Question 1

Which one of the following is an implication of M&M Proposition II without taxes?

Accepted Answer

A) A firm's optimal capital structure is 100 percent debt. 
B) WACC is unaffected by the capital structure of a firm. 
C) WACC decreases as the debt-equity ratio increases. 
D) A firm's capital structure is irrelevant. 
E) The risk of equity is affected by both financial and operating leverage.

Question 2

Which one of the following statements concerning financial leverage is correct?

Accepted Answer

A) Financial leverage increases profits and decreases losses. 
B) Financial leverage has no effect on a firm's return on equity. 
C) Financial leverage refers to the use of common stock. 
D) Financial leverage magnifies both profits and losses. 
E) Increasing financial leverage will always decrease the earnings per share.

Question 3

Which one of the following statements is the core principle of M&M Proposition I, without taxes?

Accepted Answer

A) A firm's cost of equity is directly related to the firm's debt-equity ratio. 
B) A firm's WACC is directly related to the firm's debt-equity ratio. 
C) The interest tax shield increases the value of a firm. 
D) The capital structure of a firm is totally irrelevant. 
E) Levered firms have greater value than unlevered firms.

Question 4

Glass Growers has a cost of capital of 11.1 percent.The company is considering converting to a debt-equity ratio of .46.The interest rate on debt is7.3 percent.What would be the company's new cost of equity? Ignore taxes.

Accepted Answer

A) 12.85 percent 
B) 11.13 percent 
C) 12.36 percent 
D) 12.44 percent 
E) 11.61 percent

Question 5

Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process.Which one of the following terms best applies to this situation?

Accepted Answer

A) Chapter 7 bankruptcy 
B) Liquidation 
C) Technical insolvency 
D) Accounting insolvency 
E) Reorganization

Question 6

Which one of the following represents the present value of the interest tax shield?

Accepted Answer

A) D ×(1 -Tc) 
B) D/(1 -Tc) 
C) D/Tc 
D) D-D(Tc) 
E) Tc ×D

Question 7

A firm is considering two different capital structures.The first option is an all-equity firm with 75,000 shares of stock.The second option is 50,000 shares of stock plus some debt.Ignoring taxes, the break-even level of earnings before interest and taxes between these two options is $95,000.How much money is the firm considering borrowing if the interest rate is 8 percent?

Accepted Answer

A) $353,519 
B) $395,833 
C) $386,852 
D) $400,186 
E) $403,519

Question 8

Which one of the following is the equity risk arising from the daily operations of a firm?

Accepted Answer

A) Strategic risk 
B) Financial risk 
C) Liquidity risk 
D) Industry risk 
E) Business risk

Question 9

The Park Place has a return on assets of 12.9 percent, a cost of equity of 16.2 percent, and a pretax cost of debt of 7.7 percent.What is the debt-equity ratio? Ignore taxes.

Accepted Answer

A) .44 
B) .47 
C) .67 
D) .91 
E) .63

Question 10

Assume both corporate taxes and financial distress costs apply to a firm.Given this, the static theory of capital structure illustrates that:

Accepted Answer

A) a firm's value and its weighted average cost of capital are inversely related. 
B) a firm's value and its tax rate are inversely related. 
C) the maximum value of a firm is obtained when a firm is financed solely with debt. 
D) the value of a firm rises as the interest rate on debt rises. 
E) the value of a firm rises as both the interest rate on debt and the tax rate rise.

Question 11

Which one of the following is an example of a direct bankruptcy cost?

Accepted Answer

A) Operating at a debt-equity ratio that is less than the optimal ratio 
B) Reducing the dividend payout ratio as a means of increasing a firm's equity 
C) Forgoing a positive net present value project to conserve current cash 
D) Incurring legal fees for the preparation of bankruptcy filings 
E) Losing a key customer due to concerns over a firm's financial viability

Question 12

Destruction Builders has 10,000 shares of stock outstanding and no debt.The new CFO is considering issuing $65,000 of debt and using the proceeds to retire 750 shares of stock.The coupon rate on the debt is 7.2 percent.What is the break-even level of earnings before interest and taxes between these two capital structure options?

Accepted Answer

A) $42,035 
B) $43,695 
C) $65,000 
D) $60,200 
E) $62,400

Question 13

Demolition Construction Services has 12,500 shares of stock outstanding and no debt.The new CFO is considering issuing $75,000 of debt and using the proceeds to retire 2,500 shares of stock.The coupon rate on the debt is 6.8 percent.What is the break-even level of earnings before interest and taxes between these two capital structure options?

Accepted Answer

A) $16,860 
B) $18,520 
C) $18,240 
D) $21,000 
E) $15,300

Question 14

Paying interest reduces the taxes owed by a firm.Which one of the following terms applies to this relationship?

Accepted Answer

A) Static theory of interest rates 
B) M&M Proposition I 
C) Financial risk 
D) Interest tax shield 
E) Homemade leverage

Question 15

Horizon Landscape currently has 62,000 shares of stock outstanding and no debt.The price per share is $18.50.The firm is considering borrowing funds at 7 percent interest and using the proceeds to repurchase 12,000 shares of stock.Ignore taxes.How much is the firm borrowing?

Accepted Answer

A) $240,000 
B) $222,000 
C) $184,000 
D) $1 
E) $225,000

Question 16

Last Minute Loan Services is an all-equity firm with a total market value of $1,221,350 and 50,000 shares of stock outstanding.Management is considering issuing $225,000 of debt at an interest rate of 6.25 percent and using the proceeds on a stock repurchase.Ignore taxes.How many shares will the firm repurchase if it issues the debt securities? (Round the number of shares repurchased down to the nearest whole share.)

Accepted Answer

A) 9,167 shares 
B) 12,116 shares 
C) 6,211 shares 
D) 3,211 shares 
E) 9,211 shares

Question 17

Which one of the following terms refers to the termination of a firm as a going concern?

Accepted Answer

A) Insolvency 
B) Reorganization 
C) Chapter 11 bankruptcy 
D) Prepack 
E) Liquidation

Question 18

The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:

Accepted Answer

A) M&M Proposition I. 
B) capital restructuring. 
C) homemade leverage. 
D) M&M Proposition II. 
E) financial risk management.

Question 19

Gabe's Market is comparing two different capital structures.Plan I would result in 15,000 shares of stock and $210,000 in debt.Plan II would result in 13,000 shares of stock and $252,000 in debt.The interest rate on the debt is 8 percent.Ignoring taxes, compare both of these plans to an all-equity plan assuming that EBIT will be $52,000.The all-equity plan would result in 25,000 shares of stock outstanding.Of the three plans, the firm will have the highest EPS with _____ and the lowest EPS with ____.

Accepted Answer

A) Plan I; Plan II 
B) Plan II; the all-equity plan 
C) Plan II; Plan I 
D) Plan I; the all-equity plan 
E) the all-equity plan; Plan I

Question 20

Graceful Funeral Group expects its earnings before interest and taxes to be $325,000 a year forever.Currently, the firm has no debt.The cost of equity is 19.5 percent and the tax rate is 21 percent.The company is in the process of issuing $3.7 million of bonds at par that carry an annual coupon rate of 6.5 percent.What is the unlevered value of the firm?

Accepted Answer

A) $1,455,524 
B) $1,416,066 
C) $1,191,500 
D) $1,053,420 
E) $1,316,667

Exam 13: Leverage and Capital Structure