Fundamentals of Corporate Finance, 12e (Ross)
Chapter 16 Financial Leverage and Capital Structure Policy
1) Which one of these statements is correct?
A) Capital structure has no effect on shareholder value.
B) The optimal capital structure occurs when the cost of equity is minimized.
C) The optimal capital structure maximizes shareholder value.
D) Shareholder value is maximized when WACC is also maximized.
E) Unlevered firms have more value than levered firms when firms are profitable.
2) A firm should select the capital structure that:
A) produces the highest cost of capital.
B) maximizes the value of the firm.
C) minimizes taxes.
D) is fully unlevered.
E) equates the value of debt with the value of equity.
3) The value of a firm is maximized when the:
A) cost of equity is maximized.
B) tax rate equals the cost of capital.
C) levered cost of capital is maximized.
D) weighted average cost of capital is minimized.
E) debt-equity ratio is minimized.
4) The optimal capital structure has been achieved when the:
A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) debt-equity ratio results in the lowest possible weighted average cost of capital.
5) Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before
interest and taxes (EBIT). The steeper the slope of the plotted line the:
A) lower the impact of financial leverage.
B) lower the debt-equity ratio.
C) higher the tax rate.
D) greater the sensitivity of EPS to changes in EBIT.
E) lower the probability of a negative EPS.
6) You have computed the break-even point between a levered and an unlevered capital
structure. Ignore taxes. At the break-even level, the:
A) company is earning just enough to pay for the cost of the debt.
B) company’s earnings before interest and taxes are equal to zero.
C) earnings per share for the levered option are exactly double those of the unlevered option.
D) advantages of leverage exceed the disadvantages of leverage.
E) company has a debt-equity ratio of .50.
7) Which one of the following statements is correct concerning the relationship between a
levered and an unlevered capital structure? Ignore taxes.
A) At the break-even point, there is no advantage to debt.
B) The earnings per share will equal zero when EBIT is zero for a levered firm.
C) The advantages of leverage are inversely related to the level of EBIT.
D) The use of leverage at any level of EBIT increases the EPS.
E) EPS are more sensitive to changes in EBIT when a firm is unlevered.
8) Jessica invested in QRT stock when the company was unlevered. Since then, QRT has
changed its capital structure and now has a debt-equity ratio of .36. To unlever her position,
Jessica needs to:
A) borrow some money and purchase additional shares of QRT stock.
B) maintain her current equity position as the debt of the firm does not affect her personally.
C) sell 36 percent of her shares of QRT stock and hold the proceeds in cash.
D) sell 36 percent of her shares of QRT stock and loan out the sale proceeds.
E) create a personal debt-equity ratio of .36.
9) Which one of the following makes the capital structure of a company irrelevant?
A) Taxes
B) Interest tax shield
C) 100 percent dividend payout ratio
D) Debt-equity ratio that is greater than 0 but less than 1
E) Homemade leverage
10) Homemade leverage is:
A) the incurrence of debt by a corporation in order to pay dividends to shareholders.
B) the exclusive use of debt to fund a corporate expansion project.
C) the use of personal borrowing to alter an individual’s exposure to financial leverage.
D) best defined as an increase in a company’s debt level.
E) the term used to describe the capital structure of a levered firm.
11) The concept of homemade leverage is most associated with:
A) M&M Proposition I with no tax.
B) M&M Proposition II with no tax.
C) M&M Proposition I with tax.
D) M&M Proposition II with tax.
E) the static theory proposition.
12) Which one of the following statements is correct in relation to M&M Proposition II, without
taxes?
A) The cost of equity remains constant as the debt-equity ratio increases.
B) The cost of equity is inversely related to the debt-equity ratio.
C) The required return on assets is equal to the weighted average cost of capital.
D) Financial risk determines the return on assets.
E) Financial risk is unaffected by the debt-equity ratio.
13) M&M Proposition II, without taxes, is the proposition that:
A) the capital structure of a company has no effect on that company’s value.
B) the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
C) a company’s cost of equity is a linear function with a slope equal to (RA − RD).
D) the cost of equity is equivalent to the required rate of return on assets.
E) the size of the pie does not depend on how the pie is sliced.
14) The business risk of a company:
A) depends on the company’s level of unsystematic risk.
B) is inversely related to the required return on the company’s assets.
C) is dependent upon the relative weights of the debt and equity used to finance the company.
D) has a positive relationship with the company’s cost of equity.
E) has no relationship with the required return on a company’s assets according to M&M theory.
15) Financial risk is:
A) the risk inherent in a company’s operations.
B) a type of unsystematic risk.
C) inversely related to the cost of equity.
D) dependent upon a company’s capital structure.
E) irrelevant to the value of a company.
16) Which one of the following states that the value of a company is unrelated to the company’s
capital structure?
A) Homemade leverage
B) M&M Proposition I, no tax
C) M&M Proposition II, no tax
D) Pecking-order theory
E) Static theory of capital structure
17) Which one of the following states that the cost of equity capital is directly and proportionally
related to capital structure?
