13) Which of the following is a reasonable conclusion from the Tradeoff theory of capital
structure?
A) A high debt ratio will result in a maximum price of a firm’s common stock.
B) A firm’s common stock price will not be affected by the amount of debt a firm uses.
C) A low debt ratio will result in a maximum price for a firm’s common stock.
D) Modest levels of debt have a more favorable impact on a firm’s average cost of capital and
stock price than no debt.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
14) Which of the following is consistent with the original formulation of the Modigliani and
Miller Capital Structure Theorem?
A) A firm’s composite cost of capital decreases as financial leverage is used.
B) A firm’s common stock price falls as financial leverage is used.
C) A firm’s composite cost of capital and common stock price are unaffected by the amount of
financial leverage used by the firm.
D) A firm’s composite cost of capital increases as operating leverage is used.
E) A firm’s common stock price rises as operating leverage is used.
Topic: 15.2 Capital Structure Theory
Keywords: Modigliani and Miller
Principles: Principle 3: Cash Flows Are the Source of Value
15) Which of the following will happen if the original Modigliani and Miller Theorem is relaxed
to include taxes, but not bankruptcy costs?
A) Increased usage of financial leverage will increase a firm’s composite cost of capital
indefinitely.
B) Increased usage of financial leverage will lower a firm’s composite cost of capital indefinitely.
C) Increased usage of financial leverage will not affect a firm’s composite cost of capital.
D) Increased usage of operating leverage will increase a firm’s composite cost of capital
indefinitely.
Topic: 15.2 Capital Structure Theory
Keywords: optimal capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
11
16) The Tradeoff theory of capital structure suggests that if a firm moves from zero debt in its
capital structure to moderate usage of debt, the result is an increase in a firm’s:
A) stock price.
B) cost of equity.
C) dividend payout.
D) both A and C.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
17) If interest expense lowers taxes, why does the WACC not decrease indefinitely with the
addition of more debt?
A) The tax shield effect of debt will result in a lower cost of equity.
B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
C) A firm’s common stock price will not be affected by the amount of debt a firm uses.
D) Too much common equity increases the probability of bankruptcy.
Topic: 15.2 Capital Structure Theory
Keywords: financial distress costs
Principles: Principle 3: Cash Flows Are the Source of Value
18) Capital structure theory suggests that companies may put the interests of ________ ahead of
the interests of ________.
A) Potential stockholders, existing stockholders
B) Stockholders, bondholders
C) There are no potential conflicts t arising from the way a firm manages its capital structure.
D) Existing shareholders, IRS
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
19) The inclusion of financial distress costs in firm valuation:
A) acknowledges that a firm is insulated from the impact of high debt financing.
B) provides a rationale for a saucer-shaped cost of capital curve.
C) eliminates conflicts between bondholders and stockholders.
D) causes the cost of capital to rise in a linear fashion as more debt is added to the capital
structure.
Topic: 15.2 Capital Structure Theory
Keywords: financial distress costs
Principles: Principle 3: Cash Flows Are the Source of Value
12
20) The theory that managers may prefer internal sources of funds to the lowest cost source of
funds is known as:
A) the Modigliani and Miller Proposition.
B) tradeoff theory.
C) financial stress avoidance theory.
D) pecking order theory.
Topic: 15.2 Capital Structure Theory
Keywords: pecking order
Principles: Principle 3: Cash Flows Are the Source of Value
21) The Tradeoff Theory of capital structure theory indicates that:
A) the tax shield on debt positively affects firm value, indicating that there is some benefit to
financial leverage as opposed to an all-equity capitalization.
B) the higher the firm’s financial leverage, the higher the probability the firm will be unable to
meet the financial obligations included in its debt contracts, which could ultimately lead to firm
failure.
C) there is a range of capital structures, rather than a single capital structure, that is optimal.
D) all of the above.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
22) The Tradeoff Theory view of capital structure management says that the cost of capital curve
is:
A) a straight line.
B) v-shaped.
C) s-shaped.
