Fin3403 Exam 3 Conceptual Qs

The capital intensity ratio can be defined as the level of assets needed to support a given level of sales, and we might expect to observe differences in this ratio between different industries.

A. True

B. False

A. True

Holding all other factors constant, such as interest expense and dividends, an increase in the cost of goods sold should increase a firm’s need for additional capital.

A. True

B. False

A. True

Errors in the sales forecast can be offset by similar errors in costs and income forecasts. Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm.

A. True

B. False

B. False

The term "spontaneously generated funds" generally refers to increases in the cash account that result from growth in sales, assuming the firm is operating with a positive profit margin.

A. True

B. False

B. False

Additional funds needed are typically raised from some combination of notes payable, accounts payable, accruals, long-term bonds, and common stock. We can consider these accounts to be non-spontaneous, since they require an explicit financing decision by the form to increase them.

A. True

B. False

B. False

The net present value (NPV) method assumes that intervening cash flows will be reinvested at the risk-free rate, while the internal rate of return (IRR) method assumesthat intervening cash flows will be reinvested at the firm’s cost of capital.

A. True

B. False

B. False

An increase in the firm's inventory balance will normally require additional financing unless the increase is matched by an equally large decrease in some other asset account.

A. True

B. False

A. True

To determine the amount of additional funds needed, you may subtract the expected increase in liabilities (a source of funds) from the sum of the expected increases in retained earnings and assets (both uses of funds).

A. True

B. False

B. False

Which of the following statements concerning percent of sales forecasting is most correct?

A. Simply due to its mathematical basis, the equation model for percent of sales

forecasting will produce a more accurate forecast than a spreadsheet model.

B. As long as the firm is currently operating at full capacity, fixed assets should be set as a constant percent of sales, even if they may be somewhat lumpy in reality.

C. Although the firm may exhibit economies of scale, the percentages that we observe for individual assets (such as cash, inventory, fixed assets, etc.) will not vary over time as the sales of the firm change.

D. A disadvantage of the spreadsheet model is that it is not easy to include

changes in a firm’s profit margin, changes in its dividend policy, planned

acquisitions of assets, or repayments of liabilities.

E. Determining additional funds needed (AFN) may require an iterative solution, since financing charges may lead to circular relationships: income statement determines additions to the balance sheet, which determines funding needs, which determine financing charges, which determines the income statement, and so on.

E.

Select the statement that is most correct.

A. If a firm forecasts a large need for additional funds needed, a good strategy to raise the capital is to increase the dividend payout rate.

B. Suppose a firm is operating its fixed assets below 100 percent capacity (and

assuming that it cannot sell or lease these assets) but is at 100 percent with

respect to current assets. If sales grow, the firm can offset the needed

increase in current assets simply by switching production to its idle fixed

assets.

C. Additional funds needed are typically raised from some combination of notes

payable, long-term bonds, and common stock. These accounts are

nonspontaneous in that they require an explicit financing decision to increase

them.

D. If a firm retains all of its earnings, then it will not need any additional funds to

support sales growth.

E. None of the statements above is correct

C.

Considering each action independently and holding other things constant, which of the

following actions would reduce a firm's need for additional capital?

A. An increase in the dividend payout ratio.

B. A decrease in the profit margin.

C. A decrease in the days sales outstanding.

D. An increase in expected sales growth.

E. A decrease in the accrual accounts (accrued wages and taxes).

C.

Which of the following statements is least correct (most incorrect)?

A. A firm can use regression analysis for specific item forecasting, such as

inventory. However, regression analysis can also be used in conjunction with

the Capital Asset Pricing Model (CAPM) to determine the required rate of

return on a firm’s stock: that is, we can use regression analysis to calculate a

stock’s “beta” coefficient.

B. One of the advantages of using the spreadsheet model to calculate a firm’s

AFN is that it is easier to incorporate such things as economies of scale and

lumpy assets than when using the equation model.

C. Financial forecasts should consider the effect of inflation on future prices.

Unfortunately, simply observing that total dollar sales are expected to increase

in the future does not mean that planners have included the effect of inflation

on future prices. The increase in dollar sales could simply be due to the fact

that more units will be sold, not that each unit will be sold at a higher price.

