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Chapter 13: Capital Structure and Leverage
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
Chapter 13: Capital Structure and Leverage
4. If a firm borrows money, it is using financial leverage.
a.
True
b.
False
5. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as
measured by its beta coefficient.
a.
True
b.
False
6. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than
the distribution if the firm used no leverage, other things held constant.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
7. Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial
leverage affects both EPS and EBIT.
a.
True
b.
False
8. The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt
financing.
a.
True
b.
False
9. Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not
get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more
likely to go bankrupt.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
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
12. Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every
firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.
Chapter 13: Capital Structure and Leverage
a.
True
b.
False
13. It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as
measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.
a.
True
b.
False
14. As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk
components.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
15. If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then
they must have the same amount of business risk.
a.
True
b.
False
16. In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value.
However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises
as it uses more and more debt, other things held constant.
a.
True
b.
False
17. According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is
approximately 100% debt financing.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
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
20. 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. However, that article was criticized because it assumed that no taxes existed. MM then revised their
original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it
used (almost) 100% debt.
Chapter 13: Capital Structure and Leverage
a.
True
b.
False
21. Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion
that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this
model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal
capital structure where the debt ratio is less than 100%.
a.
True
b.
False
22. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal
taxes.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
23. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal
taxes.
a.
True
b.
False
24. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the
development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt,
but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter
benefits. Under the trade-off theory, an optimal capital structure exists.
a.
True
b.
False
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
Chapter 13: Capital Structure and Leverage
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
b.
False
Chapter 13: Capital Structure and Leverage
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
30. Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms
whose assets are harder to sell (like those engaged in research and development).
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
31. Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.
a.
True
b.
False
32. A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in
"bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility,
other things held constant.
a.
True
b.
False
Chapter 13: Capital Structure and Leverage
33. If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in
earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.
a.
True
b.
False
34. An increase in the debt ratio will generally have no effect on which of these items?
a.
Business risk.
b.
Total risk.
c.
Financial risk.
d.
Market risk.
e.
The firm's beta.
35. Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not
directly contribute to) business risk?
a.
Demand variability.
b.
Sales price variability.
c.
The extent to which operating costs are fixed.
d.
The extent to which interest rates on the firm's debt fluctuate.
e.
Input price variability.
Chapter 13: Capital Structure and Leverage
36. Which of the following statements is CORRECT?
a.
Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the
WACC.
b.
Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its
WACC.
c.
Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing.
However, this action still may raise the company's WACC.
d.
Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing.
However, this action still may lower the company's WACC.
e.
Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost
of equity.
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.
Chapter 13: Capital Structure and Leverage
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.
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.
Chapter 13: Capital Structure and Leverage
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.
42. Which of the following statements is CORRECT?
a.
As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected
EPS.
b.
The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
Chapter 13: Capital Structure and Leverage
c.
The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the
stock price.
d.
The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
e.
The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
43. The firm's target capital structure should do which of the following?
a.
Maximize the earnings per share (EPS).
b.
Minimize the cost of debt (rd).
c.
Obtain the highest possible bond rating.
d.
Minimize the cost of equity (rs).
e.
Minimize the weighted average cost of capital (WACC).
44. Which of the following statements is CORRECT?
a.
A firm's business risk is determined solely by the financial characteristics of its industry.
b.
The factors that affect a firm's business risk include industry characteristics and economic conditions, both of
which are generally beyond the firm's control.
c.
One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the
risk of bankruptcy.
d.
A firm's financial risk can be minimized by diversification.
e.
The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business
risk.
Chapter 13: Capital Structure and Leverage
45. Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given
quantity of output, this
a.
normally leads to an increase in its fixed assets turnover ratio.
b.
normally leads to a decrease in its business risk.
c.
normally leads to a decrease in the standard deviation of its expected EBIT.
d.
normally leads to a decrease in the variability of its expected EPS.
e.
normally leads to a reduction in its fixed assets turnover ratio.
46. A firm's CFO is considering increasing the target debt ratio, which would also increase the company's interest
expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total
assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO's
estimates are correct, which of the following statements is CORRECT?
a.
Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases.
b.
If the plan reduces the WACC, the stock price is likely to decline.
c.
Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
d.
If the plan does increase the EPS, the stock price will automatically increase at the same rate.
e.
Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the
interest rate on the currently outstanding bonds.
Chapter 13: Capital Structure and Leverage
47. Which of the following statements is CORRECT?
a.
Increasing its use of financial leverage is one way to increase a firm's return on investors’ capital (ROIC).
b.
If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present
level of sales constant, this would increase its operating leverage.
c.
The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
d.
If a company were to issue debt and use the money to repurchase common stock, this would reduce its return
on investors’ capital (ROIC). (Assume that the repurchase has no impact on the company's operating income.)
e.
If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce
corporations' debt ratios.
48. Your firm has $500 million of investor-supplied capital, its return on investors’ capital (ROIC) is 15%, and it currently
has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at
an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common
equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the
size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the
following is most likely to occur as a result of the recapitalization?
a.
The ROA would increase.
b.
The ROA would remain unchanged.
c.
The return on investors’ capital would decline.
d.
The return on investors’ capital would increase.
e.
The ROE would increase.
Chapter 13: Capital Structure and Leverage
49. Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors’
capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 – T). However, Company HD has a higher debt
ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
a.
Company HD has a higher net income than Company LD.
b.
Company HD has a lower ROA than Company LD.
c.
Company HD has a lower ROE than Company LD.
d.
The two companies have the same ROA.
e.
The two companies have the same ROE.
50. Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors’
capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt
and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which
of the following statements is CORRECT?
a.
The two companies have the same times interest earned (TIE) ratio.
b.
Firm L has a lower ROA than Firm U.
c.
Firm L has a lower ROE than Firm U.
d.
Firm L has the higher times interest earned (TIE) ratio.
e.
Firm L has a higher EBIT than Firm U.
