Deck 13: Does Debt Policy Matter

Question 1

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 the above

Answer 1

The market value of any firm is independent of its capital structure

Question 2

For a levered 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

Answer 2

As EBIT increases, the EPS increases by a larger percent

Question 3

Capital structure of the firm can be defined as:
I. the firm's debt-equity ratio
II. the firm's mix of different securities used to finance assets
III. the market imperfection that the firm's manager can exploit

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

Answer 3

II only

Question 4

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 non-convertible 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 5

If an investor buys "a" proportion of an both debt and equity of a levered firm (firm L) Then his/her payoff is:

A) (a) * (profits)
B) (a) * (interest)
C) (a) * (profits - interest)
D) none of the above

Question 6

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

A) V = D - E
B) V = E - D
C) V = D * E
D) V = D + E

Question 7

Capital structure is irrelevant if:

A) the capital markets are perfect
B) each investor holds a fully diversified portfolio
C) each investor holds the same proportion of debt and equity of the firm
D) all of the above

Question 8

The law of conservation of value implies that:

A) The value of 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 value of a firm's debt is unchanged when common stock is added to its capital structure
D) None of the above

Question 9

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

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

Question 10

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 11

If firm U is unlevered and firm L is levered, then which of the following is true:
I. VU = EU
II. VL = EL + DL
III. VL = EU + DL

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

Question 12

If an investor buys "a" proportion of the equity of a levered firm (firm L) then his/her payoff is:

A) (a) * (profits)
B) (a) * (interest)
C) (a) * (profits - interest)
D) none of the above

Question 13

If an investor buys "a" proportion of an unlevered firm's (firm U) equity then his/her payoff is:

A) (a) * (profits)
B) (a) * (interest)
C) (a) * (profits - interest)
D) none of the above

Question 14

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 15

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 the above

Question 16

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

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

Question 17

If an individual wanted 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 18

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

A) If the issue of debt increases the probability of bankruptcy
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 19

A policy of maximizing the value of the firm is the same as a policy of maximizing the shareholders' wealth rests on two important assumptions. They are:
I. the firm can ignore dividend policy
II. the debt equity ratio of the firm does not change
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 and III only

Question 20

"Value additivity" works for:
I. combining assets
II. splitting up of assets
III. 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 21

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

A) 32%
B) 28%
C) 20%
D) None of the above

Question 22

For a levered firm, beta of equity (bE) is equal to:

A) bE = bA
B) bE = bA + (D/E) * [bA - bD]
C) bE = bA + (D/(D + E)) * [bA - bD]
D) None of the above

Question 23

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

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

Question 24

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

A) Borrow $3,000 and buy 50 more shares
B) Continue to hold 100 shares
C) Sell 50 shares and purchase $3,000 debt (bonds)
D) None of the above

Question 25

According to EPS-operating income graph, debt financing is preferred if the expected operating income is:

A) less than the break-even income
B) greater then the break-even income
C) equal to the break-even income

Question 26

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

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

Question 27

If a firm is unlevered and has a cost of equity capital 9%, what would the cost of equity be if the firms became levered at a debt-equity ratio of 2? The expected cost of debt is 7%. (Assume no taxes.)

A) 15.0%
B) 16.0%
C) 14.5%
D) 13%

Question 28

An EPS-Operating Income graph shows the trade-off between financing plans and:
I. Greater risk associated with debt financing, which is evidenced by the greater slope
II. Their break-even point
III. The minimum earnings needed to pay the debt financing for a given level of debt

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

Question 29

For a levered firm, return on equity (rE) is equal to:

A) rE = rA
B) rE = rA + (D/E) * [rA - rB]
C) rE = rA + (D/(D + E)) * [rA - rB]
D) None of the above

Question 30

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

A) $12.00
B) $19.20
C) $24.00
D) None of the above

Question 31

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

A) 8%
B) 16%
C) 13%
D) 10%
E) None of the above
RE = 10 + (60/40)(10 - 8) = 10 + 3 = 13

Question 32

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

Question 33

The cost of capital for a firm, rWACC, in a tax-free environment is:

A) Equal to the expected EBIT divided by market value of the unlevered firm
B) Equal to rA, the rate of return for that business risk class
C) Equal to the overall rate of return required on the levered firm
D) All of the above

