Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements best describes the optimal capital structure?
Answer Choices:
a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity.
d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt.
e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock.
Answer:
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.
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 Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
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: The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.
Answer Choices:
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 Choices:
a. True
b. False
Answer:
a. True
Question: If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: A firm’s capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: Other things held constant, the lower a firm’s tax rate, the more logical it is for the firm to use debt.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: Modigliani and Miller’s second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm’s value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.
Answer Choices:
a. True
b. False
Answer:
a. True
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 Choices:
a. True
b. False
Answer:
b. False
Question: The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm’s future prospects as its managers. That was called “symmetric information,” and it is questionable. The introduction of “asymmetric information” led to the development of the “signaling” theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm’s managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers’ perceptions about how their financing decisions will affect investors’ views of the firm and thus its value.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Based on the information below, what is the firm’s optimal capital structure?
Answer Choices:
a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $260.50.
b. Debt = 60%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
c. Debt = 50%; Equity = 40%; EPS = $3.18; Stock price = $312.00.
d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
Answer:
c. Debt = 50%; Equity = 40%; EPS = $3.18; Stock price = $312.00.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
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 stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
e. The capital structure that gives the firm the best bond rating also maximizes the stock price.
Answer:
d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
Question: Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.
Answer Choices:
a. True
b. False
Answer:
a. True
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 Choices:
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: Some people–including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)–have argued that one advantage of corporate debt from the stockholders’ standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm’s money on private plane and other “perks.” This is one of the factors that led to the rise of LBOs and private equity firms.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
Answer:
e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
Question: Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this
Answer Choices:
a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to an increase in its business risk.
c. normally leads to a decrease in the standard deviation of its expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.
Answer:
e. normally leads to a reduction in its fixed assets turnover ratio.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its financial leverage.
c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors’ capital (ROIC). (Assume that the repurchase has no impact on the company’s operating income.)
e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations’ debt ratios.
Answer:
c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
Question: Which of the following would tend to increase a firm’s target debt ratio, other things held constant?
Answer Choices:
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: Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
Answer Choices:
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 Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company’s stock price hits a new high.
Answer:
a. An increase in the corporate tax rate.
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 Choices:
a. True
b. False
Answer:
b. False