Financial Management: Core Concepts, 4e (Brooks)
Chapter 16 Capital Structure
1) Capital structure refers to how the firm finances its operations and growth through a
combination of ________.
A) equity types
B) security types
C) types of earnings
D) types of debt
2) ________ financial world is one without taxes, bankruptcy, and other imperfections.
A) An imperfect
B) A friction-full
C) A perfect
D) A realistic
3) ________ capital structure refers to a combination of debt and equity that maximizes the value
of the firm.
A) An optimal
B) An irrelevant
C) A perfect
D) A minimal
4) A ________ is a separate entity and in that capacity can borrow from banks, bondholders,
preferred stockholders, and common shareholders.
A) limited partnership
B) sole proprietorship
C) government organization
D) public company
5) The return to the investor is the ________.
A) reward to the borrower
B) cost to the borrower
C) cost to the manager
D) internal rate of return
6) The federal government bond market is open only to ________.
A) state government agencies
B) local government agencies
C) the federal government
D) municipal government
7) The municipal bond market is open only to ________.
A) state government agencies
B) local government agencies
C) the federal government
D) Both A and B
8) Investors Curt and Doug lend $100,000 to each new idea. Curt’s history is that he selects low-
risk projects or ideas that hit 50% of the time. Doug’s history is that she takes on high-risk
projects that hit 20% of the time. What rate of return must each successful project pay Curt and
Doug for them to break even?
A) Curt’s rate is 200% and Doug’s rate is 450%.
B) Curt’s rate is 100% and Doug’s rate is 400%.
C) Curt’s rate is 200% and Doug’s rate is 400%.
D) Curt’s rate is 450% and Doug’s rate is 100%.
9) Investors Curt and Doug lend $100,000 to each new idea. Curt’s history is that he selects low-
risk projects or ideas that hit 80% of the time. Doug’s history is that she takes on high-risk
projects that hit 40% of the time. What rate of return must each successful project pay Curt and
Doug for them to break even?
A) Curt’s rate is 150%, and Doug’s rate is 25%.
B) Curt’s rate is 40%, and Doug’s rate is 40%.
C) Curt’s rate is 25%, and Doug’s rate is 150%.
D) Curt’s rate is 30%, and Doug’s rate is 150%.
10) Rhonda lends $200,000 for each new idea. Rhonda’s history is that he selects low-risk
projects or ideas that hit 60% of the time. What rate of return must each successful project pay
Rhonda for him to break even?
A) 66.67%
B) 50.00%
C) 33.33%
D) 25.00%
11) Oprah lends $150,000 for each new idea. Oprah’s history is that she selects low-risk projects
or ideas that hit 40% of the time. What rate of return must each successful project pay Oprah for
her to break even?
A) 0%
B) 50%
C) 150%
D) 200%
12) Allied Investment Fund lends $200,000 for each new idea. The Fund’s history is that it
selects high-risk projects or ideas that hit 10% of the time. What rate of return must each
successful project pay the Fund for it to break even?
A) 100%
B) 400%
C) 600%
D) 900%
13) Which of the statements below is FALSE?
A) The “riskier” borrower will most likely have to pay a lower cost for funds.
B) In the bond market, we see different rates as the different yields on bonds for different
companies.
C) In the equity market, we see different rates as the different required returns for companies due
to their different betas.
D) In general, the cost of funds for an individual or company will be directly related to the
lender’s view of the risk of repayment of the funds.
14) A large public firm cannot issue which of the following types of securities?
A) Common stock
B) T-Bills
C) Preferred stock
D) Bonds
15) Which of the statements below is FALSE?
A) Two different individuals or companies could go to the same bank and request exactly the
same amount of funding for their projects and yet could be required to pay different costs for
their funds.
B) It is important to remember that a public company is a separate entity and in that capacity can
borrow from bondholders, preferred stockholders, and common shareholders, but not from
banks.
C) Lenders, regardless of their classification, all consider their funds as investments, for which
they hope to make a positive return.
D) The return to the investor is the cost to the seller.
16) In a perfect financial world, a company’s value is dependent on its capital structure.
