Deck 16: Debt Policy

Question 1

MM's proposition I states that the required rate of return on equity increases as the firm's debt-equity ratio increases.

Answer 1

False

Question 2

When asked about key factors of debt policy,financial managers commonly mention the tax advantage of debt and the importance of maintaining their credit rating.

Answer 2

True

Question 3

MM's proposition I,or the debt-irrelevance proposition,states that the value of a firm is unaffected by its capital structure.

Answer 3

True

Question 4

Financial risk is the risk to shareholders that results from debt financing.

Question 5

The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.

Question 6

Financial leverage describes debt financing's amplification of the effects of changes in operating income on the returns to stockholders.

Question 7

Debt financing affects neither the operating risk nor the business risk of the firm.However,if there is less equity outstanding,a change in operating income has a greater impact on earnings per share.

Question 8

MM's proposition II states that the expected return on equity increases as the firm's debt-equity ratio increases.

Question 9

Under MM II assumptions,the expected return on equity is equal to the expected return on assets for a levered firm.

Question 10

Debt financing affects neither the business risk nor the financial risk of the firm.

Question 11

The benefit of an interest tax shield is captured by the equity holders.

Question 12

Debt finance does not affect the operating risk but it does add financial risk.

Question 13

Debt financing affects neither the operating risk nor the business risk of the firm.

Question 14

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

Question 15

Debt financing does not affect the operating risk but it does add financial risk.For example,when there is only half the equity to absorb the same amount of operating risk,risk per share must double.

Question 16

MM's proposition II states that the expected return on assets increases as the debt-equity ratio increases.

Question 17

Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones.

Question 18

Even after relaxing the MM assumption of no taxes,it can be observed that restructuring does not affect the value of the firm.

Question 19

According to MM,restructuring the firm will not change its overall value.

Question 20

Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their investment,debt is no cheaper than equity.

Question 21

At some debt-equity ratio,the costs of financial distress are expected to overcome the value of the tax shield for a firm.

Question 22

Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy.

Question 23

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 30% of assets?

A) 16.14%
B) 17.00%
C) 19.00%
D) 25.67%

Question 24

Compared to other countries,the U.S.bankruptcy system is debtor-friendly.

Question 25

A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if operating income increases to $2.0 million?

A) EPS increase to $15.63.
B) EPS increase to $16.67.
C) EPS increase to $17.50.
D) EPS increase to $20.00.

Question 26

What is meant by investors being able "to undo" the effects of corporate restructuring? Investors:

A) repay their portion of the firm's debt.
B) purchase securities only in unlevered firms.
C) will pay more for unlevered shares.
D) borrow in their name and replicate the effects of restructuring.

Question 27

Financial risk refers to the:

A) risk of owning equity securities.
B) risk faced by equityholders when debt is used.
C) general business risk of the firm.
D) possibility that interest rates will increase.

Question 28

Financial slack means having ready access to cash or debt financing.

Question 29

What is the proportion of debt financing for a firm that expects a 24% return on equity,a 16% return on assets,and a 12% return on debt? Ignore taxes.

A) 54.0%
B) 60.0%
C) 66.7%
D) 75.0%

Question 30

Under the assumptions necessary for MM I,if investors can borrow or lend at the same terms as the firm,they will:

A) invest in debt only and ignore equity investments.
B) not be willing to pay more for a restructured firm.
C) require a higher rate of return on equity.
D) accept a lower rate of return on equity.

Question 31

Management's perceived signals to investors form an important component of pecking order theory.

Question 32

When additional borrowing causes the probability of financial distress to increase rapidly,the potential costs of distress begin to take a substantial bite out of firm value.

Question 33

An increase in a firm's financial leverage will:

A) increase the variability in earnings per share.
B) always reduce the operating risk of the firm.
C) increase the value of the firm in a non-MM world.
D) increase the WACC.

Question 34

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount .The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?

A) EPS decrease to $10.00.
B) EPS decrease to $11.67.
C) EPS increase to $15.00.
D) EPS increase to $22.50.

Question 35

Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.

Question 36

At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate.

Question 37

When there are no taxes and capital markets function well,the market value of a company does not depend on its capital structure.

Question 38

The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them.

