Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 1
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
1. A decrease in the debt-to-assets ratio will generally have no effect on ____ risk.
a.
Financial
b.
Total
c.
Business
d.
Systematic, or market
e.
None of the above (it will affect each type of risk above).
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Business Risk
2. Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a part
of) business risk?
a.
Demand variability.
b.
Sales price variability.
c.
The extent to which operating costs are fixed.
d.
Changes in required returns due to financing decisions.
e.
The ability to change prices as costs change.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Business Risk
3. Which of the following statements is correct?
a.
A firm’s business risk is solely determined by the financial characteristics of its industry.
b.
The factors which affect a firm’s business risk are determined partly by industry characteristics and partly by
economic conditions. Unfortunately, these and other factors which affect a firm’s business risk are not subject
to any degree of managerial control.
c.
One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes
much less important.
d.
The firm’s financial risk may have both market risk and diversifiable risk components.
e.
The above statements are all false.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 3
d.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Optimal Capital Structure
7. The firm’s target capital structure is consistent with which of the following?
a.
Maximum earnings per share.
b.
Minimum cost of debt (rd).
c.
Minimum risk.
d.
Minimum cost of equity (rs).
e.
Minimum weighted average cost of capital.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Target Capital Structure
8. The most commonly held view of capital structure, according to the text, is that the weighted average cost of capital
a.
First falls with moderate levels of leverage and then increases.
b.
Does not change with leverage.
c.
Increases proportionately with increases in leverage.
d.
Increases with moderate amounts of leverage and then falls.
e.
None of the above.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Capital Structure and WACC
9. Empirical testing has confirmed the validity of which of the following attitudes concerning dividends?
a.
Dividend irrelevance, or Modigliani-Miller, theory.
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 4
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
b.
Investors prefer dividends to capital gains because dividends are more certain.
c.
Investors prefer capital gains to dividends because capital gains are taxed at more favorable rates.
d.
Empirical testing has produced some evidence in support of each of the theories above.
e.
Empirical testing has not produced any definitive results.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividend Theories
10. In the real world, we find that dividends
a.
Usually exhibit greater stability than earnings.
b.
Fluctuate more widely than earnings.
c.
Tend to be a lower percentage of earnings for mature firms.
d.
Are usually changed every year to reflect earnings changes.
e.
Are usually set as a fixed percentage of earnings.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividend Payout
11. A decrease in a firm’s willingness to pay dividends might result from an increase in its
a.
Earnings stability.
b.
Access to capital markets.
c.
Profitable investment opportunities.
d.
Collection of accounts receivable.
e.
Stock price.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividend Payout
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 5
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12. Which of the following types of dividends is (are) never paid out in the form of cash?
a.
Regular dividend.
b.
Stock dividend.
c.
Extra dividend.
d.
Liquidating dividend.
e.
All of the above are paid in the form of cash.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Types of Dividends
13. Which of the following would not have an influence on the optimal dividend policy?
a.
The possibility of accelerating or delaying investment projects.
b.
A strong shareholders’ preference for current income versus capital gains.
c.
Bond indenture constraints.
d.
The costs associated with selling new common stock.
e.
All of the above can have an effect on dividend policy.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Optimal Dividend Policy
14. As a general rule, the capital structure that
a.
Maximizes expected EPS also maximizes the price per share of common stock.
b.
Minimizes the interest rate on debt also maximizes the expected EPS.
c.
Minimizes the required rate on equity also maximizes the stock price.
d.
Maximizes the price per share of common stock also minimizes the weighted average cost of capital.
e.
None of the above.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 7
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Financial Risk
18. The “Pure Modigliani and Miller Result” establishes, under restrictive assumptions, that the firm’s stock price will be
maximized if it uses virtually 100 percent debt. Which of the following real world conditions does the most to limit real
world corporate debt-to-assets ratios to far less than 100 percent?
a.
There are brokerage costs.
b.
At high levels of debt revenues decline.
c.
Investors can’t really borrow at the same rate as corporations.
d.
Interest rates increase as the debt-to-assets ratio rises.
e.
Dividends are relevant in the real world.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
MM and Real World Debt-to–Assets Ratios
19. If you know that your firm is facing relatively poor prospects but needs new capital, and you know that investors do
not have this information, signaling theory would predict that you would
a.
Issue debt to maintain the returns of equity holders.
b.
Issue equity to share the burden of decreased equity returns between old and new shareholders.
c.
Be indifferent between issuing debt and equity.
d.
Postpone going into capital markets until your firm’s prospects improve.
e.
Convey your inside information to investors using the media to eliminate the information asymmetry.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Signaling Theory Predictions
20. Which of the following statements is correct?
a.
When financial leverage is used, the graphical probability distribution of net income would tend to be more
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 8
peaked than a distribution where no leverage is present, other things held constant.
b.
From an operational standpoint the goal of maintaining financial flexibility translates into maintaining
adequate reserve borrowing capacity.
c.
While business risk varies from one industry to another and can change over time, it affects all firms equally
within a particular industry.
d.
The optimal capital structure is the one that maximizes EBIT, and this always calls for a debt-to-assets ratio
which is lower than the one that maximizes expected EPS.
e.
The above statements are all false.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous Concepts
21. Which of the following statements is correct?
a.
“Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of
debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and
operating leverage.
b.
If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller
tradeoff theory of capital structure were correct, then corporations should tend to increase their use of debt.
c.
If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller
tradeoff theory of capital structure were correct, then corporations should tend to decrease their use of debt.
d.
The optimal capital structure is the one which (1) maximizes the price of the firm’s stock, (2) minimizes its
WACC, and (3) maximizes its EPS.
e.
Statements b and d are both correct.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous Concepts
22. If you were to argue that the firm’s cost of equity, rs, increases as the dividend payout decreases, you would be making
an argument ____ with MM’s dividend irrelevance theory, and ____ with the theory that investors prefer dividends
received in the current period rather than capital gains received in the future.
a.
consistent; consistent
b.
inconsistent; consistent
c.
consistent; inconsistent
d.
inconsistent; inconsistent
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 9
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
e.
The argument above does not make sense; neither theory involves the cost of equity capital.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividend Theories
23. If the Modigliani and Miller hypothesis about dividends is correct, and if one found a group of companies which
differed only with respect to dividend policy, which of the following statements would be most correct?
a.
The residual dividend model should not be used, because it is inconsistent with the MM dividend hypothesis.
b.
The total expected return, which in equilibrium is also equal to the required return, would be higher for those
companies with lower payout ratios because of the greater risk associated with capital gains versus dividends.
c.
If the expected total return of each of the sample companies were divided into a dividend yield and a growth
rate, and then a scatter diagram (or regression) analysis were undertaken, then the slope of the regression line
(or b in the equation D1/P0 = a + b(g)) would be equal to +1.0.
d.
None of the above statements is true.
e.
All of the above statements are true.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
MM Dividend Theory
24. Which of the following statements is correct?
a.
If the dividend irrelevance theory (which is associated with the names Modigliani and Miller) were exactly
correct, and if this theory could be tested with “clean” data, then we would find, in a regression of dividend
yield and capital gains, a line with a slope of −1.0.
b.
The tax preference and bird-in-the-hand theories lead to identical conclusions as to the optimal dividend
policy.
c.
If a company raises its dividend by an unexpectedly large amount, the announcement of this new and higher
dividend is generally accompanied by an increase in the stock price. This is consistent with the bird-in-the–
hand theory, and Modigliani and Miller used these findings to support their position on dividend theory.
d.
If it could be demonstrated that a clientele effect exists, this would suggest that firms could alter their dividend
payment policies from year to year to take advantage of investment opportunities without having to worry
about the effects of changing dividends on capital costs.
e.
Each of the above statements is false.
ANSWER:
a
RATIONALE:
The dividend irrelevance theory is MM’s theory. Dividend relevance suggests that there
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 11
a.
The equilibrium return, rs, will not be affected by a change in dividend policy because tax effects will offset
these preferences.
b.
rs will decrease as dividends are reduced.
c.
rs will increase as dividends are reduced.
d.
rs will decrease as the retention rate increases.
e.
Dividend policy as determined by the residual dividend model is the only dividend policy which will
maximize the price per share of common stock.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividends versus Capital Gains
28. Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, others, such as Gordon and
Lintner (GL), argued that dividend policy does matter. GL’s argument rests on the contention that
a.
rs = /P0 + g is constant for any dividend policy.
b.
Because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of
expected capital gains.
c.
Investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of
dividends.
d.
Most investors will reinvest rather than spend dividends, so it would save investors’ money (taxes) if
corporations simply reinvested earnings rather than paid them out as dividends.
e.
None of the above.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Dividends versus Capital Gains
29. Which of the following statements is correct?
a.
A key advantage of the residual dividend policy is that it usually results in a stable dividend policy which is
attractive to investors.
b.
Investors should prefer that a corporation repurchase its common stock when the stock is overpriced.
c.
A reduction in the capital gains rate should work to discourage corporations from repurchasing their shares.
d.
The theory that investors prefer dividends rather than capital gains suggests that firms that increase their
dividend payout should expect to realize a higher share price and a lower cost of equity capital.
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 12
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
e.
Answers c and d are both correct.
ANSWER:
d
RATIONALE:
Statement a is false because a residual dividend policy results in unstable dividends.
Statement b is false because management is reducing firm value per share in this
situation. Statement c is false because a reduction in the capital gains rate increases the
after-tax proceeds of selling shares to the company. Thus, the company can distribute
funds to shareholders via share repurchases more easily.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous Concepts
30. Which of the following statements is correct?
a.
There have been no significant observed differences in the capital structures of U.S. corporations in
comparison to their German and Japanese counterparts.
b.
Different countries use essentially the same international accounting conventions with respect to reporting
assets on a historical versus replacement cost basis.
c.
An analysis of both bankruptcy and equity reporting costs leads to the conclusion that U.S. firms should have
more equity and less debt than firms in Japan and Germany.
d.
Equity monitoring costs are higher in the United States than in Japan and Germany.
e.
Debt monitoring costs are probably lower in the United States than in Japan and Germany.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
International Capital Structures
31. Which of the following is correct?
a.
Generally, debt to total assets ratios do not vary much among different industries although they do vary for
firms within a particular industry.
b.
Utilities generally have very high common equity ratios due to their need for vast amounts of equity supported
capital.
c.
The drug industry has a high debt to common equity ratio because their earnings are very stable and thus, can
support the large interest costs associated with higher debt levels.
d.
Wide variations in capital structures exist between industries and also between individual firms within
industries and are influenced by unique firm factors including managerial attitudes.
e.
Since most stocks sell at or around their book values, using accounting values provides an accurate picture of a
firm’s capital structure.
ANSWER:
d
Principles of Finance, 6e
Besley/Brigham
Chapter 14
ANSWER:
a
RATIONALE:
Old debt–to-assets ratio = 0.3333; New debt–to-assets ratio = 0.1667. Sales TA = 7.5
Debt = 0.3333($100,000) = $33,330. New TA = $100,000 +
$100,000 = $200,000. New Debt = $200,000(0.1667) = $33,340. Altman‘s current debt of
$33,330 represents approximately 16.67% of total assets following the expansion, thus
the firm should finance with 100 percent equity.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-1 – Analyzing
Business Program-3 – Analytic
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
New Financing
34. Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm has 10,000 shares outstanding, it pays
12 percent interest on its debt, and it faces a 40 percent marginal tax rate. Its estimated fixed costs are $80,000 while its
variable costs are estimated at 40 percent of revenue. The firm’s target capital structure is 40 percent equity and 60 percent
debt and it has total assets of $400,000. On what level of sales is Howell basing its EPS forecast?
a.
$1,000,000
b.
$480,400
c.
$316,722
d.
$292,445
e.
$105,280
ANSWER:
d
RATIONALE:
Step 1:
Calculate interest expense
Debt = 0.60 × $400,000 = $240,000.
Interest = 0.12 × $240,000 = $28,800.
= 0.40S + $95,467 + $80,000
Principles of Finance, 6e
Besley/Brigham
Chapter 14
c.
$64.8
d.
$86.4
e.
$108.0
ANSWER:
d
a.
15%
b.
20%
c.
25%
d.
30%
e.
35%
ANSWER:
c
RATIONALE:
Capital budget = $20 million. Optimal capital structure: 60% equity, 40% debt. EBIT =
$34.667 million. Assets = $200 million. rd = 10%; T = 40%. Dividend Payout = ? Debt =
0.40($200 million) = $80 million. Interest = 0.10($80 million) = $8 million.
EBIT
$34.667
INT
(8.000)
EBT
$26.667
Taxes (40%)
(10.667)
NI
$16.000
Capital Budget = $20 million. Equity needed = 0.60($20 million) = $12 million.
NI
$16
Equity needed
(12)
Amount remaining for
dividend
$ 4
Dividend Payout = $4/$16 = 25%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-1 – Analyzing
Business Program-3 – Analytic
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Residual Dividend Model
39. The following facts apply to your company:
Target capital structure:
50% debt; 50% equity
EBIT:
$200 million
Assets:
$500 million
Tax rate:
40%
Cost of new and old debt:
8%
Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will the capital
budget be?
a.
$43.2
Principles of Finance, 6e
Besley/Brigham
Chapter 14
Cengage Learning Testing, Powered by Cognero
Page 18
EBT
= EBIT − I
= $200 − $20 = $180.
NI
= $180 − Taxes
= $180 − $180(0.4) = 0.6($180) = $108 million.
Dividends = $108(0.6) = $64.80 million. Retained earnings = NI − D = $108.00 − $64.80 =
$43.20 million. Half of the capital budget will be debt, half common equity from retained
earnings, so the capital budget will be:
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-1 – Analyzing
Business Program-3 – Analytic
DISC-FIN-07 – Finance Function
Time Estimate-a – 5 min.
TOPICS:
Residual Dividend
Capital Budget
40. Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm’s capital structure consists of 40 percent
debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays
a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next
capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this
project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other
projects, what is its expected dividend payout ratio?
a.
100%
b.
60%
c.
40%
d.
20%
e.
0%
ANSWER:
d
RATIONALE:
EBIT
$2,000,000
Interest
(500,000)
($5,000,000 × 10%)
EBT
$1,500,000
Taxes
(600,000)
($1,500,000 × 40%)
