Question 1

The objective of capital structure management is to maximize the market value of the firm's equity.

Accepted Answer

The goal of capital structure management is to find the optimal mix of debt and equity that maximizes the value of the firm's equity (i.e. the value of the company's ownership shares). This is because the value of equity is the ultimate goal of both the company's managers and its shareholders. By optimizing the capital structure, a company can minimize its cost of capital and maximize its earnings per share, both of which contribute to increasing the value of the firm's equity.

Question 2

Assume that the tax rate is 40% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Madison Co.increases debt from 10% of its capital structure to 40%,cash flows to investors will
A)decrease.
B)remain the same.
C)increase.
D)A firm's cash flows are independent of its capital structure.

Accepted Answer

When Madison Co. increases its debt from 10% to 40%, its interest payments will increase. However, since interest payments are tax-deductible, the company's tax bill will decrease. The net effect of this will be an increase in cash flows to investors as the tax savings will exceed the increase in interest payments. This is known as the interest tax shield and is a key benefit of using debt in a firm's capital structure.

Question 3

Investors require a higher return on common stock investments if a firm uses less leverage.

Accepted Answer

This statement is false. Investors require a higher return on common stock investments if a firm uses more leverage, not less. This is because higher leverage means higher financial risk, and investors demand a higher return to compensate for that risk.

Question 4

If interest expense lowers taxes,why does the WACC not decrease indefinitely with the addition of more debt?
A)The tax shield effect of debt will result in a lower cost of equity.
B)Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
C)A firm's common stock price will not be affected by the amount of debt a firm uses.
D)Too much common equity increases the probability of bankruptcy.

Accepted Answer

While interest expense does lower taxes and can decrease the cost of capital, adding too much debt can increase the likelihood of financial distress and the probability of bankruptcy, thereby increasing the cost of capital. Therefore, there is an optimal level of debt that minimizes the cost of capital (WACC), and exceeding this level can lead to higher costs due to the increased risk of bankruptcy.

Question 5

The pecking order theory of capital structure is derived from
A)expectations theory.
B)the Modigliani-Miller theory.
C)liquidity preference theory.
D)agency theory.

Accepted Answer

The answer of The pecking order theory of capital structure...

Question 6

With taxes,but in the absence of financial distress costs,the optimal capital structure would be
A)100% equity.
B)50% debt,50% equity.
C)100% debt.
D)completely insensitive to the mix of debt and equity.

Accepted Answer

With taxes but in the absence of financial distress costs, the optimal capital structure would be 100% debt. This is because interest payments on debt are tax-deductible, which allows the company to have lower tax payments and therefore, higher cash flows. This, in turn, increases the value of the firm and benefits shareholders. Additionally, there are no financial distress costs, so the risk of bankruptcy is low, making it more feasible to have a high proportion of debt in the capital structure. Therefore, 100% debt would be the optimal choice.

Question 7

The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

Accepted Answer

The Modigliani and Miller Capital Structure Theorem, under the assumption of no taxes, suggests that the cost of equity increases as financial leverage increases, to compensate for the higher risk.

Question 8

The Tradeoff Theory of capital structure theory indicates that
A)the tax shield on debt positively affects firm value,indicating that there is some benefit to financial leverage as opposed to an all-equity capitalization.
B)the higher the firm's financial leverage,the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts,which could ultimately lead to firm failure.
C)there is a range of capital structures,rather than a single capital structure,that is optimal.
D)all of the above.

Accepted Answer

The Tradeoff Theory of capital structure theory suggests that there is a tradeoff between the tax shield on debt and the higher probability of financial distress as a firm's financial leverage increases. Therefore, there is a range of capital structures that can maximize the value of the firm. All of the options presented in the multiple-choice question are true statements related to the Tradeoff Theory of capital structure theory.

Question 9

Agency costs occur when managers choose the easiest form of financing over the value maximizing capital structure.