17) The best combination of debt and equity creates what we call an imperfect capital structure.
18) The return to the investor is the cost to the seller.
19) In general, the cost of funds for an individual or company will be directly related to the
lender’s view of the risk of repayment of the funds.
20) All markets are open to all borrowers.
21) The highest return to the investor is the lowest cost for the seller and vice versa.
22) Investors Bill and Maggie lend $60,000 to each new idea. Bill picks low-risk projects that are
successful 60% of the time. Maggie takes on high-risk projects that that are successful 20% of
the time. What rate of return must each successful project pay Bill and Maggie for them to break
even?
23) Two different individuals or companies can go to the same bank and request exactly the
same amount of funding for their projects and yet can be required to pay different costs for their
funds. Why? Can we find a parallel situation in the bond and equity markets? Explain.
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16.2 Benefits of Debt
1) You have a project that costs $750,000. It has a 0.30 chance of paying off $3,000,000 and a
0.70 chance of paying off $0. What is the expected payoff from the new project?
A) $500,000
B) $900,000
C) $1,000,000
D) $1,200,000
2) You have a project that costs $750,000. It has a 0.30 chance of paying off $3,000,000 and a
0.70 chance of paying off $0. What is the expected profit from the new project?
A) $300,000
B) $150,000
C) $100,000
D) zero
3) IBM Inc. has a project that costs $150,000. It has a 50% chance of paying off $300,000 and a
50% chance of paying off $50,000. What is the expected payoff and the expected profit or loss
from the new project?
A) The expected payoff is $175,000 and the expected profit is $25,000.
B) The expected payoff is $25,000 and the expected profit is $25,000.
C) The expected payoff is $175,000 and the expected loss is $175,000.
D) The expected payoff is $100,000 and the expected loss is $10,000.
4) Keystone Brewing, Inc. has a project that costs $1,000,000. It has a 50% chance of paying off
$2,000,000 and a 50% chance of paying off $0. What is the expected payoff and the expected
profit or loss from the new project?
A) The expected payoff is $1,000,000, and the expected loss is $10,000.
B) The expected payoff is $100,000, and the expected profit is $10,000.
C) The expected payoff is $100,000, and the expected loss is $100,000.
D) The expected payoff is $1,000,000, and the expected profit is $0.
5) Costa Rica Resorts, Inc. has a project that costs $500,000. It has a 40% chance of a
$1,000,000 payoff and a 60% chance of a $200,000 payoff. What is the expected payoff and the
expected profit or loss from the new project?
A) The expected payoff is $600,000, and the expected gain is $200,000.
B) The expected payoff is $440,000, and the expected loss is $40,000.
C) The expected payoff is $520,000, and the expected gain is $20,000.
D) The expected payoff is $520,000, and the expected loss is $20,000.
6) ________ is the degree to which a firm or individual utilizes borrowed money to make
money.
A) Variable leverage
B) Fixed leverage
C) Operating leverage
D) Financial leverage
7) Financial leverage is the degree to which a firm or individual utilizes ________.
A) borrowed money to pay wages
B) borrowed money to pay dividends
C) borrowed money to magnify equity earnings
D) borrowed money to diminish equity earnings
8) The process of borrowing money from others to make money on your idea is commonly
known in the investment world as ________.
A) “losing other people’s money”
B) “using other people’s money”
C) “abusing other people’s money”
D) “misusing other people’s money”
9) The more ________ used, the greater the leverage a company employs on behalf of its
owners.
A) debt
B) equity
C) debt and equity
D) All of these
10) One way of measuring the advantage of financial leverage to the owners of the company is
________.
A) to examine the earnings per share (EPS) of a company before borrowing from debt lenders
B) to examine the earnings per share (EPS) of a company after borrowing from debt lenders
C) to examine the dividends per share (DPS) of a company before and after borrowing from debt
lenders
D) to examine the earnings per share (EPS) of a company before and after borrowing from debt
lenders
11) If earnings reflect a return greater than the cost of debt, then ________.