D) saucer-shaped.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
23) Capital Structure Theory in general assumes that?
A) A firm’s value is determined by capitalizing (discounting) the firm’s expected net income by
the firm’s cost of equity.
B) A firm’s cost of capital rises as a firm uses more financial leverage.
C) A firm’s value is determined by discounting the firm’s expected cash flows by the WACC.
D) A firm’s cash flows will grow indefinitely at a constant rate.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
13
Topic: 15.2 Capital Structure Theory
Keywords: Modigliani and Miller
Principles: Principle 3: Cash Flows Are the Source of Value
25) With taxes, but in the absence of financial distress costs, the optimal capital structure would
be:
A) 100% equity.
B) 50% debt, 50% equity.
C) 100% debt.
D) completely insensitive to the mix of debt and equity.
Topic: 15.2 Capital Structure Theory
Keywords: financial distress costs
Principles: Principle 3: Cash Flows Are the Source of Value
26) Chelsea Corporation’s cost of equity is 16% and it is 100% equity financed. If it can borrow
enough money at 10% to buy back half of its stock, what would would happen to the cost of
equity be under the original assumptions of the Modigliani and Miller Capital Structure
Theorem.
A) It would remain at 16%.
B) t would rise to 22%.
C) It would fall to 11%.
D) It would fall to 13%.
Topic: 15.2 Capital Structure Theory
Keywords: Modigliani and Miller
Principles: Principle 3: Cash Flows Are the Source of Value
14
27) Lowell Corporation and Lawrence Corporation each have EBIT of $4 million. Lowell has no
debt and no interest expense; Lawrence has $2 million in debt at a before-tax rate of 8%. The tax
rate is 40%. How much cash does each firm return to its investors.
A) Lowell $2,400,000, Lawrence $2,144,000
B) Lowell $2,400,000, Lawrence $2,240,000
C) Lowell $2,400,000, Lawrence $2,464,000
D) Lowell $2,400,000, Lawrence $2,304,000
Topic: 15.2 Capital Structure Theory
Keywords: Modigliani and Miller
Principles: Principle 3: Cash Flows Are the Source of Value
28) The most acceptable view of capital structure, according to the text, is that the weighted
average cost of capital:
A) first falls with moderate levels of leverage and then increases as a firm’s leverage becomes
high.
B) does not change with leverage.
C) increases proportionately with increases in leverage.
D) increases with moderate amounts of leverage and then falls.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
29) Newbury Inc. has retained $2 million in earnings this year. It can borrow up $1.5 million at a
rate of 8% and sell the same amount of new stock at a cost of 17%. Newbury cost of common
equity without selling any new stock is 16%. If Newbury’s capital budget is $2.5 million,
pecking order theory says management will use:
A) $1.5 million in debt and $1 million in retained earnings.
B) $2 million in retained earnings and $o.5 million in debt.
C) $833,333 each from retained earnings, new debt and new stock.
D) $1.5 million in debt and $1 million in new stock.
Topic: 15.2 Capital Structure Theory
Keywords: pecking order
Principles: Principle 3: Cash Flows Are the Source of Value
15
30) Which of the following is part of a firm’s financial structure but NOT a component of its
capital structure?
A) Retained earnings
B) Mortgage bonds
C) Accounts payable
D) Both A and C
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
31) Investors require a higher return on common stock investments if a firm uses less leverage.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
32) Other things the same, the use of debt financing reduces the firm’s total tax bill, resulting in a
higher total market value.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
33) The independence hypothesis suggests that the cost of equity decreases as financial leverage
increases.
Topic: 15.2 Capital Structure Theory
Keywords: favorable financial leverage
Principles: Principle 3: Cash Flows Are the Source of Value
34) The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity
decreases as financial leverage increases.
Topic: 15.2 Capital Structure Theory
Keywords: Modigliani and Miller
Principles: Principle 3: Cash Flows Are the Source of Value
16
35) The objective of capital structure management is to maximize the market value of the firm’s
equity.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
36) Agency costs tend to occur in business organizations when ownership and management
control are confined to the same individuals.
