An increase in the corporate tax rate.
An increase in the personal tax rate.
An increase in the company’s operating leverage.
The Federal Reserve tightens interest rates in an effort to fight inflation.
The company’s stock price hits a new high.
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: Sheehan Inc. is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows might turn out to be lower than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if the firm decides to wait. Which of the following statements best describes the issues that the firm faces when considering this investment timing option?
Answer Choices:
a. The investment timing option would not affect the cash flows and therefore would have no impact on the project’s risk.
b. The more uncertainty about the future cash flows, the more logical it is to go ahead with this project today.
c. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if the firm chooses to wait a year.
d. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
e. Waiting would probably reduce the project’s risk.
Answer: e. Waiting would probably reduce the project’s risk.
Question: Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company’s total investor-supplied capital, the size of the firm (i.e., total assets), and it would not affect the firm’s return on investors’ capital (ROIC), which is 15%. The CFO believes that this recapitalization would reduce the firm’s WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?
The company’s net income would increase.
The company’s earnings per share would decline.
The company’s cost of equity would increase.
The company’s ROA would increase.
The company’s ROE would decline.
Answer Choices:
a. The company’s net income would increase.
b. The company’s earnings per share would decline.
c. The company’s cost of equity would increase.
d. The company’s ROA would increase.
e. The company’s ROE would decline.
Answer: c. The company’s cost of equity would increase.
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: Which of the following statements is CORRECT?
Since debt financing raises the firm’s financial risk, increasing the target debt ratio will always increase the WACC.
Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.
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.
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.
Since a firm’s beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.
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: 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?
Its sales are projected to become less stable in the future.
The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
Management believes that the firm’s stock is currently overvalued.
The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
The corporate tax rate is increased.
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: 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: 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: An increase in the debt ratio will generally have no effect on which of these items?
Business risk.
Total risk.
Financial risk.
Market risk.
Answer Choices:
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
Answer: e. The firm’s beta.
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?
Generally, debt ratios do not vary much among different industries, although they do vary among firms within a given industry.
Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to-equity ratios.
Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms’ weighted average costs of capital.
Answer Choices:
a. Generally, debt ratios do not vary much among different industries, although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
c. Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to-equity ratios.
d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
e. Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms’ weighted average costs of capital.
Answer: d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
Question: Which of the following statements is most CORRECT?
The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
The basic doctrine of fairness states that all debt holders must be treated equally.
Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
While the firm is in bankruptcy, the existing management is always allowed to remain in control of the firm, though the court monitors its actions closely.
To a large extent, the decision to dissolve a firm through liquidation or to keep it alive through reorganization depends upon the value of the firm if it is rehabilitated versus its value if its assets are sold off individually.
Answer Choices:
a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
b. The basic doctrine of fairness states that all debt holders must be treated equally.
c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
d. While the firm is in bankruptcy, the existing management is always allowed to remain in control of the firm, though the court monitors its actions closely.
e. To a large extent, the decision to dissolve a firm through liquidation or to keep it alive through reorganization depends upon the value of the firm if it is rehabilitated versus its value if its assets are sold off individually.
Answer: e. To a large extent, the decision to dissolve a firm through liquidation or to keep it alive through reorganization depends upon the value of the firm if it is rehabilitated versus its value if its assets are sold off individually.
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: Which of the following statements is CORRECT?
As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
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?
If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
A change in the personal tax rate should not affect firms’ capital structure decisions.
“Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WACC, and (3) maximizes its EPS.
If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation’s debt ratio.
Answer Choices:
a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms’ capital structure decisions.
c. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WACC, and (3) maximizes its EPS.
e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation’s debt ratio.
Answer: a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
Question: Which of the following would tend to increase a firm’s target debt ratio, other things held constant?
The costs associated with filing for bankruptcy increase.
The corporate tax rate is increased.
The personal tax rate is increased.
The Federal Reserve tightens interest rates in an effort to fight inflation.
The company’s stock price hits a new low.
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: Your firm has $500 million of investor-supplied capital, its return on investors’ capital (ROIC) is 15%, and it currently has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (we) is 1 – wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?
The ROA would increase.
The ROA would remain unchanged.
The return on investors’ capital would decline.
The return on investors’ capital would increase.
The ROE would increase.
Answer Choices:
a. The ROA would increase.
b. The ROA would remain unchanged.
c. The return on investors’ capital would decline.
d. The return on investors’ capital would increase.
e. The ROE would increase.
Answer: e. The ROE would increase.
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
Question: Which of the following statements is CORRECT?
Increasing its use of financial leverage is one way to increase a firm’s return on investors’ capital (ROIC).
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.
The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
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.)
If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations’ debt ratios.
Answer Choices:
a. Increasing its use of financial leverage is one way to increase a firm’s return on investors’ capital (ROIC).
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 operating 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).
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: 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 one of the following is an example of a “flexibility” option?
Answer Choices:
a. A company has an option to invest in a project today or to wait for a year before making the commitment.
b. A company has an option to close down an operation if it turns out to be unprofitable.
c. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
e. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly a commercial airline.
Answer: c. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
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