Question 1

An implicit cost of adding debt to the capital structure is that it:

Accepted Answer

A)   adds interest expense to the operating statement.
B)   increases the required return on equity.
C)   reduces the expected return on assets.
D)   decreases the firm's beta.E) B) and D)
F) B) and C)

Question 2

The trade-off theory of capital structure suggests that firms:

Accepted Answer

A)   add leverage whenever interest rates are low.
B)   with higher risk should use less debt.
C)   should use 50% debt and 50% equity.
D)   should use debt to overcome high par values of stock.E) A) and B)
F) A) and C)

Question 3

Which one of the following statements is true regarding the trade-off theory?

Accepted Answer

A)   Highly profitable firms should have low debt ratios.
B)   All firms should have the same target debt-equity ratio.
C)   Riskier firms should have high target debt ratios.
D)   Less risky firms ought to have a greater amount of debt financing.E) B) and C)
F) A) and D)

Question 4

Debt usage will have an effect on:

Accepted Answer

A)   business risk.
B)   financial risk.
C)   operating risk.
D)   asset risk.E) B) and D)
F) A) and B)

Question 5

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

Accepted Answer

A)   minimizes the financial distress costs.
B)   maximizes the present value of the interest tax shield.
C)   equates the present values of the incremental interest tax shield and the incremental financial distress costs.
D)   maximizes the after-tax cash flows that are internally generated.E) A) and C)
F) A) and B)

Question 6

Costs of financial distress are greater when a firm increases its:

Accepted Answer

A)   intangible assets as a percentage of total assets.
B)   tangible assets as a percentage of total assets.
C)   net working capital.
D)   retained earnings.E) B) and C)
F) A) and B)

Question 7

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Accepted Answer

A)   firm uses no debt in its capital structure.
B)   firm uses the maximum amount of debt in its capital structure.
C)   firm uses a debt-equity ratio of 1.0.
D)   corporate tax rate approaches 100%.E) A) and B)
F) A) and C)

Question 8

Assume a firm is financed with 60% debt on which it pays interest of 7%.What is the expected return on equity if the expected return on assets is 12%? Ignore taxes.

Accepted Answer

A)   16.14%
B)   20.30%
C)   19.50%
D)   21.67%E) C) and D)
F) A) and B)

Question 9

The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____.

Accepted Answer

A)   increases; increases
B)   increases; decreases
C)   decreases; decreases
D)   decreases; increasesE) All of the above
F) A) and B)

Question 10

Leverage will _____ shareholders' expected return and ______ their risk.

Accepted Answer

A)   increase; decrease
B)   decrease; increase
C)   increase; increase
D)   increase; do nothing toE) A) and B)
F) All of the above

Question 11

Calculate the WACC for a firm that pays 10% on its debt,requires an 18% rate of return on its equity,finances 45% of the market value of its assets with debt,and has a tax rate of 35%.

Accepted Answer

A)   12.83%
B)   14.00%
C)   14.40%
D)   18.20%E) B) and C)
F) B) and D)

Question 12

The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Accepted Answer

A) True 
 B)False

Question 13

A firm has perpetual debt of $10 million at an interest rate of 7%.What is the present value of the interest tax shield if the tax rate is 35%?

Accepted Answer

A)   $245,000
B)   $700,000
C)   $3,500,000
D)   $10,000,000E) A) and D)
F) B) and C)

Question 14

A firm with a debt-equity ratio of 0.5,a return on assets of 14%,and a return on debt of 8%,will have a return on equity of:

Accepted Answer

A)   15.25%.
B)   16.00%.
C)   17.00%.
D)   17.33%.E) C) and D)
F) B) and C)

Question 15

The pecking-order theory suggests that less profitable firms borrow more because:

Accepted Answer

A)   equity issues are more expensive.
B)   leverage is preferred over raising funds internally.
C)   debt issues are good omens.
D)   they have insufficient internal funds.E) A) and B)
F) None of the above

Question 16

When taxes are considered,the value of a levered firm equals the value of the:

Accepted Answer

A)   unlevered firm.
B)   unlevered firm plus the value of the debt.
C)   unlevered firm plus the present value of the tax shield.
D)   unlevered firm plus the value of the debt plus the value of the tax shield.E) A) and C)
F) B) and D)

Question 17

Which one of the following statements is false according to MM's proposition I?

Accepted Answer

A)   Firm value is unaffected by the firm's capital structure.
B)   Proposition I is also called the debt-irrelevance proposition.
C)   Shareholders should care about the firm's debt policy.
D)   After restructuring, the firm's value should be the same as it was prior to restructuring.E) None of the above
F) A) and C)

Question 18

A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.If the firm does not pay tax,what will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt?

