Corporate Finance, 12e (Ross)
1) The firm’s capital structure refers to the:
A) mix of current and fixed assets a firm holds.
B) amount of capital invested in the firm.
C) amount of dividends a firm pays.
D) mix of debt and equity used to finance the firm’s assets.
E) amount of cash versus receivables the firm holds.
2) A general rule for managers to follow is to set the firm’s capital structure such that the firm’s:
A) size is maximized.
B) value is maximized.
C) bondholders are secured.
D) suppliers of raw materials are satisfied.
E) dividend payout is maximized.
3) A manager should attempt to maximize the value of the firm by changing the capital structure
if and only if the value of the firm increases:
A) as a result of the change.
B) to the sole benefit of the managers.
C) to the sole benefit of the debtholders.
D) while also decreasing shareholder value.
E) while holding stockholder value constant.
4) A firm should always select the capital structure which:
A) produces the highest cost of capital.
B) maximizes the value of the firm.
C) minimizes taxes.
D) maximizes current dividends.
E) has no debt.
5) Bryan invested in Bryco stock when the firm was financed solely with equity. The firm now
has a debt-equity ratio of .3. To maintain the same level of leverage he originally had, Bryan
needs to:
A) borrow some money and purchase additional shares of Bryco stock.
B) maintain his current position in Bryco stock.
C) sell some shares of Bryco stock and hold the proceeds in cash.
D) sell some shares of Bryco stock and loan out the proceeds.
E) sell half of his Bryco stock and invest the proceeds in risk-free securities.
6) In the absence of taxes, the capital structure chosen by a firm doesn’t really matter because of:
A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leverage.
7) MM Proposition I with no tax supports the argument that:
A) business risk determines the return on assets.
B) the cost of equity rises as leverage rises.
C) it is completely irrelevant how a firm arranges its finances.
D) a firm should borrow money to the point where the tax benefit from debt is equal to the cost
of the increased probability of financial distress.
E) financial risk is determined by the debt-equity ratio.
8) The proposition that the value of a levered firm is equal to the value of an unlevered firm is
known as:
A) MM Proposition I with no tax.
B) MM Proposition II with no tax.
C) MM Proposition I with tax.
D) MM Proposition II with tax.
E) both MM I with and without tax.
9) The concept of homemade leverage is most associated with:
A) MM Proposition I with no tax.
B) MM Proposition II with no tax.
C) MM Proposition I with tax.
D) MM Proposition II with tax.
E) no MM Proposition.
10) A levered firm is a company that has:
A) accounts payable as its only liability.
B) some debt in its capital structure.
C) an all-equity capital structure.
D) a tax loss carry forward.
E) taxable income.
11) The effects of financial leverage depend on the operating earnings of the company. Based on
this relationship, assume you graph the EPS and EBI for a firm, while ignoring taxes. Which one
of these statements correctly states a relationship illustrated by the graph?
A) Financial leverage decreases the slope of the EPS line.
B) Below the break-even point unlevered structures have a lower EPS for every dollar of EBI
than levered structures do.
C) Above the break-even point the increase in EPS for unlevered structures is greater than that of
levered structures for every dollar increase in EBI.
D) Leverage only provides value above the break-even point.
E) Above the break-even point, the unlevered structure is preferred.
12) MM Proposition I without taxes proposes that:
A) the value of an unlevered firm exceeds that of a levered firm.
B) there is one ideal capital structure for each firm.
C) leverage does not affect the value of the firm.
D) shareholder wealth is directly affected by the capital structure selected.
E) the value of a levered firm exceeds that of an unlevered firm.
13) A key underlying assumption of MM Proposition I without taxes is that:
A) financial leverage increases risk.
B) individuals can borrow at lower rates than corporations.
C) individuals and corporations borrow at the same rate.
D) managers always act to maximize the value of the firm.
E) corporations are all-equity financed.
14) In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray.
The debt ray has a lower intercept because:
A) more shares are outstanding for the same level of EBI.
B) the break-even point is higher with debt.
C) a fixed interest charge must be paid even at low earnings.
D) the amount of interest per share has only a positive effect on the intercept.
E) the break-even point is lower with debt.
15) When comparing levered versus unlevered capital structures, leverage works to increase EPS
for high levels of EBIT because interest payments on the debt:
A) vary with EBIT levels.
B) stay fixed, leaving less income to be distributed over fewer shares.
