Deck 16: Capital Structure Policy

Question 1

M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio.

Answer 1

True

Question 2

M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy.

Answer 2

True

Question 3

When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring.

Answer 3

False

Question 4

A higher proportion of debt indicates a lower degree of financial leverage.

Question 5

Unlike direct bankruptcy costs, indirect costs are not considered transaction costs.

Question 6

The enterprise value of a firm is the value of equity minus the value of debt.

Question 7

Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure.

Question 8

Direct-bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process.

Question 9

Issuing debt is usually less expensive than issuing stock.

Question 10

If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate.

Question 11

A financial restructuring can change the value of a firm's real assets, such as plant and equipment.

Question 12

When calculating free cash flow, it is important to include interest and principal payments.

Question 13

More debt in a firm's capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects.

Question 14

Under the M&M assumptions with taxes, the value of a firm with debt is the value of the firm without debt plus the present value of the interest tax shield.

Question 15

Indirect bankruptcy costs will often increase when a firm is in financial stress and it may even push the company into bankruptcy.

Question 16

Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

Question 17

With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets.

Question 18

Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm.

Question 19

Direct bankruptcy costs are considered small when compared to indirect costs.

Question 20

M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions.

Question 21

An operating lease is treated like a purchase for accounting purposes.

Question 22

A firm's enterprise value is given as:

A) the value of equity plus the value of debt.
B) the value of equity minus the value of debt.
C) the value of equity minus the value of debt plus the value of future projects.
D) None of the above.

Question 23

According to M&M Proposition 2, the cost of a firm's equity

A) increases with the increase of debt-to-equity ratio.
B) decreases with the decrease of debt-to-equity ratio.
C) increases with the increase of cost of debt.
D) decreases with increase of required rate of return on the firm's underlying assets.

Question 24

M&M Proposition 2 states that the cost of a firm's common stock is directly related to

A) the debt-to-equity ratio.
B) the required rate of return on the firm's underlying assets.
C) the return of the market index.
D) Both A and B.

Question 25

When a firm is in financial distress, stockholders would like the manager to overinvest in positive NPV projects.

Question 26

Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders.

Question 27

Without debt in the capital structure, there are no asset substitution or underinvestment problems.

Question 28

More profitable firms have less debt, which supports the trade-off theory.

Question 29

The optimal capital structure of a firm

A) minimizes the cost of financing the firm's projects.
B) minimizes interest payments to creditors.
C) maximizes overall value of the firm.
D) Both A and C.

Question 30

Industries with large amounts of tangible assets typically use little debt.

Question 31

Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem.

Question 32

The weighted average cost of capital (WACC) includes

A) the required return on equity and required return on underlying firm assets.
B) the cost of any long-term debt and the cost of equity.
C) the cost of any long-term debt and required return on underlying firm assets.
D) None of the above.

Question 33

The trade-off theory of capital structure states that leverage should be increased until the marginal cost of debt is equal to the marginal benefit.

Question 34

Firms have a difficult time selling equity when they are in financial distress.

Question 35

Under the pecking order theory, debt is the cheapest source of funds due to the interest tax shield.

Question 36

A firm's capital structure is the mix of financial securities used to finance its activities and can include all of the following except which of the following:

A) common stock.
B) bonds.
C) equity options.
D) preferred stock.

Question 37

M&M Proposition 1 assumes all of the following except that,

A) there are no taxes.
B) there are no costs to acquire information.
C) there are no transactions costs.
D) the real investment policy of a firm is affected by its capital structure decisions.

Question 38

The pecking order theory says that instead of trying to achieve a specified target capital structure, firms use the cheapest form of capital available at any given time.

Question 39

Managers often focus on cash flows, but reported accounting earnings are a better indicator of a firm's economic health.

Question 40

A financial restructuring

A) will not change the value of a firm's real assets under M&M Proposition 1.
B) includes financial transactions that change the capital structure of the firm.
C) means that a firm has issued equity to retire debt.
D) Both A and B.

