Managerial Finance and Accounting

1. Which of the following statements is false in a Modigliani and Miller world with perfect capital markets?

A) If securities are fairly priced, then buying or selling securities has an NPV of zero and, therefore, should not change the value of a firm.

B) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.

D) As long as the firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.

B)

5. Which of the following statements is false?

A) The levered equity return equals the unlevered return, plus an extra "kick" due to leverage.

B) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.

C) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

D) By holding a portfolio of the firm's equity and its debt, we can replicate the cash flows from holding its levered equity.

D)

10. Which of the following statements is false?

A) To determine the benefit of leverage for the value of the firm, we must compute the present value of the stream of future interest tax shields the firm will receive.

B) Because the cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield, by the Law of One Price the same must be true for the present values of these cash flows.

C) By increasing the amount paid to debtholders through interest payments, the amount of the pre-tax cash flows that must be paid as taxes increases.

D) When a firm uses debt, the interest tax shield provides a corporate tax benefit each year

C)

10. Which of the following statements is false?

A) If there is uncertainty regarding EBIT, then with a higher interest expense there is a greater risk that interest will exceed EBIT.

B) From a tax perspective, the firm's optimal level of debt is proportional to its current earnings.

C) The optimal proportion of debt in the firm's capital structure will be higher, the higher the firm's growth rate.

D) Even for a firm with positive earnings, growth will affect the optimal leverage ratio.

C)

15. Which of the following statements is false?

A) Because many aspects of the bankruptcy process are independent of the size of the firm, the bankruptcy costs are typically higher, in percentage terms, for smaller firms.

B) Although indirect costs of bankruptcy are difficult to measure accurately, they are typically much smaller than the direct costs of bankruptcy.

C) Bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down.

D) Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy).

B)

15. Select the term that completes the following sentence: A(n) __________ is a payment of additional shares to shareholders in lieu of cash.

A) stock split
B) regular dividend
C) stock dividend
D) extra dividend

C)

15. Which of the following statements regarding stock splits is false?
A) The market price per share is reduced after the split.
B) Retained earnings are changed.
C) Proportional ownership is unchanged.
D) The number of outstanding shares is increased.

B)

20. Which of the following statements regarding the Weighted Average Cost of Capital (WACC) method is false?

A) To be profitable, a project should generate an expected return of at least the firm's weighted average cost of capital.

B) The intuition for the WACC method is that the firm's weighted average cost of capital represents the average return the firm must pay to its investors (both debtholders and equityholders) on an after-tax basis.

C) The WACC method incorporates the benefit of the interest tax shield by using the firm's before-tax cost of capital for debt.

D) The WACC method can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm's debt-equity ratio.

C)

24. Which of the following statements regarding the Flow-To-Equity (FTE) method is false?

A) Because interest payments are deducted before taxes, the firm's free cash flow has to be adjusted by the before-tax interest expense.

B) The project's free cash flow to equity (FCFE) show the expected amount of additional cash the firm will have available to pay dividends (or conduct share repurchases) each year.

C) The value of the project's FCFE represents the gain to shareholders from the project.

D) The value of the project's FCFE should be identical to the NPV computed using the WACC and APV methods.

A)

Which of the following statements is false in a Modigliani and Miller world with perfect capital markets?
A) When investors use leverage in their own portfolios to adjust the leverage choice
made by the firm, we say that they are using homemade leverage.
B) The value of the firm is determined by the present value of the cash flows from its
current and future investments.
C) The investor can re-create the payoffs of unlevered equity by borrowing and using
the proceeds to purchase the equity of the firm.
D) As long as investors can borrow or lend at the same interest rate as the firm,
homemade leverage is a perfect substitute for the use of leverage by the firm.

