk. 
A)  business risk. 
B)  financial risk. 
C)  operating risk. 
D)  asset risk.

Question 20

When taxes are considered,the value of a levered firm equals the value of the:

Accepted Answer

A)  unlevered firm. 
B)  unlevered firm plus the value of the debt. 
C)  unlevered firm plus the present value of the tax shield. 
D)  unlevered firm plus the value of the debt plus the value of the tax shield. 
A)  unlevered firm. 
B)  unlevered firm plus the value of the debt. 
C)  unlevered firm plus the present value of the tax shield. 
D)  unlevered firm plus the value of the debt plus the value of the tax shield.

Exam 16: Debt Policy

A firm with a debt-equity ratio of 0.5,a return on assets of 14%,and a return on debt of 8%,will have a return on equity of:

The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Which one of the following statements is true regarding the trade-off theory?

Assume a firm is financed with 60% debt on which it pays interest of 7%.What is the expected return on equity if the expected return on assets is 12%? Ignore taxes.

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

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

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

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%?

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

According to the trade-off theory,if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs,then the:

Leverage will _____ shareholders' expected return and ______ their risk.

An implicit cost of adding debt to the capital structure is that it:

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

The pecking-order theory suggests that less profitable firms borrow more because:

The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____.

Costs of financial distress are greater when a firm increases its:

Financial risk refers to the:

Debt usage will have an effect on:

When taxes are considered,the value of a levered firm equals the value of the:

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

Leverage will _ shareholders' expected return and __ their risk.

The present value of a perpetual tax shield increases as the firm's tax rate _ and as the amount of the debt_.