Question 1

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC)  is 15%, and it currently has no debt in its capital structure . The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc)  is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets) , total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?

Accepted Answer

A)   The ROA would increase.
B)   The ROA would remain unchanged.
C)   The return on investors' capital would decline.
D)   The return on investors' capital would increase.
E)   The ROE would increase.F) C) and D)
G) B) and E)

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A)   Increasing its use of financial leverage is one way to increase a firm's return on investors' capital (ROI
C)  .
B)   If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
C)   The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
D)   If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors' capital (ROI
C)  . (Assume that the repurchase has no impact on the company's operating income.) 
E)   If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.F) B) and E)
G) A) and D) C

Question 3

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

Accepted Answer

A)   Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
B)   An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
C)   If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
D)   An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
E)   An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.F) None of the above
G) A) and D)

Question 4

According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

Accepted Answer

A) True 
 B)False

Question 5

Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio.

Accepted Answer

A) True 
 B)False

Question 6

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Accepted Answer

A)   $164,025
B)   $182,250
C)   $202,500
D)   $225,000
E)   $247,500F) A) and C)
G) A) and E)

Question 7

The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.

Accepted Answer

A) True 
 B)False

Question 8

Based on the information below, what is the firm's optimal capital structure?

Accepted Answer

A)   Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
B)   Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
C)   Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
D)   Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
E)   Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.F) B) and E)
G) A) and B)

Question 9

Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

Accepted Answer

A) True 
 B)False

Question 10

Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

Accepted Answer

A)   Its sales are projected to become less stable in the future.
B)   The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
C)   Management believes that the firm's stock is currently overvalued.
D)   The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
E)   The corporate tax rate is increased.F) B) and D)
G) C) and E)

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)   A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
B)   The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
C)   The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
D)   If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
E)   Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.F) A) and B)
G) A) and D) B

Question 12

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

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

A)   When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.
B)   The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
C)   All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.
D)   Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
E)   Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.F) C) and E)
G) B) and C)

Question 14

Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 100,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR, per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?

Accepted Answer

A)   $2.55
B)   $2.84
C)   $3.15
D)   $3.50
E)   $3.85F) A) and D)
G) C) and D)

Question 15

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Accepted Answer

A)   The costs associated with filing for bankruptcy increase.
B)   The corporate tax rate is increased.
C)   The personal tax rate is increased.
D)   The Federal Reserve tightens interest rates in an effort to fight inflation.
E)   The company's stock price hits a new low.F) B) and C)
G) C) and D)

Question 16

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

Accepted Answer

A) True 
 B)False

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)   In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
B)   There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
C)   A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
D)   If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
E)   Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.F) A) and B)
G) B) and D)

Question 18

A firm's CFO is considering increasing the target debt ratio, which would also increase the company's interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS)  would increase. Assuming the CFO's estimates are correct, which of the following statements is CORRECT?

Accepted Answer

A)   Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases.
B)   If the plan reduces the WACC, the stock price is likely to decline.
C)   Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D)   If the plan does increase the EPS, the stock price will automatically increase at the same rate.
E)   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.F) C) and D)
G) A) and B) A

Question 19

Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT) , tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors' capital (ROIC)  exceed their after-tax costs of debt, rd(1 - T) . Which of the following statements is CORRECT?

Accepted Answer

A)   HD should have a higher return on assets (RO
A)   than LD.
B)   HD should have a higher times interest earned (TI
E)   ratio than LD.
C)   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.
D)   Given that ROIC > rd(1 - T) , HD's stock price must exceed that of LD.
E)   Given that ROIC > rd(1 - T) , LD's stock price must exceed that of HD.F) A) and D)
G) D) and E)

Question 20

It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

Accepted Answer

A) True 
 B)False

Exam 14: Capital Structure

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Which of the following statements is CORRECT?

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C

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

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Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Correct Answer
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Correct Answer
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Based on the information below, what is the firm's optimal capital structure?

Correct Answer
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Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

Correct Answer
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Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

Correct Answer
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Which of the following statements is CORRECT?

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B

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

Correct Answer
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Which of the following statements is CORRECT?

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Which of the following would tend to increase a firm's target debt ratio, other things held constant?

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

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Which of the following statements is CORRECT?

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A

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It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

Correct Answer
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Exam 14: Capital Structure

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedC

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

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Correct AnswerverifiedShow Answer

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Based on the information below, what is the firm's optimal capital structure?

Correct AnswerverifiedShow Answer

Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

Correct AnswerverifiedShow Answer

Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedB

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which of the following would tend to increase a firm's target debt ratio, other things held constant?

Correct AnswerverifiedShow Answer

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

Correct AnswerverifiedShow Answer

Which of the following statements is CORRECT?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedA

Correct AnswerverifiedShow Answer

It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

Correct AnswerverifiedShow Answer

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C

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B

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A

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