Question 1

Which of the following is NOT a factor for determining whether to use the active or passive approach to capital structure changes?

Accepted Answer

B

Question 2

If a firm changes their capital structure by waiting until the firm requires additional capital to cover capital budgeting needs and then selling more of the type of claims they wish to increase, they are using which type of capital structure change?

Accepted Answer

This type of capital structure change is known as a passive change because the firm is not actively pursuing a change in its capital structure but rather waiting for the need to arise before making a change.

Question 3

Which of the following is a true statement regarding Proposition I?

Accepted Answer

Proposition I states that with taxes, the value of utility (Vu) will be less compared to a world without taxes. This is because taxes act as an additional cost on goods and services, reducing the amount of income available for spending on other items, leading to a lower level of satisfaction or utility.

Question 4

Which of the following allows for two types of bankruptcy for which most businesses can file?

Accepted Answer

The United States Bankruptcy Code provides for two types of bankruptcy, Chapter 7 and Chapter 11, which most businesses can file. Chapter 7 is a liquidation bankruptcy, while Chapter 11 allows a business to restructure its debts and continue operating. The Securities Exchange Commission, Generally Accepted Accounting Principles, and the Internal Revenue Service do not provide for bankruptcy options.

Question 5

The mix of debt and equity that a firm uses to finance its operations is known as:

Accepted Answer

Capital structure refers to the mix of debt and equity that a firm uses to finance its operations. This includes decisions on how much debt to take on versus equity, and can have significant implications for a company's financial health and risk profile. Capital management and break even are related concepts but do not refer specifically to the mix of debt and equity used to finance operations. Separation structure is not a commonly used financial term.

Question 6

If a firm changes their capital structure by immediately selling additional claims of one type of capital and using the proceeds to retire another kind of claim, they are using which type of capital structure change?

Accepted Answer

This is an example of an active capital structure change, where the firm actively alters its mix of debt, equity, or other securities through specific transactions like issuing new shares or retiring debt.

Question 7

Which of the following is NOT a feature of the "perfect world" in M&M's theorem for optimal capital structure?

Accepted Answer

The "perfect world" in M&M's theorem assumes that asymmetric information does not exist, so choice D is not a feature of the optimal capital structure.

Question 8

Which type of bankruptcy involves an attempt to allow the firm to reorganize the business under court supervision?

Accepted Answer

Chapter 11 bankruptcy involves the attempted reorganization of a business under court supervision, allowing the business to continue operating while it works to repay its debts. Chapter 7 bankruptcy, on the other hand, involves the liquidation of a business's assets to pay off debts, while Chapter 13 bankruptcy is designed for individuals to reorganize their debts and repay them over a period of time. Chapter 9 bankruptcy is specifically for municipalities, such as cities or towns, to reorganize their debts. Therefore, only option B fits the given description.

Question 9

Which of the following is one of the most extreme examples of firm re-leveraging that occurs when someone uses a firm's debt capacity to buy out the majority of the firm's equity holders?

Accepted Answer

A leveraged buyout (LBO) is a type of acquisition where an investor or group of investors uses borrowed funds, such as loans or bonds, to finance the purchase of a controlling stake in a company. This allows the buyers to use the company's assets as collateral for the debt, and ultimately transfer ownership from the equity holders to the new debt holders. It is considered one of the most extreme examples of firm re-leveraging, as it involves a significant increase in debt and the potential for financial risk.

Question 10

How can an investor leverage itself more than the firm?

Accepted Answer

By borrowing money and investing it along with their own money, an investor can increase their potential returns (or losses) more than the firm itself. This is because the firm's returns are divided among all its shareholders, while the investor can keep all the returns on their leveraged investment. However, this also increases the investor's risk as they now owe money in addition to their initial investment.

Question 11

Which of the following is a feature of the "perfect world" in M&M's theorem for optimal capital structure?

Accepted Answer

The "perfect world" in M&M's theorem for optimal capital structure assumes perfectly efficient markets, where all information is freely available to all participants. It also assumes no taxes or chance of bankruptcy, and symmetric information sets for all participants.

Question 12

Which type of bankruptcy involves a business liquidating their assets?

Accepted Answer

Chapter 7 bankruptcy involves liquidating all of the debtor's assets to pay off creditors. This type of bankruptcy is commonly used by businesses that are unable to continue operating and want to close down.

Question 13

The level of EBIT at which EPS will be equal for two different capital structures is known as:

Accepted Answer

Break-even EBIT is the level of earnings before interest and taxes (EBIT) at which two different capital structures will have equal earnings per share (EPS). At this point, the interest expense and taxes are the same for both capital structures, and any increase in EBIT will result in an equal increase in EPS for both structures. Therefore, the break-even EBIT is an important measure of the financial leverage of a company.

Question 14

Another name for debt in the capital structure is:

Accepted Answer

Leverage is another term for debt in the capital structure, as it refers to the use of borrowed funds to finance the acquisition of assets, with the expectation that the profits made will be greater than the interest payable.

Question 15

In M&M's perfect world, their theorem's two main propositions are referred to as which of the following?

Accepted Answer

M&M's theorem proposes that in a perfect world, capital structure is irrelevant to a company's value. This is known as the capital structure irrelevance assertion. Therefore, the correct choice is C.

Question 16

What causes the change in optimal strategy when taxes are added back to the M&M theorem?

Accepted Answer

The answer of What causes the change in optimal strategy...

Question 17

Which of these is the rule under which claimants are paid in a Chapter 7 bankruptcy?

Accepted Answer

The "absolute priority" rule in Chapter 7 bankruptcy dictates the order in which claims are paid. This rule ensures that creditors with higher priority claims are paid in full before those with lower priority claims receive any payment.

Question 18

Which of the following makes this a true statement? In this slightly more realistic world with corporate taxes, managers can:

Accepted Answer

In a slightly more realistic world with corporate taxes, managers can maximize the firm's value by taking on as much debt as possible due to the tax shield provided by interest payments. However, there is an optimal level of debt beyond which the costs of financial distress outweigh the benefits of the tax shield, so managers should not finance the firm entirely with debt.

Question 19

Which of these is the assumption that decisions about which projects to fund are separate from the decisions about how to fund them?

Accepted Answer

The separation principle assumes that decisions about which projects to fund should be made separately from decisions about how to fund them. This means that the funding source should not be considered when evaluating the potential of a project, and instead, the project should be evaluated based on its own merits. The break-even principle relates to the determination of the point at which the company's revenues will equal its expenses. The capital structure principle refers to the composition of a company's funding sources, including debt and equity. The long position principle relates to the ownership of an asset in the expectation of a rise in the asset's value.

Question 20

Which of the following is a true statement?

Accepted Answer

A firm's cost of equity increases with the use of debt in the capital structure because as a firm takes on more debt, the risk to equity holders increases since debt holders have priority over equity holders in the case of liquidation. This increased risk leads to a higher required return by equity investors, thus increasing the cost of equity.

Quiz 16: Assessing Long-Term Debt, Equity, and Capital Structure