Chapter 14—CAPITAL STRUCTURE POLICY: THEORY AND PRACTICE
MULTIPLE CHOICE
1. In analyzing the value of the firm as a function of capital structure, the present value of the tax shield
benefit is offset by the present value of the expected ____, resulting in an interior optimal capital
structure.
a.
financial distress costs
b.
agency costs
c.
holding costs
d.
financial distress and agency costs
2. The Modigliani-Miller theory that the value of the firm is independent of its capital structure is based
on a(n) ____ process.
a.
reinvestment
b.
capital asset pricing model
c.
arbitraging
d.
compound interest
3. Two prominent finance researchers (Modigliani and Miller) showed that
a.
the firm’s optimal capital structure consists of approximately equal proportions of debt and
equity
b.
the value of the firm is independent of its capital structure in perfect capital markets with
no income taxes
c.
the firm’s cost of capital is minimized when its capital structure consists of approximately
equal proportions of debt and equity
d.
the value of the firm is independent of its capital structure in perfect capital markets with
income taxes
4. Perfect capital markets imply the following:
a.
there are no transactions costs for buying and selling securities
b.
relevant information is readily available for individuals and is costless to obtain
c.
all investors can borrow and lend at the same rate
d.
All of these answers are correct.
5. With an optimal capital structure
a.
overall capital costs are minimized
b.
the net present value of new projects is minimized
c.
financial leverage is minimized
d.
both overall capital costs and financial leverage are minimized
6. Holding all other things equal, as the relative amount of debt in the capital structure of the firm
increases, the cost of equity capital will
a.
increase
b.
decrease
c.
remain unchanged; there is no relationship between the two
d.
initially rise rapidly, then increase slowly beyond some point
7. As more debt is added to the capital structure of a firm, the cost of debt capital
a.
initially rises slowly, then falls beyond some point
b.
increases at a steady rate throughout the entire range
c.
beyond some point, becomes greater than the cost of equity
d.
initially rises slowly, then increases rapidly beyond some point
8. Which of the following statements is (are) true concerning the relationship between the firm’s cost of
debt and its capital structure (as measured by the debt ratio)?
a.
The range of debt ratios where the cost of debt begins to increase rapidly varies by firm
and industry, depending on the level of business risk.
b.
The precise relationship between the cost of debt and the debt ratio is simple to determine.
c.
The relationship is a saucer-shaped curve.
d.
a and b only
9. Which of the following statements is (are) true concerning the relationship between the firm’s cost of
equity and its capital structure (as measured by the debt ratio)?
a.
The exact relationship between the cost of equity and the debt ratio is difficult to
determine.
b.
The range of debt ratios where the cost of equity begins to increase rapidly varies by firm
and industry depending on the firm’s age.
c.
The relationship is a saucer-shaped curve.
d.
a and b only
10. The mix of debt, preferred stock, and common equity that minimizes the weighted cost of capital to the
firm is known as the
a.
optimal corporate structure
b.
target financial structure
c.
optimal capital structure
d.
optimal degree of combined leverage
11. The optimal capital structure is determined by several factors including all of the following except:
a.
corporate capital gains
b.
business risk
c.
potential bankruptcy risk
d.
agency costs
12. One of the primary assumptions of capital structure analysis is that the level and variability of ____ is
not expected to change as changes in capital structure are contemplated.
a.
net income
b.
earnings before taxes
c.
operating income
d.
debt
13. Generally the ____ a firm’s business risk, the ____ the amount of financial leverage that will be used in
the optimal capital structure.
a.
greater, greater
b.
smaller, less
c.
greater, less
d.
none of the above is correct
14. The objective of capital structure management is to find the capital mix that leads to
a.
maximization of earnings per share
b.
shareholder wealth maximization
c.
maximization of net income
d.
maximization of the current period’s dividends
15. Financial leverage benefits shareholders when the
a.
return on assets is greater than the cost of debt
b.
return on equity is greater than the cost of debt
c.
return on investments is less than the weighted cost of capital
d.
cost of debt is greater than the return on equity
16. Modigliani and Miller show that the value of a firm is ____ capital structure given perfect capital
markets and no corporate income taxes.
