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Which of the following are true when a firm is operating at its target capital structure point?
I. The WACC is at its minimum point.
II. The debt-equity ratio is equal to 1.
III. Shareholder value is maximized.
IV. The total value of the firm is maximized.
A) I and IV only
B) II and III only
C) I and III only
D) I, III, and IV only
E) I, II, III, and IV
D) I, III, and IV only
Which one of the following statements concerning financial leverage is correct?
A) Leverage is beneficial only when EBIT is relatively low.
B) Financial leverage lowers the risk level of a firm.
C) M&M Proposition I states that financial leverage is irrelevant to the value of a firm.
D) All of the above.
E) None of the above.
C) M&M Proposition I states that financial leverage is irrelevant to the value of a firm.
Assume there are no corporate or personal taxes. According to M&M Proposition:
A) I, the total value of the firm depends on how cash flows are divided up between stockholders and bondholders.
B) I, a firm's capital structure is relevant.
C) II, the cost of equity rises as the firm increases its use of debt financing.
D) II, the cost of equity depends on the firm's business risk but not its financial risk.
E) I and II, as debt increases, the increase in the cost of equity is more than offset by the lower cost of debt and the WACC falls.
C) II, the cost of equity rises as the firm increases its use of debt financing.
A firm that is approaching bankruptcy will find that
A) stockholders will try to push the firm into bankruptcy as rapidly as possible
B) indirect bankruptcy costs such as opportunity costs will tend to decrease
C) managers will seek to protect the value of the assets of the firm as much as possible
D) direct bankruptcy costs such as filing fees will tend to diminish
E) bondholders will attempt to push the firm into bankruptcy to prevent their position from deteriorating
E) bondholders will attempt to push the firm into bankruptcy to prevent their position from deteriorating
If borrowing (debt) provides interest tax shield and financial distress (bankruptcy) is costly then
(i)
(ii)
(iii)
Study above three results and then the following two statements carefully and then select your response from A to D:
Statement 1: Starting at 0, as D/E increases, market value of the firm first increases then attains a maximum value and then starts falling.
Statement 2: Starting at 0, as D/E increases, WACC (weighted average cost of capital) first decreases then attains a maximum value and then starts falling.
Both statements are true
Statement 1 is true and Statement 2 is false
Statement 1 is false and Statement 2 is true
Both statements are false
None of the above
Statement 1 is true and Statement 2 is false (Add pic)
Ajax Corp. has been operating as three separate divisions over the past ten years, although all capital budgeting decisions are ultimately made at the home office using the firm's overall WACC. Just recently, they discovered the divisions have significantly different risks. Which of the following is also likely to be true?
A) The divisions are being rewarded for decreasing their risk.
B) Its low earning division tends to be ignored in capital allocation even though it tends to maintain lower levels of risk.
C) Higher earning divisions will be less risky than the lower earning divisions.
D) The differences in risk among the divisions has no impact on the capital budgeting process.
E) The highest divisional cost of capital will approximately equal the firm's overall cost of capital.
B) Its low earning division tends to be ignored in capital allocation even though it tends to maintain lower levels of risk.
The equity beta of a firm depends on which of the following?
I. The firm's business risk.
II. The firm's financial policy.
III. The firm's advertising policy.
A) I and II only
B) III only
C) I and III only
D) II and III only
E) I, II, and III
A) I and II only
Firm A is levered. Firm B is unlevered. In all other aspects, Firms A and B are identical. There is no depreciation expense. Considering taxes, Firm A will have _____ net income and _____ cash flow from operations than will Firm B.
A) The same; the same
B) Lower; lower
C) Higher; higher
D) Higher; lower
E) Lower; higher
E) Lower; higher
The interest tax shield has more value when the amount of debt is _____ and the tax rate is _____.
A) Low; zero.
B) Low; high.
C) High; high.
D) High; zero.
E) Low; low.
C) High; high.
An individual investor who loans out part of their personal funds is in fact:
A) Increasing their benefits from the interest tax shield.
B) Eliminating the business risk of their investments.
C) Increasing their total financial leverage.
D) Offsetting part of the financial leverage of their investments.
E) Leveraging their investments.
D) Offsetting part of the financial leverage of their investments.
M&M Proposition I with taxes states that the:
A) Debt-equity ratio does not affect the total value of a firm.