Question 39

The stability of a firm's operating income is the focus of:

A) financial leverage.
B) weighted-average cost of capital.
C) capital structure.
D) business risk.

Question 40

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount .The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

A) EPS decrease to $10.00.
B) EPS stay at $12.50.
C) EPS increase to $30.00.
D) EPS increase to $42.50.

Question 41

When taxes are ignored,which of the following can be used to calculate the weighted-average cost of capital?

A) Ratio of expected operating income to book value of all securities
B) The expected return on equity times the debt-equity ratio
C) Ratio of expected operating income to market value of all securities
D) The required return on equity plus the required return on debt

Question 42

MM proposition I states that a firm's value is unaffected by its:

A) required rate of return on equity.
B) operating income, in the absence of taxes.
C) interest rate paid on debt.
D) mixture of debt and equity.

Question 43

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

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

Question 44

Based upon the "trade-off theory" of capital structure,what differences might you expect in the capital structure of a food producer and a defense contractor?

A) Higher debt-equity ratio for food producer.
B) Higher debt-equity ratio for defense contractor.
C) Neither firm should use debt in their structure.
D) Differences in capital structure will make no valuation differences in these firms.

Question 45

What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the stock if operating income equals $1.5 million and EPS were $2 when the firm was all-equity-financed? Ignore taxes.

A) EPS increase to $2.60.
B) EPS increase to $3.00.
C) EPS increase to $4.80.
D) EPS increase to $5.20.

Question 46

A decrease in the possible range of percentage stock returns can be achieved by:

A) a decrease in the firm's financial leverage.
B) an increase in the firm's asset risk.
C) an increase in the firm's business risk.
D) a decrease in the firm's debt beta.

Question 47

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

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.

Question 48

The reason that financial leverage increases shareholder risk is that there is:

A) more debt which increases the operating risk.
B) less equity to absorb the operating risk.
C) less business risk to be spread around.
D) more financial risk due to reduced business risk.

Question 49

According to MM,an increase in expected earnings per share can leave the share price unchanged if the:

A) firm's operating risk decreases.
B) number of shares is decreased.
C) required return on equity increases.
D) firm has no financial leverage.

Question 50

Restructuring a firm involves changing the:

A) mix of liabilities and equity.
B) dividend payout ratio.
C) managerial personnel.
D) interest rate on debt.

Question 51

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

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.

Question 52

According to MM II,as a firm's debt-equity ratio decreases:

A) its financial risk increases.
B) its operating risk increases.
C) the required rate of return on equity increases.
D) the required rate of return on equity decreases.

Question 53

When debt is risky under MM II:

A) bondholders shift more of the risk to equityholders.
B) equityholders shift more of the risk to bondholders.
C) the value of the interest tax shield is at its highest.
D) there is more overall risk in the firm.

Question 54

What is the maximum rate that can be paid on debt and maintain a 14% WACC with a 19% expected return on equity in a firm with a 60% debt-to-asset ratio? Ignore taxes.

A) 6.50%
B) 9.90%
C) 10.67%
D) 11.14%

Question 55

What is the return on equity for a firm with 15% return on assets,10% return on debt,and a .75 debt-equity ratio?

A) 18.75%
B) 20.00%
C) 23.75%
D) 26.25%

Question 56

According to MM,if individuals cannot obtain the same borrowing terms as firms,then:

A) capital structure may be relevant.
B) capital structure may be irrelevant.
C) individuals should not invest in levered firms.
D) firms should increase their payments to individuals.

Question 57

A firm is currently expected to develop $2 EPS when operating income equals $4 million and interest expense equals $2 million.How low can operating income drop before EPS are reduced by half,to $1? Ignore taxes.

A) Operating income drops to $3.5 million.
B) Operating income drops to $3.0 million.
C) Operating income drops to $2.5 million.
D) Operating income drops to $2.0 million.

Question 58

A firm's capital structure is represented by its mix of:

A) assets.
B) liabilities and equity.
C) assets and liabilities.
D) assets, liabilities, and equity.

Question 59

A decrease of debt in the capital structure tends to reduce a firm's EPS when the firm:

A) faces high interest rates.
B) faces strong growth in business conditions.
C) pays taxes.
D) does not reinvest its earnings.

