Deck 16: Capital Structure and Capital Budgeting in a Perfect Market

Question 1

Explain how maximizing firm value will usually result in the maximization of
shareholder value as well.

Answer 1

Bond investors are not stupid, and they will pay less (i.e., demand a higher interest rate)today if they suspect management might ignore their needs in the future. This will erode firm value, which, in effect, reduces shareholder value since there is less cash flow to be distributed to the shareholders.

Question 2

The optimal capital structure is the one that

A)uses the most debt since debt has a lower cost of capital.
B)maximizes the current value of the firm.
C)uses the most common equity since this results in lower risk to the existing shareholders.
D)maximizes ex-post shareholder value.

Answer 2

maximizes the current value of the firm.

Question 3

According to the M&M propositions, in a perfect market which of the following statements is true?

A)The value of the firm will be equal to the net present value of its underlying projects.
B)The net present value of a firm's projects will be higher if they are financed with debt since debt carries a lower cost.
C)The net present value of a firm's projects should exceed the present value of the firm's issued claims.
D)Both A and B are true statements.

Answer 3

The value of the firm will be equal to the net present value of its underlying projects.

Question 4

Describe how you might explain the M&M proposition using the analogy of a birthday
cake.

Question 5

Why might you expect longer-term debt issues to have more bond covenants than
short-term (i.e., no more than one year to maturity)debt issues ?

Question 6

Agency conflicts that exist in the real world mean that

A)managers will make decisions that favor either bondholders or shareholders, depending on which serves their own best interests at the time.
B)managers will always act to maximize ex-ante firm value.
C)managers will always make decisions that favor bondholders at the expense of shareholders.
D)managers will always make decisions that favor shareholders over bondholders since shareholders have the voting power.

Question 7

In Modigliani and Miller's perfect world,

A)capital structure can only affect the value of a firm if poor control arrangements exist within that structure.
B)bad capital structures will create arbitrage opportunities and will therefore be immediately eliminated.
C)managers should decide on how an investment will be financed prior to deciding whether to undertake that investment.
D)Both A and B are true statements.

Question 8

Which of the following statements is true?

A)In order to maximize shareholder wealth, management must strive to maximize the value of the firm today, which means they must consider the needs of the firm's bondholders as
Well as the needs of the firm's shareholders.
B)If management concentrates on maximizing ex-ante shareholder value, then ex-post shareholder value will also be maximized.
C)Management should focus on maximization of shareholder wealth, which means they should take the steps necessary to maximize earnings per share.
D)All of the above are true statements.

Question 9

The M&M dividend proposition states that

A)the higher a firm's dividends, the greater the shareholder value.
B)the higher a firm's dividends, the greater the firm value.
C)a firm should borrow money if necessary to maintain a stable dividend policy.
D)shareholder value is unaffected by a firm's dividend policy.

Question 10

Which of the following statements is false?

A)If management does not consider the needs of the bondholders of a firm, they could end up destroying shareholder value.
B)In a perfect capital market, if a firm's current capital structure is not optimal, one can expect that firm to be a takeover target.
C)Management should focus only on the needs of a firm's shareholders since they are the true owners of the firm and, as such, they elect the firm's directors.
D)If management chooses to ignore the needs of bondholders when structuring a firm, the firm can be expected to have to pay a higher interest rate on its debt.

Question 11

A firm can be worth $60 million or $120 million with equal probability. The debt of the firm consists of a zero-coupon bond with a $100 million face that matures in one year. Assume risk neutrality and a cost of capital of 8%.
Refer to the information above. What will the bondholders pay for this debt?

A)$83.3 million
B)$92.6 million
C)$74.1 million
D)$80.0 million

Question 12

In which of the following scenarios is maximization of firm value unlikely to maximize shareholder value as well?

A)when a firm is close to financial distress
B)Maximization of firm value is always synonymous with maximization of shareholder value in the real world.
C)when a firm issues bonds that are convertible or callable
D)when a firm issues bonds that have covenants that stipulate minimum current ratios and maximum debt ratios

Question 13

The term "ex-ante" means

A)without just cause.
B)before the fact.
C)after prior claims.
D)after the fact.

Question 14

A firm can be worth $110 or $180 with equal probability. The firm's debt consists of a zero-coupon bond with a face value of $110 that matures at the end of one year. Assume risk neutrality and a cost of capital of 10%.
Refer to the information above. What will the bondholders pay for this debt?

A)$110.00
B)$100.00
C)$131.82
D)none of the above

Question 15

Which of the following statements is true?

A)Bond covenants serve to protect bondholders at the expense of firm value.
B)Bond covenants can serve to maximize firm value, which means shareholder value is also maximized.
C)Although bond covenants may serve to maximize firm value, they destroy shareholder value.
D)None of the above is a true statement.

Question 16

According to Modigliani and Miller, in a perfect market the total value of the firm will be

A)higher when debt is used since the cost of debt is lower than the cost of equity.
B)the same regardless of the firm's choice of capital structure.
C)higher when equity is used since the firm's shareholders are exposed to less risk than if debt is used.
D)maximized if the firm uses 50% debt and 50% equity financing.

Question 17

A firm can be worth $110 or $180 with equal probability. The firm's debt consists of a zero-coupon bond with a face value of $110 that matures at the end of one year. Assume risk neutrality and a cost of capital of 10%.
Refer to the information above. What is the value of this firm's equity?

A)$31.82
B)$145.00
C)$131.82
D)$35.00

Question 18

The M&M proposition says that if a firm can be thought of as a tub of whole milk that a farmer can separate into cream and skim milk and there are no costs of separation or government
Support programs, then

A)the value of the whole milk should equal the value of the cream plus the value of the skim milk.
B)the value of the whole milk should exceed the value of the cream plus the value of the skim milk.
C)the value of the cream should be greater than the value of the skim milk plus the value of the whole milk.
D)the value of the cream should equal the value of the skim milk plus the value of the whole milk.

Question 19

Which of the following statements about homemade leverage is true?

A)Homemade leverage allows you to obtain only the control rights of claims under a better capital structure than currently exists.
B)Homemade leverage allows you to obtain both the cash flow rights and the control rights of claims under a better capital structure than currently exists.
C)Homemade leverage is only possible if you own a majority of the firm's shares.
D)Homemade leverage allows you to obtain only the cash flow rights of claims under a better capital structure than currently exists.

Question 20

If a firm can be thought of as a tub of whole milk that a farmer can separate into cream and skim milk, the skim milk would represent the

A)firm as if it were all equity financed.
B)ex-post firm value.
C)levered equity of the firm.
D)debt of the firm.

Question 21

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the expected payoff to the levered equity holders?

A)$17.5 million
B)$135 million
C)50.2 million
D)$100 million

Question 22

True, False, or Uncertain: There is no such thing as a bad capital structure.

Question 23

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the current value of the bonds?

A)$82.5 million
B)$77.83 million
C)$100 million
D)none of the above

Question 24

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the current value of the firm's levered equity?

A)$18.52 million
B)$111.11 million
C)$14.96 million
D)This cannot be determined without knowing the cost of capital for the levered equity.

Question 25

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the expected return on the levered equity?

A)4.0%
B)12.0%
C)33.7%
D)7.7%

Question 26

Assume a firm can be financed with $400 of debt that has a market beta of 0.2 and $600 of equity that has a beta of 2.0. If the risk-free rate is 3.5% and the equity premium is 5%, what is
The cost of capital of the overall firm?

A)4.5%
B)13.5%
C)4.9%
D)9.9%

Question 27

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the value of the levered equity?

A)$89.3 million
B)$11.5 million
C)$17.5 million
D)This cannot be determined without knowing the cost of equity capital.

Question 28

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the expected payoff to the levered equity holders?

A)$20 million
B)$120 million
C)$15 million
D)none of the above

Question 29

Assume a firm is financed with $2,000 debt that has a market beta of 0.1 and $3,000 equity. The risk-free rate is 3%, the equity premium is 5%, and the firm's overall cost of capital is 10%.
Refer to the information above. What is the expected return on the firm's equity?

A)8.0%
B)14.3%
C)8.6%
D)15.0%

Question 30

Assume a firm is financed with $3,000 debt and $7,000 equity. The beta of the equity is 0.8. The risk-free rate is 3%, and the equity premium is 7%. If the overall cost of capital of the firm
Is 8%, what is the beta of the firm's debt?

