Question 1

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Accepted Answer

A) True 
 B)False

Question 2

Laramie Trucking's CEO is considering a change to the company's capital structure,which currently consists of 25% debt and 75% equity.The CFO believes the firm should use more debt,but the CEO is reluctant to increase the debt ratio.The risk-free rate,rRF,is 5.0%,the market risk premium,RPM,is 6.0%,and the firm's tax rate is 40%.Currently,the cost of equity,rs,is 11.5% as determined by the CAPM.What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem. )

Accepted Answer

A)  10.95% 
B)  11.91% 
C)  12.94% 
D)  14.07% 
E)  15.29% 
A)  10.95% 
B)  11.91% 
C)  12.94% 
D)  14.07% 
E)  15.29%

Question 3

Serendipity Inc.is re-evaluating its debt level.Its current capital structure consists of 80% debt and 20% common equity,its beta is 1.60,and its tax rate is 35%.However,the CFO thinks the company has too much debt,and he is considering moving to a capital structure with 40% debt and 60% equity.The risk-free rate is 5.0% and the market risk premium is 6.0%.By how much would the capital structure shift change the firm's cost of equity?

Accepted Answer

A)  −5.20% 
B)  −5.78% 
C)  −6.36% 
D)  −6.99% 
E)  −7.69% 
A)  −5.20% 
B)  −5.78% 
C)  −6.36% 
D)  −6.99% 
E)  −7.69%

Question 4

The world-famous discounter,Fernwood Booksellers,specializes in selling paperbacks for $7 each.The variable cost per book is $5.At current annual sales of 200,000 books,the publisher is just breaking even.It is estimated that if the authors' royalties are reduced,the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant;how much more money can the publisher put into advertising (a fixed cost)and still break even?

Accepted Answer

A)  $600,000 
B)  $466,667 
C)  $333,333 
D)  $200,000 
E)  None of the above 
A)  $600,000 
B)  $466,667 
C)  $333,333 
D)  $200,000 
E)  None of the above

Question 5

If a firm utilizes debt financing,an X% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than X.

Accepted Answer

A) True 
 B)False

Question 6

The firm's target capital structure should be consistent with which of the following statements?

Accepted Answer

A)  Minimize the cost of debt (rd). 
B)  Obtain the highest possible bond rating. 
C)  Minimize the cost of equity (rs). 
D)  Minimize the weighted average cost of capital (WAC
C) . 
E)  Maximize the earnings per share (EPS). 
A)  Minimize the cost of debt (rd). 
B)  Obtain the highest possible bond rating. 
C)  Minimize the cost of equity (rs). 
D)  Minimize the weighted average cost of capital (WAC
C) . 
E)  Maximize the earnings per share (EPS).

Question 7

Barette Consulting currently has no debt in its capital structure,has $500 million of total assets,and its basic earning power is 15%.The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock,paying book value.If the company proceeds with the recapitalization,its operating income,total assets,and tax rate will remain unchanged.Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)  The ROA would remain unchanged. 
B)  The basic earning power ratio would decline. 
C)  The basic earning power ratio would increase. 
D)  The ROE would increase. 
E)  The ROA would increase. 
A)  The ROA would remain unchanged. 
B)  The basic earning power ratio would decline. 
C)  The basic earning power ratio would increase. 
D)  The ROE would increase. 
E)  The ROA would increase.

Question 8

As the text indicates,a firm's financial risk has identifiable market risk and diversifiable risk components.

Accepted Answer

A) True 
 B)False

Question 9

Merriwether Building has operating income of $20 million,a tax rate of 40%,and no debt.It pays out all of its net income as dividends and has a zero growth rate.The current stock price is $40 per share,and it has 2.5 million shares of stock outstanding.If it moves to a capital structure that has 40% debt and 60% equity (based on market values),its investment bankers believe its weighted average cost of capital would be 10%.What would its stock price be if it changes to the new capital structure?

Accepted Answer

A)  $40 
B)  $48 
C)  $52 
D)  $54 
E)  $60 
A)  $40 
B)  $48 
C)  $52 
D)  $54 
E)  $60

Question 10

A venture capital investment group received a proposal from Wireless Solutions to produce a new smart phone.The variable cost per unit is estimated at $250,the sales price would be set at twice the VC/unit,fixed costs are estimated at $750,000,and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more.What sales volume would be required in order to meet this profit goal?

Accepted Answer

A)  4,513 
B)  4,750 
C)  5,000 
D)  5,250 
E)  5,513 
A)  4,513 
B)  4,750 
C)  5,000 
D)  5,250 
E)  5,513

Question 11

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000,its variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's breakeven point,i.e. ,at what unit sales volume would income equal costs?

Accepted Answer

A)  391,667 
B)  411,250 
C)  431,813 
D)  453,403 
E)  476,073 
A)  391,667 
B)  411,250 
C)  431,813 
D)  453,403 
E)  476,073

Question 12

When a firm has risky debt,its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

Accepted Answer

A) True 
 B)False

Question 13

Two operationally similar companies,HD and LD,have the same total assets,operating income (EBIT),tax rate,and business risk.Company HD,however,has a much higher debt ratio than LD.Also HD's return on invested capital (ROIC)exceeds its after-tax cost of debt, (1-T)rd.Which of the following statements is CORRECT?

