Exam
Name___________________________________
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F‘ if the statement is false.
1) Financial managers prefer to choose the same debt level no matter which industry they operate in.
2) Even if two firms operate in the same industry, they may prefer different choices of debt–equity ratios.
3) Equity in a firm with no debt is called unlevered equity.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
4) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its
A) capital structure.
B) leverage.
C) retained earnings.
D) paid out capital.
5) A firm’s ________ ratio is the fraction of the firm’s total value that corresponds to debt.
A) debt–to–equity
B) asset
C) debt–to–value
D) liability
6) Which of the following statements is FALSE?
A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its
capital structure.
B) The most common choices are financing through equity alone and financing through a combination of
debt and equity.
C) The project’s net present value (NPV) represents the value to the new investors of the firm created by
the project.
D) When corporations raise funds from outside investors, they must choose which type of security to
issue.
7) Equity in a firm with debt is called
A) levered equity.
B) risk–free equity.
C) unlevered equity.
D) risky equity.
8) Equity in a firm with no debt is called
A) levered equity.
B) unlevered equity.
C) risk–free equity.
D) risky equity.
9) Which of the following do firms consider in the choice of securities issued?
A) The tax consequences of the chosen security.
B) The transactions costs of the chosen security.
C) Whether the chosen security will have a fair price in the market.
D) All of the above are considered.
SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.
10) What role do industries play in the capital structure choice for a firm?
11) What is the capital structure of a firm?
12) What considerations should managers have while deciding on their capital structure?
TRUE/FALSE. Write ‘T’ if the statement is true and ‘F’ if the statement is false.
13) With perfect capital markets, the total value of a firm should not depend on its capital structure.
14) With perfect capital markets, because different choices of capital structure offer a benefit to investors, they
affect the value of the firm.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
15) A financial manager makes a choice of the amount and source of capital based on how the choice will impact
A) debt–equity ratio.
B) debt value.
C) earnings per share.
D) firm value.
16) Investment cash flows are independent of financing choices in a
A) market with frictions.
B) perfect capital market.
C) setting with frictions in investment returns.
D) firm with leverage.
17) A project will give a one–time cash flow of $20,000 after one year. If the project risk requires a return of 10%,
what is the levered value of the firm with perfect capital markets?
A) $18,182
B) $20,000
C) $19,000
D) more information needed
18) A project will give a one–time cash flow of $25,000 after one year. If the project risk requires a return of 12%,
what is the levered value of the firm with perfect capital markets?
A) $19,882
B) $22,321
C) $22,000
D) more information needed
19) A firm will give a one–time cash flow of $22,000 after one year. If the project risk requires a return of 11%,
what is the levered value of the firm with perfect capital markets?
A) $18,182
B) $20,000
C) $19,820
D) more information needed
20) MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market value
of the ________ generated by its assets.
A) earnings after taxes
B) earnings after interest
C) cash flows after taxes
D) free cash flows
21) It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm
because
A) leverage decreases the risk of equity of the firm.
B) leverage changes the unlevered cost of equity.
C) leverage increases the risk of the equity of the firm.
D) cost of debt decreases in this setting.
22) By adding leverage, the returns on the firm are split between debt holders and equity holders, but equity
holder risk increases because
A) interest payments can be rolled over.
B) dividends are paid first.
C) debt and equity have equal priority.
D) interest payments have first priority.
23) In a setting where there is no risk that a firm will default, leverage ________ the risk of equity.
A) increases
B) decreases
C) does not change
D) cannot say for sure
24) A firm requires an investment of $20,000 and will return $25,000 after one year. If the firm borrows $10,000
at 7% what is the return on levered equity?
A) 43%
B) 29%
C) 37%
D) 39%
25) A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows $5,000
at 7% what is the return on levered equity?
A) 43%
B) 39%
C) 41%
D) 45%
26) A firm requires an investment of $30,000 and will return $35,000 after 1 year. If the firm borrows $20,000 at
10% what is the return on levered equity?
A) 43%
B) 30%
C) 37%
D) 39%
27) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it is
referred to as
A) outside debt.
B) retained earnings.
C) homemade leverage.
D) payout ratio.
28) A firm requires an investment of $20,000 and borrows $10,000 at 8%. If the return on equity is 20%, what is
the firm’s pre tax WACC?
A) 14%
B) 15%
C) 16%
D) 17%
29) A firm requires an investment of $30,000 and borrows $10,000 at 6%. If the return on equity is 15%, what is
the firm’s pre tax WACC?
A) 14%
B) 13%
C) 12%
D) 11%
30) A firm requires an investment of $40,000 and borrows $10,000 at 8%. If the return on equity is 20%, what is
the firm’s pre tax WACC?
A) 14%
B) 15%
C) 16%
D) 17%
31) A firm has a market value of assets of $50,000. It borrows $10,000 at 5%. If the unlevered cost of equity is
15%, what is the firm’s cost of equity capital?
A) 17.5%
B) 18.5%
C) 19.2%
D) 20.6%
32) A firm has a market value of assets of $50,000. It borrows $10,000 at 7%. If the unlevered cost of equity is
15%, what is the firm’s cost of equity capital?
A) 16%
B) 17%
C) 18%
D) 19%
33) A firm has a market value of assets of $50,000. It borrows $10,000 at 3%. If the unlevered cost of equity is
15%, what is the firm’s cost of equity capital?
A) 16%
B) 17%
C) 18%
D) 19%
34) Leverage can ________ a firm’s expected earnings per share, but does not necessarily increase the share price.
A) decrease
B) dilute
C) increase
D) not change
35) In general, issuing equity may not dilute the ownership of existing shareholders if
A) the value of new shares is equal to the value of debt.