A) the more debt the company has sold, the worse off the shareholders are
B) the less debt the company has sold, the better off the shareholders are
C) the more debt the company has sold, the better off the shareholders are
D) the more debt the company has bought, the better off the shareholders are
12) If company earnings reflect a rate of return less than the cost of debt, then more debt
________.
A) will increase the percentage of earnings available for distribution to the equity owners
B) will lower the percentage of earnings available for distribution to the debt owners
C) will increase the percentage of dividends available for distribution to the equity owners
D) will lower the percentage of earnings available for distribution to the equity owners
13) If company earnings give a rate of return less than the cost of debt, then it may be
advantageous for the firm to be ________.
A) all-equity
B) owned mostly by debt holders
C) half owned by debt holders
D) one-third owned by equity holders
14) Which of the statements below is FALSE?
A) When a company performs well, it can handle more debt and benefit the owners.
B) Borrowing from debt lenders at one rate and investing the money in the business and making
a higher rate is bad for the owners.
C) Assume that the more debt the company has sold, the better off the shareholders are. This is
the case where the earnings reflect a return greater than the cost of debt.
D) Financial leverage is the degree to which a firm or individual utilizes borrowed money to
make money.
15) Consider two companies in a world with no taxes that are alike except in borrowing choices.
Company 1 has no debt financing, and Company 2 uses debt financing. The EBIT for both
companies is $1,000. Company 1 has 500 shares outstanding and pays no interest. Company 2
has 300 shares outstanding and pays $250 in interest. What is the EPS for each company?
A) Both companies have an EPS of $2.00.
B) Both companies have an EPS of $2.67.
C) Company 1 has an EPS of $2.00 and Company 2 has an EPS of $2.27.
D) Company 1 has an EPS of $2.00 and Company 2 has an EPS of $2.67.
16) Consider two companies in a world with no taxes that are alike except in borrowing choices.
Pacific Corp. has no debt financing, and Atlantic Corp. uses debt financing. The EBIT for both
companies is $900. Pacific Corp. has 300 shares outstanding and pays no interest. Atlantic Corp.
has 200 shares outstanding and pays $200 in interest. What is the EPS for each company?
A) Both companies have an EPS of $3.50.
B) Both companies have an EPS of $3.00.
C) Pacific Corp. has an EPS of $3.50 and Atlantic Corp. has an EPS of $3.00.
D) Pacific Corp. has an EPS of $3.00 and Atlantic Corp. has an EPS of $3.50.
17) Consider two companies in a world with no taxes that are alike except in borrowing choices.
District Corp. has no debt financing, and Energy Corp. uses debt financing. The EBIT for both
companies is $2,500,000. District Corp. has 500,000 shares outstanding and pays no interest.
Energy Corp. has 350,000 shares outstanding and pays $1,000,000 in interest. What is the EPS
for each company?
A) Both companies have an EPS of $5.71.
B) Both companies have an EPS of $5.00.
C) District Corp. has an EPS of $5.71 and Energy Corp. has an EPS of $5.00.
D) District Corp. has an EPS of $5.00 and Energy Corp. has an EPS of $4.29.
18) The decision on capital structure seems to be related to the expected earnings of the company
________.
A) the less the earnings, the more debt we should sell
B) the more the earnings, the more debt we should sell
C) the more the earnings, the less debt we should sell
D) None of these
19) Graphic Design Inc. has a project that costs $150,000. It has a 50% chance of a $300,000
payoff and a 50% chance of a $100,000 payoff. What is the expected payoff and the expected
profit or loss from the new project?
A) The expected payoff is $200,000 and the expected profit is $10,000.
B) The expected payoff is $110,000 and the expected profit is $10,000.
C) The expected payoff is $200,000 and the expected profit is $50,000.
D) The expected payoff is $150,000 and the expected loss is $0.
20) The Herald Tribune Inc. has a project that costs $400,000. It has a 30% chance of a
$1,000,000 payoff and a 70% chance of a $200,000 payoff. What is the expected payoff and the
expected profit or loss from the new project?
A) The expected payoff is $1,000,000, and the expected loss is $200,000.
B) The expected payoff is $440,000, and the expected profit is $10,000.
C) The expected payoff is $400,000, and the expected loss is $40,000.
