Question 1

Which of the following statements is CORRECT,holding other things constant?

Accepted Answer

A)  An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. 
B)  If changes in the bankruptcy code make bankruptcy less costly to corporations,then this would likely reduce the debt ratio of the average corporation. 
C)  An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. 
D)  An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. 
E)  Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs,hence they tend to use relatively little debt. 
A)  An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. 
B)  If changes in the bankruptcy code make bankruptcy less costly to corporations,then this would likely reduce the debt ratio of the average corporation. 
C)  An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. 
D)  An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. 
E)  Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs,hence they tend to use relatively little debt.

Question 2

After an intensive research and development effort,two methods for producing playing cards have been identified by the Turner Company.One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards.The other method would use a less expensive machine (fixed cost = $5,000),but it would require greater variable costs ($1.50 per deck of cards).If the selling price per deck of cards will be the same under each method,at what level of output will the two methods produce the same net operating income (EBIT)?

Accepted Answer

A)  5,000 decks 
B)  10,000 decks 
C)  15,000 decks 
D)  20,000 decks 
E)  25,000 decks 
A)  5,000 decks 
B)  10,000 decks 
C)  15,000 decks 
D)  20,000 decks 
E)  25,000 decks

Question 3

Cartwright Communications is considering making a change to its capital structure to reduce its cost of capital and increase firm value.Right now,Cartwright has a capital structure that consists of 20% debt and 80% equity,based on market values.(Its D/S ratio is 0.25. )The risk-free rate is 6% and the market risk premium,rM − rRF,is 5%.Currently the company's cost of equity,which is based on the CAPM,is 12% and its tax rate is 40%.What would be Cartwright's estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity?

Accepted Answer

A)  13.00% 
B)  13.64% 
C)  14.35% 
D)  14.72% 
E)  15.60% 
A)  13.00% 
B)  13.64% 
C)  14.35% 
D)  14.72% 
E)  15.60%

Question 4

Whenever a firm borrows money,it is using financial leverage.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output,this will

Accepted Answer

A)  normally lead to a decrease in its business risk. 
B)  normally lead to a decrease in the standard deviation of its expected EBIT. 
C)  normally lead to a decrease in the variability of its expected EPS. 
D)  normally lead to a reduction in its fixed assets turnover ratio. 
E)  normally lead to an increase in its fixed assets turnover ratio. 
A)  normally lead to a decrease in its business risk. 
B)  normally lead to a decrease in the standard deviation of its expected EBIT. 
C)  normally lead to a decrease in the variability of its expected EPS. 
D)  normally lead to a reduction in its fixed assets turnover ratio. 
E)  normally lead to an increase in its fixed assets turnover ratio.

Question 6

Provided a firm does not use an extreme amount of debt,financial leverage typically affects both EPS and EBIT,while operating leverage only affects EBIT.

Accepted Answer

A) True 
 B)False

Question 7

If Miller and Modigliani had incorporated the costs of bankruptcy into their model,it is unlikely that they would have concluded that 100% debt financing is optimal.

Accepted Answer

A) True 
 B)False

Question 8

Morales Publishing's tax rate is 40%,its beta is 1.10,and it uses no debt.However,the CFO is considering moving to a capital structure with 30% debt and 70% equity.If 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)  1.53% 
B)  1.70% 
C)  1.87% 
D)  2.05% 
E)  2.26% 
A)  1.53% 
B)  1.70% 
C)  1.87% 
D)  2.05% 
E)  2.26%

Question 9

The MM model with corporate taxes is the same as the Miller model,but with zero personal taxes.

Accepted Answer

A) True 
 B)False

Question 10

Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

Accepted Answer

A) True 
 B)False

Question 11

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage,other things held constant.

Accepted Answer

A) True 
 B)False

Question 12

Which of the following is NOT associated with (or does not contribute to)business risk? Recall that business risk is affected by a firm's operations.

Accepted Answer

A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability. 
A)  Sales price variability. 
B)  The extent to which operating costs are fixed. 
C)  The extent to which interest rates on the firm's debt fluctuate. 
D)  Input price variability. 
E)  Demand variability.

Question 13

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Accepted Answer

A) True 
 B)False

Question 14

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense.The company would issue new bonds and use the proceeds to buy back shares of its common stock.The company's CFO thinks the plan will not change total assets or operating income,but that it will increase earnings per share (EPS).Assuming the CFO's estimates are correct,which of the following statements is CORRECT?

Accepted Answer

A)  If the plan reduces the WACC,the stock price is also likely to decline. 
B)  Since the plan is expected to increase EPS,this implies that net income is also expected to increase. 
C)  If the plan does increase the EPS,the stock price will automatically increase at the same rate. 
D)  Under the plan there will be more bonds outstanding,and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. 
E)  Since the proposed plan increases Daylight's financial risk,the company's stock price still might fall even if EPS increases. 
A)  If the plan reduces the WACC,the stock price is also likely to decline. 
B)  Since the plan is expected to increase EPS,this implies that net income is also expected to increase. 
C)  If the plan does increase the EPS,the stock price will automatically increase at the same rate. 
D)  Under the plan there will be more bonds outstanding,and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. 
E)  Since the proposed plan increases Daylight's financial risk,the company's stock price still might fall even if EPS increases.

