Question 1

M&M Proposition II with no tax states that a ﬁrm's cost of equity is dependent upon the ﬁrm's debt-
equity ratio.

Accepted Answer

A) True 
 B)False

Question 2

UNLEV has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and there are 20,000 shares of stock outstanding. The ﬁrm is considering issuing $8,800 in new par bonds to
Add ﬁnancial leverage to the ﬁrm. The proceeds of the debt issue will be used to repurchase equity.
The cost of debt = 10% and the tax rate = 34%. There are no ﬂotation costs.
Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. Also assume UNLEV's
Debt/equity ratio will be 0.493 after the restructuring. How could the stockholder use homemade
Leverage to unlever her investment in the ﬁrm after the restructuring? Assume there are no taxes.

Accepted Answer

A)   The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B)   The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C)   The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D)   The stockholder should lend $443 and sell 333 shares of UNLEV.
E)   The stockholder should lend $1,337 and sell 667 shares of UNLEV.F) A) and E)
G) None of the above

Question 3

Shareholders generally prefer that a distressed ﬁrm:

Accepted Answer

A)   Undergo reorganization under the Bankruptcy and Insolvency Act because the common stock generally recoups its value.
B)   Undergo liquidation under the Bankruptcy and Insolvency Act because they have ﬁrst priority over the ﬁrm's assets.
C)   Undergo reconstitution under the Bankruptcy and Insolvency Act because that option usually minimizes shareholder loss.
D)   Not declare bankruptcy because they are generally required to convert their shares into debt securities.
E)   Not declare bankruptcy since the common shares are often rendered worthless.F) B) and D)
G) None of the above

Question 4

Volatility of earnings will affect the optimal level of debt for a ﬁrm.

Accepted Answer

A) True 
 B)False

Question 5

The interest tax shield has no value for a ﬁrm when the ﬁrm is unlevered.

Accepted Answer

A) True 
 B)False

Question 6

The proposition that the value of the ﬁrm is independent of its capital structure is called:

Accepted Answer

A)   The capital asset pricing model.
B)   M&M Proposition I without taxes.
C)   M&M Proposition II.
D)   The law of one price.
E)   The eﬃcient markets hypothesis.F) A) and D)
G) All of the above

Question 7

What is the cost of equity for a ﬁrm where the required return on assets is 14%, the cost of debt is 11%, and the target debt/equity ratio is 0.5? Ignore taxes.

Accepted Answer

A)   11.0%
B)   12.5%
C)   14.0%
D)   15.5%
E)   16.0%F) None of the above
G) A) and B)

Question 8

A reorganization is deﬁned as:

Accepted Answer

A)   A situation where the senior management of a ﬁrm is replaced.
B)   A change in the reporting structure of a ﬁrm's various divisions and departments.
C)   The sale and total closure of a ﬁrm.
D)   A merger which results in the total replacement of the target ﬁrm's managers.
E)   A ﬁnancial restructuring of a distressed ﬁrm in an attempt to keep the ﬁrm operating.F) A) and D)
G) C) and D)

Question 9

Which of the following correctly completes this sentence: All else the same, _____________.

Accepted Answer

A)   The business risk of a ﬁrm increases when it takes on a risky project.
B)   The business risk of a ﬁrm increases when it takes on more debt.
C)   The ﬁnancial risk of a ﬁrm decreases when it takes on a risky project.
D)   The ﬁnancial risk of a ﬁrm increases when it takes on more equity.
E)   The higher the business risk for a ﬁrm, the higher the ﬁnancial risk as well.F) None of the above
G) A) and C)

Question 10

In relation to M&M Proposition II with no taxes, the cost of equity declines when the amount of
leverage used by a ﬁrm rises.

Accepted Answer

A) True 
 B)False

Question 11

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)

Accepted Answer

A)   Wages and salaries; consumer claims; unsecured creditors.
B)   Contributions to employee beneﬁt plans; consumer claims; common stockholders.
C)   Government tax claims; preferred stockholders; unsecured creditors.
D)   Bankruptcy-related administrative expenses; wages and salaries; common stockholders.
E)   Wages and salaries; consumer claims; preferred stockholders.F) B) and E)
G) D) and E)

Question 12

M&M Proposition I with taxes is based on the concept that:

Accepted Answer

A)   The optimal capital structure is the one that is totally ﬁnanced with equity.
B)   The capital structure of the ﬁrm does not matter because investors can use homemade leverage.
C)   The ﬁrm is better off with debt based on the weighted average cost of capital.
D)   The value of the ﬁrm increases as total debt increases because of the interest tax shield.
E)   The cost of equity increases as the debt-equity ratio of a ﬁrm increases.F) B) and E)
G) B) and C)

Question 13

Trudy's Pizza is an unlevered ﬁrm with an after-tax net income of $47,000. The unlevered cost of capital is 7.5% and the tax rate is 35%. What is the value of this ﬁrm?

