Question 1

A firm's capital structure combines all forms of financing on which the firm relies including:

Accepted Answer

A firm's capital structure includes all of the above forms of financing. Preferred shares, common equity, and long-term debt are all important components of a company's financing structure and can impact its overall financial stability and growth potential.

Question 2

A firm's capital structure combines all forms of long-term financing on which the firm relies EXCEPT:

Accepted Answer

Inventory is not a form of long-term financing, but rather an asset on the balance sheet. Long-term debt, common equity, and preferred shares are all forms of long-term financing that can make up a firm's capital structure.

Question 3

Modigliani and Miller (M&M)Proposition II states:

Accepted Answer

Modigliani and Miller Proposition II (with taxes) suggests that the cost of equity increases as a firm takes on more debt. This is because the increased leverage (use of debt) raises the financial risk for equity holders, leading to a higher required return on equity to compensate for this increased risk.

Question 4

Flyover Airlines Inc.has a cost of equity equal to 24.67%.If the firm is financed with 40% debt and 60% equity and has an average cost of capital of 18%,what is the cost of debt? Assume perfect capital markets.

Accepted Answer

The cost of debt can be calculated using the Weighted Average Cost of Capital (WACC) formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V = E + D (the total market value of the firm's financing), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. In a perfect capital market (assuming no taxes), the formula simplifies to WACC = (E/V) * Re + (D/V) * Rd. Given that the firm's WACC is 18%, the cost of equity is 24.67%, the firm is financed with 40% debt, and 60% equity, we can set up the equation: 18% = (60% * 24.67%) + (40% * Rd). Solving for Rd gives us 8.00%.

Question 5

Which of the following is NOT one of M&M's perfect capital market assumptions?

Accepted Answer

M&M's perfect capital market assumptions state that bankruptcy is costless, individuals and firms can borrow and lend at the same rates, there are no taxes, and all investors have access to the same information, including shareholders and bondholders. Therefore, choice B, which suggests that shareholders have more information than bondholders, is not one of M&M's assumptions.

Question 6

According to data assembled for U.S.firms,the average level of debt as a percentage of capital is approximately equal across industries.

Accepted Answer

The average level of debt as a percentage of capital varies significantly across industries due to differences in capital structure preferences, risk profiles, and operational needs.

Question 7

Capital structure is important,but it CANNOT impact the overall value of a firm.

Accepted Answer

Capital structure can definitely impact the overall value of a firm. The choice of debt vs equity financing can affect the cost of capital and the risk profile of the company, which in turn affects the value. The optimal capital structure for a firm depends on various factors such as industry, stage of growth, tax policies, and so on.

Question 8

Spectronix Inc.operates in a world of perfect capital markets,has no debt,and has a required rate of return on equity of 10%.An executive manager has suggested that borrowing money to buy back outstanding stock is a good idea because it would replace equity financing with less expensive debt financing,thus increasing the value of the firm.Assume the firm issues new debt with a required return of of 5% to repurchase 30% of the outstanding stock.What is the cost of equity at the conclusion of this transaction?

Accepted Answer

In a world of perfect capital markets, the Modigliani-Miller theorem (without taxes) suggests that the value of the firm is not affected by its capital structure. The cost of equity increases when debt is introduced because equity becomes riskier. The new cost of equity can be calculated using the formula: $r_E = r_0 + (r_0 - r_D) \times (D/E)$, where $r_0$ is the unlevered cost of equity (10%), $r_D$ is the cost of debt (5%), and $D/E$ is the debt-to-equity ratio after the transaction. After repurchasing 30% of the outstanding stock, the debt-to-equity ratio becomes 0.3/0.7 = 0.4286. Plugging these values into the formula gives: $r_E = 10\% + (10\% - 5\%) \times 0.4286 = 12.14\%$.

Question 9

________ refers to the difficulties experienced by firms as they attempt to meet financial commitments to their creditors.

Accepted Answer

Financial distress refers to the challenges and strain that firms experience when they are unable to meet their financial obligations to their creditors such as banks or bondholders. This usually occurs when a firm's earnings or cash flows are insufficient to cover their outstanding debts, leading to default or bankruptcy.

Question 10

PrintQuik Inc.has a cost of equity of 14% and a cost of debt of 6%.If the firm is financed with 70% equity and 30% debt,and they operate under the conditions of a perfect capital market,what is the firm's average cost of capital?

Accepted Answer

The firm's average cost of capital (WACC) is calculated as: WACC = (E/V) * Re + (D/V) * Rd, where E is equity, V is total value, Re is cost of equity, D is debt, and Rd is cost of debt. Substituting the given values: WACC = (0.7 * 14%) + (0.3 * 6%) = 9.8% + 1.8% = 11.6%.

Question 11

According to a recent study,CFOs estimated they were able to add about THIRTY percent of the overall value of the firm through financial management.

Accepted Answer

Studies on the impact of CFOs on firm value do not typically quantify their contribution as a specific percentage of the overall firm value. The impact of financial management on firm value is complex and varies widely among firms, making it difficult to generalize a specific percentage such as thirty percent.

Question 12

A leveraged buyout (LBO)is when we tend to find firms at their lowest debt levels.