C) stay fixed, leaving more income to be distributed over fewer shares.
D) stay fixed, leaving less income to be distributed over more shares.
E) stay fixed, leaving more income to be distributed over more shares.
16) The increase in risk to shareholders when financial leverage is introduced is best evidenced
by:
A) higher EPS as EBIT increases.
B) a higher variability of EPS with debt than with all-equity financing.
C) increased use of homemade leverage.
D) the increase in taxes.
E) decreasing earnings as EBIT increases.
17) The use of personal borrowing to change the overall amount of financial leverage to which
an individual is exposed is called:
A) homemade leverage.
B) dividend recapture.
C) the weighted average cost of capital.
D) private debt placement.
E) personal offset.
18) The proposition that the value of the firm is independent of its capital structure is called:
A) the capital asset pricing model.
B) MM Proposition I (no taxes).
C) MM Proposition II (no taxes).
D) the law of one price.
E) the efficient markets hypothesis.
19) The unlevered cost of capital is:
A) the cost of capital for a firm with no equity in its capital structure.
B) the cost of capital for a firm with no debt in its capital structure.
C) the interest tax shield times pretax net income.
D) the cost of preferred stock for an all-equity firm.
E) equal to the profit margin for a firm with some debt in its capital structure.
20) According to MM Proposition II with no taxes, the:
A) return on assets is determined by financial risk.
B) required return on equity is a linear function of the firm’s debt-equity ratio.
C) cost of equity in inversely related to the firm’s debt-equity ratio.
D) cost of debt must equal the cost of equity.
E) required return on assets exceeds the weighted average cost of capital.
21) MM Proposition II with no taxes supports the argument that a firm’s:
A) unlevered equity is risk-free.
B) cost of equity is inversely related to the firm’s debt-equity level.
C) cost of equity is unaffected by the firm’s unlevered cost of capital.
D) WACC will exceed the unlevered firm’s cost of equity.
E) WACC remains constant even if the firm changes its capital structure.
22) The tax savings of the firm derived from the deductibility of interest expense is called the:
A) tax shield from debt.
B) depreciable basis.
C) financing umbrella.
D) current yield.
E) tax-loss carryback.
23) The reason that MM Proposition I without taxes does not hold in the presence of corporate
taxation is because:
A) levered firms pay less taxes compared with identical unlevered firms.
B) bondholders require higher rates of return than stockholders do.
C) earnings per share are no longer relevant with taxes.
D) dividends become a tax shield.
E) debt is more expensive than equity.
24) MM Proposition I with taxes supports the theory that:
A) there is a positive linear relationship between the amount of debt in a levered firm and the
firm’s value.
B) the value of a firm is inversely related to the amount of leverage used by the firm.
C) the value of an unlevered firm is equal to the value of a levered firm plus the value of the
interest tax shield.
D) a firm’s cost of capital is the same regardless of the mix of debt and equity used by the firm.
E) a firm’s weighted average cost of capital increases as the debt-equity ratio of the firm rises.
25) MM Proposition I with taxes states that:
A) capital structure does not affect firm value.
B) increasing the debt-equity ratio increases firm value.
C) firm value is maximized when the firm is all-equity financed.
D) the cost of equity rises as the debt-equity ratio increases.
E) the unlevered cost of equity is equal to RWacc.
26) MM Proposition I with taxes is based on the concept that the:
A) optimal capital structure is the one that is totally financed with equity.
B) capital structure of the firm does not matter because investors can use homemade leverage.
C) firm is better off with debt based on the weighted average cost of capital.
D) presence of taxes causes debt to be valuable to a firm.
E) cost of equity increases as the debt-equity ratio of a firm increases.
27) MM Proposition II with taxes:
A) explains how a firm’s WACC increases with the use of financial leverage.
B) reveals how utilizing the tax shield on debt causes an increase in the value of a firm.
C) supports the argument that business risk is determined by the capital structure employed by a
firm.
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E) reaches the final conclusion that the capital structure decision is irrelevant to the value of a
firm.
28) MM Proposition II is the proposition that:
A) supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
B) the cost of levered equity depends solely on the return on debt, the debt-equity ratio, and the
tax rate.
C) a firm’s cost of equity capital is a positive linear function of the firm’s capital structure.
D) the cost of equity is equivalent to the required return on the total assets of a levered firm.
E) the cost of debt is inversely related to a firm’s debt-equity ratio.