D. One way of looking at percent of sales forecasting is in terms of sources and

uses of funds. Percentage of sales forecasting can tell us how much assets

are expected to increase in the future. However, this increase in assets is a

use of funds that must be offset by a source of funds. Some of the funds may

come from spontaneously increasing liabilities. Some of the funds may come

from additions to the firm’s retained earnings. The remaining funds are

additional funds needed and their source is determined by management.

E. Certain liabilities generally increase spontaneously with sales. These would

include any of the firm’s current liabilities, such as accounts payable, notes

payable, accruals, and capital leases, but would not include long-term liabilities

such as long-term debt or even equity.

E.

Which of the following statements is most correct?

A. Any forecast of financial requirements involves determining how much money the firm will need and is obtained by adding together increases in assets and spontaneous liabilities and subtracting operating income.

B. The percent of sales method of forecasting financial needs requires only a

forecast of the firm’s balance sheet. Although a forecasted income statement

helps clarify the need, it is not essential to the percent of sales method.

C. Because dividends are paid after taxes from retained earnings, dividends are

not included in the percent of sales method of forecasting.

D. Financing feedbacks describe the fact that interest must be paid on the debt

used to help finance AFN and dividends must be paid on the shares issued to

raise the equity part of the AFN. These payments would lower the net income

and retained earnings shown in the projected financial statements.

E. None of the statements above is correct.

D.

6. Which of the following statements is most correct?

A. If the capital intensity ratio is high, this permits sales to grow more rapidly

without much outside capital.

B. The lower the profit margin, the lower the additional funds needed because

less assets are needed to support existing sales.

C. When positive economies of scale are present, linear balance sheet

relationships no longer hold. As sales increase, a proportionately greater stock

of assets is required to support the higher sales level.

D. Technological considerations often require firms to add fixed assets in large,

discrete units. Such assets are called lumpy assets and they affect the firm’s

financial requirements through the fixed assets/sales ratio at different sales

levels.

E. The percent of sales method accounts for changing balance sheet ratios and

thus, cyclical changes in the actual sales to assets ratio do not have an impact

on financing requirements.

D.

Which of the following statements is incorrect (least correct)?

A. When using regression analysis on historical data to determine a security’s

beta, the returns for the security (dependent variable) are regressed against

the returns for the market (independent variable). The resulting slope

coefficient is equal to beta.

B. Just because a stock has a negative beta does not necessarily mean that its

expected return must also be negative.

C. The slope of the security market line defines the degree of investors’ risk

aversion. If investors become more risk averse, the slope of this line will

increase.

D. If you add enough randomly selected stocks to a portfolio, you can completely

eliminate all of the “market risk” from the portfolio.

E. It is quite simple to convert a variance/covariance matrix into a correlation

matrix, since all the data that is needed to do this is already embedded within

the variance/covariance matrix.

D.

Which of the following statements is most correct?

A. Since accounts payable and accruals must eventually be paid, as these

accounts increase, AFN also increases.

B. Suppose a firm is operating its fixed assets below 100 percent capacity but is

at 100 percent capacity with respect to current assets. If sales grow, the firm

can offset the needed increase in current assets with its idle fixed assets

capacity.

C. If a firm retains all of its earnings, then it will not need any additional funds to

support sales growth.

D. Additional funds needed are typically raised from some combination of notes

payable, long-term bonds, and common stock. These accounts are

nonspontaneous in that they require an explicit financing decision to increase

them.

E. All of the statements above are false.

D.

9. Considering each action independently and holding all other factors constant, which of

the following actions would increase a firm's need for additional capital?

A. A decrease in the firm’s dividend payout ratio.

B. An increase in the cost of goods sold.

C. A decease in the firm’s total assets outstanding

D. A decrease in the expected sales growth

E. An increase in the firm’s accounts receivable turnover.

B.

Select the statement that is most correct.

A. U.S. Treasury Bonds, banker’s acceptances, and commercial paper are all

examples of capital market instruments.

B. If the maturity risk premium (MRP) is greater than zero, then the yield curve

must be upward sloping.

C. Additional funds needed are best defined as the amount of cash generated in a

given year minus the amount of cash needed to finance the additional capital

expenditures and working capital needed to support the firm’s growth.

D. The percent of sales method is based on the assumptions that most balance

sheet accounts are tied directly to sales and that the current level of total

assets is optimal for the current sales level.

E. The yield on a 3-years corporate bond will always exceed the yield on a 2-year

corporate bond.

