Question 1

During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders.

Accepted Answer

Companies with low leverage (i.e.,high equity) are more likely to have a strong financial position and be able to maintain dividend payments during a recession. On the other hand, companies with high leverage (i.e.,low equity) may struggle to meet their debt obligations and may need to suspend or cut their dividend payments.

Question 2

The presence of personal taxes completely eliminates the benefits of debt financing.

Accepted Answer

Personal taxes do increase the cost of debt financing, but it does not completely eliminate the benefits. The benefits of debt financing include leverage, tax shields, and the ability to maintain ownership and control of the company.

Question 3

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Accepted Answer

The answer of The MM model with corporate taxes is...

Question 4

Although they operate in different industries, two firms have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

Accepted Answer

Although the firms have the same expected EPS and standard deviation, they may have different sources of risk, such as operating leverage, financial leverage, or market risk. Therefore, their overall business risk may differ.

Question 5

Which event is likely to encourage a company to raise its target debt ratio, other things held constant?
A) an increase in the corporate tax rate
B) an increase in the personal tax rate
C) an increase in the company's operating leverage
D) the company's stock price hitting a new high

Accepted Answer

An increase in the corporate tax rate makes debt financing more attractive because interest payments on debt are tax-deductible, effectively reducing the cost of borrowing. This tax shield encourages companies to increase their target debt ratio to capitalize on the tax benefits.

Question 6

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?
A) an increase in costs incurred when filing for bankruptcy
B) an increase in the corporate tax rate
C) an increase in the personal tax rate
D) the company's stock price hitting a new low

Accepted Answer

An increase in the corporate tax rate would decrease the after-tax cost of debt relative to equity, making it more attractive for a company to increase its debt ratio.

Question 7

The MM model is the same as the Miller model, but with zero corporate taxes.

Accepted Answer

The MM model refers to the Modigliani-Miller theorem on capital structure, which initially assumes no taxes, bankruptcy costs, or other market imperfections. The Miller model extends the MM framework by incorporating personal and corporate taxes to examine their effects on capital structure decisions.

Question 8

During a recession, companies with a significant portion of their capital structure in the form of debt (i.e., high leverage) often struggle to meet their legally binding interest obligations.

Accepted Answer

During a recession, companies may face lower revenues and profits, making it harder for them to meet their debt obligations. This can lead to default and potential bankruptcy. Therefore, companies with high leverage are at greater risk in a recession.

Question 9

Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?
A) demand variability
B) input price variability
C) the extent to which operating costs are fixed
D) the extent to which interest rates on the firm's debt fluctuate

Accepted Answer

The extent to which interest rates on the firm's debt fluctuate is not associated with or does not contribute to business risk because it is considered a financial risk, which is separate from business risk. Business risk is primarily affected by factors such as demand variability, input price variability, and the degree to which operating costs are fixed.

Question 10

Which of the following statements best describes WACC?
A) Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
B) Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
C) Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
D) Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.

Accepted Answer

The statement that best describes WACC is that increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC. This is because the cost of debt is usually lower than the cost of equity, but as the company takes on more debt, lenders and investors become riskier, and their required rates of return increase. Therefore, as debt financing becomes more expensive, it can offset the cheaper cost of debt and result in a higher WACC.

Question 11

The MM model employs the concept of arbitrage to develop its theory.

Accepted Answer

The MM model assumes that in an efficient market, there are no arbitrage opportunities and prices fully reflect all available information. The concept of arbitrage is instrumental in developing the theory of the MM model.

Question 12

On which of the following items will an increase in the debt ratio generally have no effect?
A) business risk
B) total risk
C) financial risk
D) market risk

Accepted Answer

The answer of On which of the following items will...

Question 13

Which of the following statements best describes capital structure?
A) The capital structure that maximizes expected EPS also maximizes the price per share of common shares.
B) The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
C) The capital structure that minimizes the required return on equity also maximizes the share price.
D) The capital structure that minimizes the WACC also maximizes the price per share of common shares.

Accepted Answer

The capital structure that minimizes the Weighted Average Cost of Capital (WACC) also maximizes the price per share of common shares. This is because the WACC is the minimum rate of return that a company must earn on its investments to satisfy its investors, and minimizing it means that the company can generate more value from its investments. As a result, investors are willing to pay a higher price per share for the company's equity.

Question 14

A firm's financial policy drives its equity beta.

Accepted Answer

A firm's financial policy, such as its use of debt financing, can impact its cost of equity and therefore drive its equity beta. The higher a firm's debt-to-equity ratio, the higher its risk and potential for volatility, which can increase its equity beta.

Question 15

Firms having positive prospects try to raise new equity capital by selling new stocks.

Accepted Answer

The answer of Firms having positive prospects try to raise...

Question 16

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

Accepted Answer

Incorporating the costs of bankruptcy into the model would have shown that there are costs associated with the risk of bankruptcy, making 100% debt financing less optimal.

Question 17

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

Accepted Answer

The answer of Firm A has a higher degree of...

Question 18

As a firm approaches bankruptcy, the indirect costs of bankruptcy (e.g., financial distress) will tend to increase.

Accepted Answer

As a firm approaches bankruptcy, the uncertainty and risk associated with its financial situation will likely cause customers, suppliers, and employees to become hesitant, resulting in indirect costs such as lost sales, decreased supplier terms, and increased employee turnover.

Question 19

It is possible that two firms could have identical financial and operating leverage yet have different degrees of risk as measured by the variability of EPS.

Accepted Answer

The variability of EPS can be affected by various factors such as competition, shifts in consumer preferences, changes in technology, and macroeconomic conditions. Therefore, even if two firms have the same financial and operating leverage, their risk levels may differ based on these external factors.

Question 20

Based on the information below, what is Ezzel Enterprises' optimal capital structure?
A) Debt = 40%; Equity = 60%; EPS = $2.95; Common share price = $26.50
B) Debt = 50%; Equity = 50%; EPS = $3.05; Common share price = $28.90
C) Debt = 60%; Equity = 40%; EPS = $3.18; Common share price = $31.20
D) Debt = 80%; Equity = 20%; EPS = $3.42; Common share price = $30.40

Accepted Answer

The optimal capital structure is the one that maximizes the company's EPS, while also minimizing the cost of capital. Based on the given information, Ezzel Enterprises' EPS is highest at 60% debt and 40% equity, with a value of $3.18. This is the highest EPS value among the given options. Additionally, the common share price at this capital structure is also the highest at $31.20, indicating that investors are willing to pay more for the company's stock at this level of leverage. Therefore, choice C is the best option for Ezzel Enterprises' optimal capital structure.

Quiz 12: Capital Structure Decisions

During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders.

The presence of personal taxes completely eliminates the benefits of debt financing.

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

Although they operate in different industries, two firms have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

Which event is likely to encourage a company to raise its target debt ratio, other things held constant?

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

The MM model is the same as the Miller model, but with zero corporate taxes.

During a recession, companies with a significant portion of their capital structure in the form of debt (i.e., high leverage) often struggle to meet their legally binding interest obligations.

Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?

Which of the following statements best describes WACC?