Accepted Answer

Agency costs arise when the interests of shareholders and managers are not aligned, and managers prioritize their own interests over those of the shareholders, leading to inefficient or suboptimal decision-making. This can manifest in managers choosing a financing structure that may be easy or convenient for them, but not necessarily the one that would maximize shareholder value.

Question 10

Other things the same,the use of debt financing reduces the firm's total tax bill,resulting in a higher total market value.

Accepted Answer

Debt financing allows firms to deduct interest expenses on their taxes, resulting in a lower taxable income and a lower tax bill. This lower tax bill results in higher net income and cash flows available to investors, which can increase the firm’s total market value.

Question 11

The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as
A)the Modigliani and Miller Proposition.
B)tradeoff theory.
C)financial stress avoidance theory.
D)pecking order theory.

Accepted Answer

The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as pecking order theory. This theory suggests that companies prefer to use internal funds first, then debt, and finally equity as a last resort. Managers prefer to use internal funds first because they are the least costly and avoid the negative signals of issuing new securities.

Question 12

Newbury Inc.has retained $2 million in earnings this year.It can borrow up to $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%.Newbury's cost of common equity without selling any new stock is 16%.If Newbury's capital budget is $2.5 million,pecking order theory says management will use
A)$1.5 million in debt and $1 million in retained earnings.
B)$2 million in retained earnings and $0.5 million in debt.
C)$833,333 each from retained earnings,new debt and new stock.
D)$1.5 million in debt and $1 million in new stock.

Accepted Answer

According to pecking order theory, a company will prioritize funding its capital budget with retained earnings, followed by debt and then equity. In this scenario, Newbury Inc. has $2 million in retained earnings and a $2.5 million capital budget. Therefore, the company can use all of its retained earnings and still need to fund $0.5 million. Since the cost of debt (8%) is lower than the cost of equity (16%), it would be more cost-effective for the company to use debt to fund the remaining $0.5 million capital budget. Therefore, the company should use $2 million in retained earnings and $0.5 million in debt, making the best choice B.

Question 13

The inclusion of bankruptcy costs and taxes in firm valuation
A)causes the cost of capital curve to be umbrella shaped.
B)is consistent with a saucer-shaped cost of capital curve.
C)is consistent with a cost of capital curve that slopes downward.
D)causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

Accepted Answer

Including bankruptcy costs and taxes results in a saucer-shaped cost of capital curve because at low levels of debt, the tax shield from debt outweighs the bankruptcy costs, leading to a decrease in the overall cost of capital. However, as debt increases, the bankruptcy costs begin to outweigh the tax shield, resulting in an increase in the overall cost of capital. This creates a saucer-shaped curve.

Question 14

The Tradeoff Theory view of capital structure management says that the cost of capital curve is
A)a straight line.
B)v-shaped.
C)s-shaped.
D)saucer-shaped.

Accepted Answer

The answer of The Tradeoff Theory view of capital structure...

Question 15

Given the existence of taxes and bankruptcy costs,the optimal capital structure is 100% debt.

Accepted Answer

The optimal capital structure is not 100% debt because of bankruptcy costs. While taxes provide a benefit to issuing debt, the risk of bankruptcy increases as the amount of debt increases. The optimal capital structure balances the benefits of the tax shield from debt against the costs of financial distress from bankruptcy.

Question 16

Lowell Corporation and Lawrence Corporation each have EBIT of $4 million.Lowell has no debt and no interest expense;Lawrence has $2 million in debt at a before-tax rate of 8%.The tax rate is 40%.How much cash does each firm return to its investors.
A)Lowell $2,400,000,Lawrence $2,144,000
B)Lowell $2,400,000,Lawrence $2,240,000
C)Lowell $2,400,000,Lawrence $2,464,000
D)Lowell $2,400,000,Lawrence $2,304,000

Accepted Answer

The answer of Lowell Corporation and Lawrence Corporation each have...

