Answer Options:
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: Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this
Answer Options:
a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to a decrease in its business risk.
c. normally leads to a decrease in the standard deviation of its expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.
Answer: E. normally leads to a reduction in its fixed assets turnover ratio.
Question: An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project’s sponsors and explaining why any differences occurred.
Answer Options:
a. True
b. False
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. 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.
Question: The firm’s target capital structure should do which of the following?
Answer Options:
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: A major contribution of the Miller model is that it demonstrates, other things held constant, that
Answer Options:
a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using corporate debt.
e. debt costs increase with financial leverage.
Answer: B. personal taxes lower the value of using corporate debt.
Question: Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors’ capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L’s debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT?
Answer Options:
a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
e. Firm L has a higher EBIT than Firm U.
Answer: B. Firm L has a lower ROA than Firm U.
Question: According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.
Answer Options:
a. True
b. False
Answer: a. True
Question: A firm’s CFO is considering increasing the target debt ratio, which would also increase the company’s interest
Answer Options:
a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
d. If the plan does increase the EPS, the stock price will automatically increase at the same rate.
e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
Answer: A. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
Question: Business risk is affected by a firm’s operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk?
Answer Options:
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm’s debt fluctuate.
e. Input price variability.
Answer: d. The extent to which interest rates on the firm’s debt fluctuate.
Question: Which of the following statements is CORRECT?
Answer Options:
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 a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.
Answer Options:
a. True
b. False
Answer: a. True
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 Options:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Options:
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.
Answer: B. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
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 Options:
a. True
b. False
Answer: a. True
Question: According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to investors that the firm’s managers think that the future does not look good.
Answer Options:
a. True
b. False
Answer: b. False
Question: An increase in the debt ratio will generally have no effect on which of these items?
Answer Options:
a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
e. The firm’s beta.
Answer: a. Business risk
Question: Which of the following statements is CORRECT?
Answer Options:
a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.
b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes the return on equity.
Answer: A. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.