Deck 16: Capital Structure

Question 1

Investment cash flows are independent of financing choices in a ________.

A) market with frictions
B) perfect capital market
C) setting with frictions in investment returns
D) firm with leverage

Answer 1

perfect capital market

Question 2

What is the capital structure of a firm?

Answer 2

The relative proportion of debt and equity used by a firm is called its capital structure.

Question 3

MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market value of the ________ generated by its assets.

A) earnings after taxes
B) earnings after interest
C) cash flows after taxes
D) free cash flows

Answer 3

free cash flows

Question 4

With perfect capital markets, because different choices of capital structure offer a benefit to investors, the capital structure affects the value of a firm.

Question 5

A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 11%, what is the levered value of the firm with perfect capital markets?

A) $15,855.86
B) $19,819.82
C) $23,783.78
D) more information needed

Question 6

A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets?

A) $20,000
B) $16,000
C) $24,000
D) more information needed

Question 7

Equity in a firm with debt is called ________.

A) levered equity
B) risk-free equity
C) unlevered equity
D) preferred equity

Question 8

A firm will give a one-time cash flow of $24,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets?

A) $17,454.55
B) $26,181.82
C) $21,818.18
D) more information needed

Question 9

What role do industries play in the capital structure choice for a firm?

Question 10

Financial managers prefer to choose the same debt level no matter which industry they operate in.

Question 11

According to researchers Modigliani and Miller, with perfect capital markets, the total value of a firm should not depend on its capital structure.

Question 12

The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its ________.

A) capital structure
B) dividend expense
C) retained earnings
D) paid out capital

Question 13

Equity in a firm with no debt is called unlevered equity.

Question 14

A financial manager makes a choice of the amount and source of capital based on how the choice will impact the ________.

A) revenue
B) face value of bonds
C) depreciation
D) firm value

Question 15

What considerations should managers have while deciding on firms' capital structure?

Question 16

Equity in a firm with no debt is called ________.

A) levered equity
B) unlevered equity
C) risk-free equity
D) preferred equity

Question 17

Even if two firms operate in the same industry, they may prefer different choices of debt-equity ratios.

Question 18

A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.

A) debt-to-equity
B) equity-to-debt
C) debt-to-value
D) liability

Question 19

Which of the following statements is FALSE?

A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure.
B) The most common choices are financing through equity alone and financing through a combination of debt and equity.
C) A project's net present value (NPV) represents the value to the new investors of a firm created by the project.
D) When corporations raise funds from outside investors, they must choose which type of security to issue.

Question 20

Which of the following does a firm consider in the choice of securities issued?

A) the tax consequences of the chosen security
B) the transactions costs of the chosen security
C) whether the chosen security will have a fair price in the market
D) All of the above are considered.

Question 21

By adding leverage, the returns on a firm are split between debt holders and equity holders, but equity holder risk increases because ________.

A) interest payments can be rolled over
B) dividends are paid first
C) debt and equity have equal priority
D) interest payments have first priority

Question 22

Which of the following is NOT one of Modigliani and Miller's set of conditions referred to as perfect capital markets?

A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm's financing decisions neither change the cash flows generated by its investments, nor do they reveal new information about them.
D) Investors and firms can trade the same set of securities at competitive market prices equal to the present value (PV) of their future cash flows.

Question 23

In general, issuing equity may not dilute the ownership of existing shareholders if ________.

A) the value of new shares is equal to the value of debt
B) the new shares are sold at a fair price
C) the firm has no debt financing
D) the firm uses debt conservatively

Question 24

A firm requires an investment of $30,000 and borrows $15,000 at 7%. If the return on equity is 19%, what is the firm's pretax WACC?

A) 13%
B) 6.5%
C) 15.6%
D) 18.2%

Question 25

A firm has a market value of equity of $30,000. It borrows $7500 at 8%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

A) 16.75%
B) 6.70%
C) 20.10%
D) 23.45%

Question 26

A firm requires an investment of $30,000 and borrows $7500 at 7%. If the return on equity is 18%, what is the firm's pretax WACC?

A) 7.6%
B) 18.3%
C) 21.4%
D) 15.3%

Question 27

A firm has a market value of equity of $30,000. It borrows $7500 at 8%. If the unlevered cost of equity is 16%, what is the firm's cost of equity capital?

A) 9.0%
B) 18.0%
C) 21.6%
D) 25.2%

Question 28

A firm has a market value of equity of $40,000. It borrows $8000 at 7%. If the unlevered cost of equity is 16%, what is the firm's cost of equity capital?

A) 8.9%
B) 21.4%
C) 17.8%
D) 24.9%

Question 29

Which of the following statements is FALSE?

