36) Which three factors are generally considered to be the most important when determining a
target debt-equity ratio?
A) Taxes, asset types, and inflation rate
B) Asset types, current operating income, and inflation rates
C) Taxes, current operating income, and future operating income
D) Taxes, asset types, and uncertainty of operating income
E) Interest rates, inflation rates, and tax rates
37) Which one of the following is not empirically correct?
A) Some firms use no debt.
B) The capital structure of a firm can vary significantly over time.
C) Capital structures are fairly constant across industries.
D) Debt levels across industries vary widely.
E) Debt ratios in most countries are considerably less than 100 percent.
38) The optimal capital structure:
A) is identical for all firms in the same industry.
B) will remain constant over time unless the firm makes an acquisition.
C) of a particular firm can change if tax rates change.
D) places more emphasis on the operations of a firm rather than the financing of a firm.
E) is unaffected by changes in the financial markets.
39) Corporations in the U.S., as compared to other countries, tend to:
A) have a median leverage ratio that’s equal to the average international median leverage ratio.
B) underutilize debt.
C) rely less on equity financing than they should.
D) have extremely high debt-equity ratios.
E) have relatively high leverage ratios due to the tax benefits gained.
40) In general, U.S. firms:
A) tend to overweigh debt in relation to equity.
B) that are highly profitable tend to have lower target debt-equity ratios than unprofitable firms.
C) tend to maintain similar capital structures across all industries.
D) tend to maximize the use of every dollar of the tax benefits of debt.
E) that are family-owned tend to have very low levels of debt.
41) Many firms base their actual capital structure decisions on which two factors?
A) Inflation and tax rates
B) Interest and tax rates
C) Need for financial slack and current interest rates
D) Need for financial slack and industry averages
E) Types of assets held and current interest rates
42) The Wiz Co. owes $60 to its bondholders for the payment of principal and interest. The
company expects to have a cash flow of $136 if the economy continues as it is but that cash flow
will decrease to $54 if the economy enters a recession. Should the company ever face the real
possibility of bankruptcy, it will incur legal and other fees of $30. What amount will the
bondholders be paid in the case of a recession?
A) $30
B) $60
C) $54
D) $24
E) $0
43) TL Company has outstanding debt of $50 that is due in one year. However, given the
financial distress costs, the debtholders will only receive $40 if the firm does well and $15 if it
does poorly. The probability the firm will do well is 60 percent with the 40 percent probability
assigned to poor conditions. What is the current value of the debt if the discount rate is 8
percent?
A) $27.78
B) $27.50
C) $30.00
D) $26.67
E) $28.40
44) Assume CRT debtholders are promised payments in one year of $35 if the firm does well
and $20 if the firm does poorly. There is a 50/50 chance of the firm doing well or poorly. If
debtholders are willing to pay $25.50 today to purchase this debt, what is the promised return to
those debtholders?
A) 7.3 percent
B) 6.8 percent
C) 1.7 percent
D) 7.8 percent
E) 8.2 percent
45) Adept Inc. is currently valued at $145,700 in a boom and $75,200 in a recession. The chance
of either economic state occurring is 50 percent. The firm owes $85,000 to its debt holders. What
is the value of the firm to the shareholders in a recession?
A) $22.50
B) $55.00
C) $27.50
D) −$10.00
E) $0
46) AZC Company is currently valued at $300 in a boom and $160 otherwise. The chance of a
boom is 35 percent. What is the value of the firm to the shareholders if the firm owes $200 to its
debtholders?
A) $0
B) $35
C) $27.50
D) $209
E) $9
47) LDL Transport is subject to claims from four parties as follows: tax claims = $6,740;
bondholder claims = $28,520; bankruptcy claims = $4,300; and shareholder claims = $33,190.
What is the total value of the marketed claims?
A) $61,710
B) $33,190
C) $72,750
D) $39,560
E) $66,010
48) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the next year to Mary if she issues stock to another individual, remains open 6 days a week,
and distributes all the residual cash flow to the shareholders?
A) $58,750
B) $61,333
C) $92,000
D) $42,000
E) $69,000
49) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the year to Mary if she issues debt, remains open 5 days a week, and distributes all the
residual cash flow to the shareholders?
A) $46,125
B) $61,500
C) $65,000
D) $71,500
E) $67,880
50) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid in
equal annual payments at the end of the next five years. Ignore taxes. What will be the cash flow
for the next year to Mary if she issues stock to another individual, remains open 5 days a week,
and distributes all the residual cash flow to the shareholders?
A) $92,000
B) $61,333
C) $69,000
D) $42,000
E) $56,250
51) Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop
open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to
$92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling
stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid at the
end of the fifth year. Ignore taxes. What will be the cash flow for this year to Mary if she issues
debt, remains open 6 days a week, and distributes all the residual cash flow to the shareholders?
A) $46,125
B) $88,500
C) $65,000
D) $71,500
E) $81,500
52) Allison’s requires $180,000 to fund a new project next year. The firm expects to earn excess
cash of $68,000 this year after all expenses, taxes, and dividends are paid. The firm can borrow
up to $150,000 at 6.5 percent interest for up to ten years or, it can issue up to 25,000 new shares
of stock that will have an estimated value of $35 a share at the end of this year. According to the
pecking-order theory, how much will the firm raise in new equity capital to fund this project?
A) $0
B) $30,000
C) $112,000
D) $90,000
E) $180,000
53) Assume the corporate tax rate is 22 percent, the personal tax rate on interest income is 15
percent, and the personal tax rate on dividends is 10 percent. Also assume the firm earns $5 per
share in taxable income and pays out 40 percent of its earnings. How much will a shareholder
receive per share in aftertax income?
A) $1.470
B) $1.782
C) $1.096
D) $1.232
E) $1.404
54) Assume BJ Companies is indifferent between issuing equity and issuing debt. Assume the
corporate tax rate is 21 percent and dividends are taxed at the personal level at 20 percent. What
is the personal tax on interest income?
A) 20 percent
B) 42 percent
C) 40 percent
D) 14 percent
E) 37 percent
55) The All-Mine Corporation is deciding whether to invest in a new one-year project. The
project would have to be financed by equity, the cost is $2,000, and the return will be a
guaranteed $2,500 in one year. The discount rate for both bonds and stock is 15 percent and the
tax rate is zero. The predicted cash flows excluding this new project are $4,500 in a good
economy, $3,000 in an average economy, and $1,000 in a poor economy. Each economic
outcome is equally likely to occur and the promised debt repayment is $3,000. Should the
company take the project? What is the value of the firm and its debt and equity components
before and after the project addition?
56) Wigdor Manufacturing is currently all-equity financed, has an EBIT of $2 million and has a
corporate tax rate of 21 percent. Louis, the company’s founder, is the lone shareholder. All
earnings are paid out as dividends to Louis. If the firm were to convert $4 million of equity into
debt at a cost of 10 percent, what would be the total cash flow from the firm to Louis if he holds
all the debt? Compare this to Louis’ total cash flow if the firm remains unlevered.
57) What is the pecking order theory and what are the implications that arise from this theory?
58) Wigdor Manufacturing is currently all-equity financed, has an EBIT of $2 million and has a
corporate tax rate of 21 percent. Louis, the company’s founder, is the lone shareholder. All
earnings are paid out as dividends to Louis. If the firm were to convert $4 million of equity into
debt, the cost would be 10 percent and Louis would hold all the debt. Assume Louis pays
personal taxes on interest income at a rate of 37 percent but pays taxes on dividends at a rate of
20 percent. Calculate the total cash flow to Louis after he pays personal taxes if the firm is
unlevered and if it is levered.
59) Is there an easily quantifiable debt-equity ratio that will maximize the value of a firm? Why
or why not?
60) Describe some of the sources of business risk and financial risk. Do financial decision
makers have the ability to “trade off” one type of risk for another type of risk?