Chapter 16 Test bank – Static Key
1.
When there are no taxes and capital markets function well, the market value of a company does not depend on its capital
structure.
2.
When asked about key factors of debt policy, financial managers commonly mention the tax advantage of debt and the
importance of maintaining their credit rating.
3.
Loan covenants can ensure that companies will accept all positive-NPV investments and reject negative ones.
4.
Debt finance does not affect the operating risk but it does add financial risk.
5.
Debt financing affects neither the business risk nor the financial risk of the firm.
6.
As long as investors can borrow or lend on their own account on the same terms as the firm, they will not pay extra for firm
leverage.
7.
Once you recognize the fact that debt also increases financial risk and causes shareholders to demand a higher return on their
investment, debt is no cheaper than equity.
8.
At moderate debt levels the probability of financial distress is trivial and therefore the tax advantages of debt dominate.
9.
Debt financing affects neither the operating risk nor the business risk of the firm.
10.
Financial leverage describes debt financing’s amplification of the effects of changes in operating income on the returns to
stockholders.
11.
Financial risk is the risk to shareholders that results from debt financing.
12.
MM’s proposition I, or the debt-irrelevance proposition, states that the value of a firm is unaffected by its capital structure.
13.
According to MM, debt restructuring will not change the firm’s overall value.
14.
According to MM’s proposition II the expected return on equity is equal to the expected return on assets for a levered firm.
15.
MM’s proposition II states that the expected return on assets increases as the debt-equity ratio increases.
16.
MM’s proposition II states that the required return on equity increases as the firm’s debt-equity ratio increases.
17.
The benefit of an interest tax shield is captured by the equity holders.
18.
The risk of tax shields can be reasonably assumed to be the same as that of the interest payments generating them.
19.
Even after relaxing the MM assumption of no taxes, restructuring should not affect the value of the firm.
20.
Costs of financial distress are costs arising from bankruptcy or distorted business decisions before bankruptcy.
21.
The “trade-off theory” of capital structure suggests that firms have an optimal level of debt.
22.
At some debt-equity ratio, the costs of financial distress are expected to overcome the value of the extra interest tax shield for
a firm.
23.
Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.
24.
that may lower the stock price.
The pecking-order theory of capital structure states that firms prefer internal financing to avoid sending out adverse signals
25.
Management’s perceived signals to investors form an important component of pecking-order theory.
26.
Financial slack means having ready access to cash or debt financing.
27.
When additional borrowing causes the probability of financial distress to increase rapidly, the potential costs of distress
begin to take a substantial bite out of firm value.
28.
A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. Ignoring taxes, this will
generate $12.50 earnings per share. What will happen to EPS if operating income increases by 33.3% to $2.0 million?
29.
A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The
firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what
will happen to EPS if the firm repurchases $2,500,000 of shares and substitutes an equal amount of additional debt?
30.
A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and an equal amount of debt. The
firm is expected to generate $1.5 million in operating income and pay $250,000 in interest. If the firm does not pay tax, what
will happen to EPS if the firm repurchases $3,750,000 of shares and substitutes an equal amount of debt?
31.
Which one of these is not an underlying assumption of MM Proposition I?
32.
Fluctuations in a firm’s operating income represent:
33.
An increase in a firm’s financial leverage will:
34.
Financial risk refers to the:
35.
What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12%
return on debt? Ignore taxes.
36.
Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the expected return on equity if the
expected return on assets is 14%? Ignore taxes.
37.
Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the expected return on equity if the
expected return on assets is 12%? Ignore taxes.
38.
According to MM Proposition II, as a firm’s debt-equity ratio decreases:
39.
An implicit cost of adding debt to the capital structure is that it:
40.
When debt is risky:
41.
What is the amount of the annual interest tax shield for a firm with $3 million in debt that pays 12% interest if the firm is in
the 35% tax bracket?
42.
A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value of the interest tax shield if the
43.
When taxes are considered, the value of a levered firm equals the value of the:
44.
Assume an unlevered firm changes its capital structure to include $1 million in permanent debt at a 7% interest rate. The tax
rate is 35%. According to MM I with taxes, the value of the firm will increase by ____ due to this change in its capital
structure.
45.
In a world with corporate taxes but no possibility of financial distress, the value of the firm is maximized when the:
46.
Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on its equity, finances 45% of the
market value of its assets with debt, and has a tax rate of 35%.
47.
What is the after-tax cost of debt for a firm in the 35% tax bracket that pays 15% on its debt?
48.
A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What debt-equity ratio produces a
WACC of 12%?
49.
If the present value of the interest tax shield on debt equals the present value of the costs of financial distress, then the trade-
off theory implies that the:
50.
The present value of the costs of financial distress increases as the debt ratio increases because the:
51.
When financial disaster is looming, management may borrow to invest in projects having a negative expected NPV because:
52.
Firms facing financial distress may pass up positive NPV projects rather than commit new equity because:
53.
The trade-off theory of capital structure suggests that firms:
54.
The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:
55.
Firms are more likely to restrict borrowing if the:
56.
According to the pecking-order theory, managers will often choose to finance with:
57.
A firm’s capital structure is represented by its mix of:
58.
Restructuring a firm involves changing the: