Deck 12: Capital Structure Decisions

Question 1

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

Answer 1

False

Question 2

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage affects only EBIT.

Answer 2

False

Question 3

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

Answer 3

False

Question 4

The Miller model begins with the MM model with taxes and then adds personal taxes.

Question 5

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

Question 6

MM shows that in a world without taxes, a firm's value is not affected by its capital structure.

Question 7

A firm's financial risk has identifiable market risk and diversifiable risk components.

Question 8

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

Question 9

In a world with no taxes, MM shows that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

Question 10

According to MM, in a world without taxes, the optimal capital structure for a firm is approximately 100% debt financing.

Question 11

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

Question 12

Financial distress, agency costs, and direct and indirect bankruptcy costs affect a firm's target capital structure.

Question 13

Financial risk refers to the extra risk shareholders bear as a result of using debt as compared with the risk they would bear if no debt were used.

Question 14

The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

Question 15

The bankruptcy risk produces an ambiguous effect on agency costs.

Question 16

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

Question 17

The benefit of an interest tax shield is captured by the equity holders, not the debtholders.

Question 18

Whenever a firm borrows money, it is using financial leverage.

Question 19

MM shows that in a world with taxes, a firm's optimal capital structure would be almost 100% debt.

Question 20

A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

Question 21

During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders.

Question 22

The presence of personal taxes completely eliminates the benefits of debt financing.

Question 23

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Question 24

Although they operate in different industries, two firms have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

Question 25

Which event is likely to encourage a company to raise its target debt ratio, other things held constant?

A) an increase in the corporate tax rate
B) an increase in the personal tax rate
C) an increase in the company's operating leverage
D) the company's stock price hitting a new high

Question 26

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

A) an increase in costs incurred when filing for bankruptcy
B) an increase in the corporate tax rate
C) an increase in the personal tax rate
D) the company's stock price hitting a new low

Question 27

The MM model is the same as the Miller model, but with zero corporate taxes.

Question 28

During a recession, companies with a significant portion of their capital structure in the form of debt (i.e., high leverage) often struggle to meet their legally binding interest obligations.

Question 29

Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?

A) demand variability
B) input price variability
C) the extent to which operating costs are fixed
D) the extent to which interest rates on the firm's debt fluctuate

Question 30

Which of the following statements best describes WACC?

A) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
B) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
C) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
D) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.

Question 31

The MM model employs the concept of arbitrage to develop its theory.

Question 32

On which of the following items will an increase in the debt ratio generally have no effect?

A) business risk
B) total risk
C) financial risk
D) market risk

Question 33

Which of the following statements best describes capital structure?

A) The capital structure that maximizes expected EPS also maximizes the price per share of common shares.
B) The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
C) The capital structure that minimizes the required return on equity also maximizes the share price.
D) The capital structure that minimizes the WACC also maximizes the price per share of common shares.

Question 34

A firm's financial policy drives its equity beta.

Question 35

Firms having positive prospects try to raise new equity capital by selling new stocks.

Question 36

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Question 37

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

Question 38

As a firm approaches bankruptcy, the indirect costs of bankruptcy (e.g., financial distress) will tend to increase.

Question 39

It is possible that two firms could have identical financial and operating leverage yet have different degrees of risk as measured by the variability of EPS.

Question 40

Based on the information below, what is Ezzel Enterprises' optimal capital structure?

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

Question 41

If debt financing is used, which of the following is correct?

A) The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
B) The percentage change in net operating income will be equal to a given percentage change in net income.
C) The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
D) The percentage change in net income will be greater than the percentage change in net operating income.

Question 42

What is the major contribution of the Miller model?

A) It demonstrates that personal taxes decrease the value of using corporate debt.
B) It demonstrates that financial distress and agency costs reduce the value of using corporate debt.
C) It demonstrates that equity costs increase with financial leverage.
D) It demonstrates that debt costs increase with financial leverage.

Question 43

Which of the following statements is correct?

A) A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
B) The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
C) The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
D) If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.

Question 44

What is likely to happen in the MM model with a high risk of bankruptcy?

