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Ch 15 Capital Structure Decisions
34. Which of the following statements is CORRECT?
a.
The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that
maximizes its stock price.
b.
The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that
maximizes its earnings per share.
c.
If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its
WACC.
d.
Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff
theory would suggest that firms should increase their use of debt.
e.
A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings
is not zero, its cost is generally lower than the after-tax cost of debt.
35. The Miller model begins with the MM model with corporate taxes and then adds personal taxes.
a.
True
b.
False
Ch 15 Capital Structure Decisions
36. The Miller model begins with the MM model without corporate taxes and then adds personal taxes.
a.
True
b.
False
37. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.
a.
True
b.
False
Ch 15 Capital Structure Decisions
38. The MM model is the same as the Miller model, but with zero corporate taxes.
a.
True
b.
False
39. The major contribution of the Miller model is that it demonstrates that
a.
personal taxes decrease the value of using corporate debt.
b.
financial distress and agency costs reduce the value of using corporate debt.
c.
equity costs increase with financial leverage.
d.
debt costs increase with financial leverage.
Ch 15 Capital Structure Decisions
e.
personal taxes increase the value of using corporate debt.
40. Which of the following statements concerning capital structure theory is NOT CORRECT?
a.
Under MM with zero taxes, financial leverage has no effect on a firm's value.
b.
Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the
product of the tax rate times the market value dollar amount of debt.
c.
Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of
debt financing.
d.
Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a
function of rsU.
e.
The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using
corporate debt.
Ch 15 Capital Structure Decisions
Eccles Inc.
Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000
of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
41. Refer to the data for Eccles Inc.What is the value of the firm according to MM with corporate taxes?
a.
$475,875
b.
$528,750
c.
$587,500
d.
$646,250
e.
$710,875
Ch 15 Capital Structure Decisions
42. Refer to the data for Eccles Inc.What is the firm's cost of equity according to MM with corporate taxes?
a.
21.0%
b.
23.3%
c.
25.9%
d.
28.8%
e.
32.0%
43. Refer to the data for Eccles Inc.Assume that the firm's gain from leverage according to the Miller model is $126,667.
If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
Ch 15 Capital Structure Decisions
a.
16.4%
b.
18.2%
c.
20.2%
d.
22.5%
e.
25.0%
44. Which of the following statements is CORRECT?
a.
Electric utilities generally have very high common equity ratios because their revenues are more volatile than
those of firms in most other industries.
b.
Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are
very stable and, thus, they can cover the high interest costs associated with high debt levels.
c.
Wide variations in capital structures exist both between industries and among individual firms within given
industries. These differences are caused by differing business risks and also managerial attitudes.
Ch 15 Capital Structure Decisions
d.
Since most stocks sell at or very close to their book values, book value capital structures are almost always
adequate for use in estimating firms' costs of capital.
e.
Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary
among firms within a given industry.
45. Which of the following statements is CORRECT?
a.
Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its
WACC.
b.
Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing.
However, this action still may raise the company's WACC.
c.
Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing.
However, this action still may lower the company's WACC.
d.
Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost
of equity.
e.
Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its
WACC.
Ch 15 Capital Structure Decisions
46. Which of the following statements is CORRECT?
a.
The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
b.
The capital structure that minimizes the required return on equity also maximizes the stock price.
c.
The capital structure that minimizes the WACC also maximizes the price per share of common stock.
d.
The capital structure that gives the firm the best credit rating also maximizes the stock price.
e.
The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
47. Based on the information below for Benson Corporation, what is the optimal capital structure?
a.
Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
b.
Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
c.
Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
d.
Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
e.
Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
Ch 15 Capital Structure Decisions
48. Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix
of debt, equity, and preferred stock that maximizes the company's ____.
a.
stock price.
b.
cost of equity.
c.
cost of debt.
d.
cost of preferred stock.
e.
earnings per share (EPS).
49. Which of the following statements is CORRECT?
Ch 15 Capital Structure Decisions
a.
The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
b.
The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the
stock price.
c.
The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
d.
The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.
e.
As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected
EPS.
50. The firm's target capital structure should be consistent with which of the following statements?
a.
Minimize the cost of debt (rd).
b.
Obtain the highest possible bond rating.
c.
Minimize the cost of equity (rs).
d.
Minimize the weighted average cost of capital (WACC).
e.
Maximize the earnings per share (EPS).
Ch 15 Capital Structure Decisions
51. Which of the following statements is CORRECT?
a.
The factors that affect a firm's business risk are affected by industry characteristics and economic conditions.
Unfortunately, these factors are generally beyond the control of the firm's management.
b.
One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of
bankruptcy.
c.
A firm's financial risk can be minimized by diversification.
d.
The amount of debt in its capital structure can under no circumstances affect a company's business risk.
e.
A firm's business risk is determined solely by the financial characteristics of its industry.
52. Which of the following statements is CORRECT?
a.
If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of
sales constant, this would decrease its operating leverage.
b.
The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
c.
If a company were to issue debt and use the money to repurchase common stock, this action would have no
impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating
income.)
d.
If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the
average corporation's debt ratio.
Ch 15 Capital Structure Decisions
e.
Increasing financial leverage is one way to increase a firm's basic earning power (BEP).
53. Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC
exceeds their after-tax cost of debt, (1-T) rd. 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 lower ROA than Company LD.
b.
Company HD has a lower ROE than Company LD.
c.
The two companies have the same ROA.
d.
The two companies have the same ROE.
e.
Company HD has a higher net income than Company LD.
Ch 15 Capital Structure Decisions
54. Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets. 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 4.8%. Both firms have positive net income. Which of the following statements is CORRECT?
a.
Firm L has a lower ROA than Firm U.
b.
Firm L has a lower ROE than Firm U.
c.
Firm L has the higher times interest earned (TIE) ratio.
d.
Firm L has a higher EBIT than Firm U.
e.
The two companies have the same times interest earned (TIE) ratio.
55. Two operationally similar companies, HD and LD, have the same total assets, operating income (EBIT), tax rate, and
business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's return on invested capital
(ROIC) exceeds its after-tax cost of debt, (1-T)rd. Which of the following statements is CORRECT?
a.
HD should have a higher times interest earned (TIE) ratio than LD.
b.
HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation
of ROE, should also be higher than LD's.
c.
Given that ROIC > (1-T) rd, HD's stock price must exceed that of LD.
d.
Given that ROIC > (1-T) rd, LD's stock price must exceed that of HD.
e.
HD should have a higher return on assets (ROA) than LD.
Ch 15 Capital Structure Decisions
56. Which of the following statements is CORRECT?
a.
The capital structure that maximizes the stock price is generally the capital structure that also maximizes
earnings per share.
b.
All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt
ratio.
c.
Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its
WACC.
d.
Since debt is cheaper than equity, increasing a company's debt ratio will always reduce its WACC.
e.
When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC
must also increase.
Ch 15 Capital Structure Decisions
57. Two operationally similar companies, HD and LD, have identical amounts of assets, operating income (EBIT), tax
rates, and business risk. Company HD, however, has a much higher debt ratio than LD. Company HD's return on invested
capital (ROIC) exceeds its after-tax cost of debt, (1-T) rd. Which of the following statements is CORRECT?
a.
Company HD has a higher times interest earned (TIE) ratio than Company LD.
b.
Company HD has a higher return on equity (ROE) than Company LD, and its risk, as measured by the
standard deviation of ROE, is also higher than LD's.
c.
The two companies have the same ROE.
d.
Company HD's ROE would be higher if it had no debt.
e.
Company HD has a higher return on assets (ROA) than Company LD.
58. Bailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is
40%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta?
a.
0.64
b.
0.67
c.
0.71
d.
0.75
e.
0.79
POINTS:
1
Ch 15 Capital Structure Decisions
59. The following information has been presented to you about the Gibson Corporation.
Total assets
$3,000 million
Tax rate
40%
Operating income (EBIT)
$800 million
Debt ratio
0%
Interest expense
$0 million
WACC
10%
Net income
$480 million
M/B ratio
1.00×
Share price
$32.00
EPS = DPS
$3.20
The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS).
The consultant believes that if the company moves to a capital structure financed with 20% debt and 80% equity (based
on market values) that the cost of equity will increase to 11% and that the pre-tax cost of debt will be 10%. If the company
makes this change, what would be the total market value (in millions) of the firm?
a.
$3,200
b.
$3,600
c.
$4,000
d.
$4,200
e.
$4,800
Ch 15 Capital Structure Decisions
60. Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to
a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and the market risk premium is 6.0%, by
how much would the capital structure shift change the firm's cost of equity?
a.
1.53%
b.
1.70%
c.
1.87%
d.
2.05%
e.
2.26%
Ch 15 Capital Structure Decisions
61. Serendipity Inc. is re-evaluating its debt level. Its current capital structure consists of 80% debt and 20% common
equity, its beta is 1.60, and its tax rate is 35%. However, the CFO thinks the company has too much debt, and he is
considering moving to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk
premium is 6.0%. By how much would the capital structure shift change the firm's cost of equity?
a.
−5.20%
b.
−5.78%
c.
−6.36%
d.
−6.99%
e.
−7.69%
Ch 15 Capital Structure Decisions
62. Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25%
debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio.
The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost
of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60%
debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)
a.
10.95%
b.
11.91%
c.
12.94%
d.
14.07%
e.
15.29%
TOPICS:
Cost of equity–unlevering and relevering betas
