Question 1

Which one of the following is the equity risk that is most related to the daily operations of a firm?
A) Market risk
B) Systematic risk
C) Extrinsic risk
D) Business risk
E) Financial risk

Accepted Answer

Business risk is the equity risk that is most related to the daily operations of a firm. It refers to the risk inherent in a company's operations, including factors such as competition, regulatory environment, technology, and management effectiveness. Market risk, systematic risk, extrinsic risk, and financial risk are all external factors that may affect a company's stock price but are not directly related to its daily operations.

Question 2

Homemade leverage is:
A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the use of personal borrowing to alter an individual's exposure to financial leverage.
D) best defined as an increase in a company's debt level.
E) the term used to describe the capital structure of a levered firm.

Accepted Answer

Homemade leverage refers to the use of personal borrowing to alter an individual's exposure to financial leverage. It is often used by investors as a way to increase the potential returns on their investments by increasing their exposure to leverage.

Question 3

A firm should select the capital structure that:
A) produces the highest cost of capital.
B) maximizes the value of the firm.
C) minimizes taxes.
D) is fully unlevered.
E) equates the value of debt with the value of equity.

Accepted Answer

The firm should select the capital structure that maximizes the value of the firm. This means that the capital structure should balance the benefits of debt (such as tax shields and potential financial leverage) with the costs of debt (such as bankruptcy risk and increased financial distress costs). By optimizing the capital structure, the firm can minimize its cost of capital and maximize the value of its equity. Option B aligns with this objective.

Question 4

Which one of the following makes the capital structure of a company irrelevant?
A) Taxes
B) Interest tax shield
C) 100 percent dividend payout ratio
D) Debt-equity ratio that is greater than 0 but less than 1
E) Homemade leverage

Accepted Answer

Homemade leverage refers to the ability of investors to create their own leverage by borrowing on their own account, rather than relying on the company to take on debt. This concept is central to the Modigliani-Miller theorem, which posits that under certain conditions, the capital structure of a company (i.e., the mix of debt and equity financing) is irrelevant to the company's value. This theorem assumes no taxes, bankruptcy costs, agency costs, or asymmetric information, and in such an idealized world, investors can undo the effects of corporate leverage on their own, making the company's choice of capital structure irrelevant.

Question 5

Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before interest and taxes (EBIT). The steeper the slope of the plotted line the:
A) lower the impact of financial leverage.
B) lower the debt-equity ratio.
C) higher the tax rate.
D) greater the sensitivity of EPS to changes in EBIT.
E) lower the probability of a negative EPS.

Accepted Answer

The steeper the slope of the plotted line, the greater the sensitivity of EPS to changes in EBIT. This suggests that even small changes in EBIT can have a significant impact on EPS. This is an indication of the degree of financial leverage used by the company, as higher leverage tends to amplify the impact of changes in EBIT on EPS. Therefore, D is the correct answer. The other answer choices are not necessarily related to the slope of the plotted line.

Question 6

Which one of the following states that the value of a company is unrelated to the company's capital structure?
A) Homemade leverage
B) M&M Proposition I, no tax
C) M&M Proposition II, no tax
D) Pecking-order theory
E) Static theory of capital structure

Accepted Answer

M&M Proposition I, no tax states that the value of a company is independent of its capital structure. In other words, the value of the company is determined by its ability to generate cash flows and not by the way it finances its operations. This proposition assumes perfect markets, no transaction costs, no taxes, and that investors have the same access to information.

Question 7

The optimal capital structure has been achieved when the:
A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) debt-equity ratio results in the lowest possible weighted average cost of capital.

Accepted Answer

The optimal capital structure is the one that results in the lowest possible weighted average cost of capital. This means that the debt-equity ratio should be such that the total cost of capital is minimized. If the company has too much debt, the cost of debt will increase due to higher interest payments and this will increase the weighted average cost of capital. On the other hand, if the company has too much equity, the cost of equity will increase due to higher expectations of returns from shareholders and this will also increase the weighted average cost of capital. Therefore, the ideal capital structure is the one that balances the costs of debt and equity to minimize the weighted average cost of capital.

