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Financial Management: Principles and Applications, 11e (Titman)
Chapter 15 Capital Structure Policy
1) The firm's optimal capital structure is the mix of financing sources that:
A) minimizes the risk of financial distress.
B) maximizes after-tax earnings.
C) maximizes the total value of the firm's debt and equity.
D) all of the above.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: unfavorable financial leverage
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) Suppose we calculate a times interest earned ratio of 29 for Colgate-Palmolive. We can
conclude:
A) Colgate-Palmolive may experience some difficulty meeting it's interest payments.
B) Colgate-Palmolive is very unlikely to have difficulty meeting it's interest payments.
C) Colgate-Palmolive has $29 of operating cash flow for every dollar of interest expense.
D) Colgate-Palmolive's EBITDA is 29 times larger than its interest expense.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) A firm's capital structure consists of which of the following?
A) The amount of debt that a firm utilizes
B) The amount of debt and preferred stock that a firm utilizes
C) The amount of debt, preferred stock, and common stock that a firm utilizes
D) None of the above
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
1
Copyright © 2011 Pearson Education, Inc.
4) The primary objective of capital structure management is to find the combination of funding
sources that will minimize the
A) interest rate.
B) WACC.
C) probability of financial distress.
D) cost of equity.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) Which of the following is NOT a component of a firm's capital structure?
A) Preferred stock
B) Bonds
C) Common stock
D) Accounts payable
E) Retained earnings
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's
equity is $6 million. The market value of Merrimac's equity is $10 million. It's Debt to Value
ratio is .5. What is the book value of Merrimac's interest- bearing debt?
A) $5 million
B) $10 million
C) $15 million
D) $20 million
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt to value ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) Merrimac Brewing company's total assets equal $18 million. The book value of Merrimac's
equity is $6 million. The market value of Merrimac's equity is $10 million. It's Debt to Value
ratio is .5. What is Merrimac's Debt Ratio?
A) .75
B) .67
C) .33
D) .25
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt ratio
2
Copyright © 2011 Pearson Education, Inc.
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) Cornucopia's liabilities and equity are shown below:
Accounts
Payable $500,000
Accrued
Expenses 250,000
Short-term
Note at 5% 300,000
Long-Term
Debt 1,250,000
Common
Equity, Book
Value 2,500,000
Common
Equity, Market
Value 6,000,000
Cornucopia's debt ratio is ________.
A) .48
B) .32
C) .21
D) .30
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
3
Copyright © 2011 Pearson Education, Inc.
9) Cornucopia's liabilities and equity are shown below:
Accounts
Payable $500,000
Accrued
Expenses 250,000
Short-term
Note at 5% 300,000
Long-Term
Debt 1,250,000
Common
Equity, Book
Value 2,500,000
Common
Equity, Market
Value 6,000,000
Cornucopia's debt to value ratio is ________.
A) .48
B) .32
C) .21
D) .30
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
10) Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total
assets of $13 million. Interest bearing liabilities total $3 million (book value). The market value
of Fibonnacci's equity is $21 million. Fibonacci's debt ratio is ________.
A) .38
B) .23
C) .125
D) .24
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
11) Fibonacci Property Management's balance sheet shows total liabilities of $5 million and total
assets of $13 million. Interest bearing liabilities total $3 million (book value). The market value
of Fibonnacci's equity is $21 million. Fibonacci's Debt to Value ratio is ________.
A) .38
B) .23
C) .125
D) .24
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt to value ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
12) Tremont Inc.'s Total Assets =$25 million. The balance sheet shows Accounts payable and
accruals totaling $7 million, common stock and retained earnings total $10 million. There is no
preferred stock. What is the book value of interest bearing debt?
A) $15 million
B) $7 million
C) $18 million
D) $8 million
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt to value ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
13) Which of the following should be excluded from a firm's capital structure?
A) Common equity
B) Non-interest bearing debt
C) Long-term debt
D) Short-term bank notes
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
14) A company that earns a rate of return on its investments lower than the interest rate on its
debt is said to have:
A) unfavorable financial leverage.
B) a sub-optimal capital structure.
C) favorable financial leverage.
D) negative financial leverage.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: unfavorable financial leverage
Principles: Principle 2: There Is a Risk-Return Tradeoff
5
Copyright © 2011 Pearson Education, Inc.
15) A company whose rate of return on investments is higher than the interest rate on its debt is
said to have:
A) unfavorable financial leverage.
B) a sub-optimal capital structure.
C) favorable financial leverage.
D) negative financial leverage.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: favorable financial leverage
Principles: Principle 2: There Is a Risk-Return Tradeoff
16) How does the text distinguish between firm's financial structure and its capital structure?
A) Financial structure includes only interest bearing debt
B) Capital structure includes only non-interest bearing debt
C) Financial structure uses market values of equity
D) Capital structure includes only interest bearing debt
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) Financial structure includes long-term and short-term sources of funds.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: financial structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) A firm's financial structure is defined by the Debt Ratio, while it's capital structure is defined
by the Debt to Value ratio.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: financial structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) The Times Interest Earned Ratio measures a firm's ability to meet both interest payments and
scheduled principal repayments.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: times interest earned ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
20) What is meant by the terms "favorable" and "unfavorable" leverage?
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: favorable financial leverage
Principles: Principle 2: There Is a Risk-Return Tradeoff
21) Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt to value ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
22) Bipolar Beverages total assets equal $360 million. The book value of Bipolar's equity is $180
million. The market value of Bipolar's equity is $ 250 million. The book value of the company's
interest bearing debt is $120 million. Compute Bipolar's Debt Ratio and Debt to Value Ratio.
Topic: 15.1 A Glance at Capital Structure Choices in Practice
Keywords: debt to value ratio
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
1) The Modigliani and Miller Capital Structure Theorem, in its original form:
A) uses unrealistic assumptions.
B) provided important insights into capital structure policy.
C) concludes that how a firm is financed is not important.
D) all of the above.
Topic: 15.2 Capital Structure Theory
Keywords: Internal sources of financing
Principles: Principle 3: Cash Flows Are the Source of Value
2) The inclusion of bankruptcy risk in firm valuation:
A) acknowledges that a firm has an upper limit to debt financing.
B) causes cost of capital curve to be linear.
C) causes the cost of capital curve to be downward sloping regardless of capital structure.
D) has no consequences for practical management of capital structure policy.
Topic: 15.2 Capital Structure Theory
Keywords: financial distress costs
Principles: Principle 3: Cash Flows Are the Source of Value
3) Which of the following is the most important factor that affects a firm's financing mix?
A) The amount of EPS
B) The amount of operating income
C) The number of shares that are outstanding
D) The predictability of cash flows
Topic: 15.2 Capital Structure Theory
Keywords: financial distress costs
Principles: Principle 3: Cash Flows Are the Source of Value
4) When the impact of taxes is considered, as the firm takes on more debt
A) there will be no change in total cash flows.
B) both taxes and total cash flow to stockholders and bondholders will decrease.
C) cash flows will increase because taxes will decrease.
D) the weighted average cost of capital will increase.
Topic: 15.2 Capital Structure Theory
Keywords: interest tax savings
Principles: Principle 3: Cash Flows Are the Source of Value
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Copyright © 2011 Pearson Education, Inc.
5) The original form of the Modigliani and Miller Capital Structure Theorem
A) ignores the effect of taxes.
B) ignores the relationship between firm value and cost of capital.
C) ignores transaction costs.
D) both A and C are true.
Topic: 15.2 Capital Structure Theory
Keywords: Internal sources of financing
Principles: Principle 3: Cash Flows Are the Source of Value
6) Optimal capital structure is:
A) the funding mix that will maximize the company's common stock price.
B) the mix of all items that appear on the right-hand side of the company's balance sheet.
C) the mix of funds that will minimize the firm's beta.
D) the mix of securities that will maximize EPS.
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
7) An optimal capital structure is achieved:
A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's break-even point is achieved.
D) when a firm's weighted average cost of capital is minimized.
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
8) From the information below, select the optimal capital structure for Mountain High Corp.
A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50
B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90
C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20
D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40
E) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
9
Copyright © 2011 Pearson Education, Inc.
9) An optimal capital structure is achieved:
A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's expected stock price is maximized.
D) when a firm's break-even point is achieved.
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
10) An optimal capital structure is achieved:
A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's expected stock price is maximized.
D) when a firm's break-even point is achieved.
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
11) The tradeoff theory of capital structure management assumes:
A) no corporate income taxes.
B) cost of equity remains constant with an increase in financial leverage.
C) firms might fail.
D) none of the above.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
12) Which of the following is consistent with the Tradeoff theory of capital structure?
A) The cost of capital continuously decreases as the firm's debt ratio increases.
B) The cost of capital remains constant as the firm's debt ratio increases.
C) The cost of capital continuously increases as the firm's debt ratio increases.
D) There is an optimal level of debt financing.
E) Capital structure does not affect a firm's cost of capital.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
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