A)0.00
B)0.12
C)0.51
D)0.24

Question 31

Does the M&M argument ignore the fact that an increased use of debt may result in a
firm's bankruptcy?

Question 32

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the promised return on the bond?

A)6.4%
B)5.6%
C)4.0%
D)This cannot be determined with the information provided.

Question 33

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the expected payoff to the bondholders?

A)$50.2 million
B)$165 million
C)$82.5 million
D)$100 million

Question 34

Assume a firm is financed with $2,000 debt that has a market beta of 0.1 and $3,000 equity. The risk-free rate is 3%, the equity premium is 5%, and the firm's overall cost of capital is 10%.
Refer to the information above. What is the expected return on the firm's debt?

A)1.4%
B)8.0%
C)3.5%
D)5.0%

Question 35

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the expected payoff on the bond?

A)$100 million
B)$130 million
C)$96.2 million
D)$120 million

Question 36

Assume a firm is financed with $1,000 debt that has a market beta of 0.05 and $3,000 of equity with a beta of 1.4. If the risk-free rate is 5% and the equity premium is 6%, what is the cost of
Capital of the firm? Round your answer to the nearest tenth of a percent.

A)11.4%
B)10.7%
C)9.5%
D)none of the above

Question 37

A firm can be worth $60 million or $120 million with equal probability. The debt of the firm consists of a zero-coupon bond with a $100 million face that matures in one year. Assume risk neutrality and a cost of capital of 8%.
Refer to the information above. What is the value of this firm's equity?

A)$9.3 million
B)$90.0 million
C)$10.0 million
D)$83.3 million

Question 38

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What is the current value of the firm's debt?

A)$96.15 million
B)$92.60 million
C)$100 million
D)none of the above

Question 39

A firm has 60% probability of being worth $100 million and a 40% probability of being worth $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 4%. The cost of capital for the firm's projects is 8%.
Refer to the information above. What are the current proportions of debt and equity financing used by the firm?

A)83.3% debt; 16.7% equity
B)80% debt; 20% equity
C)86.5% debt; 13.5% equity
D)This cannot be determined with the information provided.

Question 40

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the promised return on the firm's debt?

A)6.0%
B)12.8%
C)28.5%
D)21.2%

Question 41

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What is the expected return on the levered equity?

A)23.9%
B)52.7%
C)18.0%
D)6.0%

Question 42

Which of the following statements about a firm's capital structure is true?

A)In a world of perfect financial markets, the value of a firm will be less than the value of its financial claims due to the use of non-financial liability financing.
B)In a world of perfect financial markets, the value of the firm is increased the more a firm can use non-financial liability financing since it has no real cost.
C)In a world of perfect financial markets, the value of a firm is independent of how it is financed.
D)In a world of perfect financial markets, the value of a firm 's financial claims is independent of how it is financed.

Question 43

A firm consists of a single project. If the project is very successful, the firm will be
worth $800. If it is less successful, the firm will be worth only $360. There is a 60%
chance that the project will be very successful. The firm has a single, zero-coupon
bond with a face value of $500 and a required return of 8%. The cost of capital for the
overall firm is 12%. What is the cost of capital of the levered equity? What is the
promised rate of return on the debt?

Question 44

Which of the following statements regarding non-financial liabilites is true?

A)If there is a strong linkage between a firm's projects and its claims structure, then the firm's cost of capital is unaffected by the proportions of non-financial debt, financial debt, and
Equity financing that a firm chooses to use.
B)If arbitrageurs can easily undue suboptimal choices, then the firm's cost of capital is unaffected by the proportions of non-financial debt, financial debt, and equity financing
That a firm chooses to use.
C)The CAPM is an effective tool to use in determining the cost of non-financial liabilities.
D)All of the above are true statements.

Question 45

A firm is financed with debt that has a market beta of 0.1 and equity that has a market
beta of 1.2. The risk-free rate is 4%, and the equity premium is 6%. The overall cost of
capital for the firm is 9.2%. What is the firm's debt-equity ratio?

Question 46

A firm is equally likely to be worth $50 million, $80 million, $120 million, or $150 million. There is one bond outstanding that promises to pay $100 million at an interest rate of 6%. The appropriate cost of capital for the firm's projects is 12%.
Refer to the information above. What proportions of debt and equity financing is the firm currently using?

