Question 1

Of the following, all are conclusions that can be drawn from the capital structure puzzle EXCEPT:
A) In the framework of the static theory of capital structure, a ﬁrm can precisely identify its optimal capital structure.
B) Firms with tax shields from other sources such as depreciation will beneﬁt less from leverage.
C) Firms in lower tax brackets will tend to beneﬁt less from increases in ﬁnancial leverage.
D) The ﬁnancial structure that minimizes WACC is the one that will maximize the value of the ﬁrm.
E) All else the same, ﬁrms with tangible, liquid assets will have an incentive to borrow more.

Accepted Answer

The conclusion that a firm can precisely identify its optimal capital structure is false based on the capital structure puzzle. The puzzle highlights that there are various factors at play, such as tax shields and the cost of financial distress, that make it difficult for firms to identify their optimal capital structure.

Question 2

The equity risk derived from the ﬁrm's capital structure policy is called ___________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) ﬁnancial

Accepted Answer

The equity risk derived from the firm's capital structure policy is called financial risk. This type of risk is specific to the company and arises from the way it finances its operations and investments. It is different from market or systematic risk, which affects all companies and is related to broad economic or market factors. Extrinsic risk is not a commonly used term in finance, and business risk refers to the risk arising from a company's operations or industry factors.

Question 3

Jageman Athletic Apparel has a debt-equity ratio of .4 and earnings before interest and taxes (EBIT) of $265,000. The break-even level of EBIT is $338,000. Based on this information, you know the:
A) Firm should increase its debt-equity ratio.
B) Firm is operating at its optimal level.
C) Firm has minimized its weighted average cost of capital.
D) Firm would be more proﬁtable if it lowered its level of output.
E) Debt of the ﬁrm is a disadvantage.

Accepted Answer

The firm's EBIT is below the break-even level, indicating that the current level of debt is a disadvantage as it is not covering its interest obligations effectively.

Question 4

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)
A) Wages and salaries; consumer claims; unsecured creditors.
B) Contributions to employee beneﬁt plans; consumer claims; common stockholders.
C) Government tax claims; preferred stockholders; unsecured creditors.
D) Bankruptcy-related administrative expenses; wages and salaries; common stockholders.
E) Wages and salaries; consumer claims; preferred stockholders.

Accepted Answer

Government tax claims have higher priority than both preferred stockholders and unsecured creditors, so the ranking in option C is incorrect.

Question 5

The capital structure of a ﬁrm refers to the ﬁrm's:
A) Ratio of ﬁxed assets to total assets.
B) Mix of long-term assets including such things as oﬃce buildings, manufacturing facilities, and equipment.
C) Financing arrangements as evidenced by the ﬁrm's debt-equity ratio.
D) Ability to generate sales by utilizing the ﬁxed assets of the ﬁrm.
E) Issuance of equity securities in the ﬁrm.

Accepted Answer

The capital structure of a firm refers to its financing arrangements, which includes the debt-equity ratio. The other options given relate to the firm's assets or the issuance of equity securities, but do not fully encompass what is meant by capital structure.

Question 6

According to M&M Proposition I with taxes, the interest tax shield:
A) Affects the net earnings, but not the value of a ﬁrm.
B) Increases the pre-tax rate of return on debt.
C) Increases the value of a ﬁrm.
D) Lowers the ﬁrm's cost of equity.
E) Increases the ﬁrm's weighted average cost of capital.

Accepted Answer

The interest tax shield reduces taxable income, thereby increasing the value of a firm by the present value of the tax shield.

Question 7

All else the same, the ﬁnancial leverage of a ﬁrm will _________________.
A) Decrease as the debt/equity ratio increases.
B) Decrease as the ﬁrm's retained earnings account grows.
C) Increase by the amount of equity it issues in a given year.
D) Decrease if the ﬁrm has negative net income.
E) Decrease as the ﬁrm uses debt to fund expansion projects.

Accepted Answer

Financial leverage decreases as the firm's retained earnings grow because retained earnings increase equity, reducing the debt/equity ratio.

Question 8

The tax savings of the ﬁrm derived from the deductibility of interest expense is called the:
A) Interest tax shield.
B) Depreciable basis.
C) Financing umbrella.
D) Current yield.
E) Tax-loss carry-forward savings.

Accepted Answer

The tax savings of the firm derived from the deductibility of interest expense is called the interest tax shield. This refers to the reduction in taxes that a company can achieve due to the deduction of interest payments from taxable income. This results in a reduction in the amount of taxes that the company has to pay and increases the net income available to be distributed to shareholders or reinvested in the business.

Question 9

The equity risk derived from the ﬁrm's operating activities is called ____________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) ﬁnancial

Accepted Answer

The equity risk derived from the firm's operating activities is called business risk. Market risk pertains to the risk of the overall stock market, systematic risk refers to risk that cannot be diversified away, extrinsic risk is not a commonly used term in finance, and financial risk refers to the risk of the firm's financing decisions.

Question 10

Which of the following is true regarding bankruptcy?
A) Liquidation frequently is converted into a reorganization.
B) In a prepack, creditors agree to a reorganization plan prior to the bankruptcy ﬁling.
C) Firms cannot ﬁle bankruptcy to escape long-term leases on closed stores.
D) Creditors of the ﬁrm may not initiate bankruptcy proceedings.
E) A party other than the current ﬁrm management must take control of the ﬁrm before it comes out of bankruptcy.

Accepted Answer

In a prepack, creditors agree to a reorganization plan prior to the bankruptcy filing. This allows for a more streamlined and efficient bankruptcy process, as the plan has already been agreed upon by creditors. However, not all bankruptcies involve a prepack and not all bankruptcies lead to a reorganization. Therefore, options A, C, D, and E are false.

Question 11

The equity risk derived from a ﬁrm's operating activities is called _____ risk.
A) Market.
B) Systematic.
C) Extrinsic.
D) Business.
E) Financial.

Accepted Answer

The equity risk derived from a firm's operating activities is known as business risk. Market risk refers to the risk of losses caused by factors affecting the wider market, systematic risk refers to the overall risk within a particular market or economy, extrinsic risk refers to the risk caused by external factors, and financial risk refers to the risk associated with a firm's financing structure.

Question 12

Which one of the following statements concerning ﬁnancial leverage is correct in a world without taxes?
A) Leverage is beneﬁcial only when EBIT is relatively low.
B) EPS is decreased when leverage is used and the expected level of EBIT is achieved.
C) Financial leverage lowers the risk level of a ﬁrm.
D) The amount of ﬁnancial leverage employed has a major effect on the value of the ﬁrm.
E) M&M Proposition I states that ﬁnancial leverage is irrelevant to the value of a ﬁrm.

Accepted Answer

M&M Proposition I states that in a world without taxes, financial leverage is irrelevant to the value of a firm. Therefore, none of the other statements are correct. Choice A is incorrect because leverage can be beneficial regardless of the level of EBIT, as it can magnify profits as well as losses. Choice B is incorrect because EPS may increase or decrease depending on the level of EBIT and the amount of leverage used. Choice C is incorrect because financial leverage increases the risk level of a firm, as it magnifies both profits and losses. Choice D is incorrect because the amount of financial leverage employed does not affect the value of a firm in a world without taxes, according to M&M Proposition I.

Question 13

Assume there are no corporate or personal taxes. According to M&M Proposition:
A) I, the total value of the ﬁrm depends on how cash ﬂows are divided up between stockholders and bondholders.
B) I, a ﬁrm's capital structure is relevant.
C) II, the cost of equity rises as the ﬁrm increases its use of debt ﬁnancing.
D) II, the cost of equity depends on the ﬁrm's business risk but not its ﬁnancial risk.
E) I and II, as debt increases, the increase in the cost of equity is more than offset by the lower cost of debt and the WACC falls.

Accepted Answer

According to M&M Proposition II, in a world without taxes, the cost of equity increases as a firm increases its use of debt financing due to the increased financial risk.

Question 14

Which of the following statements is correct?
A) Decisions regarding a ﬁrm's debt and equity can be called capital budgeting decisions.
B) The asset beta is a measure of the unsystematic risk of a ﬁrm's assets.
C) In a purely capital restructuring, the composition of the assets of the ﬁrm will change.
D) The value of the overall ﬁrm will not change as a result of a capital restructuring unless the NPV of the restructuring is negative.
E) The use of personal leverage by an investor to alter the degree of ﬁnancial leverage of a ﬁrm is called homemade leverage.

Accepted Answer

Homemade leverage refers to the use of personal borrowing by an investor to adjust their own financial leverage, effectively altering the leverage of the firm from their perspective.

Question 15

The equity risk derived from a ﬁrm's capital structure policy is called _____ risk.
A) Market.
B) Systematic.
C) Extrinsic.
D) Business.
E) Financial.