C)

Which of the following statements is false?
A) The firm's marginal tax rate may fluctuate due to changes in the tax code and changes in the firm's income bracket.
B) Many large firms have a policy of maintaining a certain amount of debt on their balance sheets.
C) Typically, the level of future interest payments varies due to changes the firm makes in the amount of debt outstanding, changes in the interest rate on that debt,
and the risk that the firm may default and fail to make an interest payment.
D) Given a 35% corporate tax rate, for every €1 in new permanent debt that the firm issues, the value of the firm increases by €0.65

D)

Which of the following statements is false?
A) No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT.
B) The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT.
C) In general, as a firm's interest expense approaches its expected taxable earnings, the marginal tax advantage of debt increases, limiting the amount of equity the firm should use.
D) A biotech firm might be developing drugs with tremendous potential, but it has yet to receive any revenue from these drugs. Such a firm will not have taxable earnings. In that case, a tax-optimal capital structure does not include debt.

C)

In an agency problem known as asset substitution, the agency cost is paid by
A) the equity holders, since they will lose all their money whether or not the project is successful.
B) the debt holders, since if the risky project is not successful debt holders will lose all their money.
C) the debt holders, since if the risky project is successful debt holders will receive less money.
D) the equity holders, since the strategy has a negative expected payoff.

B)

Which of the following statements is false?
A) Differences in tax preferences create clientele effects, in which the dividend policy of a firm is optimized for the tax preference of its investor clientele.
B) Individuals in the highest tax brackets have a preference for stocks that pay high dividends, whereas tax-free investors and corporations have a preference for stocks with no or low dividends.
C) While many investors have a tax preference for share repurchases rather than dividends, the strength of that preference depends on the difference between the dividend tax rate and the capital gains tax rate that they face.
D) The dividend-capture theory states that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors receive the dividend.

B)

24. Which of the following statements is false?
A) A target leverage ratio means that the firm adjusts its debt proportionally to the project's value or its cash flows.
B) Because we don't value the tax shield separately, with the Adjusted Present Value (APV) method we need to include the benefit of the tax shield in the discount rate as we do in the Weighted Average Cost of Capital (WACC) method.
C) The first step in the Adjusted Present Value (APV) method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage.
D) To compute the present value of the interest tax shield, we need to determine the appropriate cost of capital.

B)

Which of the following statements is false?
A) The first step in the Flow-To-Equity (FTE) method is to determine the project's free cash flow to equity.
B) In the Flow-To-Equity (FTE) method, the cash flows to equity holders are discounted using the weighted average cost of capital.
C) In the Weighted Average Cost of Capital (WACC) and Adjusted Present Value (APV) methods, the value of a project is based on its free cash flow, which is computed ignoring interest and debt payments.
D) In the Flow-To-Equity (FTE) method, the free cash flow available to equity holders is explicitly calculated, taking into account all payments to and from debt holders.

B)

Which of the following statements is FALSE?
A) The Law of One Price implies that leverage will affect the total value of the firm under perfect capital market conditions.
B) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of the firm.
C) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
D) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets.

A)

4. Which of the following statements is FALSE in perfect capital markets?
A) A firm's WACC is dependent on its capital structure and is equal to its equity cost
of capital only if the firm is unlevered.
B) With no debt, the WACC is equal to the unlevered equity cost of capital.
C) Although debt has a lower cost of capital than equity, leverage does not lower a
firm's WACC.
D) As the firm borrows at the low cost of capital for debt, its equity cost of capital
rises, but the net effect is that the firm's WACC is unchanged.

A)

Which of the following statements is FALSE?
A) To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice.
B) The bankruptcy code is designed to provide an orderly process for settling a firm's debts.
C) In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process.
D) Whether paid by the firm or its creditors, the indirect costs of bankruptcy increase the value of the assets that the firm's investors will ultimately receive.

D)

Which of the following statements is FALSE?
A) If there were no costs of financial distress, the value of the firm would continue to increase with increasing debt until the interest on the debt exceeds the firm's earnings before interest and taxes and the tax shield is exhausted.
B) The costs of financial distress reduce the value of the levered firm. The amount of the reduction decreases with the probability of default, which in turn increases with the level of the debt.
C) Firms with steady, reliable cash flows, such as utility companies, are able to use high levels of debt and still have a very low probability of default.
D) The tradeoff theory states that firms should increase their leverage until it reaches the level D* for which the levered value is maximized.