Question 41

What control implications do a firm's capital structure decisions have?

A) Issuing too much debt as to cause financial distress
B) Dilution issues
C) Choice between debt and equity financing
D) All of the above

Question 42

Gangland Water Guns, Inc. has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7%, its cost of equity is 13% and it pays no tax, what is its WACC?

A) 9%
B) 10%
C) 11%
D) None of the above.

Question 43

Cadmium Electronics Inc. currently has a capital structure that is 40% debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, the risk-free rate is 3% and the firm pays no tax, what is the appropriate WACC?

A) 8.4%
B) 9.6%
C) 10.4%
D) 9.2%

Question 44

Swirlpool, Inc. has a WACC of 11%, cost of debt of 8%, and a cost of equity of 12%. What must the debt-to-equity ratio be if the firm pays no tax?

A) 1/2
B) 1/4
C) 1/6
D) 1/3

Question 45

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.)

A) 27.9% and 72.1%
B) 72.1% and 27.9%
C) 25.23 and 74.77%
D) 74.77% and 25.23%

Question 46

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much are your cash flows today?(Round the answer to two decimal places.)

A) $12.38
B) $15
C) $4.50
D) $150

Question 47

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much does Dynamo currently pay as interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant?

A) $42 and $26.25
B) $26.25 and $42
C) $160 and $37.50
D) $37.50 and $60

Question 48

Which of the following is a reason financial policy might matter?

A) Firms must pay corporate income taxes.
B) Capital structure choices can affect firm's real investment decisions, such as R&D and PP&E.
C) Information or transaction costs.
D) All of the above

Question 49

Financial risk

A) refers to the effect that a firm's financing decisions have on the riskiness of the cash flows that the stockholders will receive.
B) increases a firm's business risk.
C) decreases a firm's business risk.
D) is related to how debt affects the business decisions of a firm.

Question 50

Melba's Toast has a capital structure with 30% debt and 70% equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal corporate income tax rate is 35%. What is the appropriate WACC?

A) 8.17%
B) 6.35%
C) 8.80%
D) 7.44%

Question 51

A firm has $300 million in outstanding debt and $900 million in outstanding equity. Its cost of equity is 11%, its cost of debt is 7%, and it pays no tax. What is the WACC?

A) 6%
B) 8%
C) 9%
D) 10%

Question 52

Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7%?

A) 14%
B) 14.25%
C) 14.50%
D) 15%

Question 53

A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost of equity of 12%, and a marginal corporate income tax rate is of 35%. What percent of the firm's capital structure is financed with equity?

A) 50%
B) 60%
C) 70%
D) None of the above.

Question 54

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much is Dynamo worth today?

A) $1,765
B) $1,500
C) $2,143
D) None of the above

Question 55

Which one of the following considerations are not a concern of managers when they make capital structure decisions.

A) Financial flexibility
B) Net income risk.
C) Systematic risk
D) Earnings impact

Question 56

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per year after the restructuring according to M&M Proposition 1?

A) $15 and $60
B) $60 and $15
C) $10.80 and $22.50
D) $22.50 and $10.80

Question 57

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows? (Do not round intermediate calculations. Round the final answer to two decimal places.)

A) $1.58 and $12.38
B) $23.55 and $75
C) $1.125 and $12.38
D) None of the above

Question 58

Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity?

A) 12.15%
B) 13.15%
C) 14.15%
D) None of the above.

Question 59

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1?

A) Sell $22.50 of stock
B) Sell $10.80 worth of stock
C) Buy $22.50 worth of debt
D) Buy $10.80 worth of debt

Question 60

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity and use the debt proceeds to pay a special dividend to stockholders, how much debt should they issue?

A) $321
B) $375
C) $600
D) $225

Question 61

In order to calculate the present value of debt tax savings, the _____ is used as the discount rate.

A) WACC
B) risk-free rate
C) required rate of return on debt
D) None of the above

Question 62

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual.