Accepted Answer

A)  HD should have a higher times interest earned (TI
E) ratio than LD. 
B)  HD should have a higher return on equity (RO
E) than LD,but its risk,as measured by the standard deviation of ROE,should also be higher than LD's. 
C)  Given that ROIC > (1-T)rd,HD's stock price must exceed that of LD. 
D)  Given that ROIC > (1-T)rd,LD's stock price must exceed that of HD. 
E)  HD should have a higher return on assets (RO
A) than LD. 
A)  HD should have a higher times interest earned (TI
E) ratio than LD. 
B)  HD should have a higher return on equity (RO
E) than LD,but its risk,as measured by the standard deviation of ROE,should also be higher than LD's. 
C)  Given that ROIC > (1-T)rd,HD's stock price must exceed that of LD. 
D)  Given that ROIC > (1-T)rd,LD's stock price must exceed that of HD. 
E)  HD should have a higher return on assets (RO
A) than LD.

Question 14

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Accepted Answer

A) True 
 B)False

Question 15

Two operationally similar companies,HD and LD,have identical amounts of assets,operating income (EBIT),tax rates,and business risk.Company HD,however,has a much higher debt ratio than LD.Company HD's return on invested capital (ROIC)exceeds its after-tax cost of debt, (1-T)rd.Which of the following statements is CORRECT?

Accepted Answer

A)  Company HD has a higher times interest earned (TI
E) ratio than Company LD. 
B)  Company HD has a higher return on equity (RO
E) than Company LD,and its risk,as measured by the standard deviation of ROE,is also higher than LD's. 
C)  The two companies have the same ROE. 
D)  Company HD's ROE would be higher if it had no debt. 
E)  Company HD has a higher return on assets (RO
A) than Company LD. 
A)  Company HD has a higher times interest earned (TI
E) ratio than Company LD. 
B)  Company HD has a higher return on equity (RO
E) than Company LD,and its risk,as measured by the standard deviation of ROE,is also higher than LD's. 
C)  The two companies have the same ROE. 
D)  Company HD's ROE would be higher if it had no debt. 
E)  Company HD has a higher return on assets (RO
A) than Company LD.

Question 16

A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises.The sales price would be set at 1.5 times the variable cost per unit;the VC/unit is estimated to be $2.50;and fixed costs are estimated at $120,000.What sales volume would be required in order to break even,i.e. ,to have an EBIT of zero for the stereo business?

Accepted Answer

A)  86,640 
B)  91,200 
C)  96,000 
D)  100,800 
E)  105,840 
A)  86,640 
B)  91,200 
C)  96,000 
D)  100,800 
E)  105,840

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E) ratio. 
C)  Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing;however,this still may raise the company's WACC. 
D)  If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate,this would encourage companies to increase their debt ratios. 
E)  The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WAC
C) . 
A)  The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. 
B)  The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TI
E) ratio. 
C)  Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing;however,this still may raise the company's WACC. 
D)  If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate,this would encourage companies to increase their debt ratios. 
E)  The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WAC
C) .

Question 18

The major contribution of the Miller model is that it demonstrates that

Accepted Answer

A)  personal taxes decrease the value of using corporate debt. 
B)  financial distress and agency costs reduce the value of using corporate debt. 
C)  equity costs increase with financial leverage. 
D)  debt costs increase with financial leverage. 
E)  personal taxes increase the value of using corporate debt. 
A)  personal taxes decrease the value of using corporate debt. 
B)  financial distress and agency costs reduce the value of using corporate debt. 
C)  equity costs increase with financial leverage. 
D)  debt costs increase with financial leverage. 
E)  personal taxes increase the value of using corporate debt.

Question 19

Which of the following events is likely to encourage a company to raise its target debt ratio,other things held constant?

Accepted Answer

A)  An increase in the personal tax rate. 
B)  An increase in the company's operating leverage. 
C)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
D)  The company's stock price hits a new high. 
E)  An increase in the corporate tax rate. 
A)  An increase in the personal tax rate. 
B)  An increase in the company's operating leverage. 
C)  The Federal Reserve tightens interest rates in an effort to fight inflation. 
D)  The company's stock price hits a new high. 
E)  An increase in the corporate tax rate.

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)  A change in the personal tax rate should not affect firms' capital structure decisions. 
B)  "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt,while business risk reflects both the use of debt and such factors as sales variability,cost variability,and operating leverage. 
C)  The optimal capital structure is the one that simultaneously (1)maximizes the price of the firm's stock, (2)minimizes its WACC,and (3)maximizes its EPS. 
D)  If changes in the bankruptcy code make bankruptcy less costly to corporations,then this would likely reduce the debt ratio of the average corporation. 
E)  If corporate tax rates were decreased while other things were held constant,and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct,this would tend to cause corporations to decrease their use of debt. 
A)  A change in the personal tax rate should not affect firms' capital structure decisions. 
B)  "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt,while business risk reflects both the use of debt and such factors as sales variability,cost variability,and operating leverage. 
C)  The optimal capital structure is the one that simultaneously (1)maximizes the price of the firm's stock, (2)minimizes its WACC,and (3)maximizes its EPS. 
D)  If changes in the bankruptcy code make bankruptcy less costly to corporations,then this would likely reduce the debt ratio of the average corporation. 
E)  If corporate tax rates were decreased while other things were held constant,and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct,this would tend to cause corporations to decrease their use of debt.

Exam 15: Capital Structure Decisions

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

If a firm utilizes debt financing,an X% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than X.

The firm's target capital structure should be consistent with which of the following statements?

As the text indicates,a firm's financial risk has identifiable market risk and diversifiable risk components.

Larsen Films' is analyzing its cost structure.Its fixed operating costs are $470,000,its variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's breakeven point,i.e. ,at what unit sales volume would income equal costs?

When a firm has risky debt,its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Which of the following statements is CORRECT?

The major contribution of the Miller model is that it demonstrates that

Which of the following events is likely to encourage a company to raise its target debt ratio,other things held constant?

Which of the following statements is CORRECT?

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Risk and Return

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Cash Flow Estimation and Risk Analysis

Financial Planning and Applications to Corporate Valuation

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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