a.
maximized by having no debt in the
b.
independent of
c.
maximized by having an optimal
d.
dependent on the
17. Due to both financial distress and agency costs, a firm should have a capital structure that
a.
contains all debt
b.
contains all equity
c.
contains both debt and equity
d.
contains only long-term debt
18. Agency costs
a.
increase as the debt/total assets ratio decreases
b.
affect the present value of the tax shield
c.
decrease as financial distress increases
d.
reduce the market value of the levered firm
19. Protection for debt holders takes the form of protective covenants in the bond indenture. These
covenants place restrictions on which of the following activities?
a.
the sale of assets
b.
payment of dividends
c.
the issuance of additional debt
d.
all of these are typical protective covenants
20. As the proportion of debt in the capital structure increases, investors require a ____ return and the
value of existing debt will ____.
a.
higher, increase
b.
higher, decrease
c.
lower, increase
d.
lower, decrease
21. Investors’ required returns and the cost of equity capital ____ as the relative amount of debt used to
finance the firm ____.
a.
increase, increases
b.
increase, decreases
c.
remain constant, increases
d.
remain constant, decreases
22. Studies of capital structure changes have found that actions that increase leverage have generally been
associated with ____ stock returns, and actions that decrease leverage are associated with ____ stock
returns.
a.
negative, positive
b.
negative, no change in
c.
positive, negative
d.
no change in, positive
23. The managerial implications of capital structure theory include all of the following except:
a.
capital structure changes transmit important information to investors
b.
changes in capital structure result in changes in the market value of the firm’s equity
c.
optimal capital structure is influenced heavily by the business risk facing the firm
d.
tax shield benefits from equity lead to increased firm value
24. The optimal capital structure of a firm is a function of the ____.
a.
business risk of the firm
b.
tax structure
c.
business risk and tax structure of the firm
d.
bankruptcy costs
25. The market value of a levered firm can be represented by the following equation:
Market value of levered firm = Market value of unlevered firm ____ Present value of tax shield ____
Present value of financial distress costs ____ Present value of agency costs
a.
minus; plus; plus
b.
plus; plus; plus
c.
plus; minus; minus
d.
minus, minus, plus
26. The optimal capital structure is a function of ____.
a.
corporate income taxes
b.
financial distress costs
c.
agency costs
d.
All of these are correct.
27. According to the “pecking order theory,” firms prefer to issue ____ securities first and then issue ____
securities as a last resort.
a.
equity, debt
b.
debt, convertible debt
c.
debt, equity
d.
equity, convertible debt
28. ____ refers to the argument that officers and managers have access to information about the expected
future earnings of the firm that is not available to outside investors.
a.
Insider trading
b.
Asymmetric information
c.
Signaling effect
d.
Pecking order theory
29. A survey of Fortune 500 firms indicate that they prefer internal financing (retained earnings) to
external financing. This preference is known as ____.
a.
financial slack
b.
the pecking order theory
c.
capital structure theory
d.
asymmetric capital
30. A firm with highly liquid assets plus unused debt capacity is said to have ____.
a.
arbitrage structural capacity
b.
the optimal capital structure
c.
financial slack
d.
optimal financial structure
31. The management of Graphicopy is trying to determine how much debt they should have in their capital
structure. If they sell $500,000 in perpetual bonds with a 9 percent coupon, what would be the present
value of the tax shield? Assume the marginal tax rate is 35%.
a.
$15,750
b.
$29,250
c.
$175,000
d.
$45,000
32. What is the annual tax shield to a firm that has a capital structure consisting of $100 million of debt
and $180 million of equity, if the average interest rate on debt is 9%, the return on equity is 13%, and
the marginal tax rate is 40%?
a.
$9.0 million
b.
$5.4 million
c.
$9.36 million
d.
$3.6 million
33. What is the present value of the tax shield to a firm that has a capital structure consisting of $100
million of perpetual debt and $180 million of equity, if the average interest rate on debt is 9%, the
return on equity is 13%, and the marginal tax rate is 40%?
a.
$72 million
b.
$40 million
c.
$60 million
d.