A) $5,417
B) $5,942
C) $6,392
D) None of the above

Question 63

Suppose a firm has a cost of equity of 12%, a D/E ratio of 1/6, and the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current required rate of return on its assets and equity if the D/E ratio is changed to 1/3? (Round the answer to one decimal place of percentage.)

A) 11.35% and 13.25%
B) 11.35% and 8.25%
C) 13.25% and 11.35%
D) None of the above

Question 64

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. Suppose, revenues fall by $300, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same. (Round the answer to one decimal places.)

A) 64.5% and 60%
B) 60.0% and 64.5%
C) 59.2% and 40.8%
D) 40.8% and 59.2%

Question 65

The use of debt financing

A) causes a manager to take on riskier projects in order to make interest payments.
B) is more expensive than issuing equity due to the use of covenants.
C) allows managers to make discretionary interest payments.
D) limits the ability of managers to waste stockholders' money.

Question 66

Academic studies have estimated that the tax benefit of debt realized by firms is approximately

A) 10% of firm value.
B) a 10% reduction in WACC.
C) a 10% reduction in the cost of debt.
D) 10% of debt value.

Question 67

Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt?

A) $175 million
B) $97.5 million
C) $51 million
D) $40 million

Question 68

A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the present value of the tax savings if the debt never matures?

A) $11,025
B) $20,475
C) $350,000
D) $227,500

Question 69

The interest tax shield

A) does not affect the WACC.
B) makes it less costly to distribute cash to investors through interest payments than through dividends.
C) is given as: D × (1 − t).
D) Both B and C

Question 70

The use of debt financing

A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take.
B) increases agency costs between the stockholders and management by limiting the amount of risk the managers take.
C) increases agency costs since managers prefer to keep more retained earnings rather than paying dividends.
D) Both B And C

Question 71

Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project?

A) $100 million
B) $80 million
C) $20 million
D) $8 million

Question 72

The asset substitution problem occurs when

A) managers substitute more risky assets for less risky ones to the detriment of bondholders.
B) managers substitute less risky assets for more risky ones to the detriment of bondholders.
C) managers substitute more risky assets for less risky ones to the detriment of equity holders.
D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Question 73

The underinvestment problem occurs in a financially distressed firm when

A) the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders.
B) the value of investing in a positive NPV project is likely to go to equity holders instead of debt holders.
C) management invests in negative NPV projects to reduce their own risk.
D) issuing equity becomes difficult due to increased risk.

Question 74

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket. The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity valuation model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar.

A) $350
B) $650
C) $2,917
D) $5,417

Question 75

Suppose that UBM Corp. has invested $100 million in 8% risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60% chance of returning $200 million and a 40% chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt?

A) $100 million
B) $88.8 million
C) $48.8 million
D) None of the above

Question 76

Which of these statements about direct bankruptcy costs is NOT true?

A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and consultants.
B) Direct bankruptcy costs are less than indirect bankruptcy costs.
C) Direct bankruptcy costs include payments to suppliers on delivery.
D) Direct bankruptcy costs can be reduced by negotiating with lenders.

Question 77

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5% and an YTM of 7.9% to its capital structure. What is the net income of Banana without and with the debt?

A) $500 and $484.2
B) $484.2 and $500
C) $500 and $465
D) $490 and $500

Question 78

Which of these is NOT an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be honored.
B) Employees begin to leave the firm.
C) New accountants are brought in to help with the bankruptcy process.
D) A bankruptcy judge orders new projects to be halted.

Question 79

Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 8%. If the company's marginal tax rate is 30% and its average tax rate is 20%, what are its after-tax earnings?

A) $238
B) $272
C) $259
D) None of the above

Question 80

A firm plans to issue $1 million worth of debt at an YTM of 9%. The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its average tax rate is 15%. By how much will the new debt reduce the firm's annual tax liability?

A) $13,500
B) $22,500
C) $32,500
D) None of the above