Deck 17: Does Debt Policy Matter

Question 1

The law of conservation of value implies that

A)the return on a firm's common stock is unchanged when debt is added to its capital structure.
B)the value of any asset is preserved regardless of the nature of the claims against it.
C)the return on a firm's debt is unchanged when common stock is added to its capital structure.
D)the value of an asset increases as debt is reduced.

Answer 1

the value of any asset is preserved regardless of the nature of the claims against it.

Question 2

For a levered firm,

A)as earnings before interest and taxes (EBIT)increases, earnings per share (EPS)increases by the same percentage.
B)as EBIT increases, EPS increases by a larger percentage.
C)as EBIT increases, EPS decreases by the same percentage.
D)as EBIT increases, EPS decreases by a larger percentage.

Answer 2

as EBIT increases, EPS increases by a larger percentage.

Question 3

If an investor buys a portion (X)of an unlevered firm's equity, then his/her payoff is

A)(X)× (profits).
B)(X)× (interest).
C)(X)× (profits − interest).
D)(1/X)× (profits).

Answer 3

(X)× (profits).

Question 4

When a firm has no debt, then such a firm is known as
I.an unlevered firm;
II.a levered firm;
III.an all-equity firm

A)I only
B)II only
C)III only
D)I and III only

Question 5

Modigliani and Miller's Proposition I states that

A)the market value of any firm is independent of its capital structure.
B)the market value of a firm's debt is independent of its capital structure.
C)the market value of a firm's common stock is independent of its capital structure.
D)None of these options.

Question 6

The law of conservation of value implies that
I.the mix of common stock and preferred stock does not affect the value of the firm;
II.the mix of long-term and short-term debt does not affect the value of the firm;
III.the mix of secured and unsecured debt does not affect the value of the firm

A)I only
B)II only
C)III only
D)I, II, and III

Question 7

Value additivity works for
I.combining assets;
II.splitting up of assets;
III.the mix of debt securities issued by the firm

A)I only
B)II only
C)I and II only
D)I, II, and III

Question 8

If a firm is financed with both debt and equity, the firm's equity is known as

A)unlevered equity.
B)levered equity.
C)preferred equity.
D)None of these options.

Question 9

Under what conditions would a policy of maximizing the value of the firm not be the same as a policy of maximizing shareholders' wealth?

A)If the issue of debt increases the financial risk of the firm's equity
B)If the firm issues debt for the first time
C)If the beta of equity is positive
D)If an issue of debt affects the market value of existing debt

Question 10

The total market value (V)of the securities of a firm that has both debt (D)and equity (E)is

A)V = D − E.
B)V = E − D.
C)V = D × E.
D)V = D + E.

Question 11

If an investor buys a portion (X)of both the debt and equity of a levered firm, then his/her payoff is

A)(X)× (profits).
B)(X)× (interest).
C)(X)× (profits − interest).
D)None of these options.

Question 12

The law of conservation of value implies that
I.the mix of senior and subordinated debt does not affect the value of the firm;
II.the mix of convertible and nonconvertible debt does not affect the value of the firm;
III.the mix of common stock and preferred stock does not affect the value of the firm

A)I only
B)II only
C)III only
D)I, II, and III

Question 13

If an individual wants to borrow with limited liability, he/she should

A)invest in the equity of an unlevered firm.
B)borrow on his/her own account.
C)invest in the equity of a levered firm.
D)invest in a risk-free asset like T-bills.

Question 14

An investor can undo the effect of leverage on his/her own account by
I.investing in the equity of an unlevered firm;
II.borrowing on his/her own account;
III.investing in risk-free debt like T-bills

A)I only
B)II only
C)III only
D)I and III above

Question 15

Capital structure is irrelevant if
I.capital markets are efficient;
II.each investor can borrow/lend on the same terms as the firm;
III.there are no tax benefits to debt

A)I only
B)II only
C)III only
D)I, II, and III

Question 16

The capital structure of the firm can be defined as
I.the firm's mix of different debt securities;
II.the firm's mix of different securities used to finance assets;
III.the market imperfection that the firm's managers can exploit

A)I only
B)II only
C)III only
D)I, II, and III

Question 17

If firm U is unlevered and firm L is levered, then which of the following is true?
I.V_U = E_U.
II.V_L = E_L + D_L.
III.V_L = E_U + D_L.