$3.6 million
34. Calculate the market value of Lotle Group, a firm with total assets of $80 million and $30 million of
perpetual debt in its capital structure. The firm’s cost of equity is 14% and the cost of debt is 9%. Lotle
expects annual, perpetual net operating income (EBIT) of $9 million and a marginal tax rate of 40%.
a.
$30 million
b.
$61.3 million
c.
$57 million
d.
$64.3 million
35. What is the annual tax shield to a firm that has total assets of $80 million and a net worth of $55
million, if the average interest rate on debt is 8.5%, the average return on equity is 14%, and the
marginal tax rate is 35%?
a.
$2.125 million
b.
$1.87 million
c.
$0.85 million
d.
$0.744 million
36. What is the present value of the tax shield to a firm that has total assets of $80 million and a net worth
of $55 million, if the average interest rate on perpetual debt is 8.5%, the average return on equity is
14%, and the marginal tax rate is 35%?
a.
$8.75 million
b.
$12.25 million
c.
$0.85 million
d.
$0.744 million
37. Calculate the market value of a firm with total assets of $60 million and a net worth of $35 million.
The firm’s cost of equity is 15% and the cost of perpetual debt is 8%. The firm has a perpetual net
operating income (EBIT) of $4.5 million and a marginal tax rate of 35%.
a.
$41.67 million
b.
$30.00 million
c.
$35.83 million
d.
$30.83 million
38. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10
million shares) and debt ($150 million, 8%). The company is planning a major expansion and is
undecided between two financing plans.
Plan A:
Equity financing. Under this plan, an additional 2.5 million shares of common stock
will be sold at $15 each.
Plan B:
Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.
What is the EBIT-EPS indifference point? Assume a 40 percent marginal tax rate.
a.
$33.9 million
b.
$30.75 million
c.
$37.0 million
d.
$70.9 million
39. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10
million shares) and debt ($150 million, 8%). The company is planning a major expansion and is
undecided between two financing plans.
Plan A:
Equity financing. Under this plan, an additional 2.5 million shares of common stock
will be sold at $15 each.
Plan B:
Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.
What happens to the EBIT indifference point if the interest rate on the new debt decreases and the
common stock price remains constant?
a.
the indifference point increases
b.
the indifference point decreases
c.
the indifference point does not change
d.
cannot be determined
40. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except
that the two companies differ in their capital structures, as shown below:
Jefferson
Debt (10%)
$200 million
Common equity
$300 million
No. shares outstanding
15 million
Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the
EPS for Jefferson at an EBIT level of $50 million?
a.
$-1.20
b.
$ 1.20
c.
$ 2.20
d.
$ 3.33
41. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except
that the two companies differ in their capital structures, as shown below:
Jefferson
Debt (10%)
$200 million
Common equity
$300 million
No. shares outstanding
15 million
Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the
EPS for Jackson at an EBIT level of $50 million?
a.
$1.50
b.
$1.20
c.
$2.00
d.
$2.50
42. Alace is an all equity firm with 10 million shares outstanding that is evaluating two alternative
financing plans. With the first plan, Alace will sell 1 million shares of common stock at $15 each.
Under the second plan, the firm would sell $15 million of 12 percent long-term debt. If Alace has a
marginal tax rate of 35 percent, what is the EBIT-EPS indifference point?
a.
$12.9 million
b.
$19.8 million
c.
$11.7 million
d.
$8.4 million
43. Knight Moves is considering two alternative financing plans. The firm is expected to operate at the
$75 million EBIT level. Under Plan D (debt financing) EPS is expected to be $2.25, and under Plan E
(equity financing) EPS is expected to be $1.82. If the market is expected to assign a P/E ratio of 12 to
the debt plan and 15 to the equity plan, which plan should Knight pursue?
a.
debt
b.
equity
c.
indifferent between the two alternatives
d.
neither is satisfactory
44. What is the market value of Barings, a firm with total assets of $100 million and $30 million in
perpetual debt in its capital structure? Barings’ cost of equity is 15% and its cost of debt is 10%.
Expected perpetual net operating income (EBIT) will be $17 million and the marginal tax rate is 40%.
a.