Accepted Answer

The equity risk derived from a firm's capital structure policy is called financial risk. Financial risk is the risk associated with a company's financing decisions, such as the use of debt or equity financing, and how those decisions will impact the company's overall profitability and financial standing.

Question 16

The static theory of capital structure states that ﬁrms borrow up to the point where the tax beneﬁt of one additional dollar of debt is equal to the marginal cost of:
A) Sales.
B) Equity.
C) Financial distress.
D) Leverage.
E) Financial capital.

Accepted Answer

The static theory of capital structure suggests that firms stop borrowing when the marginal cost of financial distress imposed by lenders is equal to the marginal tax benefit of an additional dollar of debt. Therefore, the correct answer is financial distress (option C). Options A, B, D, and E are incorrect.

Question 17

Individual investors who lend out part of their personal funds are in fact:
A) Offsetting part of the ﬁnancial leverage of their investments.
B) Eliminating the business risk of their investments.
C) Increasing their total ﬁnancial leverage.
D) Increasing their beneﬁts from the interest tax shield.
E) Leveraging their investments.

Accepted Answer

Individual investors who lend out part of their personal funds are in fact leveraging their investments.

Question 18

A ﬁrm that has negative net worth is said to be:
A) Experiencing a business failure.
B) In legal bankruptcy.
C) Experiencing technical insolvency.
D) Experiencing accounting insolvency.
E) In bankruptcy reorganization.

Accepted Answer

A firm with negative net worth is experiencing accounting insolvency, meaning its liabilities exceed its assets on the balance sheet.

Question 19

The interest tax shield has more value when the amount of debt is _____ and the tax rate is _____.
A) Low; zero.
B) Low; high.
C) High; zero.
D) High; high.
E) Low; low.

Accepted Answer

According to the interest tax shield formula, the value of the tax shield is equal to the amount of interest paid multiplied by the corporate tax rate. Therefore, the interest tax shield has more value when the amount of debt is high and the tax rate is high. This is because a higher amount of debt means a higher amount of interest paid, which results in a larger tax shield. Additionally, a higher tax rate means that the tax shield will provide a greater reduction in taxable income, resulting in a larger tax benefit.

Question 20

Indirect bankruptcy costs:
A) Effectively limit the amount of equity a ﬁrm issues.
B) Serve as an incentive to increase the ﬁnancial leverage of a ﬁrm.
C) Include direct costs such as legal and accounting fees.
D) Tend to increase as the debt-equity ratio decreases.
E) Include the costs incurred by a ﬁrm as it tries to avoid seeking bankruptcy protection.

Accepted Answer

Indirect bankruptcy costs refer to the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. These costs include the expenses associated with trying to restructure debt or negotiate with creditors, as well as the loss of reputation and customer confidence that a firm may experience as a result of financial distress. Choices A, B, and D are incorrect because they do not accurately describe indirect bankruptcy costs. Choice C is also incorrect because it refers to direct bankruptcy costs, which are different from indirect bankruptcy costs.

Quiz 16: Financial Leverage and Capital Structure Policy

Of the following, all are conclusions that can be drawn from the capital structure puzzle EXCEPT:

The equity risk derived from the ﬁrm's capital structure policy is called ___________ risk.

Jageman Athletic Apparel has a debt-equity ratio of .4 and earnings before interest and taxes (EBIT) of $265,000. The break-even level of EBIT is $338,000. Based on this information, you know the:

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)

The capital structure of a ﬁrm refers to the ﬁrm's:

According to M&M Proposition I with taxes, the interest tax shield:

All else the same, the ﬁnancial leverage of a ﬁrm will _________________.

The tax savings of the ﬁrm derived from the deductibility of interest expense is called the:

The equity risk derived from the ﬁrm's operating activities is called ____________ risk.

Which of the following is true regarding bankruptcy?

The equity risk derived from a ﬁrm's operating activities is called _____ risk.

Which one of the following statements concerning ﬁnancial leverage is correct in a world without taxes?

Assume there are no corporate or personal taxes. According to M&M Proposition:

Which of the following statements is correct?

The equity risk derived from a ﬁrm's capital structure policy is called _____ risk.

The static theory of capital structure states that ﬁrms borrow up to the point where the tax beneﬁt of one additional dollar of debt is equal to the marginal cost of:

Individual investors who lend out part of their personal funds are in fact:

A ﬁrm that has negative net worth is said to be:

The interest tax shield has more value when the amount of debt is _ and the tax rate is _.

Indirect bankruptcy costs: