Question 1

Which statement concerning the MM extension with growth is incorrect?

Accepted Answer

The statement that the WACC is less than the WACC under MM's original (with tax) assumptions is incorrect. In fact, the WACC is higher under the MM extension with growth, as it takes into account the increased cost of equity due to the higher leverage. The other statements are correct: A) the value of a growing tax shield is greater than the value of a constant tax shield, B) for a given D/E, the levered cost of equity is greater than the levered cost of equity under MM's original assumptions, and D) the total value of the firm increases with the amount of debt.

Question 2

What is the major contribution of the Miller model?

Accepted Answer

The Miller model extends the Modigliani-Miller theorem by incorporating personal taxes, showing that the tax advantage of corporate debt is reduced when considering personal taxes on interest income.

Question 3

In a perfect world of no taxes,which statement regarding MM propositions is true?

Accepted Answer

Proposition II of Modigliani and Miller's theory states that in a world with no taxes, the cost of equity increases linearly as leverage increases, reflecting the increased risk taken on by equity holders.

Question 4

Which of the following statements is correct?

Accepted Answer

The statement that best explains the relationship between capital structure and firm value is B. This is because the capital structure that minimizes the weighted average cost of capital (WACC) leads to the highest stock price, as the cost of capital is reduced, which in turn increases the value of the firm. While statement A is partially correct in that retained earnings do not incur flotation costs, the cost of retained earnings is typically higher than the cost of debt as it is based on the opportunity cost of not distributing earnings to shareholders. Statement C is incorrect because minimizing the weighted average cost of capital does not necessarily equate to maximizing earnings per share. Finally, statement D is incorrect because increasing the debt ratio could increase the cost of equity, and therefore could increase the WACC.

Question 5

Senbet Ventures is considering starting a new company to produce stereos.The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50; and fixed costs are estimated at $120,000.What sales volume would be required in order to break even,i.e.,to have an EBIT of zero for the stereo business?

Accepted Answer

To break even EBIT (Earnings before interest and taxes) should be zero.
EBIT = Total Revenue – Total Costs
Let's calculate the total cost first:
Total cost = Fixed cost + Variable cost
Total cost = $120,000 + ($2.50 * Volume)
Total Revenue = 1.5 * Variable Cost / Unit * Volume

To break even EBIT = 0, the equation should be satisfied as follows:
Total Revenue - Total Cost = 0
1.5 * $2.50 * Volume - $120,000 - $2.50 * Volume = 0
$3.75 * Volume - $120,000 = 0
$3.75 * Volume = $120,000
Volume = $120,000 / $3.75
Volume = 32,000 units

Therefore, the sales volume required to break even is 96,000 units (C).

Question 6

Which statement regarding debt is correct,other things held constant?

Accepted Answer

An increase in the corporate tax rate makes debt financing more attractive because interest payments on debt are tax-deductible, which can reduce a company's taxable income and thus its tax liability. This tax shield effect encourages companies to use more debt in their capital structure.

Question 7

DeLong Inc.has fixed operating costs of $470,000,variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's break-even point,i.e.,at what unit sales volume would income equal costs?

Accepted Answer

The break-even point in units can be calculated using the formula: Break-even point = Fixed Costs / (Selling Price per Unit - Variable Cost per Unit). Plugging in the given values: $470,000 / ($4.00 - $2.80) = $470,000 / $1.20 = 391,666.67 units. Rounding to the nearest whole unit gives 391,667 units.

Question 8

Which of the following statements is correct?

Accepted Answer

A) A firm with low operating leverage has a smaller proportion of fixed costs in its total cost structure, meaning its earnings are less sensitive to changes in sales volume.

Question 9

In a perfect world of no taxes,what happens if the weighted average cost of capital (WACC) is unaffected by the capital structure?

Accepted Answer

MM proposition I states that the value of a firm is independent of its capital structure when there are no taxes, bankruptcy costs, or agency costs. In this scenario, where there are no taxes, if the WACC remains unaffected by changes in capital structure, then the value of the firm would remain constant regardless of the amount of debt or equity used to finance the firm. Therefore, MM proposition I holds true. MM proposition II and the SML are related to the effects of leverage on the cost of capital, which is not relevant in this scenario.

Question 10

Which statement concerning capital structure theory is NOT true?

Accepted Answer

This statement is not true because r_s actually decreases with leverage when corporate taxes are considered, and this decrease offsets the tax benefits of debt financing.

Question 11

Vu Enterprises expects to have the following data during the coming year.What is Vu's expected ROE? $\begin{array}{llll}
\text { Assets } & \$ 200,000 & \text { Interest rate } & 8 \% \
\text { D/A } & 65 \% & \text { Tax rate } & 40 \% \
\text { EB IT } & \$ 25,000 & &
\end{array}$

Accepted Answer

ROE = (1-t) * (EBIT/Assets) * (1/D/A)= (1-0.4) * (25000/200000) * (1/0.65)= 0.1314= 13.14%

Question 12

Which of the following statements is correct?