B)

In an agency problem known as debt overhang, if the company has risky debt outstanding, equity holders will choose to invest only if
A) the debt holders will lose all their money.
B) the NPV of the project exceeds a cutoff equal to the relative riskiness of the firm's debt times its debt-equity ratio.
C) the NPV of the project is negative.
D) the profitability index of the project exceeds a cutoff equal to the relative riskiness of the firm's debt times its debt-equity ratio.

D)

23. Which of the following statements regarding the APV method is FALSE?
A) The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage.
B) To compute the present value of the interest tax shield, we need to discount the interest tax shield with rwacc.
C) To determine the project's debt capacity for the interest tax shield calculation, we need to know the value of the project.
D) The firm's unlevered cost of capital is equal to its pre-tax weighted average cost of capital - that is, using the pre-tax cost of debt, rd, rather than its after-tax cost, rd (1 - tc ).

B)

Which of the following statements is FALSE in a Modigliani and Miller (MM) world
with perfect capital markets?
A) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.
B) When a firm changes its capital structure without changing its investments, its levered beta will remain unaltered; however, its asset beta will change to reflect the effect of the capital structure change on its risk.
C) The unlevered beta measures the market risk of the firm's business activities, ignoring any additional risk due to leverage.
D) The unlevered beta measures the market risk of the firm without leverage, which is equivalent to the beta of the firm's assets.

B)

Which of the following statements regarding the trade-off theory is FALSE?
A) The presence of financial distress costs can explain why firms choose debt levels that are too high to fully exploit the interest tax shield.
B) At the point D*, where the value of the levered firm is maximized, the tax savings that result from increasing leverage are just offset by the increased probability of incurring the costs of financial distress.
C) With higher costs of financial distress, it is optimal for the firm to choose lower leverage.
D) Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries.

A)

Which of the following statements is FALSE?
A) Covenants may limit the firm's ability to pay large dividends or may limit the types of investments that the firm can make.
B) Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants.
C) Covenants are often designed to prevent management from exploiting debt holders, so covenants may help to reduce agency costs.
D) Agency costs are smallest for long-term debt.

D)

Select the text that correctly completes the following sentence: The cost of ________ is highest for firms that are likely to have profitable future growth opportunities requiring large investments.
A) debt maturity
B) asset substitution
C) debt overhang
D) debt covenants

C)

Which of the following statements is FALSE?
A) When a firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight.
B) Managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. As a result, managers may expand (or fail to shut down) unprofitable divisions, pay too much for acquisitions, make unnecessary capital expenditures, or hire unnecessary employees.
C) Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress.
D) According to the empire building hypothesis, leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.

D)

Which of the following statements is FALSE?
A) The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is to pay no dividends at all.
B) Shareholders typically must pay taxes on the dividends they receive. They must also pay capital gains taxes when they sell their shares.
C) Firms that use dividends will have to pay a lower after-tax return to offer their investors the same pre-tax return as firms that use share repurchases.
D) If dividends are taxed at a higher rate than capital gains, then shareholders will prefer share repurchases to dividends.

C)

Which of the following statements regarding the
A) The intuition for the WACC method is that the firm's weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after-tax basis.
B) The WACC can be used throughout the firm as the company-wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm's debt-equity ratio.
C) To be profitable, a project should generate an expected return that is smaller than the firm's weighted average cost of capital.
D) An advantage of the WACC method is that you do not need to know how the firm's leverage policy is implemented to make the capital budgeting decision.

C)

Which of the following statements is FALSE?
A) In the FTE method, we explicitly calculate the free cash flow available to equity holders taking into account all payments to and from debt holders.
B) The value of the project's free cash flow to equity (FCFE) represents the gain to shareholders from the project.
C) The FTE method does not have the same disadvantage associated with the APV method: We do not need to compute the project's debt capacity to determine interest and net borrowing before we can make the capital budgeting decision.
D) The WACC and APV methods compute the firm's enterprise value, so that a separate valuation of the other components of the firm's capital structure is needed to determine the value of equity.

C)