Answer: a. True
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?
Answer Options:
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. The two companies have the same ROE.
e. Company HD’s ROE would be higher if it had no debt.
Answer: c
Question: The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes. a. True b. False
Answer: b. False
Question: If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs.
Answer Options:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT? 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: If the information content, or signaling, hypothesis is correct, then a change in a firm’s dividend policy can have an important effect on its stock price and cost of equity.
Answer Options:
a. True
b. False
Answer: True
Question: If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy.
Answer Options:
a. True
b. False
Answer: False
Question: The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm’s stock, other things held constant.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
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
Question: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm’s debt ratio, the lower its payout ratio will be, other things held constant.
Answer Options:
a. True
b. False
Answer: False
Question: The firm’s target capital structure should do which of the following? 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).
Question: If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy.
Answer Options:
a. True
b. False
Answer: False
Question: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm’s debt ratio, the lower its payout ratio will be, other things held constant.
Answer Options:
a. True
b. False
Answer: False
Question: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm’s investment opportunities, the lower its payout ratio will be, other things held constant.
Answer Options:
a. True
b. False
Answer: True
Question: Financial institutions are more diversified today than they were in the past, when federal laws kept investment banks, commercial banks, insurance companies, and similar organizations quite separate. Today the larger financial services corporations offer a variety of services, ranging from checking accounts, to insurance, to underwriting securities, to stock brokerage. a. True b. False
Answer: True
Question: Your firm adheres strictly to the residual dividend model. All else equal, which of the following factors would be most likely to lead to an increase in the firm’s dividend per share? a. The firm’s net income increases. b. The company increases the percentage of equity in its target capital structure. c. The number of profitable potential projects increases. d. Congress lowers the tax rate on capital gains, leaving the rest of the tax code unchanged. e. Earnings are unchanged, but the firm issues new shares of common stock.
Answer: a
Question: Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? 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: If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio.
Answer Options:
a. True
b. False
Answer: 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. a. True b. False
Answer: a. True
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
Question: Suppose you plotted a curve which showed a Firm U’s WACC on the vertical axis and its debt ratio on the horizontal axis. Then you plotted a similar curve for Firm V. The curve for Firm U resembled a shallow “U,” while that for Firm V resembled a sharp “V.” Both firms have debt ratios that cause their WACCs to be minimized. Other things held constant, it would be easier for Firm V than for Firm U to maintain a steady dividend and let the debt ratio vary without causing much opportunities and earnings from year to year.
Answer Options:
a. True
b. False
Answer: False
Question: According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing. a. True b. False
Answer: a. True
Question: Which of the following statements is CORRECT? a. If a company has a 2-for-1 stock split, its stock price should roughly double. b. Capital gains earned on shares repurchased are taxed less favorably than dividends, which is why companies typically pay dividends and avoid share repurchases. c. Very often, a company’s stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen. d. Stock repurchases increase the number of outstanding shares. e. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.
Answer: c
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: Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy.
Answer Options:
a. True
b. False
Answer: True