A)I only
B)I and II only
C)I, II, and III
D)III only

Question 18

An investor can create the effect of leverage on his/her account by
I.buying equity of a levered firm;
II.investing in risk-free debt like T-bills;
III.borrowing on his/her own account

A)I only
B)II only
C)III only
D)I and III only

Question 19

If an investor buys a portion (X)of the equity of a levered firm, then his/her payoff is

A)(X)× (profits).
B)(X)× (interest).
C)(X)× (profits − interest).
D)(1/X)× (profits − interest).

Question 20

A policy of maximizing the value of the firm is the same as a policy of minimizing the weighted average cost of capital providing that
I.the firm's investment policy is settled;
II.there are no taxes;
III.an issue of new debt does not affect the market value of existing debt

A)I only
B)II only
C)III only
D)I, II, and III

Question 21

Health and Wealth Company is financed entirely by common stock that is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after refinancing? (Ignore taxes.)

A)18.0 percent
B)21.0 percent
C)15.0 percent
D)10.5 percent

Question 22

For an all-equity firm,

A)as earnings before interest and taxes (EBIT)increases, the earnings per share (EPS)increases by the same percentage.
B)as EBIT increases, the EPS increases by a larger percentage.
C)as EBIT increases, the EPS decreases at the same rate.
D)as EBIT increases, the EPS decreases by a larger percentage.

Question 23

An EPS-operating income graph, such as Figure 17.1, shows the
I.greater risk associated with debt financing, which is evidenced by a greater slope;
II.the break-even point where EPS of two different debt ratios are equal;
III.the minimum operating income needed to pay the interest for a given level of debt

A)I only
B)II only
C)III only
D)I, II, and III only

Question 24

The effect of financial leverage on the performance of the firm depends on the

A)expected rate of return on equity.
B)firm's level of operating income.
C)current market value of the debt.
D)rate of dividend growth.

Question 25

According to an EPS-operating income graph, such as Figure 17.1, EPS is higher when expected operating income is

A)less than the break-even income.
B)greater than the break-even income.
C)equal to the break-even income.
D)not able to be determined.

Question 26

Wealth and Health Company is financed entirely by common stock that is priced to offer a 15 percent expected return. The common stock price is $40/share. The earnings per share (EPS)is expected to be $6. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected value of earnings per share after refinancing? (Ignore taxes.)

A)$6.00
B)$7.52
C)$7.20
D)$6.90

Question 27

In an EPS-operating income graph, such as Figure 17.1, the slope of the line is steeper when the debt ratio is higher. The debt line has a negative intercept because

A)the break-even point is higher with debt.
B)a fixed interest charge must be paid even at low earnings.
C)the amount of interest per share has only a positive effect on the intercept.
D)the higher the interest rate, the greater the slope.

Question 28

A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

A)8 percent
B)10 percent
C)12 percent
D)14 percent

Question 29

A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes?

A)21 percent
B)18 percent
C)15 percent
D)16 percent

Question 30

A firm is unlevered and has a cost of equity capital of 9 percent. What is the cost of equity if the firm becomes levered at a debt-equity ratio of 2? The expected cost of debt is 7 percent. (Assume no taxes.)

A)15.0 percent
B)16.0 percent
C)14.5 percent
D)13.0 percent

Question 31

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected return. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected return on its common stock after refinancing?

A)32 percent
B)28 percent
C)20 percent
D)14 percent

Question 32

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. The company wishes to repurchase 50 percent of the stock and substitutes an equal value of debt yielding 8 percent. Suppose that before refinancing, an investor owned 100 shares of Learn and Earn common stock. What should he do if he wishes to ensure that risk and expected return on his investment are unaffected by this refinancing?