D.

Firms that are comprised of multiple divisions of differing degrees of risk, but which use a corporate-wide cost of capital to evaluate projects, are likely to reject good (positive NPV), high risk and high rate of return projects while accepting bad (negative NPV), low risk and low rate of return projects

A. True

B. False

B. False

The sensitivity of an NPV profile, at least in part, is a function of the timing of the cash flows.

A. True

B. False

A. True

The NPV of a project will increase as the cost of capital decreases, even for projects

with complex cash flows (multiple changes in sign).

A. True

B. False

B. False

Simulation analysis is a computerized version of scenario analysis that, instead of using

finite states of nature (or future states of the world/economy) like scenario analysis, uses

continuous probability distributions of the input variables.

A. True

B. False

A. True

If comparing two mutually exclusive projects that have “normal” cash flows, conflicts

between NPV and IRR will arise if the cost of capital exceeds the discount rate at which

their NV profiles cross.

A. True

B. False

B. False

The net present value (NPV) method assumes that cash flows are reinvested at the cost

of capital, while the internal rate of return (IRR) method assumes that cash flows are

reinvested at the project’s IRR.

A. True

B. False

A. True

A project’s rate of depreciation (for example, the use of MACRS versus straight line) can

have an impact on the operating cash flows for the project, even though depreciation is

not a cash expense.

A. True

B. False

A. True

In general, the greater the strategic advantages of being the first competitor to enter a

given market, the more attractive it may be to exercise an investment timing option and

wait before making the investment.

A. True

B. False

B. False

Changes in net operating working capital do not need to be considered in capital

budgeting cash flow analysis as long as the nominal (undiscounted) values of the

changes are identical in each time period.

A. True

B. False

B. False

If an investment project would make use of land which the firm currently owns, the

project should be charged with the opportunity cost of the land.

A. True

B. False

A. True

Assume that a project has a risky cash outflow at the end of the project’s life (e.g., a

reclamation expenditure). If this outflow is riskier than the project’s cash inflows, then it

should be discounted back at a higher risk-adjusted discount rate.

A. True

B. False

B. False

Changes in net operating working capital do not need to be considered in capital

budgeting cash flow analysis as long as the nominal (undiscounted) values of the

changes are identical in each time period.

A. True

B. False

B. False

Estimating project cash flows is considered the most important and the most difficult step

in the capital budgeting process. Both the number of variables and the

nterdepartmental nature of the process contribute to the difficulty of estimating cash flows.

A. True

B. False

A. True

Real options occur when managers have the opportunity to change the cash flows of a

project by responding to changing conditions after the project has been implemented.

A. True

B. False

A. True

Just like with any other security, the price of an option decreases as the risk, or

underlying volatility, increases.

A. True

B. False

B. False

Because present value refers to the value of cash flows that occur at different points in

time, present values cannot be added to determine the value of a capital budgeting

project.

A. True

B. False

B. False

One advantage of the payback period method of evaluating fixed asset investment

possibilities is that it provides a rough measure of a project's liquidity and risk.

A. True

B. False

A. True

Conflicts between two mutually exclusive projects, where the NPV method chooses one

project but the IRR method chooses the other, should generally be resolved in favor of

the project with the higher NPV.

A. True

B. False

A. True

Other things held constant, an increase in the cost of capital discount rate will result in a

decrease in a project's IRR.

A. True

B. False

B. False

The NPV method's assumption that cash inflows are reinvested at the cost of capital is

more reasonable than the IRR's assumption that cash flows are reinvested at the IRR.

This makes the NPV method preferable to the IRR method.

A. True

B. False

A. True

Which of the statements below is incorrect (least correct)?

A. One of the problems with using the profitability index for mutually exclusive

projects is that the relative superiority of one project over another can be

influenced by the scale of the projects.

B. Net present value (NPV) analysis assumes that cash flows from a project can

be reinvested at the current risk-free rate.

C. Net present value (NPV) profiles can be influenced by the timing of a project’s

cash flow. Projects with a “later” cash flow will be more sensitive to changes in

the cost of capital and will have a steeper NPV profile.

D. Using payback may lead to incorrect investment decisions, since it ignores all

cash flows that occur after the payback period and, unless cash flows are

discounted, it ignores the time value of money.

