CHAPTER 13: CAPITAL STRUCTURE CONCEPTS
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 costs 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 firm’s cost of capital is maximized when its capital structure consists of approximately equal proportions
of debt and equity
4. Perfect capital markets imply the following:
a. there are no transactions costs for buying and selling securities
b. relevant information is unavailable for individuals
c. all investors can borrow and lend at the same rate
d. a single investor can influence security prices
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. the weighted cost of capital is maximized
Chapter 13: Capital Structure Concepts
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 true regarding 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. The relationship is determined by the static tradeoff theory.
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. The relationship is determined by the static tradeoff theory.
10. The amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance
a firm defines the firm’s
a. financial structure
b. capital structure
c. target capital structure
d. optimal financial structure
Chapter 13: Capital Structure Concepts
11. 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
12. 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
13. 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
14. 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. smaller, greater
15. All of the following factors influence a firm’s business risk except:
a. degree of operating leverage
b. variability of interest rates
c. variability of operating costs
d. variability of selling prices
Chapter 13: Capital Structure Concepts
16. Operating leverage involves the use of
a. equity and debt in equal proportions
b. market power
c. debt
d. assets having fixed costs
17. The use of fixed cost sources of funds, such as debt and preferred stock affect a firm’s .
a. financial risk
b. degree of operating leverage
c. market power
d. business risk
18. The use of fixed-cost financing sources is referred to as the use of
a. operating leverage
b. a leveraged buyout
c. financial leverage
d. combined leverage
19. 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
20. 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. return on equity is less than the cost of debt
Chapter 13: Capital Structure Concepts
21. 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
22. 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
23. 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
24. 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
25. 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
Chapter 13: Capital Structure Concepts
26. 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
27. 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, negative
28. 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
29. The increased variability in earnings per share due to the firm’s use of debt is a definition of .
a. combined leverage
b. agency risk
c. financial risk
d. operating risk
30. In determining the capital structure for an international firm, the managerial objective is to
a. minimize exchange rate risk
b. minimize the risk of expropriation
c. minimize the overall cost of capital
d. minimize available local low-cost financing
Chapter 13: Capital Structure Concepts
31. represents the permanent sources of the firm’s financing.
a. Financial structure
b. Capital structure
c. Equity structure
d. Cost structure
32. The optimal capital structure of a firm is a function of the .
a. business risk of the firm
b. tax structure
c. business risk of the firm and the tax structure
d. the variability of sales volumes
33. The less a firm’s business risk, the the amount of that will be used in the optimal capital structure,
holding constant all other relevant factors.
a. less; financial leverage
b. more; financial leverage
c. less; equity capital
d. more; debt capital
34. 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, plus, minus
35. The optimal capital structure is a function of .
a. corporate income taxes
b. financial distress costs
c. agency costs
d. corporate income taxes, financial distress costs, and agency costs
Chapter 13: Capital Structure Concepts
36. 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
37. 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
38. 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
39. 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
40. 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
Chapter 13: Capital Structure Concepts
41. 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
42. 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
43. 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
44. 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
Chapter 13: Capital Structure Concepts
45. 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
46. 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
47. 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
48. 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
Chapter 13: Capital Structure Concepts
49. 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. $55,800
50. Feldspar Inc. is considering the capital structure for a new division. Management has been given the following
cost information:
kd(Cost of Debt)
ke(Cost of Equity)
.10
.125
.105
.13
.11
.135
.117
.142
.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
Chapter 13: Capital Structure Concepts
51. 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
52. 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
Chapter 13: Capital Structure Concepts
53. 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
54. 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
Chapter 13: Capital Structure Concepts
55. 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
56. The airline industry is extremely price competitive, as well as having huge fixed costs and very low variable
costs.
This is an example of:
a. low asset performance
b. high profitability
c. high operating leverage
d. low fixed threshold
57. The capital structure decision attempts to minimize which maximizes the value of the firm.
a. leverage costs
b. the cost of capital
c. labor costs
d. compensation packages
58. The greater the variability of costs, the greater the business risk of the firm. This is reflected in the:
a. selling price
b. cost of inputs used to produce a firm’s output
c. sales volume
d. existence of market power
Chapter 13: Capital Structure Concepts
59. The process of simultaneously buying and selling the same or equivalent securities in different markets to take
advantage of price differences and make a profit is called:
a. option pricing
b. diversification
c. arbitrage
d. margining
60. Arbitrage transactions are:
a. risky
b. illegal
c. speculative
d. risk-free
61. The tax deductibility of interest payments provides the firm with a:
a. market advantage
b. learning curve
c. tax shield
d. safeguard against auditing
62. In considering a firm’s capital structure, the firm should increase its which will maximize its value.
a. stock outstanding
b. earnings
c. cash flow from investing
d. debt
63. With financial leverage, a change in EBIT results in a change in:
a. fixed costs
b. EPS
c. financial risk
d. EBT
Chapter 13: Capital Structure Concepts
64. A firm accepts the risk of fixed-cost financing is to:
a. increase stock sales.
b. decrease overhead costs.
c. increase possible returns to stockholders.
d. develop synergy.
65. In considering the arbitrage process in perfect capital markets with no income taxes, the market value of a firm
is ____.
a. dependent on its capital structure.
b. independent of its capital structure.
c. reliant on stock equity prices.
d. reliant on management expertise.
66. The tax deductibility of the interest payments on corporate debt is known as:
a. the tax structure
b. the tax shield
c. the optimal capital structure
d. Section 402a of the IRS tax code.
67. What is optimal capital structure?
a. It is the mix of debt, preferred stock and common equity that maximizes profits.
b. It is the mix of debt, preferred stock and common equity that minimizes risk.
c. It is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firm’s
employed capital.
d. It is the mix of common and preferred stock that maximizes dividends to the stockholders.
68. The amount of debt in a firm’s optimal capital structure is often referred to as the firm’s:
a. debt capacity
b. lending ability
c. line of credit
d. loan limit
Chapter 13: Capital Structure Concepts
69. How do signaling effects impact the firm’s capital structure decision?
70. What is the pecking order theory with regard to managerial preferences for financing alternatives?
71. There are many factors that influence a firm’s business risk. List them.
72. Explain how industry effects need to be considered in the capital structure decision.
Chapter 13: Capital Structure Concepts
73. List the factors that determine the specific capital structure for a multinational firm.
74. When a corporation must get external financing, the first place to look for funds is with debt. There are various
reasons for this preference. List the reasons why debt is generally issued first.
75. There are many benefits to a leveraged buy-out. However, the benefits from LBOs come with significant costs.
Explain the down-side of LBOs.