Accepted Answer

A)   $219,333
B)   $328,333
C)   $407,334
D)   $626,667
E)   $733,333F) A) and B)
G) A) and D)

Question 14

When a ﬁrm is operating at its target capital structure point, shareholder value is maximized.

Accepted Answer

A) True 
 B)False

Question 15

Victoria Dry Goods has expected earnings before interest and taxes of $14,600, an unlevered cost of capital of 15%, and a tax rate of 35%. The company also has $3,500 of debt that carries a 6%
Coupon. The debt is selling at par value. What is the value of this ﬁrm?

Accepted Answer

A)   $63,267
B)   $64,184
C)   $64,492
D)   $65,211
E)   $66,267F) C) and D)
G) A) and E)

Question 16

A reduction in tax rates will tend to diminish the beneﬁt of the interest tax shield.

Accepted Answer

A) True 
 B)False

Question 17

Assume there are no personal or corporate income taxes and that the ﬁrm's WACC is unaffected by its capital structure. Which of the following is true?

Accepted Answer

A)   A ﬁrm's cost of equity depends on the ﬁrm's business and ﬁnancial risks.
B)   The value of the ﬁrm is dependent on its capital structure.
C)   The cost of equity increases as the ﬁrm's leverage decreases.
D)   Tax minimization occurs at optimal WACC.
E)   WACC becomes irrelevant without taxes.F) A) and C)
G) C) and D)

Question 18

Which of the following would be considered an indirect bankruptcy cost?

Accepted Answer

A)   The cost of the extra insurance the bankruptcy court requires the ﬁrm to carry on its assets.
B)   The cost the ﬁrm must pay to the court when ﬁling its bankruptcy petition.
C)   The cost of the appraisals a ﬁrm must obtain on its assets by order of the bankruptcy court.
D)   The fee the ﬁrm pays its lawyer to draw up the bankruptcy petition.
E)   The cost to the ﬁrm of projects in-progress terminated in order to preserve cash.F) All of the above
G) C) and E)

Question 19

A ﬁrm has a debt-equity ratio of .40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring taxes, what is the cost of equity?

Accepted Answer

A)   7.8%
B)   9.6%
C)   11.8%
D)   15.2%
E)   17.2%F) D) and E)
G) A) and D)

Question 20

Parker & Thomas, Inc., (P&T)  currently is an all equity ﬁrm with 20,000 shares of stock outstanding at a market price of $40 a share. The company's earnings before interest and taxes are $50,000. The
ﬁrm's dividend payout ratio is 100%. P&T has decided to add leverage to its ﬁnancial operations by
Issuing $400,000 of debt at a 9% interest rate. This $400,000 will be used to repurchase shares of
Stock. You own 2,500 shares of P&T stock. You lend funds at a 9% rate of interest. How many of
Your shares of stock in P&T must you sell to offset the leverage that the ﬁrm is assuming? Assume
That you loan out all of the funds you receive from the sale of your stock.

Accepted Answer

A)   500 shares
B)   750 shares
C)   1,000 shares
D)   1,250 shares
E)   1,500 sharesF) A) and B)
G) B) and C)

Exam 16: Financial Leverage and Capital Structure Policy

Shareholders generally prefer that a distressed ﬁrm:

Correct Answer
verified

When a ﬁrm is operating at its target capital structure point, shareholder value is maximized.

Correct Answer
verified

Which of the following correctly completes this sentence: All else the same, _____________.

Correct Answer
verified

A reduction in tax rates will tend to diminish the beneﬁt of the interest tax shield.

Correct Answer
verified

A ﬁrm has a debt-equity ratio of .40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring taxes, what is the cost of equity?

Correct Answer
verified

Correct Answer
verified

Trudy's Pizza is an unlevered ﬁrm with an after-tax net income of $47,000. The unlevered cost of capital is 7.5% and the tax rate is 35%. What is the value of this ﬁrm?

Correct Answer
verified

M&M Proposition II with no tax states that a ﬁrm's cost of equity is dependent upon the ﬁrm's debt- equity ratio.

Correct Answer
verified

The proposition that the value of the ﬁrm is independent of its capital structure is called:

Correct Answer
verified

Victoria Dry Goods has expected earnings before interest and taxes of $14,600, an unlevered cost of capital of 15%, and a tax rate of 35%. The company also has $3,500 of debt that carries a 6% Coupon. The debt is selling at par value. What is the value of this ﬁrm?

Correct Answer
verified

The interest tax shield has no value for a ﬁrm when the ﬁrm is unlevered.

Correct Answer
verified

Volatility of earnings will affect the optimal level of debt for a ﬁrm.

Correct Answer
verified

M&M Proposition I with taxes is based on the concept that:

Correct Answer
verified

In relation to M&M Proposition II with no taxes, the cost of equity declines when the amount of leverage used by a ﬁrm rises.

Correct Answer
verified

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)

Correct Answer
verified

A reorganization is deﬁned as:

Correct Answer
verified

What is the cost of equity for a ﬁrm where the required return on assets is 14%, the cost of debt is 11%, and the target debt/equity ratio is 0.5? Ignore taxes.

Correct Answer
verified

Assume there are no personal or corporate income taxes and that the ﬁrm's WACC is unaffected by its capital structure. Which of the following is true?

Correct Answer
verified

Which of the following would be considered an indirect bankruptcy cost?

Correct Answer
verified

Correct Answer
verified

Exam 16: Financial Leverage and Capital Structure Policy

Shareholders generally prefer that a distressed ﬁrm:

Correct AnswerverifiedShow Answer

When a ﬁrm is operating at its target capital structure point, shareholder value is maximized.

Correct AnswerverifiedShow Answer

Which of the following correctly completes this sentence: All else the same, _____________.

Correct AnswerverifiedShow Answer

A reduction in tax rates will tend to diminish the beneﬁt of the interest tax shield.

Correct AnswerverifiedShow Answer

A ﬁrm has a debt-equity ratio of .40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring taxes, what is the cost of equity?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

Trudy's Pizza is an unlevered ﬁrm with an after-tax net income of $47,000. The unlevered cost of capital is 7.5% and the tax rate is 35%. What is the value of this ﬁrm?

Correct AnswerverifiedShow Answer

M&M Proposition II with no tax states that a ﬁrm's cost of equity is dependent upon the ﬁrm's debt- equity ratio.

Correct AnswerverifiedShow Answer

The proposition that the value of the ﬁrm is independent of its capital structure is called:

Correct AnswerverifiedShow Answer

Victoria Dry Goods has expected earnings before interest and taxes of $14,600, an unlevered cost of capital of 15%, and a tax rate of 35%. The company also has $3,500 of debt that carries a 6% Coupon. The debt is selling at par value. What is the value of this ﬁrm?

Correct AnswerverifiedShow Answer

The interest tax shield has no value for a ﬁrm when the ﬁrm is unlevered.

Correct AnswerverifiedShow Answer

Volatility of earnings will affect the optimal level of debt for a ﬁrm.

Correct AnswerverifiedShow Answer

M&M Proposition I with taxes is based on the concept that:

Correct AnswerverifiedShow Answer

In relation to M&M Proposition II with no taxes, the cost of equity declines when the amount of leverage used by a ﬁrm rises.

Correct AnswerverifiedShow Answer

Which of the following does not correctly rank the priority of claims of the parties to a corporate bankruptcy? (Rank from strongest to weakest.)

Correct AnswerverifiedShow Answer

A reorganization is deﬁned as:

Correct AnswerverifiedShow Answer

What is the cost of equity for a ﬁrm where the required return on assets is 14%, the cost of debt is 11%, and the target debt/equity ratio is 0.5? Ignore taxes.

Correct AnswerverifiedShow Answer

Assume there are no personal or corporate income taxes and that the ﬁrm's WACC is unaffected by its capital structure. Which of the following is true?

Correct AnswerverifiedShow Answer

Which of the following would be considered an indirect bankruptcy cost?

Correct AnswerverifiedShow Answer

Correct AnswerverifiedShow Answer

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