Question 60

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 70% of assets?

A) 16.14%
B) 17.00%
C) 19.00%
D) 25.67%

Question 61

Which of the following statements is false regarding MM's proposition I?

A) Firm value is unaffected by its capital structure.
B) It 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.

Question 62

How much debt is outstanding in a firm that has calculated the present value of a perpetual tax shield to be $300,000 if the tax rate is 35% and the debt carries a 10% rate of return?

A) $300,000
B) $857,143
C) $3,000,000
D) $3,750,000

Question 63

As the debt-equity ratio decreases when debt is not risk free:

A) debtholders demand a higher expected return.
B) debtholders demand a lower expected return.
C) the expected return on equity increases.
D) the expected return on assets increases.

Question 64

The WACC is used to value:

A) projects with any risk.
B) projects with the same risk as the firm's current business.
C) projects with the same risk as the firm's debt.
D) projects with the same risk as the firm's equity.

Question 65

What is the expected rate of return to equityholders if the firm has a 35% tax rate,a 10% rate of interest paid on debt,a 15% WACC,and a 60% debt-asset ratio?

A) 12.50%
B) 21.25%
C) 22.50%
D) 27.75%

Question 66

The interest tax shield is equal to the:

A) difference between interest expense and income taxes.
B) amount of interest paid in a given year.
C) product of the interest expense and the tax rate.
D) product of the debt principal and the interest rate on debt.

Question 67

Any financial benefit derived from the interest tax shield accrues to the:

A) bondholders.
B) shareholders.
C) bondholders and shareholders, equally.
D) shareholders and the federal government.

Question 68

MM's proposition II states that the:

A) expected return on equity increases as financial leverage increases.
B) expected return on assets decreases as expected return on debt decreases.
C) firm's capital structure is irrelevant to value determination.
D) greater the proportion of equity, the higher the expected return on debt.

Question 69

Which of the following would not be expected to change with changes in the firm's capital structure?

A) Weighted-average cost of capital
B) Expected return on equity
C) Expected return on assets
D) Expected earnings per share

Question 70

Debt usage will have an effect on:

A) business risk.
B) financial risk.
C) operating risk.
D) asset risk.

Question 71

Calculate the firm's expected return on its assets if its expected return on debt is 10%,its expected return on equity is 20%,and its WACC is 14%.

A) 14%
B) 15%
C) 16%
D) Cannot be calculated

Question 72

As a firm's debt-equity ratio approaches zero,the firm's expected return on equity approaches:

A) the expected return on debt.
B) the expected return on assets.
C) its maximum.
D) zero.

Question 73

One advantage of debt financing over equity financing is:

A) tax-deductible dividends.
B) tax-deductible interest.
C) tax-deductible principal repayment.
D) tax-free interest income.

Question 74

With risky debt and MM II,the expected return on assets _____ as the debt-equity ratio ____.

A) increases; increases
B) decreases; increases
C) increases; decreases
D) is constant; increases

Question 75

Stockholders' expected return on a stock priced at $25 per share with zero-growth dividends of $4.00 is:

A) 6.25%.
B) 13.64%.
C) 16.00%.
D) 21.00%.

Question 76

Leverage will __________ shareholders' expected return and _________ their risk.

A) increase; decrease
B) decrease; increase
C) increase; increase
D) increase; do nothing to

Question 77

A firm with a debt-equity ratio of 1/2,return on assets of 15%,and return on debt of 10% will have return on equity of:

A) 15.00%.
B) 16.67%.
C) 20.00%.
D) 21.17%.

Question 78

According to MM II,if the expected return on assets decreases,what happens to the expected return on equity?

A) Depends on the firm's capital structure
B) Decreases
C) Stays constant
D) Increases

Question 79

With the inclusion of taxes,MM I is incorrect and the capital structure of the firm can be important due to:

A) lower tax rates on dividends than on debt.
B) higher tax rates on retained earnings than on debt.
C) lower tax liability due to interest deductibility.
D) higher operating income from less dividends.

Question 80

Debt may be the preferred form of external financing for many firms because:

A) most firms already have too much equity.
B) tax rates on equity are lower.
C) debt will not adversely affect the firm's financial ratios.
D) equity issuance is considered by investors to be a negative sign.