E. For a single project with a normal cash flow stream (a single cash outflow at

the beginning of the project), both NPV and IRR will lead to the same

accept/reject decision.

B.

Which of the following statements is most correct?

A. For most projects, the modified internal rate of return (MIRR) will be superior to

the internal rate of return (IRR), since MIRR assumes that cash flows can be

reinvested at the project’s IRR, while IRR assumes that cash flows can be

reinvested at the project’s cost of capital (WACC).

B. If a project has net cash outflows during the life of the project (say reclamation

expense at the end of the project’s life), and these cash outflows are riskier

than the net cash inflows for the project, it would be most correct to discount

these cash outflows at a higher cost of capital to adjust for this risk.

C. Since a firm’s investment in net working capital for a specific project will be

recaptured at the end of the project’s life, the net effect is zero and we can

therefore ignore net working capital when performing a capital budgeting

analysis for the project.

D. Inflation should always be considered when performing a capital budgeting

analysis. Because of non-neutral inflation, there may be a difference in terms

of net present value (NPV) when discounting real cash flows at real rates

versus discounting nominal cash flows at nominal rates.

E. If a project has multiple internal rates of return (IRR), the correct IRR to use for

decision analysis is the lowest value. The lowest value is the best indicator of

the true return on the project and will lead to correct accept/reject decisions

when it is compared to the project’s cost of capital.

D.

Which of the following statements is most correct?

A. The terminal value of a project is equal to its net present value compounded

forward at the modified internal rate of return for n years, where n is the life of

the project.

B. The NPV method assumes that cash flows will be reinvested at the cost of

capital while the IRR method assumes reinvestment at the risk-free rate.

C. The NPV method assumes that cash flows will be reinvested at the cost of

capital while the IRR method assumes reinvestment at the IRR.

D. NPV and IRR are both similar and different. They are similar in that they are

both additive and can be divided into component parts. They are different in

that they lead to differing accept/reject decisions for mutually exclusive

projects.

E. The IRR method does not consider all relevant cash flows, particularly those

cash flows beyond the payback period.

C.

4. Which of the following statements is most correct?

A. The ability to abandon a project if cash flows are lower than expected can have

value irrespective of whether the project is of higher or lower than average risk.

B. Proper analysis of project’s cash flows to determine its NPV requires that those

cash flows include both opportunity costs and sunk costs.

C. Monte Carlo simulation can provide valuable information about the risk of a

project’s cash flow, such as the standard deviation of the cash flow, but it

cannot tell us anything about the expected cash flow.

D. Changes in net operating working capital can be excluded from a project’s cash

flows because the funds will be recaptured at the conclusion of the project.

E. A company that uses accelerated depreciation will have higher net income in

the early years and lower net income in the later years, all other things held

constant.

A.

Select the statement that is most correct.

A. The ability to abandon a project if cash flows are lower than expected can have

value irrespective of whether the project is of higher or lower than average risk.

B. Proper analysis of project’s cash flows to determine its NPV requires that those

cash flows include both opportunity costs and sunk costs.

C. Monte Carlo simulation can provide valuable information about the risk of a

project’s cash flow, such as the standard deviation of the cash flow, but it

cannot tell us anything about the expected cash flow.

D. Changes in net operating working capital can be excluded from a project’s cash

flows because the funds will be recaptured at the conclusion of the project.

E. Since depreciation is a non-cash expense, the firm does not need to know the

rate of depreciation when calculating operating cash flows.

A.

Which of the following statements is most correct?

A. The use of modified internal rate of return gets rid of the reinvestment rate

problem associated with internal rate of return, but may still lead to multiple

internal rates of return.

B. When we calculate a project’s cash flow for a net present value analysis, it is

essentially the same as the free cash flow concept discussed at the beginning

of the term. That is, the project’s free cash flow is equal to the operating cash

flow generated by the project, less the firm’s incremental investment in net

operating working capital, less the firm’s incremental investment in gross fixed

assets.

C. A project’s modified internal rate of return will always be less than its internal

rate of return, even if the project has no intervening cash flows over the life of

the project.

D. Real options embedded within a project have value. Therefore, if a project has

an investment timing option (the firm can delay taking on the project), the firm

can increase the project’s net present value by exercising the option and simply

postponing the date at which the project is taken on.

E. If a 10-year project has only a single cash outflow at the start of the project

(Year 0) and a single cash inflow at the end of the project (Year 10), then it is

impossible to calculate an equivalent annual annuity for the project.

B.

Assume that a project has a cash outflow at Year 0 and a single cash inflow at Year 5

(no intervening cash flows during Years 1-4). Which of the following statements is

most correct?

A. The project’s MIRR will always be greater that the project’s IRR, regardless of

the value of the cost of capital.

B. The project’s MIRR will always be equal to the project’s IRR, regardless of the

value of the cost of capital.

C. The project’s MIRR will always be less than the project’s IRR, regardless of the

value of the cost of capital.

D. The projects’ MIRR will be greater than the project’s IRR if the cost of capital is

less than the project’s IRR.

E. The project’s MIRR will be greater than the project’s IRR if the cost of capital is

greater than the project’s IRR.

B.

Which of the following statements is most correct?

A. If an asset to be used by a potential project is already owned by the firm, and if

that asset could be leased to another firm if the new project were not

undertaken, then the net rent that could be obtained should be charged as a

cost to the project under consideration.

B. Only incremental cash flows are relevant in project analysis and the proper

incremental cash flows are the reported accounting profits because they form

the true basis for investor and managerial decisions.

C. It is unrealistic to expect that increases in net operating working capital required

at the start of an expansion project are simply recovered at the project’s

completion. Thus, these cash flows are included only at the start of a project.

D. In a capital budgeting analysis where part of the funds used to finance the project

are raised as debt, failure to include interest expense as a cost in the cash flow

statement when determining the project’s cash flows will lead to an upward bias

in the NPV.

E. All of the statements above are incorrect.

A.

Which of the following statements is incorrect (least correct)?

A. In calculating a project’s cash flow, a firm should not subtract out financing

costs, such as interest expense, since these costs are already included in the

weighted average cost of capital, which is used to discount the project’s cash

flows.

B. Since it is a non-cash expense, the firm does not need to know the

depreciation rate (depreciation expense) associated with a project when

calculating the operating cash flows for a project.

C. The net present value method assumes that cash flows are reinvested at the

firm’s cost of capital, while the internal rate of return method assumes that cash

flows are reinvested at the project’s internal rate of return.

D. If a project has only a single cash outlay and a single cash inflow (no

intervening cash flows) then the modified internal rate of return for the project

will be equal to the project’s internal rate of return.

E. The internal rate of return is dependent only a project’s cash flows and the

timing of these flows, not the cost of capital (risk-adjusted discount rate) that

the firm assigns to the project.

B.

Select the statement that is most correct.

A. A firm should never undertake an investment if accepting the project would

cause an increase in the firm's cost of capital.

B. Given two mutually exclusive projects and a zero cost of capital, the payback

method and NPV method of selecting investments will always lead to the same

decision on which project to undertake.

C. Under certain conditions, a particular project may have more than one IRR.

One condition under which this situation can occur is if, in addition to the initial

investment at time = 0, a negative cash flow occurs at the end of the project's

life.

D. Other things held constant, an increase in the cost of capital discount rate will

result in a decrease in a project's IRR.

E. The modified IRR (MIRR) method has wide appeal to professors, but most

business executives prefer the NPV method to either the regular or modified

IRR.

C.

Select the statement that is most correct.

A. Real options affect the size, but not the risk, of a project’s expected cash flows.

B. Since the focus of capital budgeting is on cash flows rather than on net income,

changes in non-cash balance sheet accounts, such as inventory, are not

relevant in the analysis.

C. With the current techniques available, estimating cash flows has become the

easiest step in the analysis of a capital budgeting project.

D. A firm which bases its capital budgeting decisions on either NPV or IRR will be

more likely to accept a given project if it uses MACRS accelerated depreciation

than if it uses the optional straight-line alternative, other things being equal.

E. Externalities present in projects being considered in capital budgeting are very

difficult to quantify and, as a result of this, they should be excluded from the

financial analyses.

D.

The optimal capital structure for a firm simultaneously maximizes EPS and minimizes

the weighted average cost of capital (WACC).

A. True

B. False

B. False

When a company increases its debt ratio, the costs of equity and debt capital both

increase. Therefore, the weighted average cost of capital (WACC) must also increase.