Accepted Answer

A)   EPS decreases by 33.3% to $10.00.
B)   EPS stays at $12.50.
C)   EPS increases by 140% to $30.00.
D)   EPS increases by 240% to $42.50.E) B) and C)
F) None of the above

Question 19

According to the trade-off theory,if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs,then the:

Accepted Answer

A)   tax shield has been calculated incorrectly.
B)   firm is too heavily levered.
C)   firm has reached its optimal debt level.
D)   firm appears to have a low risk of financial distress.E) C) and D)
F) All of the above

Question 20

Financial risk refers to the:

Accepted Answer

A)   risk of owning equity securities.
B)   risk faced by equityholders of firms with debt.
C)   general business risk of the firm.
D)   possibility that interest rates will increase.E) B) and D)
F) A) and D)

Exam 16: Debt Policy

Which one of the following statements is false according to MM's proposition I?

Correct Answer
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The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

Correct Answer
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Assume a firm is financed with 60% debt on which it pays interest of 7%.What is the expected return on equity if the expected return on assets is 12%? Ignore taxes.

Correct Answer
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Leverage will _ shareholders' expected return and __ their risk.

Correct Answer
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A firm with a debt-equity ratio of 0.5,a return on assets of 14%,and a return on debt of 8%,will have a return on equity of:

Correct Answer
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The present value of a perpetual tax shield increases as the firm's tax rate _ and as the amount of the debt_.

Correct Answer
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Calculate the WACC for a firm that pays 10% on its debt,requires an 18% rate of return on its equity,finances 45% of the market value of its assets with debt,and has a tax rate of 35%.

Correct Answer
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A firm has perpetual debt of $10 million at an interest rate of 7%.What is the present value of the interest tax shield if the tax rate is 35%?

Correct Answer
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The trade-off theory of capital structure suggests that firms:

Correct Answer
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Correct Answer
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Which one of the following statements is true regarding the trade-off theory?

Correct Answer
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Financial risk refers to the:

Correct Answer
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Costs of financial distress are greater when a firm increases its:

Correct Answer
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An implicit cost of adding debt to the capital structure is that it:

Correct Answer
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When taxes are considered,the value of a levered firm equals the value of the:

Correct Answer
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In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Correct Answer
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The pecking-order theory suggests that less profitable firms borrow more because:

Correct Answer
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The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Correct Answer
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Debt usage will have an effect on:

Correct Answer
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According to the trade-off theory,if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs,then the:

Correct Answer
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Exam 16: Debt Policy

Which one of the following statements is false according to MM's proposition I?

Correct AnswerverifiedShow Answer

The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:

Correct AnswerverifiedShow Answer

Assume a firm is financed with 60% debt on which it pays interest of 7%.What is the expected return on equity if the expected return on assets is 12%? Ignore taxes.

Correct AnswerverifiedShow Answer

Leverage will _____ shareholders' expected return and ______ their risk.

Correct AnswerverifiedShow Answer

A firm with a debt-equity ratio of 0.5,a return on assets of 14%,and a return on debt of 8%,will have a return on equity of:

Correct AnswerverifiedShow Answer

The present value of a perpetual tax shield increases as the firm's tax rate _____ and as the amount of the debt_____.

Correct AnswerverifiedShow Answer

Calculate the WACC for a firm that pays 10% on its debt,requires an 18% rate of return on its equity,finances 45% of the market value of its assets with debt,and has a tax rate of 35%.

Correct AnswerverifiedShow Answer

A firm has perpetual debt of $10 million at an interest rate of 7%.What is the present value of the interest tax shield if the tax rate is 35%?

Correct AnswerverifiedShow Answer

The trade-off theory of capital structure suggests that firms:

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Which one of the following statements is true regarding the trade-off theory?

Correct AnswerverifiedShow Answer

Financial risk refers to the:

Correct AnswerverifiedShow Answer

Costs of financial distress are greater when a firm increases its:

Correct AnswerverifiedShow Answer

An implicit cost of adding debt to the capital structure is that it:

Correct AnswerverifiedShow Answer

When taxes are considered,the value of a levered firm equals the value of the:

Correct AnswerverifiedShow Answer

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Correct AnswerverifiedShow Answer

The pecking-order theory suggests that less profitable firms borrow more because:

Correct AnswerverifiedShow Answer

The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals that may lower the stock price.

Correct AnswerverifiedShow Answer

Debt usage will have an effect on:

Correct AnswerverifiedShow Answer

According to the trade-off theory,if the PV of the tax shield generated by debt is equal to the PV of the financial distress costs,then the:

Correct AnswerverifiedShow Answer

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Leverage will _ shareholders' expected return and __ their risk.

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The present value of a perpetual tax shield increases as the firm's tax rate _ and as the amount of the debt_.

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