Financial Management, 12e (Titman/Keown/Martin)
Chapter 15 Capital Structure Policy
15.1 A Glance at Capital Structure Choices in Practice
1) The irm’s optimal capital structure is the mix of inancing sources that
A) minimizes the risk of inancial distress.
B) maximizes after-tax earnings.
C) maximizes the total value of the irm’s debt and equity.
D) maximizes favorable leverage.
Question Status: Revised
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
2) Suppose we calculate a times interest earned ratio of 29 for Colgate-Palmolive. We can
conclude
A) Colgate-Palmolive may experience some diiculty meeting its interest payments.
B) Colgate-Palmolive is very unlikely to have diiculty meeting its interest payments.
C) Colgate-Palmolive has $29 of operating cash low for every dollar of interest expense.
D) Colgate-Palmolive’s EBITDA is 29 times larger than its interest expense.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
3) A irm’s capital structure consists of which of the following?
A) The amount of debt that a irm uses
B) The amount of debt and preferred stock that a irm uses
C) The amount of debt, preferred stock, and common stock that a irm uses
D) The mix of long and short-term debt used by the irm
Question Status: Revised
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
1
4) The enterprise value of the irm is deined as
A) (Market Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity
B) (Book Value of Interest Bearing Debt-Excess Cash) + Market Value of Equity
C) (Book Value of Interest Bearing Debt-Excess Cash) + Book Value of Equity
D) Market Value of Interest Bearing Debt + Market Value of Equity
Question Status: New question
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
5) Which of the following is NOT a component of a irm’s capital structure?
A) Preferred stock
B) Bonds
C) Common stock
D) Accounts payable
E) Retained earnings
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
6) Merrimac Brewing company’s total assets equal $18 million. The book value of
Merrimac’s equity is $6 million. Excess cash is $200,000. The market value of Merrimac’s
equity is $10 million. Its Debt to Enterprise Value ratio is .5. What is the book value of
Merrimac’s interest- bearing debt?
A) $5.25 million
B) $10.2 million
C) $15 million
D) $20.4 million
Question Status: Revised
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
2
7) Merrimac Brewing company’s total assets equal $18 million. The book value of
Merrimac’s equity is $6 million. Excess cash is $200,000. The market value of Merrimac’s
equity is $10 million. Its Debt to Enterprise Value ratio is .5. What is Merrimac’s Debt
Ratio?
A) .75
B) .67
C) .33
D) .25
Question Status: Revised
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
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
What is Cornucopia’s debt ratio?
A) .48
B) .32
C) .21
D) .30
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
3
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
What is Cornucopia’s debt to value ratio?
A) .48
B) .32
C) .21
D) .30
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
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. What is Fibonacci’s debt ratio?
A) .38
B) .23
C) .125
D) .24
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
4
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). Excess
cash $500,000. The market value of Fibonnacci’s equity is $21 million. What is Fibonacci’s
Debt to Enterprise Value ratio?
A) .38
B) .23
C) .125
D) .106
Question Status: Revised
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
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
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
13) Which of the following should be excluded from a irm’s capital structure?
A) Common equity
B) Non-interest bearing debt
C) Long-term debt
D) Short-term bank notes
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
5
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 inancial leverage.
B) a sub-optimal capital structure.
C) favorable inancial leverage.
D) negative inancial leverage.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
15) A company whose rate of return on investments is higher than the interest rate on its
debt is said to have
A) unfavorable inancial leverage.
B) a sub-optimal capital structure.
C) favorable inancial leverage.
D) negative inancial leverage.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
16) How does the text distinguish between irm’s inancial 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.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
17) Financial structure includes long-term and short-term sources of funds.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
6
18) A irm’s inancial structure is deined by the Debt Ratio, while its capital structure is
deined by the Debt to Value ratio.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
19) The Times Interest Earned Ratio measures a irm’s ability to meet both interest
payments and scheduled principal repayments.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
20) The debt ratio is usually computed using book values for both debt and equity.
Question Status: New question
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
21) Debt ratios and debt to enterprise value ratios difer widely from one industry to
another.
Question Status: New question
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
7
22) What is meant by the terms “favorable” and “unfavorable” leverage?
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
23) Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
24) 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.
Question Status: Previous edition
Objective: 15.1 Describe a irm’s capital structure.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
8
15.2 Capital Structure Theory
1) In its original form, the Modigliani and Miller Capital Structure Theorem
A) uses unrealistic assumptions.
B) provided important insights into capital structure policy.
C) concludes that how a irm is inanced is not important.
D) all of the above.
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
2) The inclusion of bankruptcy risk in irm valuation
A) acknowledges that a irm has an upper limit to debt inancing.
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.
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
3) Which of the following is the most important factor that afects a irm’s inancing 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 lows
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
9
4) When the impact of taxes is considered, as the irm takes on more debt
A) there will be no change in total cash lows.
B) both taxes and total cash low to stockholders and bondholders will decrease.
C) cash lows will increase because taxes will decrease.
D) the weighted average cost of capital will increase.
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
5) The original form of the Modigliani and Miller Capital Structure Theorem
A) ignores the efect of taxes.
B) ignores the relationship between irm value and cost of capital.
C) ignores transaction costs.
D) both A and C are true.
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
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 irm’s beta.
D) the mix of securities that will maximize EPS.
Question Status: Previous edition
Objective: 15.2 Explain why irms have diferent capital structures and how capital structure
inluences a irm’s weighted average cost of capital.
Keywords: capital structure
Principles: Principle 2: There Is a Risk-Return Tradeof
10