A) As long as a firm's choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero and, therefore, should not change the value of a firm.
C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Question 30

Which of the following statements is FALSE?

A) The Law of One Price implies that leverage will affect the total value of a firm under perfect capital market conditions.
B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security holders is equal to the total cash flow generated by the firm's assets.
C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of a firm.
D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Question 31

Leverage can ________ a firm's expected earnings per share, but does not necessarily increase the share price.

A) decrease
B) dilute
C) increase
D) never change

Question 32

It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm because ________.

A) leverage decreases the risk of equity of the firm
B) leverage changes the unlevered cost of equity
C) leverage increases the risk of the equity of the firm
D) cost of debt decreases in this setting

Question 33

A firm requires an investment of $25,000 and will return $36,500 after 1 year. If the firm borrows $20,000 at 7%, what is the return on levered equity?

A) 162%
B) 202%
C) 242%
D) 283%

Question 34

Which of the following statements is FALSE?

A) When a firm borrows significant money to repurchase shares or pay a large cash dividend, the transaction is called a leveraged recapitalization.
B) MM Proposition I applies to capital structure decisions made at any time during the life of a firm.
C) By choosing positive-NPV projects that are worth more than their initial investment, a firm can enhance its value.
D) The choice of capital structure does not change the value of a firm if the cost of equity is higher than the cost of debt.

Question 35

A firm requires an investment of $18,000 and will return $25,000 after one year. If the firm borrows $10,000 at 6%, what is the return on levered equity?

A) 80%
B) 64%
C) 96%
D) 112%

Question 36

A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows $6000 at 7%, what is the return on levered equity?

A) 35%
B) 52%
C) 43%
D) 61%

Question 37

In a setting where there is no risk that a firm will default, leverage ________ the risk of equity.

A) increases
B) decreases
C) does not change
D) cannot say for sure

Question 38

A firm requires an investment of $36,000 and borrows $12,000 at 9%. If the return on equity is 20%, what is the firm's pretax WACC?

A) 8.2%
B) 19.6%
C) 16.3%
D) 22.9%

Question 39

Which of the following statements is FALSE?

A) As long as investors can borrow or lend at the same interest rate as a firm, homemade leverage is a perfect substitute for the use of leverage by the firm.
B) When investors use leverage in their own portfolios to adjust the leverage choice made by a firm, we say that they are using homemade leverage.
C) The value of a firm is determined by the present value (PV) of the cash flows from its current and future investments.
D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of a firm.

Question 40

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it is referred to as ________.

A) outside debt
B) retained earnings
C) homemade leverage
D) payout ratio

Question 41

After the repurchase, how many shares will Luther have outstanding?

A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion

Question 42

Which of the following statements is FALSE?

A) The levered equity return equals the unlevered return plus an extra "kick" due to leverage.
B) By holding a portfolio of a firm's equity and its debt, we can replicate the cash flows from holding its levered equity.
C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio.
D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

Question 43

The E in the equation above represents ________.

A) the value of the firm's equity
B) the value of the firm's debt
C) the value of the firm's unlevered equity
D) the market value of the firm's assets

Question 44

Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are currently trading at $20 per share.
The market value of Luther's non-cash assets is closest to ________.

A) $20 billion
B) $19 billion
C) $25 billion
D) $24 billion

Question 45

The U in the equation above represents ________.

A) the value of the firm's equity
B) the market value of the firm's assets
C) the value of the firm's unlevered equity
D) the value of the firm's debt

Question 46

With perfect capital markets, what is the market price per share of Luther's stock after the share repurchase?

A) $20
B) $24
C) $15
D) $25

Question 47

Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5000 of your own money to invest and you plan on buying Firm Y stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock?

A) $10,000
B) $5,000
C) $2,500
D) $0

Question 48

Which of the following statements is TRUE?

A) Holding cash has the opposite effect of leverage on risk and return.
B) We use the market value of a firm's net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets.
C) Since the WACC does not change with the use of leverage, the value of a firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.
D) Even if a firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.

Question 49

Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. The market value of Luther's non-cash assets is closest to ________.

A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion

Question 50

Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
According to MM Proposition I, the stock price for Firm X is closest to ________.

A) $8.00
B) $24.00
C) $6.00
D) $12.00

Question 51

Which of the following statements is FALSE?

A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
C) We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of capital.
D) The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.

Question 52

Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?

A) 1.15 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion

Question 53

The A in the equation above represents ________.

A) the value of the firm's debt
B) the market value of the firm's assets
C) the value of the firm's equity
D) the value of the firm's unlevered equity

Question 54

Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5,000 investment in Firm Y stock. The number of shares of Firm X stock you purchased is closest to ________.

A) 100
B) 417
C) 1,650
D) 825

Question 55

Which of the following statements is FALSE?