A)82.5% debt; 17.5% equity
B)87.2% debt; 12.8% equity
C)66.7% debt; 33.3% equity
D)none of the above

Question 47

As the amount of a debt a firm uses increases,

A)the expected return on debt increases, but its promised return remains the same.
B)the cost of debt increases, but the cost of equity remains unchanged.
C)the costs of both debt and equity increase, but the weighted average cost of capital for the firm remains unchanged.
D)the costs of both debt and equity increase, which will cause the weighted average cost of capital for the firm to increase.

Question 48

Assume a firm is financed with $1 million debt and $4 million equity. The debt has a
market beta of 0.2 , and the equity has a market beta of 0.9. The risk-free rate is 5%,
and the equity premium is 8%. What is this firm's overall cost of capital?

Question 49

The cost of a firm's equity

A)must always be less than the firm's weighted average cost of capital.
B)is independent of the firm's capital structure.
C)will always be higher than the stated interest rate on the financial debt of the firm.
D)can be substantially higher than the firm's weighted average cost of capital.

Question 50

A firm is financed with 100% equity and its cost of capital is 12%. What will be the cost of capital if the firm issues debt at a cost of 6% and uses the proceeds to repurchase half of the
Firm's outstanding equity?

A)8%
B)12%
C)9%
D)This cannot be determined with the information provided.

Question 51

A firm has a single bank loan at a quoted interest rate of 7%. Is 7% the appropriate rate
to use in the WACC formula? Why or why not?

Question 52

What assumption is necessary for the All Claims M&M and the Everything M&M to
hold?

Question 53

A firm is worth $50 million and has a cost of capital of 15%. It is all equity financed. If the firm sells $25 million of debt with a 7% promised return and uses it to repurchase part of the firm's
Stock, what will the firm's cost of capital then be?

A)15%
B)13%
C)11%
D)This cannot be determined with the information provided.

Question 54

Which of the following statements is true in a perfect M&M world?

A)The value of a firm is independent of both its cash flow and its control rights.
B)Levered equity is riskier than full ownership of the firm, and full ownership of a firm is riskier than the debt of a firm.
C)The value of a firm is independent of its cash flow rights, but not of its control rights.
D)The levered equity of a firm will normally offer a lower expected return than full ownership of a firm.

Question 55

The cost of debt for a firm is

A)equal to the promised rate of return on the debt.
B)equal to the expected rate of return on the debt.
C)equal to the interest rate quoted by the bank.
D)All of the above could be true; it depends on several factors.

Question 56

A firm should use as much non-financial liability financing as it can if

A)arbitrageurs can easily and quickly undo choices that are suboptimal.
B)its risk-adjusted cost of capital is below that of other sources of financing.
C)there is an operational linkage involved.
D)None of the above is true; a firm should try to limit the amount of non-financial liability financing it uses.

Question 57

Which of the following statements about the relation of the M&M propositions to the real world is true?

A)While the propositions state that capital structure does not matter, in the real world capital structure can matter.
B)Although the propositions are based on the assumption that financial markets are perfect, all of the conclusions drawn work in the real world as well.
C)Although some of the conclusions don't work in the real world, it is true that a firm's cost of capital is independent of the firm's capital structure choice.
D)Both B and C are true statements.

Question 58

The weighted average cost of capital for a firm

A)will increase as the firm increases its use of debt financing because the increased use of debt increases the firm's risk.
B)will decrease as the firm increases its use of debt financing because the cost of debt is lower than the cost of equity financing.
C)may increase or decrease, depending on the relative costs of debt and equity.
D)will remain the same when the firm increases its use of debt financing because the overall risk of the firm stays the same.

Question 59

A bond's promised rate of return will be

A)greater than or equal to the firm's overall weighted average cost of capital.
B)greater than or equal to its expected rate of return.
C)less than or equal to its expected rate of return, but greater than the expected return on equity.
D)less than its expected rate of return, but greater than the expected return on equity.

Question 60

All else equal, the use of debt will

A)result in both a lower earnings per share and a lower P/E ratio.
B)result in a lower earnings per share and, thus, a higher P/E ratio.
C)result in a higher earnings per share and, thus, a lower P/E ratio.
D)None of the above is a true statement.