Corporate Finance: Core Principles & Apps, 5e (Ross)
Chapter 14 Capital Structure: Basic Concepts
1) Shareholders value firms based on their
A) sizes.
B) profits.
C) original costs.
D) depreciated values.
E) market values.
2) A firm’s capital structure refers to the
A) division of a firm’s assets into current and fixed assets.
B) amount shareholders have invested into the firm.
C) types of fixed assets owned by the firm.
D) mix of debt and equity used to finance the firm’s assets.
E) amount of cash and cash equivalents held by a firm.
3) Managers should select the capital structure that
A) maximizes the value of the firm.
B) has no debt.
C) is fully levered.
D) minimizes taxes.
E) produces the highest current level of net income.
4) When selecting a capital structure, managers should aim to maximize the
A) tax deductions that are available to the company.
B) value of the firm for its managers and employees.
C) size of the firm.
D) value of the firm for its shareholders.
E) growth rate of the company.
5) An unlevered firm is a company that
A) pays no current dividends.
B) has only one geographic location.
C) has no debt.
D) produces a single product.
E) is undervalued based on its current capital structure.
6) A general rule for managers to follow is to establish a firm’s capital structure such that the firm’s
A) cost of equity is minimized.
B) bondholders are fully secured.
C) current market value is maximized.
D) dividend payout is maximized.
E) assets are minimized.
7) Assume you are reviewing a graph depicting earnings per share (EPS) on the vertical axis and
earnings before interest (EBI) on the horizontal axis. Data points for both a levered and an
unlevered firm are displayed. Given this, which statement accurately describes this graph?
A) The unlevered firm has a greater reaction to a change in EBI than does the levered firm.
B) The levered firm consistently has higher EPS than the unlevered firm.
C) Both the levered and unlevered firms have zero EPS when EBI is zero.
D) Debt becomes a greater disadvantage to a firm as EBI increases.
E) When earnings exceed the breakeven point, the levered firm has the higher EPS.
8) MM Proposition I, without taxes, illustrates that
A) the value of an unlevered firm is greater than that of a levered firm.
B) any one capital structure is just as valuable as any other capital structure for a given firm.
C) corporate use of homemade leverage affects the value of the firm to its shareholders.
D) the value of a firm is directly related to the use of debt.
E) firm valuation is dependent upon shareholders aversion to homemade leverage.
9) MM Proposition I, without taxes, assumes that
A) debt is riskless.
B) individuals and corporations can borrow at the same rate.
C) firms can borrow at the risk-free rate.
D) individuals and firms are taxed at the same rate thereby making taxes irrelevant.
E) all firms will prefer an unlevered capital structure.
10) MM Proposition I, without taxes, supports the argument that
A) business risk determines the return on assets.
B) it is completely irrelevant how a firm arranges its finances.
C) the cost of equity rises as leverage rises.
D) a firm should borrow money up to the point where the cost of debt equals the cost of equity.
E) financial risk is determined by the debt-equity ratio.
11) In an EPS-EBI graphical relationship, the debt line and the no debt line intersect. Which one of
these is true at the intersection point?
A) The advantages of debt outweigh the disadvantages of debt.
B) The aftertax earnings of both capital structures are equal.
C) The earnings per share for both capital structures equal zero.
D) There is no advantage or disadvantage to debt.
E) The EPS is maximized for both the levered and the unlevered firm.
12) When comparing levered versus unlevered capital structures, leverage works to increase EPS
for high levels of EBIT because interest payments on the debt
A) increase as EBIT increases.
B) stay fixed, leaving more income to be distributed over fewer shares.
C) stay fixed, leaving less income to be distributed over fewer shares.
D) stay fixed, leaving less income to be distributed over more shares.
E) decrease as EBIT increases.
13) Ignoring taxes, financial leverage affects the performance of a firm by
A) increasing the volatility of the firm’s EBI.
B) decreasing the volatility of the firm’s EBI.
C) decreasing the volatility of the firm’s net income.
D) increasing the volatility of the firm’s EPS.
