Question 1

The present value of the costs of financial distress increases with increases in the debt ratio because the:

Accepted Answer

The costs of financial distress, such as legal fees and loss of customers, increase as the probability of default or bankruptcy increases due to higher debt ratios. Therefore, the present value of these costs also increases with the debt ratio. Choices A and B are incorrect because they are not directly related to the costs of financial distress. Choice C is incorrect because the equity tax shield is not relevant to the costs of financial distress.

Question 2

Leverage will __________ shareholders' expected return and _________ their risk.

Accepted Answer

The answer of Leverage will __________ shareholders' expected return and...

Question 3

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount,i.e.,$5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 50% and the number of shares in circulation is cut by 50% (assuming that the share price remains unchanged with this change in capital structure)?(Use values in dollar.)

Accepted Answer

With the increase in borrowing and interest expense by 50%, the new interest expense becomes $375,000 ($250,000 * 1.5). The operating income remains the same at $1.5 million. Therefore, the new net income is $1,125,000 ($1,500,000 - $375,000). With the number of shares cut by 50%, the new number of shares is 50,000 (100,000 * 0.5). The new EPS is $22.50 ($1,125,000 / 50,000).

Question 4

Which of the following would not be expected to change with changes in the firm's capital structure?

Accepted Answer

Expected return on assets is based on the operations of the firm and is not affected by changes in the capital structure. Conversely, the weighted-average cost of capital, expected return on equity, and expected earnings per share are all dependent on the firm's capital structure.

Question 5

The present value of a perpetual tax shield increases as the firm's tax rate _____ and the amount of principal _____.

Accepted Answer

The present value of a perpetual tax shield is calculated as the tax shield amount divided by the discount rate. As the tax rate increases, the tax shield amount increases, and as the amount of principal increases, the tax shield amount also increases. Therefore, choice A is correct.

Question 6

MM's proposition II states that the:

Accepted Answer

The answer of MM's proposition II states that the:
...

Question 7

Debt may be the preferred form of external financing for many firms because:

Accepted Answer

Equity issuance is often perceived by the market as a signal that a firm's stock might be overvalued, leading to a negative reaction. This phenomenon is known as the "signaling theory." Debt financing, on the other hand, does not generally carry this negative connotation and can be more attractive due to the tax deductibility of interest payments.

Question 8

An increase in a firm's financial leverage will:

Accepted Answer

An increase in financial leverage means that the firm is taking on more debt, which usually leads to an increase in interest payments. This can result in variability in earnings per share because the firm will have to make those interest payments regardless of whether or not it is profitable in a given period.

Question 9

In a world with corporate taxes but no possibility of financial distress,the value of the firm is maximized when the:

Accepted Answer

In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the firm uses no equity in its capital structure. This is because debt interest payments are tax-deductible, which reduces the firm's taxable income and thus its tax liability, increasing the overall value of the firm. This concept is derived from the Modigliani-Miller theorem on capital structure, which, under these conditions, suggests that a firm can reduce its overall cost of capital and increase value by financing entirely with debt.

Question 10

According to pecking-order theory,managers will often choose to finance with:

Accepted Answer

Pecking-order theory suggests that managers prefer to use retained earnings first, then debt, and finally equity as a last resort. This is because issuing new equity can lead to a reduction in share price due to information asymmetry and adverse selection, whereas debt financing does not dilute ownership and may be viewed more positively by investors. Thus, managers will often choose debt over new equity to avoid reduced share price.

Question 11

Financial risk refers to the:

Accepted Answer

Financial risk specifically refers to the risk faced by equity holders when debt is used. This is because when a company takes on debt, they have the obligation to pay interest and principal payments. If the company experiences financial difficulties and is unable to make these payments, equity holders may see their investment decline in value or even become worthless.

Question 12

The pecking-order theory suggests that less profitable firms borrow more because:

Accepted Answer

The pecking-order theory suggests that firms prefer to finance their investments with internal funds (retained earnings), followed by debt, and finally equity. However, less profitable firms may not have sufficient internal funds and would be forced to rely on external financing, particularly debt, to fund their investments. Therefore, the answer is D: they have insufficient internal funds.

Question 13

What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the stock if operating income equals $1.5 million and EPS were $2 when the firm was all equity financed? Ignore taxes.(Use values in dollar.)

Accepted Answer

When the firm uses $1 million of 20% debt to repurchase two-thirds of its stock, it reduces the number of shares outstanding, potentially increasing EPS. The interest expense on the debt is $200,000 (20% of $1 million). The remaining operating income after interest is $1.3 million ($1.5 million - $200,000). If EPS was $2 before the repurchase, the firm had $1.5 million in earnings spread over $0.75 million worth of shares (since $1.5 million / $2 per share = $0.75 million shares). After repurchasing two-thirds of the stock, one-third remains, equating to $0.25 million worth of shares. The new EPS is $1.3 million / $0.25 million = $5.20.

Question 14

A firm issues 100,000 equity shares with a total market value of $5,000,000.The firm's market value of debt is also of equal amount,i.e.,$5,000,000.The firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if the firm's borrowing and interest expense increases by 75% and the number of shares in circulation is cut by 75% (assuming that the share price remains unchanged with this change in capital structure)?

Accepted Answer

The increase in borrowing and interest expense by 75% leads to higher interest payments, reducing net income. However, reducing the number of shares by 75% significantly decreases the share count, leading to a higher EPS despite the lower net income. This is because the reduction in shares has a more substantial effect on EPS calculation than the increase in interest expense.

Question 15

If a firm's expected return on equity equals its expected return on assets,then the:

Accepted Answer

If a firm's expected return on equity equals its expected return on assets, it means that the firm has no debt in its capital structure because debt is typically cheaper than equity and would result in a higher expected return on assets.

Question 16

If the present value of the tax shield equals the present value of the costs of financial distress,then the:

Accepted Answer

The answer of If the present value of the tax...

Question 17

The stability of a firm's operating income is the focus of:

Accepted Answer

Business risk refers to the risk associated with a firm's operations and the likelihood that its operating income will fluctuate from year to year. Therefore, the stability of a firm's operating income is the focus of business risk.

Question 18

The "trade-off theory" of capital structure suggests that:

Accepted Answer

The "trade-off theory" of capital structure suggests that firms with higher risk should use less debt. This is because adding more debt increases the financial risk of the firm and may result in financial distress, bankruptcy, and ultimately, the inability to repay debt. Therefore, firms need to consider the trade-off between the tax benefits of debt (i.e., interest payments are tax-deductible) and the increased financial risk of debt. If the firm is highly risky, it may be better to use less debt to avoid financial distress.

Question 19

A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.Ignoring taxes,this will generate $12.50 earnings per share.What will happen to EPS if operating income increases to $2.0 million?

Accepted Answer

The answer of A firm is expected to generate $1.5...

Question 20

The pecking-order theory of capital structure suggests the following order of financing:

Accepted Answer

The pecking-order theory suggests that companies prioritize their sources of financing (from internal financing to equity) according to the principle of least effort, or least resistance, preferring to raise equity as a last resort. Hence, they start with internal funds, move to debt, and only issue equity if absolutely necessary.

Quiz 16: Debt and Payout Policy