A) almost 100% debt financing
B) valuable projects are foregone to preserve cash
C) wasteful expenditures are often found
D) management buys back shares from the open market

Question 45

Other things held constant, which event is most likely to encourage a firm to increase the amount of debt in its capital structure?

A) Its sales become less stable over time.
B) The costs that would be incurred in the event of bankruptcy increase.
C) Management believes that the firm's stock has become overvalued.
D) The corporate tax rate increases.

Question 46

Which statement best describes optimal capital structure?

A) As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
B) The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
C) The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
D) The optimal capital structure simultaneously maximizes common share price and minimizes the WACC.

Question 47

In a perfect world of no taxes, what happens if the weighted average cost of capital (WACC) is unaffected by the capital structure?

A) MM proposition I holds.
B) MM proposition II holds.
C) SML is positively sloped.
D) SML is negatively sloped.

Question 48

What should the firm's target capital structure be set to do?

A) Maximize the earnings per share (EPS).
B) Minimize the cost of debt (r_d).
C) Minimize the cost of equity (r_s).
D) Minimize the weighted average cost of capital (WACC).

Question 49

Which statement concerning the MM extension with growth is incorrect?

A) The value of a growing tax shield is greater than the value of a constant tax shield.
B) For a given D/E, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.
C) For a given D/E, the WACC is less than the WACC under MM's original (with tax) assumptions.
D) The total value of the firm increases with the amount of debt.

Question 50

Which of the following statements is correct?

A) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
B) There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions.
C) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else is equal.
D) If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.

Question 51

Suppose a firm increases the operating leverage used to produce a given quantity of output. What will this normally lead to?

A) a decrease in the standard deviation of its expected EBIT
B) a decrease in its business risk
C) a decrease in the variability of its expected EPS
D) a reduction in its fixed assets turnover ratio

Question 52

Which statement regarding debt is correct, other things held constant?

A) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs; hence, they tend to use relatively little debt.
B) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
C) An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
D) An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.

Question 53

Which statement concerning capital structure theory is NOT true?

A) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.
B) Under MM with zero taxes, financial leverage has no effect on a firm's value.
C) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
D) Under MM with corporate taxes, r_s increases with leverage, and this increase exactly offsets the tax benefits of debt financing.

Question 54

Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. What would also be likely to occur if the company goes ahead with the recapitalization plan?

A) The company's net income would increase.
B) The company's earnings per share would decline.
C) The company's cost of equity would increase.
D) The company's ROE would decline.

Question 55

Which of the following statements is correct?

A) The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC.
B) The capital structure that maximizes the common share price is also the capital structure that maximizes earnings per share.
C) Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC.
D) Increasing personal tax rate but decreasing corporate tax rate would encourage companies to increase their debt ratios.

Question 56

With corporate taxes but no personal taxes, and without financial distress, what happens?

A) An unlevered firm cannot benefit from increased leverage.
B) Equity costs decrease with more debt financing.
C) The optimal amount of leverage for a firm is 100% debt.
D) Debt costs increase with financial leverage.

Question 57

In a perfect world of no taxes, which statement regarding MM propositions is true?

A) According to proposition I, a firm is able to find its optimal capital structure.
B) Proposition II implies that an increase in leverage raises the risk of equity and thereby the required return on equity.
C) According to proposition II, changes in the capital mix of a firm will not affect the debt and equity values of the firm.
D) Proposition I states that the total firm value critically depends on capital structure.

Question 58

Which of the following statements regarding risk, or the avoidance of risk, is correct?

A) A firm's business risk is determined solely by the financial characteristics of its industry.
B) Risk due to industry characteristics is beyond the control of the firm's management.
C) One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.
D) A firm's financial risk can be minimized by diversification.

Question 59

Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company's interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is correct?

A) Since the proposed plan increases Volga's financial risk, the company's share price still might fall even if EPS increases.
B) If the plan reduces the WACC, the share price is also likely to decline.
C) Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
D) If the plan does increase the EPS, the share price will automatically increase at the same rate.

Question 60

Which statement best describes the optimal capital structure?

A) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS).
B) The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.
C) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity.
D) The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt.

Question 61

Senbet Ventures is considering starting a new company to produce stereos. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000. What sales volume would be required in order to break even, i.e., to have an EBIT of zero for the stereo business?