Question 8

The value of a firm is maximized when the:
A) cost of equity is maximized.
B) tax rate equals the cost of capital.
C) levered cost of capital is maximized.
D) weighted average cost of capital is minimized.
E) debt-equity ratio is minimized.

Accepted Answer

The value of a firm is maximized when the weighted average cost of capital (WACC) is minimized. This is because the WACC represents the average rate of return a company must earn on its investments to satisfy its shareholders and debt holders. A lower WACC means the company needs to earn less on its investments to satisfy its capital providers, which in turn increases the value of the firm.

Question 9

Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to:
A) borrow some money and purchase additional shares of QRT stock.
B) maintain her current equity position as the debt of the firm does not affect her personally.
C) sell 36 percent of her shares of QRT stock and hold the proceeds in cash.
D) sell 36 percent of her shares of QRT stock and loan out the sale proceeds.
E) create a personal debt-equity ratio of .36.

Accepted Answer

To unlever her position, Jessica should sell 36 percent of her shares and loan out the sale proceeds to offset the firm's leverage.

Question 10

Financial risk is:
A) the risk inherent in a company's operations.
B) a type of unsystematic risk.
C) inversely related to the cost of equity.
D) dependent upon a company's capital structure.
E) irrelevant to the value of a company.

Accepted Answer

Financial risk is dependent upon a company's capital structure, as it relates to the potential impact on a company's earnings and cash flow due to its use of debt financing.

Question 11

Which one of the following statements is correct in relation to M&M Proposition II, without taxes?
A) The cost of equity remains constant as the debt-equity ratio increases.
B) The cost of equity is inversely related to the debt-equity ratio.
C) The required return on assets is equal to the weighted average cost of capital.
D) Financial risk determines the return on assets.
E) Financial risk is unaffected by the debt-equity ratio.

Accepted Answer

M&M Proposition II without taxes states that the required return on assets (or the firm's overall cost of capital) remains constant and is equal to the weighted average cost of capital (WACC), regardless of the firm's capital structure. This implies that changes in the debt-equity ratio do not affect the WACC.

Question 12

M&M Proposition I with no tax supports the argument that:
A) business risk has no effect on the return on assets.
B) the cost of equity rises as leverage rises.
C) a company's debt-equity ratio is completely irrelevant.
D) business risk is irrelevant.
E) homemade leverage is irrelevant.

Accepted Answer

M&M Proposition I with no tax states that the value of a firm is unaffected by its capital structure, implying that the debt-equity ratio is irrelevant to the firm's value.

Question 13

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.
A) At the break-even point, there is no advantage to debt.
B) The earnings per share will equal zero when EBIT is zero for a levered firm.
C) The advantages of leverage are inversely related to the level of EBIT.
D) The use of leverage at any level of EBIT increases the EPS.
E) EPS are more sensitive to changes in EBIT when a firm is unlevered.

Accepted Answer

At the break-even point, there is no advantage to debt because both levered and unlevered firms will have the same cost of capital. This is because, ignoring taxes, the benefits of debt (such as interest tax shields) do not apply, making the cost of capital for both types of firms equal at the break-even point.

Question 14

M&M Proposition II, without taxes, is the proposition that:
A) the capital structure of a company has no effect on that company's value.
B) the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
C) a company's cost of equity is a linear function with a slope equal to (RA − RD).
D) the cost of equity is equivalent to the required rate of return on assets.
E) the size of the pie does not depend on how the pie is sliced.

Accepted Answer

M&M Proposition II without taxes states that a company's cost of equity is a linear function of its capital structure. The slope of this function is determined by the difference between the return on assets (RA) and the cost of debt (RD), indicating how the cost of equity increases as more debt is introduced into the capital structure. This proposition does not involve taxes, making options involving tax rates or the tax implications on capital structure irrelevant.