$86.0 million
b.
$104.0 million
c.
$98.0 million
d.
$92.7 million
45. Calculate the market value of a firm with total assets of $105 million and $50 million of 10% perpetual
debt in the capital structure. The firm’s cost of equity is 14% on the $55 million in equity in the capital
structure. The perpetual EBIT is expected to be $9 million and the marginal tax rate is 40%.
a.
$88.6 million
b.
$67.1 million
c.
$114.3 million
d.
$78.6 million
46. RoTek has a capital structure of $300,000 in equity and $300,000 in perpetual debt. The firm’s cost of
equity is 14 percent and its cost of debt is 9 percent. If the firm has an expected, perpetual net
operating income of $120,000 and a marginal tax rate of 40 percent, what is the market value of
RoTek? Assume all net income is paid out as dividends.
a.
$698,571
b.
$814,286
c.
$818,571
d.
$489,000
47. Feldspar Inc. is considering the capital structure for a new division. Management has been given the
following cost information:
Debt/assets
kd
ke
.30
.10
.125
.40
.105
.13
.50
.11
.135
.60
.117
.142
.70
.13
.155
Based on this information, what capital structure (debt/asset ratio) should management accept?
Assume the marginal tax rate is 40%.
a.
40% has lowest cost of capital
b.
50% has lowest cost of capital
c.
60% has lowest cost of capital
d.
70% has lowest cost of capital
0.3(0.10)(0.6) + 0.7(0.125) = 0.1055
0.4(0.105)(0.6) + 0.6(0.13) = 0.1032
0.5(0.11)(0.6) + 0.5(0.135) = 0.1005
0.6(0.117)(0.6) + 0.4(0.142) = 0.0989
0.7(0.13)(0.6) + 0.3(0.155) = 0.1011
48. Seduak has estimated the costs of debt and equity capital for various proportions of debt in its capital
structure:
% of Debt
Cost of Debt
Cost of Equity
0%
–
13.0%
10
5.4%
13.3
20
5.4
13.8
30
5.8
14.4
40
6.3
15.2
50
7.0
16.0
60
8.2
17.0
Based on these estimates, determine Seduak’s optimal capital structure.
a.
30% debt
b.
40% debt
c.
50% debt
d.
60 % debt
49. Technico has determined that its optimal capital structure is 40% debt, at which point its weighted cost
of capital, ka, is 13.7%. Due to financial problems, the firm has decided to raise the proportion of debt
to 50%, which will increase its weighted cost of capital to 14.4%. What is the effect on the stock price
of Technico? The current dividend is $1.60 and the long-term growth rate of dividends is expected to
be 8.5%.
a.
Decrease $3.65
b.
Decrease $3.96
c.
Increase $3.65
d.
Increase $3.96
50. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital
structure:
% of Debt
Cost of Debt
Cost of Equity
35
5.4%
13.8%
40
5.6
14.0
45
5.9
14.3
50
6.4
14.7
Based on these estimates, determine Biotec’s optimal capital structure.
a.
35% debt
b.
40% debt
c.
45% debt
d.
50% debt
51. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital
structure:
% of Debt
Cost of Debt
Cost of Equity
35
5.4%
13.8%
40
5.6
14.0
45
5.9
14.3
50
6.4
14.7
If Biotec pays a current dividend of $1.00 and expects dividends to grow at a constant rate of 7%, what
is Biotec’s stock price if it obtains its optimal capital structure?
a.
$14.66
b.
$30.40
c.
$30.14
d.
$29.40
52. Triad Labs has total assets of $120 million and $40 million of debt in its capital structure. Its current
cost of equity is 13% and its cost of debt is 8.5%. Triad is considering increasing its debt to $70
million and purchasing its own stock with proceeds from the sale of $30 million in debt with a cost of
9.5%, reducing equity to $50 million. The cost of equity will increase to 14.5%. Net operating income
(EBIT) will remain at $12 million. If Triad has a marginal tax rate of 40%, should the firm increase its
debt? Assume that both debt and EBIT are perpetual.
a.
No, the value of the firm decreases $15.9 million
b.
No, the value of the firm decreases $30.0 million
c.