E) lowering the firm’s level of risk.
14) The use of leverage by a firm
A) increases the variability of EBIT.
B) replaces all use of homemade leverage.
C) increases shareholder risk.
D) affects EBIT more than net income.
E) increases EPS at low levels of income.
15) Ignoring taxes, leverage becomes a disadvantage to a firm as soon as the firm’s earnings before
interest
A) become negative.
B) exceed the breakeven point.
C) exceed the interest expense.
D) exceed the firm’s unlevered earnings.
E) fall below the breakeven point.
16) Which one of these statements is correct?
A) There is no condition known to date whereby a corporation can increase firm value through the
use of leverage.
B) Corporations generally pay a lower cost on debt than do individuals due to their vast pool of
liquid assets.
C) If individuals pay a higher cost to borrow than corporations do, then corporations can increase
firm value by borrowing.
D) Margin accounts tend to be high interest rate sources of funds for individuals.
E) Corporations can increase firm value by borrowing provided their interest rate on debt exceeds
that paid by individuals.
17) Which of the following are given as reasons why individual investors may be able to borrow at
the same rates as corporations?
I. Corporate loans must be negotiated and supervised.
II. Corporations often borrow using illiquid assets as collateral.
III. Individuals tend to borrow smaller amounts.
IV. Individuals can borrow on margin through a broker.
A) I and II only
B) III and IV only
C) II, III, and IV only
D) I, II, and IV only
E) I, II, III, and IV
18) You are writing a comparison of an all-equity structure to a levered capital structure for a firm.
It is accurate to state in this comparison that
A) earnings per share will always be higher in the all-equity structure.
B) firms will only select the levered structure when individual rates on borrowed funds are lower
than corporate rates.
C) leverage lowers shareholders’ returns in bad financial times.
D) the all-equity firm has a greater advantage the higher the firm’s earnings before interest.
E) leverage improves shareholders’ returns regardless of the firm’s level of earnings.
19) In the absence of taxes, MM argues that
A) no one capital structure for a firm is superior to any other capital structure for that firm.
B) the cost of equity for a levered firm is equal to the firm’s unlevered WACC.
C) homemade leverage is insufficient to offset a firm’s use of leverage.
D) the value of a levered firm exceeds the value of the unlevered firm.
E) the cost of equity decreases as the debt-equity ratio increases.
20) Which one of these argues than the value of a firm is independent of its capital structure?
A) MM Proposition I, without taxes
B) MM Proposition II, without taxes
C) MM Proposition I, with taxes
D) MM Proposition II, with taxes
E) None of the MM Propositions
21) Bryan invested in Bryco stock when the firm was financed solely with equity. The firm is now
utilizing debt in its capital structure. To unlever his position, Bryan needs to
A) borrow some money and purchase additional shares of Bryco stock.
B) sell some shares of Bryco stock and loan out the sale proceeds.
C) sell some shares of Bryco stock and hold the proceeds in cash.
D) maintain his current position because the firm’s use of leverage did not affect him.
E) sell some of his shares and also borrow money to increase his cash reserves.
22) Which one of these statements is correct?
A) Firms across all industries in the U.S. tend to have similar debt-to-equity ratios.
B) The banking industry tends to have the lowest debt-to-equity ratio of any United States
industry.
C) Financial leverage lowers risk to equity holders.
D) MM Propositions ignore bankruptcy costs.
E) MM Propositions, without taxes, illustrate that a firm’s overall cost of capital is affected by
leverage.
23) Which one of these presents the idea that the cost of equity is a positive linear function of
capital structure?
A) MM Proposition I, without taxes
B) MM Proposition II, without taxes
C) Capital asset pricing model
D) MM Proposition I, with taxes
E) Homemade leverage
24) R0 is defined as the
A) cost of capital for an unlevered firm.
B) pretax cost of debt.
C) cost of capital in a risk-free world without taxes.
D) cost of capital for a fully levered firm.
E) aftertax cost of debt.
25) Given a world without taxes, RWACC of an unlevered firm will equal
A) RS.