Question 15

Which one of these statements is correct?
A) Capital structure has no effect on shareholder value.
B) The optimal capital structure occurs when the cost of equity is minimized.
C) The optimal capital structure maximizes shareholder value.
D) Shareholder value is maximized when WACC is also maximized.
E) Unlevered firms have more value than levered firms when firms are profitable.

Accepted Answer

The optimal capital structure is the one that maximizes shareholder value. This means finding the right balance between debt and equity financing that balances the tax advantages of debt with the risk associated with higher levels of debt, ultimately leading to maximized shareholder value. Choices A, B, D, and E are incorrect because capital structure does have an effect on shareholder value, the optimal capital structure is not only about minimizing the cost of equity but balancing debt and equity, shareholder value is not maximized when WACC is maximized, and levered firms can have more value than unlevered firms depending on profitability.

Question 16

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the:
A) company is earning just enough to pay for the cost of the debt.
B) company's earnings before interest and taxes are equal to zero.
C) earnings per share for the levered option are exactly double those of the unlevered option.
D) advantages of leverage exceed the disadvantages of leverage.
E) company has a debt-equity ratio of .50.

Accepted Answer

At the break-even level between a levered and an unlevered capital structure, the company is earning just enough to cover the cost of the debt. This means that the benefits of taking on debt (leverage) exactly offset the costs associated with it, such as interest payments.

Question 17

The concept of homemade leverage is most associated with:
A) M&M Proposition I with no tax.
B) M&M Proposition II with no tax.
C) M&M Proposition I with tax.
D) M&M Proposition II with tax.
E) the static theory proposition.

Accepted Answer

Homemade leverage is associated with M&M Proposition I with no tax, which states that in a perfect market, the value of a firm is unaffected by its capital structure. Investors can create their own leverage by borrowing or lending on their own account.

Question 18

Which one of the following is the equity risk related to capital structure policy?
A) Market risk
B) Systematic risk
C) Static risk
D) Business risk
E) Financial risk

Accepted Answer

Financial risk is the equity risk related to capital structure policy. This refers to the risk that comes from the use of debt to finance a company's operations, which can lead to increased financial leverage and potentially higher returns for equity holders. However, it also increases the risk of insolvency and bankruptcy, which can result in a significant reduction in the value of a company's equity. Market risk, systematic risk, static risk, and business risk are all related to different issues, such as market fluctuations, overall economic conditions, and the specific risks associated with a particular business or industry.

Question 19

The business risk of a company:
A) depends on the company's level of unsystematic risk.
B) is inversely related to the required return on the company's assets.
C) is dependent upon the relative weights of the debt and equity used to finance the company.
D) has a positive relationship with the company's cost of equity.
E) has no relationship with the required return on a company's assets according to M&M theory.

Accepted Answer

Business risk is related to the company's cost of equity because higher business risk increases the uncertainty of returns, leading to a higher required return by equity investors.

Question 20

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?
A) Static theory of capital structure
B) M&M Proposition I
C) M&M Proposition II
D) Homemade leverage
E) Pecking-order theory

Accepted Answer

M&M Proposition II states that the cost of equity capital is directly and proportionally related to the company's capital structure. This proposition, part of the Modigliani-Miller theorem, suggests that as a firm increases its leverage, the cost of equity increases linearly to compensate for the increased risk.

Quiz 16: Financial Leverage and Capital Structure Policy

Which one of the following is the equity risk that is most related to the daily operations of a firm?

Homemade leverage is:

A firm should select the capital structure that:

Which one of the following makes the capital structure of a company irrelevant?

Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before interest and taxes (EBIT) . The steeper the slope of the plotted line the:

Which one of the following states that the value of a company is unrelated to the company's capital structure?

The optimal capital structure has been achieved when the:

The value of a firm is maximized when the:

Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to:

Financial risk is:

Which one of the following statements is correct in relation to M&M Proposition II, without taxes?

M&M Proposition I with no tax supports the argument that:

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.

M&M Proposition II, without taxes, is the proposition that:

Which one of these statements is correct?

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the:

The concept of homemade leverage is most associated with:

Which one of the following is the equity risk related to capital structure policy?

The business risk of a company:

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?