B) the new shares are sold at a fair price.
C) the firm has no debt financing.
D) the firm uses debt conservatively.
36) Which of the following is NOT one of Modigliani and Miller’s set of conditions referred to as perfect capital
markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm’s financing decisions do not change the cash flows generated by its investments, nor do they
reveal new information about them.
D) Investors and firms can trade the same set of securities at competitive market prices equal to the
present value (PV) of their future cash flows.
37) Which of the following statements is FALSE?
A) The Law of One Price implies that leverage will affect the total value of the firm under perfect capital
market conditions.
B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm’s security
holders is equal to the total cash flow generated by the firm’s assets.
C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and
equity, without altering the total cash flows of the firm.
D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows
generated by its assets and is not affected by its choice of capital structure.
38) Which of the following statements is FALSE?
A) As long as the firm’s choice of securities does not change the cash flows generated by its assets, the
capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero
and, therefore, should not change the value of a firm.
C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan
it receives up front.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or
her own portfolio.
39) Which of the following statements is FALSE?
A) As long as investors can borrow or lend at the same interest rate as the firm, homemade leverage is a
perfect substitute for the use of leverage by the firm.
B) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we
say that they are using homemade leverage.
C) The value of the firm is determined by the present value (PV) of the cash flows from its current and
future investments.
D) The investor can re–create the payoffs of unlevered equity by borrowing and using the proceeds to
purchase the equity of the firm.
40) Which of the following statements is FALSE?
A) When a firm issues new shares that account for a significant percentage of its outstanding shares, the
transaction is called a leveraged recapitalization.
B) MM Proposition I applies to capital structure decisions made at any time during the life of the firm.
C) By choosing positive–NPV projects that are worth more than their initial investment, the firm can
enhance its value.
D) The choice of capital structure does not change the value of the firm if the cash flows generated by the
firm’s assets are assumed to remain constant.
41) Which of the following statements is FALSE?
A) Investors can alter the leverage choice of the firm to suit their personal tastes either by borrowing and
reducing leverage or by holding bonds and adding more leverage.
B) On the market value balance sheet the total value of all securities issued by the firm must equal the
total value of the firm‘s assets.
C) The market value balance sheet captures the idea that value is created by a firm’s choice of assets and
investments.
D) One application of MM Proposition I is the useful device known as the market value balance sheet of
the firm.
Use the information for the question(s) below.
Consider two firms, With and Without, that have identical assets that generate identical cash flows. Without is an
all–equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares
outstanding and $12 million in debt at an interest rate of 5%.
42) According to MM Proposition I, the stock price for With is closest to:
A) $8.00
B) $24.00
C) $6.00
D) $12.00
43) Assume that MM’s perfect capital markets conditions are met and that you can borrow and lend at the same
5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock.
Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of
your margined purchase of Without stock will be the same as a $5000 investment in With stock?
A) $10,000
B) $5000
C) $2500
D) $0
44) Assume that MM’s perfect capital markets conditions are met and that you can borrow and lend at the same
5% rate as With. You have $5000 of your own money to invest and you plan on buying Without stock.
Using homemade leverage you borrow enough in your margin account so that the payoff of your margined
purchase
of
Without stock will be the same as a $5000 investment in With stock. The number of shares of Without stock
you purchased is closest to:
A) 425
B) 1650
C) 2000
D) 825
45) Assume that MM’s perfect capital markets conditions are met and that you can borrow and lend at the same
5% rate as With. You have $5000 of your own money to invest and you plan on buying With stock. Using
homemade (un)leverage, how much do you need to invest at the risk–free rate so that the payoff of your
account will be the same as a $5000 investment in Without stock?
A) $5000
B) $0
C) $2500
D) $4000
46) Assume that MM’s perfect capital markets conditions are met and that you can borrow and lend at the same
5% rate as With. You have $5000 of your own money to invest and you plan on buying With stock. Using
homemade (un)leverage you invest enough at the risk–free rate so that the payoff of your account will be the
same as a $5000 investment in Without stock. The number of shares of With stock you purchased is closest
to:
A) 100
B) 425
C) 1650
D) 825
Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to use this cash to
repurchase shares from its investors and has already announced the stock repurchase plan. Currently Luther is an
all–equity firm with 1.25 billion shares outstanding. Luther’s shares are currently trading at $20 per share.
47) The market value of Luther’s non–cash assets is closest to:
A) $20 billion
B) $19 billion
C) $25 billion
D) $24 billion
48) After the repurchase how many shares will Luther have outstanding?
A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion
49) With perfect capital markets, what is the market value of Luther’s equity after the share repurchase?
A) $15 billion
B) $10 billion
C) $25 billion
D) $20 billion
50) With perfect capital markets, what is the market price per share of Luther’s stock after the share repurchase?
A) $25
B) $24
C) $15
D) $20
51) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to
employees valued at $2 billion. The market value of Luther’s non–cash assets is closest to:
A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion
52) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to
employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?
A) 1.0 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion
Consider the following equation for the question(s) below:
E + D = U = A
53) The E in the equation above represents
A) the value of the firm’s equity.
B) the value of the firm’s debt.
C) the value of the firm’s unlevered equity.
D) the market value of the firm’s assets.
54) The U in the equation above represents
A) the value of the firm’s equity.
B) the market value of the firm’s assets.
C) the value of the firm’s unlevered equity.
D) the value of the firm’s debt.
55) The A in the equation above represents
A) the value of the firm’s debt.
B) the market value of the firm’s assets.
C) the value of the firm’s equity.
D) the value of the firm’s unlevered equity.
56) Which of the following statements is FALSE?
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm’s equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.