Accepted Answer

A leveraged buyout (LBO) is when a company is acquired using a significant amount of debt financing, often leaving the company with high levels of debt. LBOs typically occur when a company is undervalued or has substantial assets that can be used as collateral for the debt financing. Therefore, it is not necessary for the company to be at its lowest debt levels for an LBO to occur.

Question 13

Capital budgeting is the mix of debt and common equity (as well as preferred equity)of a firm.

Accepted Answer

Capital budgeting is the process used by companies to evaluate long-term investments in assets such as property, plant, and equipment, and determine the mix of debt, equity, and retained earnings used to finance these investments. However, the mix itself is not capital budgeting but rather part of the financing decision.

Question 14

A firm's risk level will fluctuate as its ________ changes.

Accepted Answer

All of the above factors can affect a firm's risk level. Financial leverage (the use of debt financing) can increase a firm's risk due to the added interest expenses and the potential for default. Debt-to-equity ratio, which measures a firm's level of debt relative to its equity, can also impact risk as higher levels of debt can increase financial distress risk. And finally, the degree of financial leverage, which measures the sensitivity of a firm's earnings per share to changes in its earnings before interest and taxes, can also impact a firm's risk level. Therefore, all of these factors are important to consider when evaluating a firm's risk.

Question 15

Modigliani and Miller each won a Nobel prize in economics in at least in part because of their work with capital structure.

Accepted Answer

Modigliani and Miller won the Nobel prize in economics in 1985 for their work on corporate finance, including their pioneering analysis of capital structure.

Question 16

Which of the following is NOT a reason why banks are more willing to lend to some firms than to others?

Accepted Answer

Banks do not typically have a preference for lending to firms that remain in a specific geographical region. This is not a factor that would impact a bank's decision to lend to a particular firm. Therefore, option C is the correct answer. Options A and B are reasons why banks may be more willing to lend to some firms than to others, while option D is incorrect because it suggests that all the options are preferences for banks, which is not true.

Question 17

Which of the following is NOT one of M&M's perfect capital market assumptions?

Accepted Answer

M&M's perfect capital market assumptions include no taxes, individuals can borrow or lend at the same rate, and every party has equal access to information. The assumption that bankruptcy costs are reasonably low is not part of M&M's perfect capital market assumptions.

Question 18

In M&M Proposition II the cost of equity changes with changes in the amount of debt financing.Which of the following is the correct formula for Proposition II?

Accepted Answer

The correct formula for M&M Proposition II, which describes how the cost of equity increases with leverage, is: $r_E = r_0 + (r_0 - r_D) \left( \frac{D}{E} \right)$, where $r_E$ is the cost of equity, $r_0$ is the cost of capital for an all-equity firm, and $r_D$ is the cost of debt. Choice B is a representation of this formula, indicating that the cost of equity increases with the debt-to-equity ratio ($\frac{D}{E}$).

Question 19

Modigliani and Miller (M&M)Proposition I states:

Accepted Answer

M&M Proposition I states that the overall market value of a firm is equal to the sum of the market value of its equity and debt. Therefore, choice C is the correct option.

Question 20

Under conditions of perfect capital markets,M&M suggest that the average cost of capital for the firm will ________ with the ________ of debt.

Accepted Answer

According to the Modigliani-Miller theorem, in perfect capital markets, the value of a company is not affected by its capital structure. Therefore, the average cost of capital (WACC) remains the same regardless of the amount of debt in the company's capital structure. This means that adding or reducing debt does not affect the WACC. Therefore, the correct answer is B, which states that the average cost of capital for the firm will remain the same with the addition of debt.

Quiz 11: Understanding Financing and Payout Decisions

A firm's capital structure combines all forms of financing on which the firm relies including:

A firm's capital structure combines all forms of long-term financing on which the firm relies EXCEPT:

Modigliani and Miller (M&M) Proposition II states:

Flyover Airlines Inc.has a cost of equity equal to 24.67%.If the firm is financed with 40% debt and 60% equity and has an average cost of capital of 18%,what is the cost of debt? Assume perfect capital markets.

Which of the following is NOT one of M&M's perfect capital market assumptions?

According to data assembled for U.S.firms,the average level of debt as a percentage of capital is approximately equal across industries.

Capital structure is important,but it CANNOT impact the overall value of a firm.

________ refers to the difficulties experienced by firms as they attempt to meet financial commitments to their creditors.

PrintQuik Inc.has a cost of equity of 14% and a cost of debt of 6%.If the firm is financed with 70% equity and 30% debt,and they operate under the conditions of a perfect capital market,what is the firm's average cost of capital?

According to a recent study,CFOs estimated they were able to add about THIRTY percent of the overall value of the firm through financial management.

A leveraged buyout (LBO)is when we tend to find firms at their lowest debt levels.

Capital budgeting is the mix of debt and common equity (as well as preferred equity)of a firm.

A firm's risk level will fluctuate as its ________ changes.

Modigliani and Miller each won a Nobel prize in economics in at least in part because of their work with capital structure.

Which of the following is NOT a reason why banks are more willing to lend to some firms than to others?

Which of the following is NOT one of M&M's perfect capital market assumptions?

In M&M Proposition II the cost of equity changes with changes in the amount of debt financing.Which of the following is the correct formula for Proposition II?

Modigliani and Miller (M&M) Proposition I states:

Under conditions of perfect capital markets,M&M suggest that the average cost of capital for the firm will with the of debt.