Answer Options:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Options:
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: Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?
Answer Options:
a. The abandonment option tends to reduce a project’s NPV.
b. The abandonment option tends to reduce a project’s risk.
c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project.
d. A project can either have an abandonment option or an investment timing option, but never both.
e. Investment timing options always increase the value of a project.
Answer: b. The abandonment option tends to reduce a project’s risk.
Question: Other things held constant, the lower a firm’s tax rate, the more logical it is for the firm to use debt.
Answer Options:
a. True
b. False
Answer: b. False
Question: Modigliani and Miller’s first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.
Answer Options:
a. True
b. False
Answer: b. False
Question: Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers any real options that might be associated with projects. Which of the following statements is most likely to describe its situation?
Answer Options:
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 estimate abandonment and growth options.
c. Omitting estimated growth and timing options probably makes the optimal capital budget too small, so it is failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, so it is unclear what impact the failure to consider real options has on the overall capital budget.
d. 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.
e. 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: If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.
Answer Options:
a. True
b. False
Answer: b. False
Question: The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm’s stock price.
Answer Options:
a. True
b. False
Answer: True
Question: Modigliani and Miller’s second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm’s value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
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 Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
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). (Assume that the repurchase has no impact on the company’s operating income.)
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: Which one of the following statements is most CORRECT?
Answer Options:
a. Real options change the size, but not the risk, of projects’ expected NPVs.
b. Real options change the risk, but not the size, of projects’ expected NPVs.
c. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows.
d. Very few projects actually have real options. They are theoretically interesting but of little practical importance.
e. Real options are more valuable when there is very little uncertainty about the true values of future sales and costs.
Answer: c. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows.
Question: Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
Answer Options:
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: The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the “trade-off” model, where the firm’s value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.
Answer Options:
a. True
b. False
Answer: a. True
Question: The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.
Answer Options:
a. True
b. False
Answer: a. True
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 Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT, holding other things constant?
Answer Options:
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: As the text indicates, a firm’s financial risk can and should be divided into separate market and diversifiable risk components.
Answer Options:
a. True
b. False
Answer: b. False
Question: The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.
Answer Options:
a. True
b. False
Answer: a. True