Question 1

Which of the following are given as reasons why individual investors may be able to borrow at the same rates as corporations? I.Corporate loans must be negotiated and supervised.
II)Corporations often borrow using illiquid assets as collateral.
III)Individuals tend to borrow smaller amounts.
IV)Individuals can borrow on margin through a broker.
A)I and II only
B)III and IV only
C)II,III,and IV only
D)I,II,and IV only
E)I,II,III,and IV

Accepted Answer

I, II, and IV are reasons why individual investors may be able to borrow at the same rates as corporations. Corporate loans require negotiation and supervision, corporations may use illiquid assets as collateral, and individuals can borrow on margin, potentially leveling the playing field with corporate borrowing rates.

Question 2

Which one of these argues than the value of a firm is independent of its capital structure?
A)MM Proposition I,without taxes
B)MM Proposition II,without taxes
C)MM Proposition I,with taxes
D)MM Proposition II,with taxes
E)None of the MM Propositions

Accepted Answer

MM Proposition I, without taxes, states that the market value of a firm is independent of its capital structure. It suggests that the value of a firm is determined by its earning power and the risk of its underlying assets, not how those assets are financed. Therefore, changing the mix of debt and equity in a firm's capital structure does not affect its overall value.

Question 3

Shareholders value firms based on their
A)sizes.
B)profits.
C)original costs.
D)depreciated values.
E)market values.

Accepted Answer

Shareholders value firms based on their market values, which reflect the current perceived value of a company based on its assets, liabilities, and performance. Market values are determined by supply and demand in the stock market, and can fluctuate based on a range of factors such as economic conditions, industry trends, and individual company performance. Size, profits, original costs, and depreciated values may all be relevant factors in determining a company's market value, but they are not the primary driver of shareholder valuation.

Question 4

You are writing a comparison of an all-equity structure to a levered capital structure for a firm.It is accurate to state in this comparison that
A)earnings per share will always be higher in the all-equity structure.
B)firms will only select the levered structure when individual rates on borrowed funds are lower than corporate rates.
C)leverage lowers shareholders' returns in bad financial times.
D)the all-equity firm has a greater advantage the higher the firm's earnings before interest.
E)leverage improves shareholders' returns regardless of the firm's level of earnings.

Accepted Answer

Leverage may increase returns when the firm's earnings are higher, but it also increases the risk of financial distress and bankruptcy. In bad financial times, the firm may be unable to meet its debt obligations, and this could result in lower returns, or even losses for shareholders. The other choices are not accurate; for example, earnings per share may be higher or lower depending on the level of earnings and the cost of capital, and firms may select a levered structure for many reasons, not just because individual rates on borrowed funds are lower.

Question 5

An unlevered firm is a company that
A)pays no current dividends.
B)has only one geographic location.
C)has no debt.
D)produces a single product.
E)is undervalued based on its current capital structure.

Accepted Answer

An unlevered firm is a company that has no debt in its capital structure. Therefore, option C is the correct answer. The other options do not define an unlevered firm.

Question 6

A firm's capital structure refers to the
A)division of a firm's assets into current and fixed assets.
B)amount shareholders have invested into the firm.
C)types of fixed assets owned by the firm.
D)mix of debt and equity used to finance the firm's assets.
E)amount of cash and cash equivalents held by a firm.

Accepted Answer

A firm's capital structure refers to the mix of debt and equity used to finance the firm's assets. It is the way a company finances its operations and growth by using different sources of funds, including equity, debt, and hybrid securities. A company's capital structure can have a significant impact on its profitability, financial flexibility, risk profile, and cost of capital.

Question 7

In the absence of taxes,MM argues that
A)no one capital structure for a firm is superior to any other capital structure for that firm.
B)the cost of equity for a levered firm is equal to the firm's unlevered WACC.
C)homemade leverage is insufficient to offset a firm's use of leverage.
D)the value of a levered firm exceeds the value of the unlevered firm.
E)the cost of equity decreases as the debt-equity ratio increases.

Accepted Answer

In the absence of taxes, MM argues that the capital structure of a firm does not affect its overall value. According to MM, investors can create their own homemade leverage if they want to adjust their risk exposure. Therefore, there is no single superior capital structure for a firm. This is known as the irrelevance theory of capital structure.

Question 8

Assume you are reviewing a graph depicting earnings per share (EPS)on the vertical axis and earnings before interest (EBI)on the horizontal axis.Data points for both a levered and an unlevered firm are displayed.Given this,which statement accurately describes this graph?
A)The unlevered firm has a greater reaction to a change in EBI than does the levered firm.
B)The levered firm consistently has higher EPS than the unlevered firm.
C)Both the levered and unlevered firms have zero EPS when EBI is zero.
D)Debt becomes a greater disadvantage to a firm as EBI increases.
E)When earnings exceed the breakeven point,the levered firm has the higher EPS.