Topic: 15.2 Capital Structure Theory
Keywords: agency costs
Principles: Principle 3: Cash Flows Are the Source of Value
37) The pecking order theory of capital structure indicates that firms prefer to finance investment
opportunities with external financial capital first, then with internally generated funds.
Topic: 15.2 Capital Structure Theory
Keywords: pecking order
Principles: Principle 3: Cash Flows Are the Source of Value
38) The trade-off theory of capital structure recognizes the tax-shield benefit of debt financing,
but also recognizes that the benefit is offset by costs associated with debt financing.
Topic: 15.2 Capital Structure Theory
Keywords: tradeoff theory
Principles: Principle 3: Cash Flows Are the Source of Value
39) The tax shield on interest is calculated by multiplying the interest rate paid on debt by the
principal amount of the debt and the firm’s marginal tax rate.
Topic: 15.2 Capital Structure Theory
Keywords: interest tax savings
Principles: Principle 3: Cash Flows Are the Source of Value
40) According to the pecking order theory of capital structure, when external funding is needed,
common stock will be used to raise the funds.
Topic: 15.2 Capital Structure Theory
Keywords: pecking order
Principles: Principle 3: Cash Flows Are the Source of Value
17
41) Adams Inc. expects EBIT of $50 million if there is a recession, $100 million if the economy
is normal, and $150 million if the economy expands. Bellingham Inc. also expects EBIT of $50
million if there is a recession, $100 million if the economy is normal, and $150 million if the
economy expands. Adams is financed entirely with equity while Bellingham is financed 50%
with debt at 10%. Adams has $200 million in equity; Bellingham is financed with $100 million
of debt and $100 million of equity. The tax rate is 30%. Both firms pay out all available earnings
as dividends. If there is a recession, compare dividends and total distributions to investors for
each company.
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Principles: Principle 3: Cash Flows Are the Source of Value
42) Cheshire Corporation is now financed 100% with equity. The cost of equity is 15%. Cheshire
is considering a proposal to borrow enough money at 7% to buy back half of its common stock.
It would then be financed 50% with debt and 50% with equity. Assume that this does not affect
the cost of equity. Cheshire’s tax rate is 40%. What is Cheshire’s cost of capital without and with
the stock repurchase?
7%(1 – .4)(.5) + 15%(.5) = 9.6%
Topic: 15.2 Capital Structure Theory
Keywords: capital structure
Topic: 15.2 Capital Structure Theory
Keywords: agency costs
Principles: Principle 3: Cash Flows Are the Source of Value
18
44) Briefly explain what the empirical evidence suggests about financial managers’ actions as
they relate to the capital structure theory.
Topic: 15.2 Capital Structure Theory
Keywords: agency costs
Principles: Principle 3: Cash Flows Are the Source of Value
1) Which of the following factors favors the use of more debt in a company’s financial structure?
A) High levels of taxable income
B) Low levels of taxable income
C) The business is basically risky with unpredictable cash flows.
D) Risk of bankruptcy would make customers reluctant to buy the company’s products.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: financial structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
2) Which industry would you expect to have the highest Debt to Asset ratios?
A) Business oriented software
B) Electric utilities
C) Communications equipment
D) Retail clothing
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) In which countries would you expect companies to have the lowest leverage ratios?
A) Countries with very high tax rates.
B) Countries that tend to subsidize key industries and protect them from failure.
C) Countries where creditors have very strong legal protection.
D) Countries where the market value of companies is high compared to their book values.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: interest tax savings
19
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: interest tax savings
Principles: Principle 2: There Is a Risk-Return Tradeoff
5) For all U.S. companies the Debt to Value ratio is about:
A) 12%.
B) 90%.
C) 33%.
D) 42%.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) U. S. companies differ very little in their capital structures.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) Companies faced with higher tax burdens are likely to use more debt.
Topic: 15.3 Why Do Capital Structures Differ across Industries?
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeoff
20