D) The expected payoff is $440,000, and the expected profit is $40,000.
21) Simplistic Inc. has a project that costs $800,000. It has a 70% chance of a $1,500,000 payoff
and a 30% chance of a $50,000 payoff. What is the expected payoff and the expected profit or
loss from the new project?
A) The expected payoff is $1,065,000, and the expected gain is $265,000.
B) The expected payoff is $700,000, and the expected loss is $100,000.
C) The expected payoff is $600,000, and the expected gain is $0.
D) The expected payoff is $500,000, and the expected loss is $100,000.
22) Shareholders can be made better off in terms of EPS with financial leverage when earnings
are sufficiently high to offset the interest expense of debt.
23) When earnings are less than the cost of debt, it follows that the more debt, the lower the
percentage of earnings available for distribution to shareholders.
24) Leverage magnifies both gains and losses.
25) Why is financial leverage attractive?
1) Refer to the scenario above. What level of EBIT would make this an attractive strategy?
A) $6,000
B) $5,120
C) $4,600
D) $3,400
2) Refer to the scenario above. If Southern Cornbread’s EBIT is $6,000, compare EPS before and
after the new debt.
A) All-equity EPS = $3.00, leveraged-equity EPS = $4.50
B) All-equity EPS = $4.50, leveraged-equity EPS = $3.00
C) All-equity EPS = $0.75, leveraged-equity EPS = $0.787
D) All-equity EPS = $0.787, leveraged-equity EPS = $0.75
3) Refer to the scenario above. What would the unleveraged and leveraged EPSs look like if
EBIT were only $4,000?
A) All-equity EPS = $0.50, leveraged-equity EPS = $0.453
B) All-equity EPS = $0.453, leveraged-equity EPS = $0.50
C) All-equity EPS = $2.00, leveraged-equity EPS = $3.00
D) All-equity EPS = $3.00, leveraged-equity EPS = $2.00
4) Refer to the scenario above. What would the unleveraged and leveraged EPSs look like if
EBIT were $5,120?
A) All-equity EPS = $0.64, leveraged-equity EPS = $0.64
B) All-equity EPS = $0.75, leveraged-equity EPS = $0.844
C) All-equity EPS = $0.844, leveraged-equity EPS = $0.75
D) All-equity EPS = $0.90, leveraged-equity EPS = $1.21
5) Donat Corp. is a small company looking at two possible capital structures. Currently, the firm
is an all-equity firm with $600,000 in assets and 100,000 shares outstanding. The market value of
each share is $6.00. The CEO of Donat is thinking of leveraging the firm by selling $300,000 of
debt financing and retiring 50,000 shares, leaving 50,000 shares outstanding. The cost of debt is
5% annually, and the current corporate tax rate for Donat is 30%. The CEO believes that Donat
will earn $50,000 per year before interest and taxes. Which of the statements below is TRUE?
A) All-equity EPS is $0.35.
B) 50/50 debt-to-equity EPS is $0.49.
C) Shareholders will be better off by $0.14 per share under a firm with $300,000 in debt
financing versus a firm that is all-equity.
D) Statements A, B, and C are all true.
6) Firewall Corp. is a small company looking at two possible capital structures. Currently, the
firm is an all-equity firm with $900,000 in assets and 100,000 shares outstanding. The market
value of each share is $9.00. The CEO of Firewall is thinking of leveraging the firm by selling
$270,000 of debt financing and retiring 30,000 shares, leaving 70,000 shares outstanding. The
cost of debt is 6% annually, and the current corporate tax rate for Firewall is 30%. The CEO
believes that Firewall will earn $100,000 per year before interest and taxes. Which of the
statements below is TRUE?
A) All-equity EPS is $0.70.
B) 30/70 debt-to-equity EPS is $0.838.
C) Shareholders will be better off by almost $0.14 per share under a firm with $270,000 in debt
financing versus a firm that is all-equity.
D) Statements A, B, and C are all true.
7) Above the break-even EBIT, there is no benefit in debt financing.
8) Below the break-even EBIT, the owners can benefit from financial leverage.