A)Borrow $3,000 and buy 50 more shares.
B)Continue to hold 100 shares.
C)Sell 50 shares and purchase $3,000 of 8 percent debt (bonds).
D)Sell 8 percent of his stock and invest in bonds.

Question 33

The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)

A)1.50
B)1.10
C)0.30
D)0.15

Question 34

The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?

A)1.20
B)0.73
C)0.20
D)0.87

Question 35

A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be

A)8 percent.
B)16 percent.
C)13 percent.
D)10 percent.

Question 36

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because interest payments on the debt

A)vary with EBIT levels.
B)stay fixed, leaving less income to be distributed over fewer shares.
C)stay fixed, leaving less income to be distributed over more shares.
D)stay fixed, leaving more income to be distributed over fewer shares.

Question 37

MM Proposition II states that
I.the expected return on equity is positively related to leverage;
II.the required return on equity is a linear function of the firm's debt to equity ratio;
III.the risk to equity increases with leverage

A)I only
B)II only
C)III only
D)I, II, and III

Question 38

Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the earnings per share are $12. If the company repurchases 50 percent of the stock and substitutes an equal value of debt yielding 8 percent, what is the expected earnings per share value after refinancing?

A)$12.00
B)$19.20
C)$24.00
D)$15.60

Question 39

For a levered firm where b_A = beta of assets and b_D = beta of debt, the return on equity (r_E)is equal to

A)r_E = r_A.
B)r_E = r_A + (D/E)× [r_A − r_D]
C)r_E = r_A + (D/(D +E))× [r_A - r_D]
D)None of these options.

Question 40

The cost of capital for a firm, r_WACC, in a tax-free environment is
I.equal to the market value weighted average of the return on equity and the return on debt;
II.equal to r_A, the rate of return for that business risk class;
III.equal to the overall rate of return required on the levered firm

A)I only
B)II only
C)III only
D)I, II, and III

Question 41

For a levered firm where b_A = beta of assets and b_D = beta of debt, the equity beta (b_E)equals

A)b_E = b_A
B)b_E = b_A + (D/E)× [b_A - b_D]
C)b_E = b_A + (D/(D +E))× [b_A − b_D]
D)None of these options.

Question 42

A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10 percent. Its overall cost of capital is 14 percent. What is its cost of equity if there are no taxes?

A)13 percent
B)16 percent
C)15 percent
D)18 percent

Question 43

The beta of an all-equity firm is 1.2. Suppose the firm changes its capital structure to 50 percent debt and 50 percent equity using 8 percent debt financing. What is the equity beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)

A)1.2
B)2.2
C)2.4
D)1.7

Question 44

According to Modigliani and Miller Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged.

Question 45

Generally, which of the following is true?

A)r_E < r_D < r_A
B)r_D < r_A < r_E
C)r_E < r_A < r_D
D)r_D < r_E < r_A

Question 46

Modigliani and Miller Proposition II states that the rate of return required by shareholders increases steadily as the firm's debt-equity ratio increases.

Question 47

The M&M Company is financed by $4 million (market value)in debt and $6 million (market value)in equity. The cost of debt is 5 percent and the cost of equity is 10 percent. Calculate the weighted average cost of capital. (Assume no taxes.)

A)10 percent
B)15 percent
C)8 percent
D)7 percent

Question 48

Which of the following is true?

A)b_D > b_A > b_E
B)b_E > b_A > b_D
C)b_A > b_E > b_D
D)b_A > b_D > b_E

Question 49

A firm's return on assets is 12 percent and the cost of the firm's debt is 7 percent. Given a 0.7 debt-equity-ratio, what is the levered cost of equity? Assume that there are no taxes.

A)7.0 percent
B)12.0 percent
C)13.6 percent
D)15.5 percent

Question 50

According to Modigliani and Miller Proposition II, the rate of return required by debtholders linearly increases as the firm's debt-equity ratio increases.

Question 51

The law of conservation of value does not apply to the mix of a firm's debt securities.

Question 52

The firm's mix of securities used to finance its assets is called the firm's capital structure.

