Deck 16: Capital Structure Policy

Question 1

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

Answer 1

False

Question 2

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 2

True

Question 3

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

Answer 3

True

Question 4

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 5

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

Question 6

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

Question 7

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

Question 8

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

Question 9

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

Question 10

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

Question 11

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 12

Issuing debt is less expensive than issuing stock.

Question 13

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.

Question 14

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

Question 15

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 16

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

Question 17

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

Question 18

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 19

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

Question 20

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

Question 21

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

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

Question 22

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

Question 23

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 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

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 26

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 27

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 28

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

Question 29

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 30

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

Question 31

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 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 is increased until the marginal cost of debt is equal to the marginal benefit.

Question 34

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

Question 35

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

Question 36

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

Question 37

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 38

Firms have a difficult time selling equity when it is in financial distress.

Question 39

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

Question 40

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

Question 41

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 42

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 43

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 44

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 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

Gangland Water Guns, Inc. has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC?

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

Question 48

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 calculation. 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 49

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?

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

Question 50

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 51

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 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

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 annum after the restructuring as per the 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 54

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 55

Suppose a firm has a cost of equity of 12%, a D/E ratioof 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 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 56

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 57

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%, and the risk-free rate is 3%, what is the appropriate WACC?

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

Question 58

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 59

A firm has $300 million in outstanding debt and $900 million in outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the appropriate WACC?

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

Question 60

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 61

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 62

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 63

The interest tax shield

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

Question 64

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 65

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 66

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 67

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 68

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 dividend.
D) Both B And C

Question 69

Suppose that, JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm's management has just identified a project that will require an initial outlay of $10 million and will return a NPV of $16 million, risk-free. The firm currently has no cash. What would be the net return to stockholders if they took on this project?

A) −$10 million
B) $0 million
C) $26 million
D) $70 million

Question 70

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 71

Which of the following supports the trade-off theory of capital structure?

A) Firms use cash on hand first, since issuing equity and debt is expensive.
B) A firm's capital structure is the result of past equity and debt issuance decisions.
C) Firms have a target capital structure.
D) Both A and B

Question 72

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 73

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 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 74

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 75

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 this debt issuance reduce the firm's annual tax liability?

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

Question 76

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 in perpetuity?

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

Question 77

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 78

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. Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?

A) 1/3
B) 1/4
C) 1/5
D) 1/6

Question 79

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 80

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