Question 17

Capital structure theory suggests that companies may put the interests of ________ ahead of the interests of ________.
A)Potential stockholders,existing stockholders
B)Stockholders,bondholders
C)Existing shareholders,IRS
D)There are no potential conflicts arising from the way a firm manages its capital structure.

Accepted Answer

According to capital structure theory, when a company decides to increase its debt-to-equity ratio, it may benefit the shareholders by reducing their financial risk and increasing their returns through tax shields. However, this may pose a risk to bondholders who are already invested in the company, as an increase in debt also increases the risk of default. Therefore, companies may prioritize the interests of stockholders over the interests of bondholders in their capital structure decisions.

Question 18

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed.If it can borrow enough money at 10% to buy back half of its stock,what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.
A)It would remain at 16%.
B)It would rise to 22%.
C)It would fall to 11%.
D)It would fall to 13%.

Accepted Answer

According to the Modigliani and Miller theorem, when a firm takes on debt, the cost of equity increases because equity holders demand a higher return for the increased risk. The cost of equity would rise to 22% as the firm becomes leveraged.

Question 19

The most acceptable view of capital structure,according to the text,is that the weighted average cost of capital
A)first falls with moderate levels of leverage and then increases as a firm's leverage becomes high.
B)does not change with leverage.
C)increases proportionately with increases in leverage.
D)increases with moderate amounts of leverage and then falls.

Accepted Answer

The text suggests that the most acceptable view of capital structure is that the weighted average cost of capital first falls with moderate levels of leverage and then increases as a firm's leverage becomes high. This is due to the fact that the cost of debt is generally lower than the cost of equity, but as a company becomes more highly leveraged, lenders become more concerned about the company's ability to service its debts, leading to higher borrowing costs.

Question 20

Which of the following is part of a firm's financial structure but NOT a component of its capital structure?
A)Retained earnings
B)Mortgage bonds
C)Accounts payable
D)Both A and C

Accepted Answer

Accounts payable is a component of a firm's financial structure, which represents its short-term liabilities. On the other hand, both retained earnings and mortgage bonds are components of a firm's capital structure, which represents its long-term financing sources. Retained earnings represent the portion of a firm's profits that are retained for reinvestment in the business, while mortgage bonds represent long-term debt that is secured by the firm's assets.

Quiz 15: Capital Structure Policy

The objective of capital structure management is to maximize the market value of the firm's equity.

Assume that the tax rate is 40% and bankruptcy costs are negligible until a firm's debt to equity ratio is greater than one.If Madison Co.increases debt from 10% of its capital structure to 40%,cash flows to investors will

Investors require a higher return on common stock investments if a firm uses less leverage.

If interest expense lowers taxes,why does the WACC not decrease indefinitely with the addition of more debt?

The pecking order theory of capital structure is derived from

With taxes,but in the absence of financial distress costs,the optimal capital structure would be

The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

The Tradeoff Theory of capital structure theory indicates that

Agency costs occur when managers choose the easiest form of financing over the value maximizing capital structure.

Other things the same,the use of debt financing reduces the firm's total tax bill,resulting in a higher total market value.

The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as

The inclusion of bankruptcy costs and taxes in firm valuation

The Tradeoff Theory view of capital structure management says that the cost of capital curve is

Given the existence of taxes and bankruptcy costs,the optimal capital structure is 100% debt.

Lowell Corporation and Lawrence Corporation each have EBIT of $4 million.Lowell has no debt and no interest expense;Lawrence has $2 million in debt at a before-tax rate of 8%.The tax rate is 40%.How much cash does each firm return to its investors.

Capital structure theory suggests that companies may put the interests of ahead of the interests of .

Chelsea Corporation's cost of equity is 16% and it is 100% equity financed.If it can borrow enough money at 10% to buy back half of its stock,what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem.

The most acceptable view of capital structure,according to the text,is that the weighted average cost of capital

Which of the following is part of a firm's financial structure but NOT a component of its capital structure?