Yes, the value of the firm increases $14.1 million
d.
Yes, the value of the firm increases $30.0 million
53. Dagger Company has a current capital structure consisting of $60 million in long-term debt with an
interest rate of 9% and $60 million in common equity (12 million shares). The firm is considering an
expansion plan costing $23 million. The expansion plan can be financed with additional long-term
debt at a 12% interest rate or the sale of new common stock at $8 per share. The firm’s marginal tax
rate is 40%. Determine the indifference level of EBIT for the two financing plans.
a.
-$30.24 million
b.
$18.36 million
c.
$30.24 million
d.
$19.68 million
54. Sulzar’s capital structure consists only of common stock (20 million shares), but the firm is planning a
major expansion which will require $100 million of new capital. Sulzar has a choice of obtaining the
needed capital through the sale of 5 million shares of common stock at $20 per share or the sale of
$100 million of first mortgage bonds that would have a coupon rate of 9%. If Sulzar has a marginal tax
rate of 40%, calculate the EBIT-EPS indifference point.
a.
$45 million
b.
$36 million
c.
$5 million
d.
$9 million
55. Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share.
Higgins also has a $20 million mortgage bond outstanding that has an 11 percent coupon rate. Higgins
is considering two alternatives to financing a major expansion. Plan A is to sell $10 million of
additional long-term debt with a 12.5 percent coupon. Plan B is to sell 200,000 shares of common
stock at $30 per share and $4 million in long-term debt with a 11.25 percent coupon. What is the EBIT
indifference level between these two alternatives? Assume the marginal tax rate is 40 percent.
a.
$1,374,000
b.
$11,450,000
c.
$4,554,000
d.
$9,409,000
56. Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an
average EBIT of $3 million per year. To finance this new plant, Midwest is considering two financing
plans. The first plan is to sell 600,000 shares of common stock at $15 each. The second plan is to sell
200,000 shares of common stock at $15 each and $6 million of 13 percent long-term debt. If Midwest
has a marginal tax rate of 40 percent, what is the EBIT-EPS indifference point for this plant?
a.
$702,000
b.
$234,000
c.
$2,234,000
d.
$1,170,000
57. Jocko Inc. has a capital structure that consists of 60% common equity (2.0 million shares), 30% long-
term debt ($10 million with 12% coupon), and 10% preferred stock ($50 par value with $4.75
dividend). The company is planning a major plant expansion and is undecided between the following
two financing plans:
1. Equity financing: Sale of 400,000 shares of common at $10 each.
2. Debt financing: Sale of $4 million of 12.5 percent long-term bonds.
Calculate the EBIT-EPS indifference point. Assume the marginal tax rate is 40%.
a.
$4.253 million
b.
$3.051 million
c.
$3.654 million
d.
$4.728 million
58. Twin City Printing is considering two financial alternatives for financing a major expansion program.
Under either alternative EBIT is expected to be $15.6 million. Currently the firm’s capital structure
consists of 4 million shares of common stock and $35 million in 11% long-term bonds. Under the debt
financing alternative $10 million in 12% long-term bonds will be sold and under the equity financing
alternative the firm would sell 500,000 shares of common stock. The P/E under the debt alternative
would be 15 and the P/E under the equity alternative would be 16. The firm’s marginal tax rate is 40%.
Which alternative would produce the higher stock price?
a.
debt—stock price of $23.75
b.
debt—stock price of $32.29
c.
equity—stock price of $25.07
d.
equity—stock price of $33.28
59. Crown Data(CD) has a current capital structure that consists of $120 million in common equity (15
million shares) and $80 million in long-term debt with an average interest rate of 11 percent. CD is
considering an expansion project that will cost $22 million. The project will be financed either by
issuing long-term debt at a cost of 12.5 percent, or the sale of new common stock at $35 per share. The
firm’s marginal tax rate is 40%. What is the EBIT indifference point between the two financing
options?
a.
$71.5 million
b.
$77.2 million
c.
$68.3 million
d.
$ 1.0 million
ESSAY
1. Explain the pecking order theory.
2. What are the factors that firms consider in setting their target capital structure?