978-0133423822 Chapter 15 Part 2

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7) An optimal capital structure is achieved

A) when a irm’s expected proits are maximized.

B) when a irm’s expected EPS are maximized.

C) when a irm’s break-even point is achieved.

D) when a irm’s weighted average cost of capital is minimized.

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

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

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) An optimal capital structure is achieved

A) when a irm’s expected proits are maximized.

B) when a irm’s expected EPS are maximized.

C) when a irm’s expected stock price is maximized.

D) when a irm’s break-even point is achieved.

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) Using the original Modigliani and Miller assumptions if a irm’s cost of capital is 12%

when it is all equity inanced and it’s cost of debt is 8%, the cost of equity will be ________%

when the irm is inanced with equal amount of debt and equity.

A) 12%

B) 24%

C) 16%

D) cannot be determined with the information given.

Question Status: New question

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

11) The tradeof theory of capital structure management assumes

A) no corporate income taxes.

B) cost of equity remains constant with an increase in inancial leverage.

C) irms might fail.

D) none 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

12) Which of the following is consistent with the Tradeof theory of capital structure?

A) The cost of capital continuously decreases as the irm’s debt ratio increases.

B) The cost of capital remains constant as the irm’s debt ratio increases.

C) There are no costs associated with bankruptcy.

D) There is an optimal level of debt inancing.

Question Status: Revised

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

13) Which of the following is a reasonable conclusion from the Tradeof theory of capital

structure?

A) A high debt ratio will result in a maximum price of a irm’s common stock.

B) A irm’s common stock price will not be afected by the amount of debt a irm uses.

C) A low debt ratio will result in a maximum price for a irm’s common stock.

D) Modest levels of debt have a more favorable impact on a irm’s average cost of capital

and stock price than no debt.

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

14) Which of the following is consistent with the original formulation of the Modigliani and

Miller Capital Structure Theorem?

A) A irm’s composite cost of capital decreases as inancial leverage is used.

B) A irm’s common stock price falls as inancial leverage is used.

C) A irm’s composite cost of capital and common stock price are unafected by the amount

of inancial leverage used by the irm.

D) A irm’s composite cost of capital increases as operating leverage is used.

Question Status: Revised

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

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 inancial leverage will increase a irm’s composite cost of capital

indeinitely.

B) Increased usage of inancial leverage will lower a irm’s composite cost of capital

indeinitely.

C) Increased usage of inancial leverage will not afect a irm’s composite cost of capital.

D) Increased usage of operating leverage will increase a irm’s composite cost of capital

indeinitely.

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

16) The Tradeof theory of capital structure suggests that if a irm moves from zero debt in

its capital structure to moderate usage of debt, the result is an increase in a irm’s

A) stock price.

B) cost of equity.

C) dividend payout.

D) both A and C.

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

17) If interest expense lowers taxes, why does the WACC not decrease indeinitely with the

addition of more debt?

A) The tax shield efect of debt will result in a lower cost of equity.

B) Increasing debt too much can result in a greater likelihood of irm failure (inancial

distress).

C) A irm’s common stock price will not be afected by the amount of debt a irm uses.

D) Too much common equity increases the probability of bankruptcy.

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

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) Existing shareholders, IRS

D) There are no potential conlicts arising from the way a irm manages its capital

structure.

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

19) The inclusion of bankruptcy costs and taxes in irm valuation

A) causes the cost of capital curve to be umbrella shaped.

B) is consistent with a saucer-shaped cost of capital curve.

C) is consistent with a cost of capital curve that slopes downward.

D) causes the cost of capital to rise in a linear fashion as more debt is added to the capital

structure.

Question Status: New question

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

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) tradeof theory.

C) inancial stress avoidance theory.

D) pecking order theory.

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

21) The Tradeof Theory of capital structure theory indicates that

A) the tax shield on debt positively afects irm value, indicating that there is some beneit

to inancial leverage as opposed to an all-equity capitalization.

B) the higher the irm’s inancial leverage, the higher the probability the irm will be unable

to meet the inancial obligations included in its debt contracts, which could ultimately lead

to irm failure.

C) there is a range of capital structures, rather than a single capital structure, that is

optimal.

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

22) The Tradeof 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.

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

23) Assume that the tax rate is 40% and bankruptcy costs are negligible until a irm’s debt

to equity ratio is greater than one. If Madison Co. increases debt from 10% of its capital

structure to 40%, cash lows to investors will

A) decrease.

B) remain the same.

C) increase.

D) A irm’s cash lows are independent of its capital structure.

Question Status: New question

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

24) The pecking order theory of capital structure is derived from

A) expectations theory.

B) the Modigliani-Miller theory.

C) liquidity preference theory.

D) agency theory.

Question Status: New question

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

25) With taxes, but in the absence of inancial 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.

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

26) Chelsea Corporation’s cost of equity is 16% and it is 100% equity inanced. 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) It would rise to 22%.

C) It would fall to 11%.

D) It would fall to 13%.

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

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 irm 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

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

28) The most acceptable view of capital structure, according to the text, is that the

weighted average cost of capital

A) irst falls with moderate levels of leverage and then increases as a irm’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.

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

29) Newbury Inc. has retained $2 million in earnings this year. It can borrow up to $1.5

million at a rate of 8% and sell the same amount of new stock at a cost of 17%. Newbury’s

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 $0.5 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.

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

30) Which of the following is part of a irm’s inancial structure but NOT a component of its

capital structure?

A) Retained earnings

B) Mortgage bonds

C) Accounts payable

D) Both A and C

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

31) Investors require a higher return on common stock investments if a irm uses less

leverage.

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

32) Other things the same, the use of debt inancing reduces the irm’s total tax bill,

resulting in a higher total market value.

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

33) Given the existence of taxes and bankruptcy costs, the optimal capital structure is

100% debt.

Question Status: New question

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

34) The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity

decreases as inancial leverage increases.

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

35) The objective of capital structure management is to maximize the market value of the

irm’s equity.

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

36) Agency costs occur when managers choose the easiest form of inancing over the value

maximizing capital structure.

Question Status: New question

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

37) The pecking order theory of capital structure indicates that irms prefer to inance

investment opportunities with least expensive forms of inancing irst and the most

expensive last.

Question Status: New question

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

38) The trade-of theory of capital structure recognizes the tax-shield beneit of debt

inancing, but also recognizes that the beneit is ofset by costs associated with debt

inancing.

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

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 irm’s marginal tax rate.

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