Question 1

Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure?

Accepted Answer

A)  A high debt ratio will result in a maximum price of a firm's common stock. 
B)  A firm's common stock price will not be affected by the amount of debt a firm uses. 
C)  A low debt ratio will result in a maximum price for a firm's common stock. 
D)  Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

Question 2

The original form of the Modigliani and Miller Capital Structure Theorem

Accepted Answer

A)  ignores the effect of taxes. 
B)  ignores the relationship between firm value and cost of capital. 
C)  ignores transaction costs. 
D)  both A and C are true.

Question 3

Total shares outstanding will be

Accepted Answer

A)  20,000 under alternative I and zero under alternative II. 
B)  40,000 under alternative I and 60,000 under alternative II. 
C)  60,000 under alternative I and 40,000 under alternative II. 
D)  60,000 under both alternative I and alternative II.

Question 4

The total interest obligation will be

Accepted Answer

A)  $105,000 under alternative I and $9,000 under alternative II. 
B)  $9,000 under alternative I and $105,000 under alternative II. 
C)  zero under alternative I and $96,000 under alternative II. 
D)  $105,000 under both alternative I and alternative II.

Question 5

Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

Accepted Answer

The answer of Briefly explain what the empirical evidence suggests...

Question 6

The inclusion of bankruptcy risk in firm valuation

Accepted Answer

A)  acknowledges that a firm has an upper limit to debt financing. 
B)  causes cost of capital curve to be linear. 
C)  causes the cost of capital curve to be downward sloping regardless of capital structure. 
D)  has no consequences for practical management of capital structure policy.

Question 7

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one. If Madison Co. increases debt from 10% of its capital structure to 40%, cash flows to investors will

Accepted Answer

A)  decrease. 
B)  remain the same. 
C)  increase. 
D)  A firm's cash flows are independent of it's capital structure.

Question 8

Companies faced with higher tax burdens are likely to use more debt.

Accepted Answer

A) True 
 B)False

Question 9

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

Accepted Answer

A)  It would remain at 16%. 
B)  t would rise to 22%. 
C)  It would fall to 11%. 
D)  It would fall to 13%.

Question 10

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value). Excess cash $500,000. The market value of Fibonacci's equity is $21 million. Fibonacci's Debt to Enterprise Value ratio is

Accepted Answer

A)  .38. 
B)  .23. 
C)  .125. 
D)  .106.

Question 11

When benchmarking a firm's capital structure, management should compare it

Accepted Answer

A)  firms in S&P 500. 
B)  firms in the same geographic region. 
C)  firms recognized for the quality of their management. 
D)  firms in similar lines of business.

Question 12

Which of the following is a good reason for a company to have higher than average debt ratios?

Accepted Answer

A)  The company's cash flows are difficult to predict. 
B)  The company generates little taxable income. 
C)  Customer support is an important aspect of the company's business. 
D)  The company faces high marginal tax rates.

Question 13

Which of the following factors favors the use of more debt in a company's financial structure?

Accepted Answer

A)  High levels of taxable income 
B)  Low levels of taxable income 
C)  The business is basically risky with unpredictable cash flows. 
D)  Risk of bankruptcy would make customers reluctant to buy the company's products.

Question 14

In which countries would you expect companies to have the lowest leverage ratios?

Accepted Answer

A)  Countries with very high tax rates. 
B)  Countries that tend to subsidize key industries and protect them from failure. 
C)  Countries where creditors have very strong legal protection. 
D)  Countries where the market value of companies is high compared to their book values.

Question 15

The debt ratio is usually computed using book values for both debt and equity.

Accepted Answer

A) True 
 B)False

Question 16

The Tradeoff Theory view of capital structure management says that the cost of capital curve is

Accepted Answer

A)  a straight line. 
B)  v-shaped. 
C)  s-shaped. 
D)  saucer-shaped.

Question 17

Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock. There are no issuance costs for either the bonds or the stock. If Zybeck issues common stock this year, what will projected EPS be next year?

Accepted Answer

A)  $2.10 
B)  $2.96 
C)  $2.33 
D)  $1.67

Question 18

Cornucopia's liabilities and equity are shown below:  Cornucopia's debt ratio is

Accepted Answer

A)  .48. 
B)  .32. 
C)  .21. 
D)  .30.

Question 19

Financial structure includes long-term and short-term sources of funds.

Accepted Answer

A) True 
 B)False

Question 20

The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial leverage regardless of the financing plan chosen by the financial manager.

Accepted Answer

A) True 
 B)False

Exam 15: Capital Structure Policy

Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure?

The original form of the Modigliani and Miller Capital Structure Theorem

Total shares outstanding will be

The total interest obligation will be

Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

The inclusion of bankruptcy risk in firm valuation

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one. If Madison Co. increases debt from 10% of its capital structure to 40%, cash flows to investors will

Companies faced with higher tax burdens are likely to use more debt.

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million. Interest bearing liabilities total $3 million (book value) . Excess cash $500,000. The market value of Fibonacci's equity is $21 million. Fibonacci's Debt to Enterprise Value ratio is

When benchmarking a firm's capital structure, management should compare it

Which of the following is a good reason for a company to have higher than average debt ratios?

Which of the following factors favors the use of more debt in a company's financial structure?

In which countries would you expect companies to have the lowest leverage ratios?

The debt ratio is usually computed using book values for both debt and equity.

The Tradeoff Theory view of capital structure management says that the cost of capital curve is

Cornucopia's liabilities and equity are shown below: Cornucopia's debt ratio is

Financial structure includes long-term and short-term sources of funds.

The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial leverage regardless of the financing plan chosen by the financial manager.