Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
If interest rates increase, a 10-year zero coupon bond’s price will drop by a greater percentage than will a 10-year, 8% coupon bond.
One nice thing about zero coupon bonds is that individual investors do not have to pay any taxes on a zero coupon bond until it matures, even if they are not holding the bonds as part of a tax-deferred account.
If a bond with a sinking fund provision has a yield to maturity greater than its coupon rate, the issuing company would prefer to comply with the sinking fund by calling the bonds in at par rather than buying the bonds back in the open market.
Because of the IRS’s tax treatment of zero coupon bonds, pension funds and other tax-exempt entities rarely, if ever, invest in zero coupon bonds.
Interest must be paid on a zero coupon bond’s accrued value, but while the first year’s interest is taxable at the ordinary income tax rate, subsequent years are taxed at the long-term capital gains rate (since they are received after more than a year).
Answer Choices:
a. If interest rates increase, a 10-year zero coupon bond’s price will drop by a greater percentage than will a 10-year, 8% coupon bond.
b. One nice thing about zero coupon bonds is that individual investors do not have to pay any taxes on a zero coupon bond until it matures, even if they are not holding the bonds as part of a tax-deferred account.
c. If a bond with a sinking fund provision has a yield to maturity greater than its coupon rate, the issuing company would prefer to comply with the sinking fund by calling the bonds in at par rather than buying the bonds back in the open market.
d. Because of the IRS’s tax treatment of zero coupon bonds, pension funds and other tax-exempt entities rarely, if ever, invest in zero coupon bonds.
e. Interest must be paid on a zero coupon bond’s accrued value, but while the first year’s interest is taxable at the ordinary income tax rate, subsequent years are taxed at the long-term capital gains rate (since they are received after more than a year).
Answer: a. If interest rates increase, a 10-year zero coupon bond’s price will drop by a greater percentage than will a 10-year, 8% coupon bond.
Rationale:
The 10-year bond has payments that come sooner than the zero coupon bond’s payments. Therefore, some of the 10-year bond’s cash flows will be discounted for fewer periods and will lose less of their value. Therefore, the value of the 10-year coupon bond will drop by more than the 8% coupon bond. Therefore, statement a is correct. Statement b used to be true, but the IRS caught on that people were trying to avoid taxes by buying zero coupon bonds, and they changed the Tax Code. Therefore, statement b is false. If the YTM is higher than the coupon rate, then the bond is selling at a discount. The company pays less buying it on the open market than purchasing it at par value. So statement c is false. Statement d is false because zero coupon bonds require the holder to pay taxes on accrued capital gains before any gain is realized, it is pension funds and other tax-exempt entities that are the likely holders. Statement e is false because all interest payments on accrued value are taxed at the ordinary income tax rate.
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 Choices:
a. True
b. False
Answer: b. False
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 Choices:
a. True
b. False
Answer: b. False
Question: Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies’ returns on investors’ capital (ROIC) exceed their after-tax cost of debt, r_d(1 – T). Which of the following statements is CORRECT?
Company HD has a higher return on assets (ROA) than Company LD.
Company HD has a higher times interest earned (TIE) ratio than Company LD.
Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD’s.
The two companies have the same ROE.
Company HD’s ROE would be higher if it had no debt.
Answer Choices:
a. Company HD has a higher return on assets (ROA) than Company LD.
b. Company HD has a higher times interest earned (TIE) ratio than Company LD.
c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also 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. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD’s.
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 Choices:
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.
True
False
Answer Choices:
a. True
b. False
Answer: a. True
Question: Leveraged buyouts (LBOs) occur when a firm’s managers, generally backed by private equity groups, try to gain control of a publicly owned company by buying shares in the company using large amounts of borrowed money.
True
False
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT, holding other things constant?
Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
If changes in the bankruptcy code made bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
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.
An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structure.
Answer Choices:
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 made 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: 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 Choices:
a. True
b. False
Answer: b. False
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 Choices:
a. True
b. False
Answer: a. True
Question: Which one of the following statements best describes the most likely impact that a profitable abandonment option would have on a project’s expected cash flow and risk?
Answer Choices:
a. No impact on the PV of expected cash flows, but risk will increase.
b. The PV of expected cash flows increases and risk decreases.
c. The PV of expected cash flows increases and risk increases.
d. The PV of expected cash flows decreases and risk decreases.
e. The PV of expected cash flows decreases and risk increases.
Answer: b. The PV of expected cash flows increases and risk decreases.
Question: The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.
Answer Choices:
a. True
b. False
Answer: a. True
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 Choices:
a. True
b. False
Answer: b. False
Question: A firm’s capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.
Answer Choices:
a. True
b. False
Answer: a. True