Chapter 13: Capital Structure and Leverage
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1. A firm’s business risk is largely determined by the financial characteristics of its industry, especially by the amount of
debt the average firm in the industry uses.
a. True
b. False
2. Financial risk refers to the extra risk borne by stockholders as a result of a firm’s use of debt as compared with their risk
if the firm had used no debt.
a. True
b. False
3. A firm’s capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating
cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.
a. True
b. False
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a. True
b. False
10. Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.
a. True
b. False
11. Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect
on a firm’s value.
a. True
b. False
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a. True
b. False
18. According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls
for approximately 100% debt financing.
a. True
b. False
19. According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on
the firm’s value.
a. True
b. False
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25. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were
assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm
has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm’s
optimal debt ratio.
a. True
b. False
26. Some people—including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke) —have
argued that one advantage of corporate debt from the stockholders’ standpoint is that the existence of debt forces managers
to focus on cash flow and to refrain from spending too much of the firm’s money on private plane and other “perks.” This
is one of the factors that led to the rise of LBOs and private equity firms.
a. True
b. False
27. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the
same information about a firm’s future prospects as its managers. That was called “symmetric information,” and it is
questionable. The introduction of “asymmetric information” led to the development of the “signaling” theory of capital
structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a
signal that the firm’s managers are worried about its future. Other actions give off different signals, and the end result is
that capital structure is affected by managers’ perceptions about how their financing decisions will affect investors’ views
of the firm and thus its value.
a. True
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b. False
28. According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if
and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to
investors that the firm’s managers think that the future does not look good.
a. True
b. False
29. Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less
stable sales.
a. True
b. False
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37. Which of the following statements is CORRECT?
a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
c. The capital structure that minimizes the required return on equity also maximizes the stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
e. The capital structure that gives the firm the best bond rating also maximizes the stock price.
38. Based on the information below, what is the firm’s optimal capital structure?
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.
39. Which of the following statements best describes the optimal capital structure?
a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s
earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock
price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of
equity.
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d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of
debt.
e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of
preferred stock.
40. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held
constant?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the company’s operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company’s stock price hits a new high.
41. Which of the following would tend to increase a firm’s target debt ratio, other things held constant?
a. The costs associated with filing for bankruptcy increase.
b. The corporate tax rate is increased.
c. The personal tax rate is increased.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company’s stock price hits a new low.