29) The tax shield on debt has no value for a firm when:
A) the firm’s debt-equity ratio is exactly equal to 1.
B) the firm’s debt-equity ratio is exactly .5.
C) the firm is unlevered.
D) shareholders fully utilize homemade leverage.
E) RS is less than R0.
30) The tax shield on debt is one reason why:
A) the required rate of return on assets rises when debt is added to the capital structure.
B) the value of an unlevered firm is equal to the value of a levered firm.
C) the net cost of debt to a firm is generally less than the cost of equity.
D) the cost of debt is equal to the cost of equity for a levered firm.
E) firms prefer equity financing over debt financing.
31) CT Stores has debt with a book value of $325,000 and a market value of $319,000. The
firm’s equity has a book value of $526,000 and a market value of $684,000. The tax rate is 21
percent and the cost of capital is 11.2 percent. What is the market value of this firm based on
MM Proposition I without taxes?
A) $923,250
B) $1,003,000
C) $984,300
D) $851,000
E) $769,750
32) Thompson & Thomson is an all-equity firm that has 280,000 shares of stock outstanding.
The company is in the process of borrowing $2.4 million at 5.5 percent interest to repurchase
75,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes?
A) $8,960,000
B) $9,240,000
C) $10,710,000
D) $12,500,000
E) $11,360,000
33) Uptown Interior Designs is an all-equity firm that has 40,000 shares of stock outstanding.
The company has decided to borrow $74,000 to buy out the 2,100 shares of a deceased
stockholder. What is the total value of this firm if you ignore taxes?
A) $2,008,157
B) $1,388,056
C) $1,409,524
D) $3,885,000
E) $2,630,620
34) You own 25 percent of Unique Vacations, Inc. You have decided to retire and want to sell
your shares in this closely held, all-equity firm. The other shareholders have agreed to have the
firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this
firm if you ignore taxes?
A) $4.8 million
B) $5.1 million
C) $5.4 million
D) $5.7 million
E) $6.0 million
35) Assume an unlevered firm has total assets of $6,000, earnings before interest and taxes of
$600, and 500 shares of stock outstanding. Further assume the firm decides to change 40 percent
of its capital structure to debt with an interest rate of 8 percent. Ignore taxes. What will be the
amount of the change in the earnings per share as a result of this change in the capital structure?
A) $.16
B) $.09
C) No change
D) −$.09
E) −$.16
36) Assume an initial scenario where a levered firm has total assets of $8,000, earnings before
interest and taxes of $600, 400 shares of stock outstanding, a debt-equity ratio of .25, and a cost
of debt of 7 percent. Now assume a second scenario where the firm changes to an all-equity
structure by issuing new shares to pay off debt while a shareholder holding 10 percent of the
stock borrows funds at 7 percent and uses homemade leverage to offset the firm’s change in
capital structure. Ignore taxes. What are the net earnings for this shareholder under the initial
scenario? Under the second scenario?
A) $90.00; $90.00
B) $90.00; $112.50
C) $48.80; $38.80
D) $48.80; $48.80
E) $45.00; $48.80
37) A firm has a debt-equity ratio of .64, a pretax cost of debt of 8.5 percent, and a required
return on assets of 12.6 percent. What is the cost of equity if you ignore taxes?
A) 8.06 percent
B) 8.55 percent
C) 11.12 percent
D) 15.22 percent
E) 16.38 percent
38) Bigelow has a levered cost of equity of 14.29 percent and a pretax cost of debt of 7.23
percent. The required return on the assets is 11 percent. What is the firm’s debt-equity ratio based
on MM Proposition II with no taxes?
A) .67
B) .87
C) .72
D) .75
E) .81
39) The Backwoods Lumber Co. has a debt-equity ratio of .68. The firm’s required return on
assets is 11.7 percent and its levered cost of equity is 15.54 percent. What is the pretax cost of
debt based on MM Proposition II with no taxes?
A) 6.76 percent
B) 6.39 percent
C) 7.25 percent
D) 6.05 percent
E) 7.50 percent
40) A firm has zero debt in its capital structure and has an overall cost of capital of 10 percent.
The firm is considering a new capital structure with 60 percent debt at an interest rate of 8
percent. Assuming there are no taxes or other imperfections, what would be the cost of equity
with the new capital structure?
A) 9 percent
B) 10 percent
C) 13 percent
D) 14 percent
E) 11 percent