Accepted Answer

The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC. This is because the WACC is a weighted average of the costs of equity and debt, and as the proportion of debt in the capital structure increases, the cost of equity decreases due to the tax shield provided by debt. However, if the debt ratio is too high, the cost of debt may start to increase, leading to an overall increase in the WACC. Therefore, the optimal capital structure is the one that balances the benefit of debt with its associated cost. Earnings per share may not necessarily be maximized under this optimal capital structure. Option C is partially correct but incomplete, and option D is incorrect; increasing personal tax rates would reduce the tax shield benefit of debt, thereby discouraging companies from increasing their debt ratios.

Question 13

Which of the following statements is correct?

Accepted Answer

The answer of Which of the following statements is correct?
...

Question 14

Elephant Books sells paperback books for $7 each.The variable cost per book is $5.At current annual sales of 200,000 books,the publisher is just breaking even.It is estimated that if the authors' royalties are reduced,the variable cost per book will drop by $1.Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?

Accepted Answer

With the reduction in variable cost per book from $5 to $4, the contribution margin per book increases from $2 to $3. At the same sales volume of 200,000 books, this results in an additional $200,000 ($1 extra per book times 200,000 books) that can be allocated to advertising while still breaking even.

Question 15

Which of the following statements is correct?

Accepted Answer

This statement correctly acknowledges that there are wide variations in capital structures both between industries and among individual firms within those industries. These variations are caused by factors such as differing business risks and managerial attitudes. Choice A is incorrect because debt-to-total-assets ratios can vary significantly between industries, especially if one industry relies heavily on debt financing (e.g. airlines) and another industry favors equity financing (e.g. technology). Choice B is incorrect because electric utilities are known for having high debt ratios, not high common equity ratios. Finally, choice C is incorrect because prescription drug companies are not necessarily known for having high debt-to-equity ratios; this may vary depending on the company and its specific capital structure.

Question 16

Reynolds Resorts is currently 100% equity financed.The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock.The recapitalization would not change the company's total assets,nor would it affect the firm's basic earning power,which is currently 15%.The CFO believes that this recapitalization would reduce the WACC and increase stock price.What would also be likely to occur if the company goes ahead with the recapitalization plan?

Accepted Answer

The cost of equity would likely increase after the recapitalization due to the increased financial risk from the added debt.

Question 17

What is likely to happen in the MM model with a high risk of bankruptcy?

Accepted Answer

In the Modigliani-Miller (MM) model, when there's a high risk of bankruptcy, companies might forego valuable projects to preserve cash. This is because they need to ensure they have enough liquidity to meet their short-term obligations and avoid bankruptcy, rather than investing in new projects that could potentially increase their long-term value but would also increase their short-term financial risk.

Question 18

Other things held constant,which event is most likely to encourage a firm to increase the amount of debt in its capital structure?

Accepted Answer

An increase in the corporate tax rate would increase the tax shield benefit of debt financing, thus making it more attractive for firms to use more debt in their capital structure.

Question 19

The CFO of Google believes that its greatest strategic goal is to maintain flexibility.To achieve this goal,which of the following financial structures is in place at Google?

Accepted Answer

By holding large amounts of cash and short-term investments, Google maintains flexibility by having the ability to quickly invest in new projects or acquire new companies without having to rely on external financing. This also allows Google to weather any unexpected economic downturns or industry disruptions without having to make drastic changes to its operations or lay off employees.

Question 20

With corporate taxes but no personal taxes,and without financial distress,what happens?

Accepted Answer

DIn a world with corporate taxes but no personal taxes, and without financial distress, the interest payments on debt are tax-deductible, which can reduce a firm's taxable income and thus its taxes. This creates a tax shield that makes debt financing more attractive, leading to the conclusion that the optimal amount of leverage could be 100% debt (C) because the firm would maximize its tax shield. Additionally, as a firm increases its financial leverage, the risk to debt holders increases because there is more debt that needs to be serviced. This increased risk leads to higher required returns by debt holders, meaning the costs of debt increase with financial leverage (D).

Quiz 12: Capital Structure Decisions

Which statement concerning the MM extension with growth is incorrect?

What is the major contribution of the Miller model?

In a perfect world of no taxes,which statement regarding MM propositions is true?

Which of the following statements is correct?

Which statement regarding debt is correct,other things held constant?

DeLong Inc.has fixed operating costs of $470,000,variable costs of $2.80 per unit produced,and its products sell for $4.00 per unit.What is the company's break-even point,i.e.,at what unit sales volume would income equal costs?

Which of the following statements is correct?

In a perfect world of no taxes,what happens if the weighted average cost of capital (WACC) is unaffected by the capital structure?

Which statement concerning capital structure theory is NOT true?

Vu Enterprises expects to have the following data during the coming year.What is Vu's expected ROE? $\begin{array}{llll}\text { Assets } & \$ 200,000 & \text { Interest rate } & 8 \% \\\text { D/A } & 65 \% & \text { Tax rate } & 40 \% \\\text { EB IT } & \$ 25,000 & &\end{array}$

Which of the following statements is correct?

Which of the following statements is correct?

Which of the following statements is correct?

What is likely to happen in the MM model with a high risk of bankruptcy?

Other things held constant,which event is most likely to encourage a firm to increase the amount of debt in its capital structure?

The CFO of Google believes that its greatest strategic goal is to maintain flexibility.To achieve this goal,which of the following financial structures is in place at Google?

With corporate taxes but no personal taxes,and without financial distress,what happens?