A) 86,640
B) 91,200
C) 96,000
D) 100,800

Question 62

What is the firm's cost of equity?

A) 23.3%
B) 25.9%
C) 28.8%
D) 32.0%

Question 63

Vu Enterprises expects to have the following data during the coming year. What is Vu's expected ROE? Assets
$200,000
Interest rate
8%
D/A
65%
Tax rate
40%
EBIT
$25,000

A) 12.51%
B) 13.14%
C) 13.80%
D) 14.49%

Question 64

Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?

A) $600,000
B) $466,667
C) $333,333
D) $200,000

Question 65

What is the value of the firm according to MM with corporate taxes?

A) $475,875
B) $528,750
C) $587,500
D) $646,250

Question 66

Which of the following statements is correct?

A) Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
B) Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
C) Prescription drug companies generally have high debt-to-equity ratios because their earnings are very stable, and therefore they can cover the high interest costs associated with high debt levels.
D) Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.

Question 67

DeLong Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its products sell for $4.00 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs?

A) 391,667
B) 411,250
C) 431,813
D) 453,403

Question 68

Which of the following statements is correct?

A) If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted trade-off theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
B) A change in the personal tax rate should not affect firms' capital structure decisions.
C) "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
D) The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS.

Question 69

Ang Enterprises has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Ang's beta be if it used no debt, i.e., what is its unlevered beta?

A) 0.67
B) 0.71
C) 0.75
D) 0.79

Question 70

Suppose the corporate tax rate is 34%, personal tax rate on interest income is 10%, and personal tax rate on equity income is 50%. How much value will leverage add to the unlevered firm per dollar of debt?

A) -$0.188
B) $0.340
C) $0.500
D) $0.633

Question 71

Suppose that the personal tax rate on income from bonds is 34%, and the personal tax rate on income from stocks is 20%. What is the critical corporate tax rate below which leverage will add no value to the unlevered firm per dollar of debt?

A) 32.4%
B) 25.8%
C) 17.5%
D) 15.0%

Question 72

Lauterbach Corporation uses no debt, has a beta of 1.10, and its tax rate is 40%. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. The risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the firm's cost of equity change as a result of altering its capital structure?

A) 1.53%
B) 1.70%
C) 1.87%
D) 2.05%

Question 73

If the value of a levered firm is $5 million, what is the value of the same firm with all-equity financing?

A) $7 million
B) $6 million
C) $5 million
D) $4 million

Question 74

ABC Co. has an asset beta of 1.05 and a debt beta of 0.8. Target debt-to-equity (D/E) ratio is 0.6. With no taxes, what is the equity beta?

A) 1.20
B) 1.05
C) 0.90
D) 0.65

Question 75

Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is T_S = 20%, what is the implied personal tax rate on debt income?

A) 18.2%
B) 20.2%
C) 22.5%
D) 25.0%

Question 76

The Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but with greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards is the same under each method, at what level of output will the two methods produce the same net operating income (EBIT)?

A) 5,000 decks
B) 10,000 decks
C) 15,000 decks
D) 20,000 decks

Question 77

What is the amount of annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the corporate tax rate is 35%?

A) $126,000
B) $234,000
C) $360,000
D) $1,050,000

Question 78

Suppose a firm has a debt-to-equity ratio (D/E) of 0.5, return on assets of 18%, and return on debt of 12%. What will its return on equity be?

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

Question 79

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, fixed costs are estimated at $750,000, and the investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet this profit goal?

A) 4,513
B) 4,750
C) 5,000
D) 5,250

Question 80

The CFO of Google believes that its greatest strategic goal is to maintain flexibility. To achieve this goal, which of the following financial structures is in place at Google?

A) Google has issued significantly more long-term debt than equity (common shares) because debt has a significantly lower after-tax cost.
B) Google has issued significantly more equity (common shares) to avoid the restrictions that debt would imposed through restrictive covenants.
C) Google holds large amounts of cash and short-term investments in spite of the opportunity loss resulting from low investment earnings.
D) Google maintains a dividend payout ratio in line with other firms in the industry to ensure that its common shares are attractive to investors.