Question 53

The after-tax weighted average cost of capital (WACC)is given by (corporate tax rate = T_C):

A)WACC = (r_D)(D/V)+ (r_E)(E/V)
B)WACC = (r_D)(D/V)+[(r_E )(E/V)/(1 − T_C)]
C)WACC = [(r_D)(D/V)+ (r_E)(E/V)]/(1 − T_C)
D)WACC = (r_D)(1 − T_C)(D/V)+ (r_E)(E/V)

Question 54

If MM's Proposition I holds, minimizing the weighted average cost of capital (WACC)is the same as maximizing the

A)market value of the firm.
B)book value of the firm.
C)profits of the firm.
D)liquidating value of the firm.

Question 55

Generally, which of the following is true?

A)r_D > r_A > r_E
B)r_E > r_D > r_A
C)r_E > r_A > r_D
D)r_A > r_E > r_D

Question 56

Assume the following data for U&P Company: Debt (D)= $100 million; Equity (E)= $300 million; r_D = 6%; r_E = 12%; and T_C = 30%. Calculate the after-tax weighted average cost of capital (WACC):

A)10.5 percent
B)15.00 percent
C)10.05 percent
D)9.45 percent

Question 57

The M&M Company is financed by $10 million in debt (market value)and $40 million in equity (market value). The cost of debt is 10 percent and the cost of equity is 20 percent. Calculate the weighted average cost of capital assuming no taxes.

A)18 percent
B)20 percent
C)10 percent
D)12 percent

Question 58

Generally, which of the following is true? (b = beta)

A)b_D < b_A < b_E
B)b_E < b_A < b_D
C)b_A < b_E < b_D
D)b_A < b_D < b_E

Question 59

Modigliani and Miller's Proposition I states that the market value of any firm is independent of its capital structure.

Question 60

If the debt beta is zero, then the relationship between the equity beta and the asset beta is given by

A)equity beta = 1 + [(beta of assets)/(debt-equity ratio)].
B)equity beta = (1 − debt-equity ratio)(beta of assets).
C)equity beta = (1 + debt-equity ratio)(beta of assets).
D)equity beta = 1 + (debt-equity ratio/ beta of assets).

Question 61

According to the graph of WACC for Union Pacific, which of the following is (are)true?
I.The cost of equity is an increasing function of the debt-equity ratio.
II.The cost of debt is an increasing function of the debt-equity ratio.
III.The weighted average cost of capital (WACC)is a decreasing function of the debt-equity ratio.

A)I only
B)I and II only
C)III only
D)I, II, and III

Question 62

The principle of value additivity holds for the aggregation of assets but does not apply to the division of assets.

Question 63

A firm's equity beta is 1.2 and its debt is risk free. Given a 0.7 debt to equity ratio, what is the firm's asset beta? (Assume no taxes.)

A)0.7
B)1.0
C)1.2
D)0.0

Question 64

Briefly explain how changes in the debt-equity ratio change the firm's equity beta.

Question 65

According to Modigliani and Miller Proposition II, since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.

Question 66

Explain the concept of value additivity.

Question 67

Investors require higher returns on levered equity than on equivalent unlevered equity.

Question 68

State the generalized version of Modigliani-Miller Proposition I.

Question 69

Briefly discuss some of the applications of the law of conservation of value.

Question 70

State and explain MM's Proposition II.

Question 71

A firm's asset beta equals the weighted average of the betas on its debt and equity, given the assumption of no taxes.

Question 72

According to Modigliani and Miller Proposition II, the firm's expected return on assets depends on several factors including the firm's capital structure.

Question 73

Financial leverage increases the expected return and risk of the shareholder.

Question 74

Briefly describe the traditionalists' position on capital structure.

Question 75

The firm's asset beta is usually higher than the firm's equity beta.

Question 76

What circumstances violate MM's Proposition I? Briefly discuss.

Question 77

Describe the break-even point, as displayed on an EPS-operating income graph.

Question 78

Explain why, as a function of the debt-equity ratio, the cost of debt graph is concave at high levels of debt.

Question 79

State the law of conservation of value.

Question 80

The firm's debt beta is usually approximately 1.0.