Accepted Answer

The graph is depicting the relationship between EPS and EBI for both a levered and an unlevered firm. The fact that there are data points for both firms suggests that they are being compared. Option A is incorrect because there is no information to suggest that the unlevered firm has a greater reaction to a change in EBI. Option B is incorrect because the graph does not consistently show that the levered firm has higher EPS. Option C is incorrect because the graph does not show any data points at (0,0) indicating that both firms have zero EPS when EBI is zero. Option D is incorrect because there is no information to suggest that debt becomes a greater disadvantage to a firm as EBI increases. Option E is correct because the graph shows that the levered firm has higher EPS than the unlevered firm when earnings exceed the breakeven point.

Question 9

When selecting a capital structure,managers should aim to maximize the
A)tax deductions that are available to the company.
B)value of the firm for its managers and employees.
C)size of the firm.
D)value of the firm for its shareholders.
E)growth rate of the company.

Accepted Answer

When selecting a capital structure, managers should aim to maximize the value of the firm for its shareholders. This means choosing a mix of debt and equity financing that generates the most value for the company's owners. By maximizing shareholder value, managers can ensure that the company is providing a good return on investment and attracting new investors. While tax deductions and other factors may also play a role in capital structure decisions, the primary focus should be on creating shareholder value.

Question 10

Ignoring taxes,financial leverage affects the performance of a firm by
A)increasing the volatility of the firm's EBI.
B)decreasing the volatility of the firm's EBI.
C)decreasing the volatility of the firm's net income.
D)increasing the volatility of the firm's EPS.
E)lowering the firm's level of risk.

Accepted Answer

Financial leverage increases the volatility of a firm's EPS (earnings per share) as it is calculated by dividing the firm's net income by the number of outstanding shares. When a firm uses debt financing, it incurs interest expenses that are deducted from its net income, thereby reducing the earnings available to shareholders. As a result, any increase or decrease in EBIT (earnings before interest and taxes) has a magnified effect on EPS, leading to higher volatility.

Question 11

Which one of these statements is correct?
A)There is no condition known to date whereby a corporation can increase firm value through the use of leverage.
B)Corporations generally pay a lower cost on debt than do individuals due to their vast pool of liquid assets.
C)If individuals pay a higher cost to borrow than corporations do,then corporations can increase firm value by borrowing.
D)Margin accounts tend to be high interest rate sources of funds for individuals.
E)Corporations can increase firm value by borrowing provided their interest rate on debt exceeds that paid by individuals.

Accepted Answer

If individuals pay a higher cost to borrow than corporations do, then corporations can increase firm value by borrowing. This is because corporations can use the borrowed funds to invest in projects that generate returns higher than the cost of borrowing.

Question 12

MM Proposition I,without taxes,illustrates that
A)the value of an unlevered firm is greater than that of a levered firm.
B)any one capital structure is just as valuable as any other capital structure for a given firm.
C)corporate use of homemade leverage affects the value of the firm to its shareholders.
D)the value of a firm is directly related to the use of debt.
E)firm valuation is dependent upon shareholders aversion to homemade leverage.

Accepted Answer

MM Proposition I states that, in the absence of taxes and other market imperfections, the value of a firm is determined by its earning power and the risk of its underlying assets and is not affected by its capital structure. This means that any one capital structure is just as valuable as any other capital structure for a given firm. Therefore, the answer is B.

Question 13

Managers should select the capital structure that
A)maximizes the value of the firm.
B)has no debt.
C)is fully levered.
D)minimizes taxes.
E)produces the highest current level of net income.

Accepted Answer

The goal of a firm is to maximize shareholder wealth, and the capital structure decision can have a significant impact on the value of the firm. Therefore, managers should choose the capital structure that maximizes the value of the firm. This means determining the optimal mix of debt and equity financing that balances the benefits of debt (such as tax shields and lower cost of capital) against the costs of debt (such as increased risk and potential financial distress).

Question 14

MM Proposition I,without taxes,assumes that
A)debt is riskless.
B)individuals and corporations can borrow at the same rate.
C)firms can borrow at the risk-free rate.
D)individuals and firms are taxed at the same rate thereby making taxes irrelevant.
E)all firms will prefer an unlevered capital structure.

Accepted Answer

MM Proposition I, without taxes, assumes that individuals and corporations can borrow at the same rate, known as the "cost of capital," implying that the cost of debt is the same for both parties. This proposition concludes that the value of the firm is independent of its capital structure, implying that different capital structures will not affect the firm's overall value. However, this proposition assumes no taxes, no agency costs, no bankruptcy costs, and perfect information.

