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. MM’s proposition I states that the required rate of return on equity increases as the firm’s
debt-equity ratio increases.
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, restructuring the firm will not change its overall value.
14. Under MM II assumptions, 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, it can be observed that restructuring
does 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 interest tax shield for a firm.
23. Studies suggest that the indirect costs of bankruptcy are typically of a significant
magnitude.
24. The pecking-order theory of capital structure depicts the fact that firms prefer internal
financing to avoid sending out adverse signals that may lower the stock price.
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 to $2.0 million?
29. A firm issues 100,000 equity shares with a total market value of $5,000,000. The firm’s
market value of debt is also of equal amount (i.e., $5,000,000). The 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 the firm’s borrowing and interest expense
increases by 50% and the number of shares in circulation is cut by 50% (assuming that the share
price remains unchanged with this change in capital structure)?
30. A firm issues 100,000 equity shares with a total market value of $5,000,000. The firm’s
market value of debt is also of equal amount (i.e., $5,000,000). The 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 the firm’s borrowing and interest expense
increases by 75% and the number of shares in circulation is cut by 75% (assuming that the share
price remains unchanged with this change in capital structure)?
31. Which one of these is
not
an underlying assumption of MM Proposition I?
32. The stability of a firm’s operating income is the focus of:
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 9%. What is the expected
return on equity if the expected return on assets is 14%?
e
37. Assume a firm is financed with 60% debt on which it pays 7%. What is the expected
return on equity if the expected return on assets is 12%?
e
38. According to MM 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 under MM II:
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 tax rate is 35%?
43. When taxes are considered, the value of a levered firm equals the value of the: