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Multiple Choice
1. In analyzing the value of a 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
d
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
c
3. Two prominent finance researchers (Modigliani and Miller) showed that the firm’s ____.
a.
optimal capital structure consists of approximately equal proportions of debt and equity
b.
value is independent of its capital structure in perfect capital markets with no income taxes
c.
cost of capital is minimized when its capital structure consists of approximately equal proportions of debt and
equity
d.
cost of capital is maximized when its capital structure consists of approximately equal proportions of debt and
equity
b
4. Which of the following is implied by perfect capital markets?
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.
c
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
a
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
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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.
becomes greater than the cost of equity beyond a certain point
d.
initially rises slowly, then increases rapidly beyond some point
d
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 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
b
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
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12. The optimal capital structure is determined by several factors, including all except which of the following?
a.
Corporate capital gains
b.
Business risk
c.
Potential bankruptcy risk
d.
Agency costs
a
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
c
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
c
15. All except which of the following factors influence a firm’s business risk?
a.
Degree of operating leverage
b.
Variability of interest rates
c.
Variability of operating costs
d.
Variability of selling prices
b
16. Operating leverage involves the use of ____.
a.
equity and debt in equal proportions
b.
market power
c.
debt
d.
assets having fixed costs
d
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
a
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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
b
20. Financial leverage benefits shareholders when the return on ____.
a.
assets is greater than the cost of debt
b.
equity is greater than the cost of debt
c.
investments is less than the weighted cost of capital
d.
equity is less than the cost of debt
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
b
22. Due to both financial distress and agency costs, a firm should have a capital structure that contains ____.
a.
all debt
b.
all equity
c.
both debt and equity
d.
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
d
24. Protection for debt holders takes the form of protective covenants in the bond indenture. These covenants place
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restrictions on which of the following activities?
a.
The sale of assets
b.
Payment of dividends
c.
The issuance of additional debt
d.
All other choices are typical protective covenants.
d
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
b
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 except which of the following?
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.
d
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
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30. In determining the capital structure for an international firm, the managerial objective is to minimize ____.
a.
exchange rate risk
b.
the risk of expropriation
c.
the overall cost of capital
d.
available local low-cost financing
c
31. ____ structure represents the permanent sources of the firm’s financing.
a.
Financial
b.
Capital
c.
Equity
d.
Cost
b
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
c
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
b
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
c
35. The optimal capital structure is a function of ____.
a.
corporate income taxes
b.
financial distress costs
c.
agency costs
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d.
corporate income taxes, financial distress costs, and agency costs
d
36. Per 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
c
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
b
38. A survey of Fortune 500 firms indicates 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
b
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
c
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% coupon, what would be the present value of the tax shield? Assume the
marginal tax rate is 35%.
a.
$18,750
b.
$29,250
c.
$175,000
d.
$45,000
c
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
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b.
$5.4 million
c.
$9.36 million
d.
$3.6 million
d
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
b
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
d
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
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c.
$35.83 million
d.
$30.83 million
c
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
a
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
b
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%
and its cost of debt is 9%. If the firm has an expected, perpetual net operating income of $120,000 and a marginal tax rate
of 40%, 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
a
50. Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost
information:
Debt/assets
kd(Cost of Debt)
ke(Cost of Equity)
.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
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d.
70% has lowest cost of capital
c
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
c
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
b
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
c
54. Biotec has estimated the costs of debt and equity capital for various proportions of debt in its capital structure:
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% 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
a
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
c
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
c
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
b
58. The greater the variability of costs, the greater the business risk of the firm. This is determined by the ____.
a.
selling price
b.
cost of inputs used to produce a firm’s output
c.
sales volume
d.
existence of market power
b
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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
c
60. Arbitrage transactions are ____.
a.
risky
b.
illegal
c.
speculative
d.
risk-free
d
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
c
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
d
63. With financial leverage, a change in EBIT results in a change in ____.
a.
fixed costs
b.
EPS
c.
financial risk
d.
EBT
b
64. A firm accepts the risk of fixed-cost financing to ____.
a.
increase stock sales
b.
decrease overhead costs
c.
increase possible returns to stockholders
d.
develop synergy
c
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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
b
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
b
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 to the firm of its
employed capital.
d.
It is the mix of common and preferred stock that maximizes dividends to the stockholders.
c
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
a
Essay
69. How do signaling effects impact the firm’s capital structure decision?
common stock have led to positive stock returns.
70. What is the pecking order theory regarding managerial preferences for financing alternatives?
reflect their investment opportunities and thereby avoid the issuance of new securities.
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71. List some of the many factors that influence a firm’s business risk.
72. Explain how industry effects need to be considered in the capital structure decision.
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.