Question 15

When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt
A)increase as EBIT increases.
B)stay fixed,leaving more income to be distributed over fewer shares.
C)stay fixed,leaving less income to be distributed over fewer shares.
D)stay fixed,leaving less income to be distributed over more shares.
E)decrease as EBIT increases.

Accepted Answer

When a company uses leverage in its capital structure, it incurs interest expenses on the debt which reduce its net income. However, this reduction is proportional to the level of EBIT. In other words, as the level of EBIT increases, the interest payment does not increase at the same rate, leading to a higher net income and EPS. This happens because the interest payments are fixed, regardless of EBIT, and represent a smaller percentage of the total income at higher levels of EBIT. Therefore, choice B is the correct answer.

Question 16

In an EPS-EBI graphical relationship,the debt line and the no debt line intersect.Which one of these is true at the intersection point?
A)The advantages of debt outweigh the disadvantages of debt.
B)The aftertax earnings of both capital structures are equal.
C)The earnings per share for both capital structures equal zero.
D)There is no advantage or disadvantage to debt.
E)The EPS is maximized for both the levered and the unlevered firm.

Accepted Answer

At the intersection point, the EPS for both the levered and unlevered capital structures are equal, indicating there is no advantage or disadvantage to using debt.

Question 17

The use of leverage by a firm
A)increases the variability of EBIT.
B)replaces all use of homemade leverage.
C)increases shareholder risk.
D)affects EBIT more than net income.
E)increases EPS at low levels of income.

Accepted Answer

Leverage increases shareholder risk because it amplifies the potential returns and losses, making the firm's earnings more volatile and increasing the financial risk to shareholders.

Question 18

Ignoring taxes,leverage becomes a disadvantage to a firm as soon as the firm's earnings before interest
A)become negative.
B)exceed the breakeven point.
C)exceed the interest expense.
D)exceed the firm's unlevered earnings.
E)fall below the breakeven point.

Accepted Answer

The answer of Ignoring taxes,leverage becomes a disadvantage to a...

Question 19

MM Proposition I,without taxes,supports the argument that
A)business risk determines the return on assets.
B)it is completely irrelevant how a firm arranges its finances.
C)the cost of equity rises as leverage rises.
D)a firm should borrow money up to the point where the cost of debt equals the cost of equity.
E)financial risk is determined by the debt-equity ratio.

Accepted Answer

MM Proposition I, without taxes, states that the value of a firm is not affected by its capital structure. Thus, it is completely irrelevant how a firm arranges its finances. This means that in the absence of taxes, the cost of equity and the WACC (Weighted Average Cost of Capital) are constant regardless of the firm's capital structure. Therefore, choice B is the correct answer. The other choices are incorrect based on the assumptions of MM Proposition I.

Question 20

A general rule for managers to follow is to establish a firm's capital structure such that the firm's
A)cost of equity is minimized.
B)bondholders are fully secured.
C)current market value is maximized.
D)dividend payout is maximized.
E)assets are minimized.

Accepted Answer

A firm's capital structure should aim to maximize its current market value. This can be achieved through a balance of debt and equity financing that minimizes the overall cost of capital while also providing sufficient funds for investment. Bondholder security and dividend payouts are important considerations, but maximizing the firm's value should be the primary objective. Minimizing assets would not be beneficial as it would limit the firm's ability to generate profits.

Quiz 14: Capital Structure: Basic Concepts

Which one of these argues than the value of a firm is independent of its capital structure?

Shareholders value firms based on their

You are writing a comparison of an all-equity structure to a levered capital structure for a firm.It is accurate to state in this comparison that

An unlevered firm is a company that

A firm's capital structure refers to the

In the absence of taxes,MM argues that

Assume you are reviewing a graph depicting earnings per share (EPS) on the vertical axis and earnings before interest (EBI) on the horizontal axis.Data points for both a levered and an unlevered firm are displayed.Given this,which statement accurately describes this graph?

When selecting a capital structure,managers should aim to maximize the

Ignoring taxes,financial leverage affects the performance of a firm by

Which one of these statements is correct?

MM Proposition I,without taxes,illustrates that

Managers should select the capital structure that

MM Proposition I,without taxes,assumes that

When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt

In an EPS-EBI graphical relationship,the debt line and the no debt line intersect.Which one of these is true at the intersection point?

The use of leverage by a firm

Ignoring taxes,leverage becomes a disadvantage to a firm as soon as the firm's earnings before interest

MM Proposition I,without taxes,supports the argument that

A general rule for managers to follow is to establish a firm's capital structure such that the firm's