Answer:
d
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:
True
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, rd(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? 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:
c
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 Options:
a. True
b. False
Answer:
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 Options:
a. True
b. False
Answer:
False
Question: Miller and Modigliani’s dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on either its cost of capital or its stock price. a. True b. False
Answer:
True
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:
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: A firm’s treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in “bad times.” This is called “financial flexibility,” and the lower the firm’s debt ratio, the greater its financial flexibility, other things held constant.
Answer Options:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is most CORRECT?
Answer Options:
a. A conglomerate merger is one where a firm combines with another firm in the same industry.
b. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
c. Defensive mergers are designed to make a company less vulnerable to a takeover.
d. The equity residual method values a target firm by discounting residual cash flows at the acquiring firm’s overall cost of capital reflecting the combined firm’s post-merger capital structure.
e. A financial merger occurs when the operations of the firms involved are integrated in the hope of achieving synergistic benefits.
Answer:
c. Defensive mergers are designed to make a company less vulnerable to a takeover.
Question: Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow funds using long-term debt, use the funds to repurchase some of the company’s own stock.
Answer Options:
a. True
b. False
Answer:
b. False
Question: Which of the following statements about dividend policies is CORRECT?
Answer Options:
a. Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the “bird-in-the-hand” effect.
b. One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing stock is that dividends are normally taxed at a lower rate than gains on repurchased stock.
c. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.
d. One key advantage of the residual dividend model is that it enables a company to follow a stable dividend policy.
e. The clientele effect suggests that companies should follow a stable dividend policy.
Answer:
e. The clientele effect suggests that companies should follow a stable dividend policy.
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. a. True b. False
Answer:
True
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: 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:
b. False
Question: If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares.
Answer Options:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT? a. Other things held constant, the less debt a firm uses, the lower its return on total assets will be. b. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company’s operating efficiency is that the BEP does not reflect the effects of debt and taxes. c. The return on common equity (ROE) is generally regarded as being less significant, from a stockholder’s viewpoint, than the return on total assets (ROA). d. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being more risky and/or less likely to enjoy higher future growth. e. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A’s total debt to total capital ratio is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A’s higher profit margin.
Answer:
b. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company’s operating efficiency is that the BEP does not reflect the effects of debt and taxes.