A. True

B. False

B. False

Because of leverage effects and tax shelter effects, a firm’s use of additional debt

financing will increase the firm’s return on equity, but may also increase the

stockholders’ required rate of return.

A. True

B. False

B. False

A change in a firm’s capital structure (debt versus equity) can have an immediate impact

on the levered or equity beta of the firm’s stock, but should have no impact on the firm’s

asset or unlevered beta unless the firm also changes the composition (i.e., risk) of its

assets.

A. True

B. False

A. True

In a world with no taxes, MM show that the capital structure of a firm does not affect the

value of the firm. However, when taxes are considered, MM show a positive relationship

between debt and value.

A. True

B. False

A. True

In a world with no taxes, MM (Modigliani and Miller) show that the capital structure of a

firm does not affect the value of the firm (i.e., capital structure is irrelevant). However,

when taxes are considered, MM show a positive relationship between debt and value

(i.e., firm’s should go towards 100 percent debt financing).

A. True

B. False

A. True

The optimal capital structure for a firm will maximize the firm’s weighted average cost of

capital and minimize the firm’s net income (i.e., the free cash flow that goes to the equity

shareholders).

A. True

B. False

B. False

The optimal capital structure for a firm will minimize the firm’s weighted average cost of

capital and maximize the firm’s net income (i.e., the free cash flow that goes to the

equity shareholders).

A. True

B. False

B. False

Modigliani and Miller showed that in a world without taxes, a firm’s optimal capital

structure would be to go towards 100 percent debt financing.

A. True

B. False

B. False

The graphical probability distribution for return on equity (ROE) when financial leverage

is used, would tend to be more peaked and have less dispersion than a distribution

where no leverage is present, other things held constant.

A. True

B. False

B. False

Financial leverage affects both EPS and EBIT, while operating leverage only affects

EBIT.

A. True

B. False

B. False

Assume that the equity beta for an all equity (unlevered) firm is 1.0. Assume now that

the firm changes its capital structure to 50% debt and 50% equity, using 8% debt

financing, and a tax rate of 40%. You may also assume that the beta for debt is zero.

Given these conditions, which of the following statements is most correct?

A. The beta of the firm’s equity will increase.

B. The beta of the firm’s underlying assets will increase.

C. The beta of the firm’s equity will decrease.

D. The beta of the firm’s underlying assets will decrease.

E. The beta of the firm’s equity will remain unchanged.

A.

Which of the following statements is incorrect (least correct)?

A. If a firm un-expectantly increases the amount of debt in its capital structure, but

is not required to refinance its existing debt, then there may be a transfer of

wealth form existing debtholders to existing shareholders.

B. The possibility of bankruptcy has a negative effect on the value of the firm

because a bankruptcy has real costs associated with it.

C. Modigliani and Miller stated that the value of the firm, when including the effect

of corporate income taxes, can be expressed as VL = VU + (TC)(D).

D. If a firm were facing the possibility of immediate bankruptcy, then rational equity

investors would prefer the company to cut its dividend payments to conserve

cash.

E. For an all equity firm, as earnings before interest and taxes (EBIT) increase, the

earnings per share (EPS) will increase by a higher percent.

E.

Which of the following statements is most correct?

A. A firm’s optimal capital structure will maximize the cash flow (net income)

available to the equity investors.

B. The more highly levered a firm is, the less risk there is to bondholders, since

they will then control more votes when it comes time to elect the board of

directors at the firm’s annual meeting.

C. When a firm increases the amount of debt in its capital structure and becomes

more highly levered, the firm’s WACC will go down and a project’s NPV will go

up, but the increase in interest expense will also lead to smaller operating cash

flows and a reduction in the project’s IRR.

D. In a profitable firm with a degree of operating leverage greater than one,

increasing sales will lead to a more than proportional increase in net income.

E. Modigliani and Miller conclusively showed that the amount of debt in a firm’s

capital structure is totally irrelevant, even when corporate taxes are considered.

D.

Which of the following statements is false (least correct)? As a firm increases its

operating leverage for a given quantity of output, this:

A. changes its operating cost structure.

B. increases its business risk.

C. increases the standard deviation of its EBIT.

D. increases the variability in earnings per share.

E. decreases its financial leverage.

E.

Select the statement that is most correct.

A. A firm’s optimal capital structure will maximize the cash flow (net income)

available to the equity investors.