Question 15

Which of the following statements is CORRECT?

Accepted Answer

A)  Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. 
B)  Drug companies (prescription,not illegal!)generally have high debt-to-equity ratios because their earnings are very stable and,thus,they can cover the high interest costs associated with high debt levels. 
C)  Wide variations in capital structures exist both between industries and among individual firms within given industries.These differences are caused by differing business risks and also managerial attitudes. 
D)  Since most stocks sell at or very close to their book values,book value capital structures are almost always adequate for use in estimating firms' costs of capital. 
E)  Generally,debt-to-total-assets ratios do not vary much among different industries,although they do vary among firms within a given industry. 
A)  Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. 
B)  Drug companies (prescription,not illegal!)generally have high debt-to-equity ratios because their earnings are very stable and,thus,they can cover the high interest costs associated with high debt levels. 
C)  Wide variations in capital structures exist both between industries and among individual firms within given industries.These differences are caused by differing business risks and also managerial attitudes. 
D)  Since most stocks sell at or very close to their book values,book value capital structures are almost always adequate for use in estimating firms' costs of capital. 
E)  Generally,debt-to-total-assets ratios do not vary much among different industries,although they do vary among firms within a given industry.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  If a firm lowered its fixed costs while increasing its variable costs,holding total costs at the present level of sales constant,this would decrease its operating leverage. 
B)  The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. 
C)  If a company were to issue debt and use the money to repurchase common stock,this action would have no impact on its basic earning power ratio.(Assume that the repurchase has no impact on the company's operating income. ) 
D)  If changes in the bankruptcy code made bankruptcy less costly to corporations,this would likely reduce the average corporation's debt ratio. 
E)  Increasing financial leverage is one way to increase a firm's basic earning power (BEP). 
A)  If a firm lowered its fixed costs while increasing its variable costs,holding total costs at the present level of sales constant,this would decrease its operating leverage. 
B)  The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. 
C)  If a company were to issue debt and use the money to repurchase common stock,this action would have no impact on its basic earning power ratio.(Assume that the repurchase has no impact on the company's operating income. ) 
D)  If changes in the bankruptcy code made bankruptcy less costly to corporations,this would likely reduce the average corporation's debt ratio. 
E)  Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.Unfortunately,these factors are generally beyond the control of the firm's management. 
B)  One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. 
C)  A firm's financial risk can be minimized by diversification. 
D)  The amount of debt in its capital structure can under no circumstances affect a company's business risk. 
E)  A firm's business risk is determined solely by the financial characteristics of its industry. 
A)  The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.Unfortunately,these factors are generally beyond the control of the firm's management. 
B)  One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. 
C)  A firm's financial risk can be minimized by diversification. 
D)  The amount of debt in its capital structure can under no circumstances affect a company's business risk. 
E)  A firm's business risk is determined solely by the financial characteristics of its industry.

Question 18

It is possible that two firms could have identical financial and operating leverage,yet have different degrees of risk as measured by the variability of EPS.

Accepted Answer

A) True 
 B)False

Question 19

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

Accepted Answer

A) True 
 B)False

Question 20

Which of the following statements is CORRECT?

Accepted Answer

A)  Since debt financing is cheaper than equity financing,raising a company's debt ratio will always reduce its WACC. 
B)  Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.However,this action still may raise the company's WACC. 
C)  Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.However,this action still may lower the company's WACC. 
D)  Since a firm's beta coefficient it not affected by its use of financial leverage,leverage does not affect the cost of equity. 
E)  Since debt financing raises the firm's financial risk,increasing a company's debt ratio will always increase its WACC. 
A)  Since debt financing is cheaper than equity financing,raising a company's debt ratio will always reduce its WACC. 
B)  Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.However,this action still may raise the company's WACC. 
C)  Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.However,this action still may lower the company's WACC. 
D)  Since a firm's beta coefficient it not affected by its use of financial leverage,leverage does not affect the cost of equity. 
E)  Since debt financing raises the firm's financial risk,increasing a company's debt ratio will always increase its WACC.

Exam 15: Capital Structure Decisions

Which of the following statements is CORRECT,holding other things constant?

Whenever a firm borrows money,it is using financial leverage.

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output,this will

Provided a firm does not use an extreme amount of debt,financial leverage typically affects both EPS and EBIT,while operating leverage only affects EBIT.

If Miller and Modigliani had incorporated the costs of bankruptcy into their model,it is unlikely that they would have concluded that 100% debt financing is optimal.

The MM model with corporate taxes is the same as the Miller model,but with zero personal taxes.

Other things held constant,an increase in financial leverage will increase a firm's market (or systematic)risk as measured by its beta coefficient.

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage,other things held constant.

Which of the following is NOT associated with (or does not contribute to)business risk? Recall that business risk is affected by a firm's operations.

Firm A has a higher degree of business risk than Firm B.Firm A can offset this by using less financial leverage.Therefore,the variability of both firms' expected EBITs could actually be identical.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

It is possible that two firms could have identical financial and operating leverage,yet have different degrees of risk as measured by the variability of EPS.

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

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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