Answer Choices:
a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs).
b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.
e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.
Answer:
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.
Question: If a firm borrows money, it is using financial leverage.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Business risk is affected by a firm’s operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk?
Answer Choices:
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm’s debt fluctuate.
e. Input price variability.
Answer:
d. The extent to which interest rates on the firm’s debt fluctuate.
Question: The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: The firm’s target capital structure should do which of the following?
Answer Choices:
a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (r_d).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (r_s).
e. Minimize the weighted average cost of capital (WACC).
Answer:
e. Minimize the weighted average cost of capital (WACC).
Question: According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm’s value.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT, holding other things constant?
Answer Choices:
a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
d. An increase in the company’s degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structure.
Answer:
e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structure.
Question: Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development).
Answer Choices:
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 Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.
Answer:
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs).
b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.
e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.
Answer:
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.
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 Choices:
a. True
b. False
Answer:
b. False
Question: A firm’s CFO is considering increasing the target debt ratio, which would also increase the company’s interest cover.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.
Answer:
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
Question: Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since debt financing raises the firm’s financial risk, increasing the target debt ratio will always increase the 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 costs 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 costs of both debt and equity financing. However, this action still may lower the company’s WACC.
e. Since a firm’s beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.
Answer:
d. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company’s WACC.
Question: According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to investors that the firm’s managers think that the future does not look good.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: An increase in the debt ratio will generally have no effect on which of these items?
Answer Choices:
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
e. The firm’s beta.
Answer:
d. Market risk
Question: The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Financial risk refers to the extra risk borne by stockholders as a result of a firm’s use of debt as compared with their risk if the firm had used no debt.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
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: Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.
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.