A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its cost of debt as the cost of capital for the project.
B) We can calculate the cost of capital of a firm's assets by computing the weighted average of the firm's equity and debt cost of capital, which we refer to as the firm's weighted average cost of capital.
C) The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were unlevered.
D) When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the project's free cash flow.

Question 56

Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm Y stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock. The number of shares of Firm Y stock you purchased is closest to ________.

A) 425
B) 1,650
C) 2,000
D) 825

Question 57

Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5,000 investment in Firm Y stock?

A) $5,000
B) $0
C) $2,500
D) $4,000

Question 58

Which of the following statements is FALSE?

A) Investors can alter the leverage choice of a firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.
B) As per MM proposition II, the cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio.
C) The MM propositions imply that the true role of a firm's financial policy is to deal with financial market imperfections such as taxes and transaction costs.
D) In practice, we will find that capital structure can have an effect on a firm's value.

Question 59

Which of the following statements is FALSE?

A) With no debt, the WACC is equal to the unlevered equity cost of capital.
B) With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is unlevered.
C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firm's WACC is unchanged.
D) As debt has a lower cost of capital than equity, higher leverage lowers a firm's WACC.

Question 60

With perfect capital markets, what is the market value of Luther's equity after the share repurchase?

A) $15 billion
B) $10 billion
C) $25 billion
D) $20 billion

Question 61

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is weak?

A) 8.0%
B) -37.5%
C) -58.6%
D) 10.28%

Question 62

A firm that does not have trouble meeting its debt obligations is said to be in financial distress.

Question 63

Suppose a project financed via an issue of debt requires six annual interest payments of $18 million each year. If the tax rate is 35% and the cost of debt is 8%, what is the value of the interest rate tax shield?

A) $23.30 million
B) $29.12 million
C) $34.95 million
D) $58.25 million

Question 64

How does the interest paid by a firm affect its value to investors?

Question 65

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is strong?

A) 8.0%
B) 8.95%
C) 28.6%
D) 38.0%

Question 66

A firm requires an investment of $60,000 and borrows $30,000 at 9%. If the return on equity is 22% and the tax rate is 35%, what is the firm's WACC?

A) 11.1%
B) 13.9%
C) 16.7%
D) 27.9%

Question 67

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company uses no leverage, what is expected return to equity holders?

A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%

Question 68

What are some implications of market imperfections?

Question 69

The direct costs of bankruptcy are estimated to be far greater, as a percent of assets, than the indirect costs of bankruptcy.

Question 70

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is expected return to equity holders? Assume the demand is as expected.

A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%

Question 71

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. What is the value of the company if the demand is as expected?

A) $23,148.15
B) $32,407.40
C) $41,666.67
D) Cannot be determined with the information given.

Question 72

Suppose a project financed via an issue of debt requires five annual interest payments of $12 million each year. If the tax rate is 35% and the cost of debt is 5%, what is the value of the interest rate tax shield?

A) 14.55 million
B) $21.82 million
C) $36.37 million
D) $18.18 million

Question 73

A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy include ________.

A) dividend payments
B) raw material costs
C) costs of hiring legal experts, appraisers, and auctioneers
D) taxes

Question 74

The following equation:
X =
RE +
RD
Can be used to calculate all of the following EXCEPT ________.

A) the cost of capital for a firm's assets
B) the levered cost of preferred equity
C) the unlevered cost of equity
D) the weighted average cost of capital

Question 75

Suppose a project financed via an issue of debt requires five annual interest payments of $18 million each year. If the tax rate is 35% and the cost of debt is 7%, what is the value of the interest rate tax shield?

A) $20.66 million
B) $31.00 million
C) $25.83 million
D) $51.66 million

Question 76

Which of the following statements is FALSE assuming a perfect market?

A) The unlevered beta measures the market risk of a firm's business activities, ignoring any additional risk due to leverage.
B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt.
C) The unlevered beta measures the market risk of a firm without leverage, which is equivalent to the beta of the firm's assets.
D) As the amount of debt decreases, the debt becomes riskier because there is a chance the firm will default.

Question 77

A firm requires an investment of $60,000 and borrows $20,000 at 8%. If the return on equity is 14% and the tax rate is 30%, what is the firm's WACC?

A) 11.2%
B) 9.0%
C) 13.4%
D) 22.4%

Question 78

In general, the gain to investors from the tax deductibility of interest payments is referred to as the interest rate tax shield.

Question 79

What effect does debt have on a firm's weighted average cost of capital?

Question 80

A firm requires an investment of $30,000 and borrows $20,000 at 9%. If the return on equity is 15% and the tax rate is 30%, what is the firm's WACC?

A) 9.20%
B) 7.36%
C) 11.04%
D) 18.40%