Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. A firm’s business risk is determined solely by the financial characteristics of its industry.
b. The factors that affect a firm’s business risk include industry characteristics and economic conditions, both of which are generally beyond the firm’s control.
c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.
d. A firm’s financial risk can be minimized by diversification.
e. The amount of debt in its capital structure can under no circumstances affect a company’s EBIT and business risk.
Answer: B. The factors that affect a firm’s business risk include industry characteristics and economic conditions, both of which are generally beyond the firm’s control.
Question: A firm’s business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.
Answer Options:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Options:
a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions.
c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
d. If a firm’s after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.
Answer: A. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
Question: Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm’s optimal debt ratio.
Answer Options:
a. True
b. False
Answer: b. False
Question: Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies’ returns on investors’ capital (ROIC) exceed their after-tax costs of debt, r_d(1 – T). Which of the following statements is CORRECT?
Answer Options:
a. HD should have a higher return on assets (ROA) than LD.
b. HD should have a higher times interest earned (TIE) ratio than LD.
c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD’s.
d. Given that ROIC > r_d(1 – T), HD’s stock price must exceed that of LD.
e. Given that ROIC > r_d(1 – T), LD’s stock price must exceed that of HD.
Answer: C. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD’s.
Question: According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.
Answer Options:
a. True
b. False
Answer: b. False
Question: Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?
Answer Options:
a. Its sales are projected to become less stable in the future.
b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
c. Management believes that the firm’s stock is currently overvalued.
d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
e. The corporate tax rate is increased.
Answer: E. The corporate tax rate is increased.
Question: A firm’s treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in “bad times.” This is called “financial flexibility,” and the lower the firm’s debt ratio, the greater its financial flexibility, other things held constant.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which one of the following will NOT increase the value of a real option?
Answer Options:
a. Lengthening the time during which a real option must be exercised.
b. An increase in the volatility of the underlying source of risk.
c. An increase in the risk-free rate.
d. An increase in the cost of obtaining the real option.
e. A decrease in the probability that a competitor will enter the market of the project in question.
Answer: d. An increase in the cost of obtaining the real option.
Question: Which of the following would tend to increase a firm’s target debt ratio, other things held constant?
Answer Options:
a. The costs associated with filing for bankruptcy increase.
b. The corporate tax rate is increased.
c. The personal tax rate is increased.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company’s stock price hits a new low.
Answer: b. The corporate tax rate is increased.
Question: Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment.
b. In general, the greater the strategic advantages of being the first competitor to enter a given market, the more attractive it probably is to wait before making an investment.
c. In general, the higher the discount rate, the more attractive it probably is to wait before making an investment.
d. In general, investment timing options are more valuable than abandonment options.
e. In general, abandonment options are rarely seen in the real world.
Answer: a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment.
Question: Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.
Answer Options:
a. True
b. False
Answer: a. True
Question: The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.
Answer Options:
a. True
b. False
Answer: b. False
Question: Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.
Answer Options:
a. True
b. False
Answer: b. False
Question: Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient.
Answer Options:
a. True
b. False
Answer: a. True
Question: Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm’s value would be maximized if it used (almost) 100% debt.
Answer Options:
a. True
b. False
Answer: a. True