B) Cost of equity financing increases as the debt-equity ratio rises.
C) Required return on assets is determined by the level of financial risk.
D) Value of a levered firm is equal to the present value of the interest tax shield plus the value of an unlevered firm.
E) Return on equity is dependent upon the marginal tax rate and the debt-equity ratio.
D) Value of a levered firm is equal to the present value of the interest tax shield plus the value of an unlevered firm.
The net present value of capital restructuring is equal to the:
A) Resulting change in the total value of the firm.
B) Additional debt incurred minus the additional interest expense.
C) Debt outstanding minus the market value of the equity.
D) Net change in the total debt outstanding.
E) Change in the shareholders value minus the additional interest expense incurred
A) Resulting change in the total value of the firm.
The value of a restructuring is equal to the net present value of the:
A) Resulting change in the total value of the firm.
B) Additional debt incurred minus the additional interest expense.
C) Debt outstanding minus the market value of the equity.
D) Net change in the total debt outstanding.
E) Change in the shareholders value minus the additional interest expense incurred.
A) Resulting change in the total value of the firm.
Short-run financial risk arising from the need to buy or sell at uncertain prices or rates in the near future is called __________________.
A) risk maximization
B) volatility maximization
C) economic exposure
D) transactions exposure
E) translation exposure
D) transactions exposure
The financial management goal as it pertains to the capital structure of a firm is to operate at the point where the debt-equity mix:
A) Creates the largest tax shield for the firm.
B) Maximizes the financial distress costs.
C) Maximizes the value of the firm
D) Minimizes the potential bankruptcy costs.
E) None of the above.
C) Maximizes the value of the firm
According to __________, a firm's cost of equity increases with greater debt financing, while the WACC first decreases and then increases.
A) M&M Proposition I with taxes
B) M&M Proposition I without taxes
C) the static theory of capital structure
D) M&M Proposition II without taxes
E) M&M Proposition II with taxes
C) the static theory of capital structure
According to ___________, a firm's cost of equity increases with greater debt financing, but the WACC remains unchanged.
A) M&M Proposition I with taxes
B) M&M Proposition I without taxes
C) the static theory of capital structure
D) M&M Proposition II without taxes
E) M&M Proposition II with taxes
D) M&M Proposition II without taxes
All else the same, which of the following is true about the interest tax shield of a firm with positive EBIT?
A) The higher the corporate tax rate, the less valuable the interest tax shield.
B) The interest tax shield increases as a firm reduces its level of outstanding debt.
C) The interest tax shield becomes more valuable as the size of the debt increases.
D) The lower the corporate tax rate, the more valuable the interest tax shield.
E) None of the above.
C) The interest tax shield becomes more valuable as the size of the debt increases.
Which of the following is true concerning the EPS of a levered firm in terms of the possible range of earnings? There are no taxes.
A) The EPS do not differ from those of an unlevered firm.
B) The EPS are greater than for an unlevered firm on the upside and equal on the downside.
C) The EPS are the same as for an unlevered firm on the upside and lower on the downside.
D) The EPS are greater than for an unlevered firm on the upside and lower on the downside.
E) The EPS are the same as for an unlevered firm on the upside and greater on the downside.
D) The EPS are greater than for an unlevered firm on the upside and lower on the downside.
Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure. Which of the following is true?
I. A firm's cost of equity depends on the firm's business and financial risks.
II. The value of the firm is dependent on its capital structure.
III. The cost of equity increases as the firm's leverage decreases.
A) I only
B) II only
C) III only
D) I and III only
E) II and III only
A) I only
According to M&M Proposition II without taxes, a firm's cost of equity is a function of which of the following factors?
I. The required rate of return on the firm's assets
II. The firm's debt/equity ratio
III. The firm's cost of debt
A) II only
B) I and II only
C) I and III only
D) II and III only
E) I, II, and III
E) I, II, and III
Which of the following statements is correct?
A) The use of personal leverage by an investor to alter the degree of financial leverage of a firm is called homemade leverage
B) The asset beta is a measure of the unsystematic risk of a firm's assets
C) In a purely capital restructuring, the composition of the assets of the firm will change
D) All of the above
E) None of the above
A) The use of personal leverage by an investor to alter the degree of financial leverage of a firm is called homemade leverage
Which of the following is not accurate regarding financial leverage?
A) The level of financial leverage that produces the highest firm value is the one most beneficial to stockholders.