Question 34

MM Proposition II states that:

A) The expected return on equity is positively related to leverage
B) The required return on equity is a linear function of the firm's debt to equity ratio
C) The risk to equity increases with leverage
D) All of the above
E) None of the above

Question 35

When comparing levered vs. unlevered capital structures, leverage works to increase EPS
For high levels of operating income because:

A) Interest payments on the debt vary with EBIT levels
B) Interest payments on the debt stay fixed leaving less income to be distributed over fewer shares
C) Interest payments on the debt stay fixed, leaving less income to be distributed over more shares
D) Interest payments on the debt stay fixed, leaving more income to be distributed over less number of shares

Question 36

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

A) 18%
B) 21%
C) 15%
D) None of the above

Question 37

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

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

Question 38

In an EPS-Operating Income graphical relationship, the slope of the debt line is steeper than the equity line. The debt line has a negative value for 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 39

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

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

Question 40

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

A) $6.00
B) $7.52
C) $7.20
D) None of the above

Question 41

The beta of an all equity firm is 1.2. If the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing, what will be the 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) None of the above

Question 42

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

Question 43

Minimizing the weighted average cost of capital (WACC) is the same as:

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

Question 44

A firm's return on assets is estimated to be 12% and the cost of the firm's debt is 7%. Given a .7 debt to equity ratio, what is the levered cost of equity?

A) 7%
B) 12%
C) 13.6%
D) 15.5%

Question 45

The "law of conservation of value" is not applicable to the mix of debt securities.

Question 46

According to the graph of WACC for Union Pacific, the following is (are) true:
I. cost of equity is an increasing function of the debt-equity ratio.
II. cost of debt is an increasing function of the debt-equity ratio.
III. 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 47

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

Question 48

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) 1.2
B) 0.73
C) 0.2
D) None of the above

Question 49

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% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)

A) 10%
B) 15%
C) 8%
D) None of the above

Question 50

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

A) 10.5%
B) 15%
C) 10.05%
D) 9.45%

Question 51

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

A) bD < bA < bE
B) bE < bA < bD
C) bA < bE < bD
D) None of the above is true

Question 52

Generally, which of the following is true?

A) rD > rA > rE
B) rE > rD > rA
C) rE > rA > rD
D) None of the above is true

Question 53

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% and the cost of equity is 20%. Calculate the weighted average cost of capital assuming no taxes.

A) 18%
B) 20%
C) 10%
D) None of the above

Question 54

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

A) WACC = (rD)(D/V) + (rE)(E/V)
B) WACC = (rD)(D/V) +[(rE )(E/V)/(1 - TC)]
C) WACC = [(rD)(D/V) + (rE)(E/V)]/(1 - TC)
D) WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)

Question 55

If beta of debt is zero, then the relationship between equity beta and 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) None of the above

Question 56

Which of the following is true?

A) bD > bA > bE
B) bE > bA > bD
C) bA > bE > bD
D) None of the above is true

Question 57

Generally, which of the following is true?

A) rE < rD < rA
B) rD < rA < rE
C) rE < rA < rD
D) None of the above is true

Question 58

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

Question 59

Value additivity does not hold good when assets are split up.

Question 60

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) 1.5
B) 1.1
C) 0.3
D) None of the above

Question 61

State and explain MM's Proposition II.

Question 62

Explain the concept of arbitrage.

Question 63

Briefly explain how EPS-Operating Income analysis helps determine the capital structure of a firm?

Question 64

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

Question 65

State the generalized version of Modigliani-Miller proposition I.

Question 66

MM's proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the need of such a clientele.

Question 67

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

Question 68

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

Question 69

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

Question 70

The beta of the firm is equal to the weighted average of the betas on its debt and equity under the assumption of no taxes.

Question 71

State the law of conservation of value.

Question 72

Briefly describe the traditional position on capital structure.

Question 73

Under what circumstances would MM's proposition is violated? Briefly discuss.

Question 74

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

Question 75

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 76

Discuss a successful example of corporations trying to add value through innovative financing.

Question 77

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

Question 78

Expected return on assets depends on several factors including the firm's capital structure.