Deck 16: Capital Structure Policy

Question 1

Corning Consumer's total assets equal $360 million.The book value of Corning's equity is $180 million.The market value of Corning's equity is $ 250 million.The book value of the company's interest bearing debt is $120 million.Compute Corning's Debt Ratio and Debt to Value Ratio.

Answer 1

Debt Ratio = 180,000,000/360,000,000 =.50 Debt to value ratio = $120,000,000/ ($120,000,000 + 250,000,000)= .324

Question 2

Hayes Market's Total Assets = $25 million.The balance sheet shows Accounts payable and accruals totalling $7 million, common stock and retained earnings total $10 million.There is no preferred stock.What is the book value of interest bearing debt?

A)$15 million
B)$7 million
C)$18 million
D)$8 million

Answer 2

D

Question 3

How does the text distinguish between firm's financial structure and its capital structure?

A)Financial structure includes only interest bearing debt
B)Capital structure includes only non-interest bearing debt
C)Financial structure uses market values of equity
D)Capital structure includes only interest bearing debt

Answer 3

D

Question 4

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million.Interest bearing liabilities total $3 million (book value).The market value of Fibonacci's equity is $21 million.Fibonacci's debt ratio is -

A).38.
B).23.
C).125.
D).24.

Question 5

When the impact of taxes is considered, but the impact of financial distress is ignored, the optimal financial structure is

A)all equity.
B)an equal mix of debt and equity.
C)any mix of debt and equity.The proportions will not matter.
D)all, or nearly all, debt.

Question 6

Salut Wine and Spirits company's total assets equal $18 million.The book value of Salut's equity is $6 million.Excess cash is $200,000.The market value of Salut's equity is $10 million.Its Debt to Enterprise Value ratio is .5.What is Salut's Debt Ratio?

A).75
B).67
C).33
D).25

Question 7

What is meant by the terms "favourable" and "unfavourable" leverage?

Question 8

The inclusion of bankruptcy risk in firm valuation

A)acknowledges that a firm has an upper limit to debt financing.
B)causes cost of capital curve to be linear.
C)causes the cost of capital curve to be downward sloping regardless of capital structure.
D)has no consequences for practical management of capital structure policy.

Question 9

The Modigliani and Miller Capital Structure Theorem, in its original form

A)uses unrealistic assumptions.
B)provided important insights into capital structure policy.
C)concludes that how a firm is financed is not important.
D)all of the above.

Question 10

A company whose rate of return on investments is higher than the interest rate on its debt is said to have

A)unfavourable financial leverage.
B)a sub-optimal capital structure.
C)favourable financial leverage.
D)negative financial leverage.

Question 11

Roger Co.liabilities and equity are shown below: Roger's debt ratio is

A).48.
B).32.
C).21.
D).30.

Question 12

Royalton Inc.'s total interest bearing debt is $10,000,000 on which it pays interest at the rate of 5%.Royalton's rate of return on assets is 10%.How much cash flow does leverage add to shareholders equity?

A)$(500,000)negative cash flow
B)$(1,000,000)negative cash flow.
C)$1,000,000
D)$500,000

Question 13

Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total assets of $13 million.Interest bearing liabilities total $3 million (book value).Excess cash $500,000.The market value of Fibonacci's equity is $21 million.Fibonacci's Debt to Enterprise Value ratio is -

A).38.
B).23.
C).125.
D).106.

Question 14

A company that earns a rate of return on its investments lower than the interest rate on its debt is said to have

A)unfavourable financial leverage.
B)a sub-optimal capital structure.
C)favourable financial leverage.
D)negative financial leverage.

Question 15

Suppose we calculate a times interest earned ratio of 29 for Colgate-Palmolive.We can conclude that

A)Colgate-Palmolive may experience some difficulty meeting its interest payments.
B)Colgate-Palmolive is very unlikely to have difficulty meeting its interest payments.
C)Colgate-Palmolive has $29 of operating cash flow for every dollar of interest expense.
D)Colgate-Palmolive's EBITDA is 29 times larger than its interest expense.

Question 16

The firm's optimal capital structure is the mix of financing sources that

A)minimizes the risk of financial distress.
B)maximizes after-tax earnings.
C)maximizes the total value of the firm's debt and equity.
D)maximizes favourable leverage.

Question 17

Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?

Question 18

The enterprise value of the firm is defined as

A)(Market Value of Interest Bearing Debt-Excess Cash)+ Market Value of Equity.
B)(Book Value of Interest Bearing Debt-Excess Cash)+ Market Value of Equity.
C)(Book Value of Interest Bearing Debt-Excess Cash)+ Book Value of Equity.
D)Market Value of Interest Bearing Debt + Market Value of Equity.

Question 19

Roger Co.liabilities and equity are shown below: Roger's Debt to Enterprise Value ratio is [blank].Excess cash is negligible.

A).48
B).32
C).21
D).30

Question 20

Salut Wine and Spirits company's total assets equal $18 million.The book value of Salut's equity is $6 million.Excess cash is $200,000.The market value of Salut's equity is $10 million.Its Debt to Enterprise Value ratio is .5.What is the book value of Salut's interest- bearing debt?

A)$5 .25million
B)$10.2 million
C)$15 million
D)$20.4 million

Question 21

An optimal capital structure is achieved

A)when a firm's expected profits are maximized.
B)when a firm's expected EPS are maximized.
C)when a firm's expected stock price is maximized.
D)when a firm's break-even point is achieved.

Question 22

Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem?

A)A firm's weighted average cost of capital decreases as financial leverage is used.
B)A firm's common stock price falls as financial leverage is used.
C)A firm's weighted average cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm.
D)A firm's weighted average cost of capital increases as operating leverage is used.

Question 23

Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs?

A)Increased usage of financial leverage will increase a firm's weighted average cost of capital indefinitely.
B)Increased usage of financial leverage will lower a firm's weighted average cost of capital indefinitely.
C)Increased usage of financial leverage will not affect a firm's weighted average cost of capital.
D)Increased usage of operating leverage will increase a firm's weighted average cost of capital indefinitely.

Question 24

The original form of the Modigliani and Miller Capital Structure Theorem

A)ignores the effect of taxes.
B)ignores the relationship between firm value and cost of capital.
C)ignores transaction costs.
D)both A and C are true.

Question 25

Which of the following is a reasonable conclusion from the trade-off theory of capital structure?

A)A high debt ratio will result in a maximum price of a firm's common stock.
B)A firm's common stock price will not be affected by the amount of debt a firm uses.
C)A low debt ratio will result in a maximum price for a firm's common stock.
D)Modest levels of debt have a more favourable impact on a firm's average cost of capital and stock price than no debt.

Question 26

An optimal capital structure is achieved

A)when a firm's expected profits are maximized.
B)when a firm's expected EPS are maximized.
C)when a firm's break-even point is achieved.
D)when a firm's weighted average cost of capital is minimized.

Question 27

When the impact of taxes is considered, as the firm takes on more debt

A)there will be no change in total cash flows.
B)both taxes and total cash flow to stockholders and bondholders will decrease.
C)cash flows will increase because taxes will decrease.
D)the weighted average cost of capital will increase.

Question 28

Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and its cost of debt is 8%, the cost of equity will be [blank] % when the firm is financed with equal amount of debt and equity.

A)12%
B)24%
C)16%
D)cannot be determined with the information given.

Question 29

Which of the following is consistent with the trade-off theory of capital structure?

A)The cost of capital continuously decreases as the firm's debt ratio increases.
B)The cost of capital remains constant as the firm's debt ratio increases.
C)There are no costs associated with bankruptcy.
D)There is an optimal level of debt financing.

Question 30

Assume that the tax rate is 34% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Millers Inc.increases debt from 10% of its capital structure to 40%, cash flows to investors will -.

A)decrease.
B)remain the same.
C)increase.
D)A firm's cash flows are independent of its capital structure.

Question 31

Optimal capital structure is

A)the funding mix that will maximize the company's common stock price.
B)the mix of all items that appear on the right-hand side of the company's balance sheet.
C)the mix of funds that will minimize the firm's beta.
D)the mix of securities that will maximize EPS.

Question 32

The trade-off theory of capital structure management assumes

A)no corporate income taxes.
B)cost of equity remains constant with an increase in financial leverage.
C)firms might fail.
D)none of the above.

Question 33

The inclusion of bankruptcy costs and taxes in firm valuation

A)causes the cost of capital curve to be umbrella shaped.
B)is consistent with a saucer-shaped cost of capital curve.
C)is consistent with a cost of capital curve that slopes downward
D)causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

Question 34

What is being traded off in trade-off theory?

A)Tax savings from interest and financial distress costs
B)Cost of equity and cost of debt
C)Dividend payments and interest payments
D)EBIT and EPS

Question 35

From the information below, select the optimal capital structure for Mountain High Corp.

A)Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50
B)Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90
C)Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20
D)Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40

Question 36

The Trade-off Theory view of capital structure management says that the cost of capital curve is

A)a straight line.
B)v-shaped.
C)s-shaped.
D)saucer-shaped.

Question 37

The Trade-off Theory of capital structure theory indicates that

A)the tax shield on debt positively affects firm value, indicating that there is some benefit to financial leverage as opposed to an all-equity capitalisation.
B)the higher the firm's financial leverage, the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts, which could ultimately lead to firm failure.
C)there is a range of capital structures, rather than a single capital structure, that is optimal.
D)all of the above.

Question 38

Which of the following is a conclusion of agency theory?

A)Managers may accept excessive financial risks to increase the returns to shareholders.
B)Managers tend to avoid high-risk, high-return investments that may jeopardize their positions if successful.
C)Managers will always use the least expensive source of funds to finance investments.
D)Managers will tend to put the stockholders interests before their own security and ambitions.

Question 39

With taxes, but in the absence of financial distress costs, the optimal capital structure would be -

A)100% equity.
B)50% debt, 50% equity.
C)100% debt.
D)completely insensitive to the mix of debt and equity.

Question 40

If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?

A)The tax shield effect of debt will result in a lower cost of equity.
B)Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
C)A firm's common stock price will not be affected by the amount of debt a firm uses.
D)Too much common equity increases the probability of bankruptcy.

Question 41

Peterson Corporation and Patterson Corporation each have EBIT of $4 million.Peterson has no debt and no interest expense; Patterson has $2 million in debt at a before-tax rate of 8%.The tax rate is 40%.How much cash does each firm return to its investors?

A)Peterson $2,400,000, Patterson $2,144,000
B)Peterson $2,400,000, Patterson $2,240,000
C)Peterson $2,400,000, Patterson $2,464,000
D)Peterson $2,400,000, Patterson $2,304,000

Question 42

Which of the following is a good reason for a company to have higher than average debt ratios?

A)The company's cash flows are difficult to predict.
B)The company generates little taxable income.
C)Customer support is an important aspect of the company's business.
D)The company faces high marginal tax rates.

Question 43

Sophie Corporation expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands.Olive Corporation also expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands.Sophie is financed entirely with equity while Olive is financed 50% with debt at 10%.Sophie has $200 million in equity; Olive is financed with $100 million of debt and $100 million of equity.The tax rate is 30%.Both firms pay out all available earnings as dividends.If there is a recession, compare dividends and total distributions to investors for each company.

Question 44

Which industry would you expect to have the highest Debt to Asset ratios?

A)Business-oriented software
B)Electric utilities
C)Communications equipment
D)Retail clothing

Question 45

The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital

A)first falls with moderate levels of leverage and then increases as a firm's leverage becomes high.
B)does not change with leverage.
C)increases proportionately with increases in leverage.
D)increases with moderate amounts of leverage and then falls.

Question 46

Zybeck Corp.projects operating income of $4 million next year.The firm's income tax rate is 40%.Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt.The firm is considering two alternatives to finance a new product: (a)the issuance of $6 million of 10% bonds, or (b)the issuance of 60,000 new shares of common stock at $10 per share.If Zybeck issues common stock this year, what will the firm's return on equity be next year?

