Question 1

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

Accepted Answer

A) True 
 B)False

Question 2

Firms in which one of the following industries are most apt to have the highest debt ratios?

Accepted Answer

A)  Integrated oil and gas 
B)  Railroad 
C)  Software 
D) Communications equipment

Question 3

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.

Question 4

Assume a firm maintains debt at a permanent $2.3 million level at an interest rate of 7%. The corporate tax rate is 35% and there is no chance of financial distress. What would be the unlevered value of this firm if the levered value is $2.28 million?

Accepted Answer

The answer of Assume a firm maintains debt at a...

Question 5

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

Accepted Answer

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

Question 6

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

Accepted Answer

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

Question 7

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.

Question 8

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 9

MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure.

Accepted Answer

A) True 
 B)False

Question 10

If interest tax shields are valuable, why don't all tax-paying firms borrow as much as possible?

Accepted Answer

The answer of If interest tax shields are valuable, why...

Question 11

What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes.

Accepted Answer

A)  54.0% 
B)  60.0% 
C)  66.7% 
D) 75.0%

Question 12

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.

Question 13

When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating.

Accepted Answer

A) True 
 B)False

Question 14

With the inclusion of taxes, MM I is incorrect and the capital structure of the firm can be important due to the:

Accepted Answer

A)  lower tax rates on dividends than on debt. 
B)  higher tax rates on retained earnings than on debt. 
C)  lower tax liability due to interest deductibility. 
D) higher operating income from lower dividends.

Question 15

As the debt-equity ratio decreases when debt is not risk free:

Accepted Answer

A)  debtholders demand a higher expected return. 
B)  debtholders demand a lower expected return. 
C)  the expected return on equity increases. 
D) the expected return on assets increases.

Question 16

When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm _____ the PV of the tax shield _____ the costs of financial distress.

Accepted Answer

A)  plus; plus 
B)  minus; plus 
C)  plus; minus 
D) minus; minus

Question 17

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

Question 18

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.

Question 19

Which one of these statements corresponds to MM proposition I without taxes?

Accepted Answer

A)  Debt interest has no effect on either equity income or firm value. 
B)  Debt interest reduces equity income and increases firm value. 
C)  Debt interest reduces equity income but does not affect firm value. 
D) The value of a firm increases as its debt-equity ratio increases.

Question 20

Which one of these is a disadvantage to tax-paying individual investors?

Accepted Answer

A)  Receiving interest income rather than dividends 
B)  Receiving capital gains rather than dividends 
C)  Receiving capital gains rather than interest income 
D) Receiving dividends rather than interest income

Exam 16: Debt Policy

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

Firms in which one of the following industries are most apt to have the highest debt ratios?

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

Assume a firm maintains debt at a permanent $2.3 million level at an interest rate of 7%. The corporate tax rate is 35% and there is no chance of financial distress. What would be the unlevered value of this firm if the levered value is $2.28 million?

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

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

MM's proposition II without taxes states that the:

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

MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure.

If interest tax shields are valuable, why don't all tax-paying firms borrow as much as possible?

What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes.

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

When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating.

With the inclusion of taxes, MM I is incorrect and the capital structure of the firm can be important due to the:

As the debt-equity ratio decreases when debt is not risk free:

When corporate taxes and the cost of financial distress are taken into consideration, the market value of a firm is equal to the value of the all-equity firm _ the PV of the tax shield _ the costs of financial distress.

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.

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

Which one of these statements corresponds to MM proposition I without taxes?

Which one of these is a disadvantage to tax-paying individual investors?