Answer Options:
a. True
b. False
Answer: True
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 Options:
a. True
b. False
Answer: a. True
Question: Other things held constant, the higher a firm’s target payout ratio, the higher its expected growth rate should be.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
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: Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors’ capital (ROIC), and their ROICs exceed their after-tax costs of debt, r_d(1 – T). However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
Answer Options:
a. Company HD has a higher net income than Company LD.
b. Company HD has a lower ROA than Company LD.
c. Company HD has a lower ROE than Company LD.
d. The two companies have the same ROA.
e. The two companies have the same ROE.
Answer: B. Company HD has a lower ROA than Company LD.
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 Options:
a. True
b. False
Answer: b. False
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 Options:
a. True
b. False
Answer: a. True
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 Options:
a. True
b. False
Answer: a. True
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 Options:
a. True
b. False
Answer: a. True
Question: Weisbach Electronics is considering investing in India. Which of the following factors would make the company less likely to proceed with the investment?
Answer Options:
a. The company would have the option to withdraw from the investment after 2 years if it turns out to be unprofitable.
b. The investment would increase the odds of the company being able to subsequently make a successful entry into China.
c. The investment would preclude the company from being able to make a profitable investment in China.
d. Competitors are considering similar investments in India, and the firm can discourage them from trying by entering now.
e. The new plant could be easily retrofitted to manufacture many of the firm’s other products.
Answer: c. The investment would preclude the company from being able to make a profitable investment in China.
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
Answer Options:
a. Your firm’s ROIC will increase, which would typically be reflected in the stock price.
b. The firm’s earnings per share (EPS) would decline, assuming the firm has positive net income.
c. The firm’s WACC should decline, which will likely lead to a higher stock valuation.
d. The percentage of equity in the firm’s capital structure will decrease.
e. The firm’s stock price should remain unchanged because its ROIC will remain at 15%, and its WACC will remain unchanged.
Answer: D. The percentage of equity in the firm’s capital structure will decrease.
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 Options:
a. True
b. False
Answer: a. True