B) Leverage is most beneficial when EBIT is relatively high.
C) Investors can undo the effects of the firm's capital structure by using homemade leverage.
D) Increasing financial leverage will always increase the EPS for stockholders.
E) None of the above.
D) Increasing financial leverage will always increase the EPS for stockholders.
The optimal capital structure is the mixture of debt and equity which:
I. Maximizes the value of the firm.
II. Minimizes the firm's weighted average cost of capital.
III. Maximizes the market price of the firm's bonds.
A) I only
B) III only
C) I and II only
D) I and III only
E) I, II, and III
C) I and II only
Which of the following is true about the WACC?
A) Since discount rates and firm value move in the same direction, minimizing the WACC will minimize the value of the firm.
B) The optimal capital structure is the one that maximizes the WACC.
C) The value of the firm will be maximized when the WACC is minimized.
D) All of the above.
E) None of the above.
C) The value of the firm will be maximized when the WACC is minimized.
The weighted average cost of capital can also be defined as the:
A) Market weighted cost of equity financing.
B) Rate of return based on net book value.
C) Adjusted homemade leverage rate of return.
D) Required return on a firm's overall assets.
E) None of the above.
D) Required return on a firm's overall assets.
The equity risk derived from the firm's capital structure policy is called ___________ risk.
A) market
B) systematic
C) financial
D) business
E) diversifiable
C) financial
The equity risk derived from the firm's operating activities is called ____________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) financial
D) business
The proposition that the value of the firm is independent of its capital structure is called:
A) The Capital Asset Pricing Model.
B) M&M Proposition I (without taxes).
C) M&M Proposition II.
D) The Law of One Price.
E) The Efficient Markets Hypothesis.
B) M&M Proposition I (without taxes).
The use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed is called:
A) Homemade leverage.
B) Dividend recapture.
C) The weighted average cost of capital.
D) Private debt placement.
E) A privileged subscription offer.
A) Homemade leverage.
The unlevered cost of capital is _________________.
A) the cost of capital for a firm with no equity in its capital structure
B) the cost of capital for a firm with no debt in its capital structure
C) the interest tax shield times pretax net income
D) the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure
E) equal to the profit margin for a firm with some debt in its capital structure
B) the cost of capital for a firm with no debt in its capital structure
The implicit costs associated with corporate default, such as lost sales, are the __________ of the firm.
A) flotation costs
B) default beta coefficients
C) direct bankruptcy costs
D) indirect bankruptcy costs
E) default risk premia
D) indirect bankruptcy costs
The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called the:
A) Static Theory of Capital Structure.
B) M&M Proposition I.
C) M&M Proposition II.
D) Capital Asset Pricing Model.
E) Open Markets Theorem.
A) Static Theory of Capital Structure.
The complete termination of the firm as a going business concern is called a ______________.
A) merger
B) repurchase program
C) liquidation
D) reorganization
E) divestiture
C) liquidation
A capital restructuring occurs when a firm:
A) Increases its debt-equity ratio while maintaining a constant debt-to-asset ratio.
B) Changes its debt-equity ratio without changing its total assets.
C) Reduces both its debt and its equity while maintaining a constant debt-equity ratio.
D) Changes its level of debt without changing its total equity.
E) Refinances its debt at a lower rate of interest.
B) Changes its debt-equity ratio without changing its total assets.
The cost of equity capital, based on M&M Proposition II (Case I), can be defined as:
A) RE = RD + (RA - RD) (D/E).
B) RE = RA + (RA - RD) (E/D).
C) RE = RA + (RA - RD) (D/E).
D) RE = RA + (RD - RA) (E/D).
E) RE = RD - (RD - RA) (D/E).
C) RE = RA + (RA - RD) (D/E).
The static theory of capital structure states that firms borrow up to the point where the tax benefit of one additional dollar of debt is equal to the marginal cost of:
A) Sales.
B) Equity.
C) Financial distress.
D) Leverage.
E) Financial capital
C) Financial distress.
When choosing a capital structure, the objective of the firm should be to:
A) Choose the one that maximizes the current value of the firm's bonds.
B) Choose the one that minimizes the value of the firm.
C) Choose the one that minimizes the firm's WACC.
D) Choose the one that results in the largest interest tax shield.
E) Choose any capital structure since it is always irrelevant.
