Answer Choices:
a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.
b. Its estimated capital budget is probably too large due to its failure to discount abandonment and growth options.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.
d. Real options should not have any effect on the size of the optimal capital budget.
Answer: a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.
Question: Which of the following statements is CORRECT?
The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
The capital structure that minimizes the required return on equity also maximizes the stock price.
The capital structure that minimizes the WACC also maximizes the price per share of common stock.
The capital structure that gives the firm the best bond rating also maximizes the stock price.
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: Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in the terms to merger agreements.
True
False
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.
True
False
Answer Choices:
a. True
b. False
Answer: b. False
Question: Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD’s return on investors’ capital (ROIC) exceeds its after-tax cost of debt, r_d(1 – T). Which of the following statements is CORRECT?
HD should have a higher return on assets (ROA) than LD.
HD should have a higher times interest earned (TIE) ratio than LD.
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.
Given that ROIC > r_d(1 – T), HD’s stock price must exceed that of LD.
Given that ROIC > r_d(1 – T), LD’s stock price must exceed that of HD.
Answer Choices:
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: If a firm borrows money, it is using financial leverage.
Answer Choices:
a. True
b. False
Answer: a. True
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: 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: a. True
Question: In a world with no taxes, Modigliani and Miller (MM) show that a firm’s capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm’s value rises as it uses more and more debt, other things held constant.
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?
Demand variability.
Sales price variability.
The extent to which operating costs are fixed.
The extent to which interest rates on the firm’s debt fluctuate.
Input price variability.
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: A firm’s CFO is considering increasing the target debt ratio, which would also increase the company’s interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO’s estimates are correct, which of the following statements is CORRECT?
Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
If the plan reduces the WACC, the stock price is likely to decline.
Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
If the plan does increase the EPS, the stock price will automatically increase at the same rate.
Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
Answer Choices:
a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
d. If the plan does increase the EPS, the stock price will automatically increase at the same rate.
e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
Answer: a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
Question: Which of the following statements best describes the optimal capital structure?
The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock.
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: Which of the following statements is CORRECT?
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.
The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
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 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: 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 joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.
True
False
Answer Choices:
a. True
b. False
Answer: a. True
Question: Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors’ capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L’s debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?
The two companies have the same times interest earned (TIE) ratio.
Firm L has a lower ROA than Firm U.
Firm L has a lower ROE than Firm U.
Firm L has the higher times interest earned (TIE) ratio.
Answer Choices:
a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
Answer: c. Firm L has a lower ROE than Firm U.
Question: Is it possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs).
The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.
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.
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 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: The firm’s target capital structure should do which of the following?
Maximize the earnings per share (EPS).
Minimize the cost of debt (rd).
Obtain the highest possible bond rating.
Minimize the cost of equity (rs).
Minimize the weighted average cost of capital (WACC).
Answer Choices:
a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).
Answer: e. Minimize the weighted average cost of capital (WACC).