A)16.7%
B)18.2%
C)22.1%
D)26.4%
E)29.6%

Question 47

Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

Question 48

Diverse Contractor's cost of equity is 16% and it is 100% equity financed.If it can borrow enough money at 10% to buy back half of its stock, what would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem?

A)It would remain at 16%.
B)t would rise to 22%.
C)It would fall to 11%.
D)It would fall to 13%.

Question 49

If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk?

A)The average cost of capital would most likely rise.
B)The price of the firm's common stock would definitely decline.
C)If economic forces cause a reduction of sales, the firm's EPS might decline.
D)The firm's WACC might decline.

Question 50

Zybeck Corp.projects operating income of $4 million next year.The firm's income tax rate is 40%.Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt.The firm is considering two alternatives to finance a new product: (a)the issuance of $6 million of 10% bonds, or (b)the issuance of 60,000 new shares of common stock.There are no issuance costs for either the bonds or the stock.If Zybeck issues common stock this year, what will projected EPS be next year?

A)$2.10
B)$2.96
C)$2.33
D)$1.67

Question 51

The total interest obligation will be

A)$105,000 under alternative I and $9,000 under alternative II.
B)$9,000 under alternative I and $105,000 under alternative II.
C)zero under alternative I and $96,000 under alternative II.
D)$105,000 under both alternative I and alternative II.

Question 52

Under what conditions are shareholders likely to incur agency costs when managers make capital budgeting decisions?

Question 53

Babbit Corp has a debt ratio (debt to assets)of 40%.Management is wondering if its current capital structure is too conservative.Babbit Corp's present EBIT is $4.5 million, and profits available to common shareholders are $2,851,200, with 480,000 shares of common stock outstanding.If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $2,791,800, but only 384,000 common shares would be outstanding.What is the difference in EPS at a debt ratio of 60% versus 40%?

A)$5.94
B)$1.33
C)$1.09
D)$ -0.12

Question 54

Abbot Corp has a debt ratio (debt to assets)of 20%.Management is wondering if its current capital structure is too conservative.Abbot Corp's present EBIT is $4.5 million, and profits available to common shareholders are $2,910,600, with 600,000 shares of common stock outstanding.If the firm were to instead have a debt ratio of 40%, additional interest expense would cause profits available to stockholders to decline to $2,851,200, but only 480,000 common shares would be outstanding.What is the difference in EPS at a debt ratio of 40% versus 20%?

A)$4.85
B)$6.34
C)$1.09
D)$-0.10

Question 55

Martinson Inc.is now financed 100% with equity.The cost of equity is 15%.Martinson is considering a proposal to borrow enough money at 7% to buy back half of its common stock.It would then be financed 50% with debt and 50% with equity.Assume that this does not affect the cost of equity.Martinson's tax rate is 40%.What is Martinson's cost of capital without and with the stock repurchase?

Question 56

Allston-Brighton Corp.has total assets of $10 million, and total liabilities of $4 million, of which $1 million are non-interest bearing.Interest expense was $180,000.Earnings before interest and taxes were $2.5 million.Depreciation was $1.5 million.Calculate the following ratios: Debt ratio, Interest-bearing debt ratio and EBITDA coverage ratio.

Question 57

Farar, Inc.projects operating income of $4 million next year.The firm's income tax rate is 40%.Farar presently has 750,000 shares of common stock, no preferred stock and no debt.The firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not expected to generate an increase in income for two years.If Farar issues the bonds this year, what will projected EPS be next year?

A)$1.53
B)$1.98
C)$2.72
D)$4.53

Question 58

[blank] showed that, under some idealistic conditions, it does not matter whether a firm uses no debt, a little debt or a lot of debt in its capital structure.

A)Pecking theory
B)Modigliani and Merton Miller
C)The Australian government
D)Yogi Berra

Question 59

In which countries would you expect companies to have the lowest leverage ratios?

A)Countries with very high tax rates
B)Countries that tend to subsidize key industries and protect them from failure
C)Countries where creditors have very strong legal protection
D)Countries where the market value of companies is high compared to their book values