C) Choose the one that minimizes the firm's WACC.
Which of the following statements is/are true regarding corporate borrowing when EBIT is positive?
I. Increasing financial leverage increases the sensitivity of EPS and ROE to changes in EBIT
II. The effect of financial leverage depends on the company's EBIT, that is, leverage is unfavourable when EBIT is relatively high, and leverage is favourable when EBIT is relatively low
III. High leverage decreases the returns to shareholders (as measured by ROE)
A) I only
B) II only
C) III only
D) I and II only
E) I, II, and III
A) I only
Which of the following statements regarding leverage is false?
A) The ultimate effect of leverage depends on the firm's EBIT.
B) If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).
C) As a firm levers up, shareholders are exposed to greater risk.
D) The benefits of leverage will not be as great in a firm with substantial accumulated losses or other types of tax shields compared to a firm without many tax shields.
E) Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.
B) If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).
According to _________, the value of the firm is independent of its capital structure.
A) M&M Proposition I without taxes
B) M&M Proposition I with taxes
C) the static theory of capital structure
D) M&M Proposition II without taxes
E) M&M Proposition II with taxes
A) M&M Proposition I without taxes
_____________ implies that the firm should issue as much debt as possible.
A) M&M Proposition I with taxes
B) M&M Proposition I without taxes
C) the static theory of capital structure
D) M&M Proposition II without taxes
E) M&M Proposition II with taxes
A) M&M Proposition I with taxes
Which of the following apply to levered firms but not to unlevered firms?
I. Financial risk
II. Systematic risk
III. Business risk
IV. Interest tax shield
A) I only
B) I and IV only
C) II and III only
D) II, III, and IV only
E) I, II, and IV only
B) I and IV only
Which one of the following statements is true?
A) The total value of a firm decreases as debt is initially added to an all equity firm, if taxes are considered.
B) The tax shield applies to both debt and equity financing.
C) The ideal capital structure minimizes the total tax liability.
D) Capital structure does matter when taxes are included.
E) The general conclusions of M&M Proposition II do not hold when taxes are considered.
D) Capital structure does matter when taxes are included.
Firm A is levered. Firm B is unlevered. In all other aspects, Firms A and B are identical. There is no depreciation expense. Considering taxes, Firm A will have _____ net income and _____ cash flow from operations than will Firm B.
A) The same; the same
B) Lower; lower
C) Lower; higher
D) Higher; lower
E) Higher; higher
C) Lower; higher
Which of the following are indirect costs of bankruptcy?
I. Loss of key employees
II. Foregone profitable projects due to debt restrictions
III. Loss created by sale of assets which was required to improve liquidity
IV. Accounting and legal fees incurred in the bankruptcy process
A) I and III only
B) I, II, and III only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, III, and IV
B) I, II, and III only
Which one of the following groups is most apt to push a company towards filing bankruptcy once the firm becomes financially distressed?
A) Executives
B) Employees
C) Stockholders
D) Bondholders
E) Suppliers
D) Bondholders
The cost of bankruptcy:
A) Includes only the direct costs associated with the actual bankruptcy filing.
B) At least partially offsets the benefits of the interest tax shield.
C) Is minimal due to the regulated processes that have been established under the Bankruptcy and Insolvency Act.
D) Is not affected by the level of the debt-equity ratio.
E) Ignores all opportunity costs.
B) At least partially offsets the benefits of the interest tax shield.
The optimal firm value is achieved when the:
A) Present value of the bankruptcy cost is minimized.
B) The interest tax shield on debt is maximized.
C) Weighted average cost of capital is minimized.
D) Debt-equity ratio is maximized.
E) Total net gain from leverage is equal to zero.
C) Weighted average cost of capital is minimized.
The interest tax shield has more value when the amount of debt is _____ and the tax rate is _____:
A) Low; zero.
B) Low; high.
C) High; zero.
D) High; high.
E) Low; low.
D) High; high.
Firm A has a debt-equity ratio of .5. Firm B has a debt-equity ratio of .8. All other features of these firms are identical. The return on equity of Firm A is:
A) Equally as volatile as the return of equity of Firm B.
B) Less volatile than the return on equity of Firm B.
C) More volatile than the return on equity of Firm B.
D) Unaffected by the debt-equity ratio.
E) None of the above
B) Less volatile than the return on equity of Firm B.