B) RB.
C) R0.
D) RS – R0.
E) RS – RB.
26) The formula associated with MM Proposition II, without taxes, is
A) R0 = RS + (B / S)(RS – RB).
B) RWACC = RS – RB.
C) Rs = R0 + (B / S)(R0 – RB).
D) R0 = RB – R0.
E) RWACC = R0 + RB.
27) MM Proposition II, without taxes, is the proposition that
A) supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
B) a firm’s cost of equity increases in direct relationship to the increase in debt.
C) the cost of levered equity is determined solely by the return on debt, the debt-equity ratio, and
the tax rate.
D) the cost of equity depends on the market value of the firm’s assets.
E) supports the argument that the size of the pie does not depend on how the pie is sliced.
28) MM Proposition II, without taxes, implies that the required return on equity is
A) a result of homemade leverage.
B) inversely related to the firm’s debt-to-equity ratio.
C) directly affected by the firm’s debt-to-equity ratio.
D) independent of the firm’s capital structure.
E) a linear function of the market’s rate of interest.
29) Which one of these represents the difference between the value of a levered and an unlevered
firm?
A) R0 – RS
B) RS × tcB
C) VU + R × tcB
D) (B / S)(1 – tc)( R0 – RS)
E) tcB
30) Which one of these symbols is correctly matched with its definition?
A) tc: Taxable corporate income
B) VU: Present value of unlevered firm
C) R0: Levered cost of equity
D) RWACC: Levered cost of equity
E) RB: Weight of debt in the capital structure
31) Why does MM Proposition I, without taxes, not hold in the presence of corporate taxation?
A) Bondholders require higher rates of return when their interest payments are taxed.
B) Dividends are no longer relevant when taxes are introduced.
C) A levered firm will pay less tax than the identical firm unlevered.
D) The cost of equity increases with leverage.
E) The pretax cost of debt increases when taxes are considered.
32) Consider the pie models of corporate structure. What is the difference between the all-equity
pie and the levered pie for a firm in the presence of taxes?
A) The size of the levered pie is smaller than the all-equity pie.
B) Taxes eat a slice of the levered pie but pass by the all-equity pie.
C) Both pies are the same size and are sliced identically.
D) Taxes eat a slice of both pies but take a larger slice of the all-equity pie.
E) The all-equity pie is smaller in size than the levered pie.
33) What does the present value of the tax shield from debt formula assume?
A) The interest rate on the debt is less than cost of equity.
B) The debt will not be replaced when paid.
C) Interest on the debt is paid only when the debt matures.
D) The interest is paid semiannually.
E) The debt is perpetual.
34) Which one of these proposes that the value of a levered firm exceeds the value of an unlevered
firm by the present value of the tax shield?
A) MM Proposition I, with and without taxes
B) MM Proposition I, with tax
C) MM Proposition II, with tax
D) MM Proposition I, without tax
E) MM Proposition II, without tax
35) The fact that interest payments on debt are tax deductible is a key factor in which of these
propositions?
A) Both MM Proposition I and II, with taxes
B) MM Proposition I, without tax
C) MM Proposition II, without tax
D) MM Proposition I, with tax
E) MM Proposition II, with tax
36) If R0 exceeds RB then
A) RS increases with leverage.
B) RWACC increases with leverage.
C) RS decreases with leverage.
D) RS remains constant as leverage changes.
E) RS = RB.
37) Which one of these events might cause the biggest challenge to the MM propositions?
A) An increase in the corporate tax rates
B) A decrease in the cost of debt
C) An increase in a firm’s unlevered WACC
D) A new law requiring equal lending rates for all borrowers
E) A change in tax laws to treat interest and dividends equally
38) MM Proposition I, with tax, supports the theory that
A) the value of an unlevered firm is equal to the value of a levered firm plus the interest tax shield.
B) the value of a firm is inversely related to the amount of leverage used by the firm.
C) there is a positive linear relationship between the debt-to-equity ratio and firm value.
D) a firm’s cost of capital is the same regardless of the mix of debt and equity used by the firm.