B. The more highly levered a firm is, the less risk there is to bondholders, since

they will then control more votes when it comes time to elect the board of

directors at the firm’s annual meeting.

C. When a firm increases the amount of debt in its capital structure and becomes

more highly levered, the firm’s WACC will go down and a project’s NPV will go

up, but the increase in interest expense will also lead to smaller operating cash

flows and a reduction in the project’s IRR.

D. In a profitable firm with a degree of operating leverage greater than one,

increasing sales will lead to a more than proportional increase in net income.

E. Modigliani and Miller conclusively showed that the amount of debt in a firm’s

capital structure is totally irrelevant, even when corporate taxes are considered.

D.

Which of the following statements is most correct?

A. By its very nature, there is a symmetrical relationship between the degree of

operating leverage (DOL) and the degree of financial leverage (DFL). That is,

firms with a high DOL will also have a high DFL and firms with a low DOL will

also have a low DFL.

B. In a Miller and Modigliani world with corporate taxes, the tax shelter created by

the use of additional debt will exactly offset the higher cost of equity that arises

because of the increased leverage. This results in the weighted average cost

of capital remaining constant for all levels of debt.

C. A firm’s use of debt/leverage can increase expected ROE. This implies that the

optimal course of action for the firm is to increase its level of debt until

expected ROE is maximized.

D. For any positive debt/equity ratio and tax rate less than 100 percent, the firm’s

levered beta will be less than its unlevered beta. This potential decrease in the

cost of equity as the firm adds more debt to its capital structure is what allows

the weighted average cost of capital to decrease.

E. An example of an agency problem would be a firm increasing its total debt level

without first retiring its old debt. Since the original debt holders are now

exposed to more risk (greater leverage), their required rate of return goes up

and the value of their debt goes down.

E.

Which of the following statements is incorrect (least correct)?

A. A decrease in a firm’s debt ratio will generally have no effect on a firm’s

business risk.

B. A decrease in a firm’s degree of operating leverage may encourage a firm to

increase the amount of debt in its capital structure, especially if it wishes to

maintain its degree of total leverage.

C. An increase in a firm’s debt ratio may have an effect on the firm’s financial risk,

its total risk (sigma or stand alone risk), and its market (beta) risk.

D. An increase in the corporate tax rate is likely to increase the use of debt by the

average firm, since an increase in the tax rate will increase the value of interest

tax shelters.

E. The optimal capital structure for a firm is found by determining the debt-equity

mix that will maximize EPS, which in turn will maximize the value of the firm,

the price per share, and hence shareholders’ wealth.

E.

For an all equity firm,

A. As earnings before interest and taxes (EBIT) increases, the earnings per share

(EPS) increases by the same percent

B. As EBIT increases, the EPS increases by a larger percent

C. As EBIT increases, the EPS decreases

D. None of the above

A.

MM's Proposition I corrected for the inclusion of corporate income taxes is expressed

as:

A. VL = VU

B. VL = VU + D(1-TC)

C. VL = VU + (TC)(D)

D. VU = VL + (TC)(D)

C.

What are some of the possible consequences of financial distress?

A. Debtholders, who face the prospect of getting only part of their money back,

are likely to want the company to take additional risks.

B. Equity investors would like the company to cut its dividend payments to

conserve cash.

C. Equity investors would like the firm to shift toward riskier lines of business

D. Equity investors would like the firm to settle up with creditors as fast as

possible

C.

The possibility of bankruptcy has a negative effect on the value of the firm because:

A. Increased bankruptcy risk lowers value

B. Reorganization is costless but risk is not

C. A bankruptcy has real costs associated with it

D. Value enhancing strategies are no longer available

C.

Select the statement that is most correct.

A. The firm's business risk is largely determined by the financial characteristics of

its industry.

B. If a firm utilizes debt financing and has a constant tax rate, then a decrease in

earnings before interest and taxes (EBIT) will result in a more than

proportionate decrease in earnings per share.

C. Firm A has a higher degree of business risk than Firm B. Firm A can offset this

by using less financial leverage. Therefore, the variability of both firms'

expected EBITs could actually be identical.

D. According to MM, in a world without taxes, the optimal capital structure for a

firm is approximately 100 percent debt financing.

E. Other things held constant, an increase in financial leverage will decrease a

firm's market (or systematic) risk as measured by its beta coefficient.

B.