E) a firm’s weighted average cost of capital increases as the debt-equity ratio of the firm increases.
39) MM Proposition I, with taxes, is based on the concept that the
A) optimal capital structure is the one that is totally financed with equity.
B) capital structure of the firm does not matter because investors can use homemade leverage.
C) firm is worse off levered than unlevered.
D) value of the firm increases as total debt increases because of the interest tax shield.
E) cost of equity increases as the debt-equity ratio of a firm increases.
40) MM Proposition II, with taxes
A) reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.
B) reveals how the interest tax shield relates to the value of a firm.
C) supports the argument that business risk is determined by the capital structure employed by a
firm.
D) has the same general implications as MM Proposition II, without taxes.
E) supports the argument that the cost of equity decreases as the debt-equity ratio increases.
41) The interest tax shield has no value for a firm when the
I. tax rate is equal to zero.
II. debt-equity ratio is exactly equal to 1.
III. firm is unlevered.
IV. firm elects an all-equity capital structure.
A) I and III only
B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, and IV only
42) The interest tax shield is a key reason why
A) the value of an unlevered firm is equal to the value of a levered firm.
B) the net cost of debt to a firm is generally less than the cost of equity.
C) firms tend to minimize their borrowing.
D) the cost of debt is equal to the cost of equity for a firm with a debt–to-equity ratio of 1.
E) firms prefer equity financing over debt financing.
43) The MM propositions would suggest that firms should prefer which one of these
debt-to-equity ratios?
A) 0.0
B) 0.1
C) 0.5
D) 0.7
E) 0.9
44) Simpson’s is an all-equity firm that has 400,000 shares of stock outstanding. The company is in
the process of borrowing $1.5 million at 5 percent interest to repurchase 30,000 of the firm’s
outstanding shares. Ignore taxes. What will be the market value of equity after the repurchase?
A) $20.0 million
B) $19.2 million
C) $18.5 million
D) $19.8 million
E) $18.9 million
45) Durbin, Inc., is an unlevered firm with a total market value of $460,000 and 40,000 shares of
stock outstanding. The firm has expected EBIT of $48,000 if the economy is normal and $56,000
if the economy booms. The firm is considering a bond issue of $57,500 with an attached interest
rate of 6.8 percent. The bond proceeds will be used to repurchase shares. Ignore taxes. What will
be the earnings per share after the repurchase if the economy booms?
A) $1.49
B) $1.63
C) $1.45
D) $1.54
E) $1.68
46) Marley’s is an unlevered firm with a total market value of $220,000 and 5,000 shares of stock
outstanding. The firm has expected EBIT of $10,000 if the economy is normal and $12,000 if the
economy booms. The firm is considering a bond issue of $88,000 with an attached interest rate of
5.9 percent. The bond proceeds will be used to repurchase shares. Ignore taxes. What will be the
earnings per share after the repurchase if the economy booms?
A) $1.55
B) $1.61
C) $2.27
D) $2.48
E) $2.36
47) Hazlett’s is an unlevered firm with a total market value of $280,000 and 10,000 shares of stock
outstanding. The firm has expected EBIT of $16,000 if the economy is normal and $19,000 if the
economy booms. The firm is considering a bond issue of $42,000 with an attached interest rate of
7.3 percent. The bond proceeds will be used to repurchase shares. The tax rate is 35 percent. What
will be the earnings per share after the repurchase if the economy is normal?
A) $1.27
B) $0.63
C) $0.99
D) $1.05
E) $1.18
48) Brown’s is an unlevered firm with a total market value of $368,000 and 18,400 shares of stock
outstanding. The firm has expected EBIT of $17,500 if the economy is normal and $19,000 if the
economy booms. The firm is considering a bond issue of $120,000 with an attached interest rate of
5.9 percent. The bond proceeds will be used to repurchase shares. The tax rate is 34 percent. What
will be the earnings per share after the repurchase if the economy booms?
A) $0.92
B) $0.84
C) $0.75
D) $0.59
E) $0.63