A) Static theory of capital structure
B) M&M Proposition I
C) M&M Proposition II
D) Homemade leverage
E) Pecking-order theory
18) Which one of the following is the equity risk that is most related to the daily operations of a
firm?
A) Market risk
B) Systematic risk
C) Extrinsic risk
D) Business risk
E) Financial risk
19) Which one of the following is the equity risk related to capital structure policy?
A) Market risk
B) Systematic risk
C) Static risk
D) Business risk
E) Financial risk
20) M&M Proposition I with no tax supports the argument that:
A) business risk has no effect on the return on assets.
B) the cost of equity rises as leverage rises.
C) a company’s debt-equity ratio is completely irrelevant.
D) business risk is irrelevant.
E) homemade leverage is irrelevant.
21) Westover Mills reduced its taxes last year by $210 by increasing its interest expense by
$1,000. Which one of the following terms is used to describe this tax savings?
A) Interest tax shield
B) Interest credit
C) Homemade leverage shield
D) Current tax yield
E) Tax-loss interest
22) M&M Proposition I with tax implies that the:
A) weighted average cost of capital decreases as the debt-equity ratio increases.
B) value of a company is inversely related to the amount of leverage used by that company.
C) value of an unlevered company equals the value of a levered company plus the value of the
interest tax shield.
D) cost of capital is the same regardless of the mix of debt and equity used.
E) cost of equity increases as the debt-equity ratio decreases.
23) M&M Proposition I with taxes is based on the concept that:
A) the optimal capital structure is the one that is totally financed with equity.
B) capital structure is irrelevant because investors and companies have differing tax rates.
C) WACC is unaffected by a change in the company’s capital structure.
D) the value of a taxable company increases as the level of debt increases.
E) the cost of equity increases as the debt-equity ratio increases.
24) M&M Proposition II with taxes:
A) has the same general implications as M&M Proposition II without taxes.
B) states that capital structure is irrelevant to shareholders.
C) supports the argument that business risk is determined by the capital structure decision.
D) supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E) concludes that the capital structure decision is irrelevant to the value of a firm.
25) The present value of the interest tax shield is expressed as:
A) TCD/RA.
B) VU + TCD.
C) TCDRA.
D) [EBIT(TCD)]/RA.
E) TCD.
26) The interest tax shield is a key reason why:
A) the required rate of return on assets rises when debt is added to the capital structure.
B) the value of an unlevered company is equal to the value of a levered company.
C) the net cost of debt is generally less than the cost of equity.
D) the cost of debt is equal to the cost of equity for a levered company.
E) companies prefer equity financing over debt financing.
27) Based on M&M Proposition I with taxes, the weighted average cost of capital:
A) is equal to the aftertax cost of debt.
B) has a linear relationship with the cost of equity capital.
C) is unaffected by the tax rate.
D) decreases as the debt-equity ratio increases.
E) is equal to RU(1 − TC).
28) The symbol “RU” refers to the cost of capital for a(n) ________ while “RA” represents the:
A) privately owned entity; unlevered cost of capital.
B) all-equity company; weighted average cost of capital.
C) levered company; cost of capital for an all-equity company.
D) levered company; weighted average cost of capital.
E) unlevered company; average cost of equity.
29) The explicit costs, such as legal and administrative expenses, associated with corporate
default are classified as ________ costs.
A) flotation
B) issue
C) direct bankruptcy
D) indirect bankruptcy
E) unlevered
30) Which one of the following is a direct cost of bankruptcy?
A) Bypassing a positive NPV project to avoid additional debt
B) Investing in cash reserves
C) Maintaining a debt-equity ratio that is lower than the optimal ratio
D) Losing a key company employee
E) Paying an outside accountant to prepare bankruptcy reports
31) The costs incurred by a business in an effort to avoid bankruptcy are classified as ________
costs.
A) flotation
B) direct bankruptcy
C) indirect bankruptcy
D) financial solvency
E) capital structure
32) The proposition that a company borrows up to the point where the marginal benefit of the
interest tax shield derived from increased debt is just equal to the marginal expense of the
resulting increase in financial distress costs is called:
A) the static theory of capital structure.
B) M&M Proposition I, with taxes.
C) M&M Proposition II, with taxes.
D) the pecking-order theory.
E) the open markets theorem.
33) If a company has the optimal amount of debt, then the:
A) direct financial distress costs must equal the present value of the interest tax shield.
B) value of the levered company will exceed the value of the unlevered company.
C) company has no financial distress costs.
D) Value of the firm is equal to VL + TCD.
E) debt-equity ratio is equal to 1.
34) Which one of the following provides the greatest tendency to increase the percentage of debt
included in a company’s optimal capital structure?
A) Exceptionally high depreciation expenses
B) Very low marginal tax rate
C) Substantial tax shields from other sources
D) Low probability of financial distress
E) Minimal taxable income
35) The capital structure that maximizes the value of a company also:
A) minimizes financial distress costs.
B) minimizes the cost of capital.
C) maximizes the present value of the tax shield on debt.
D) maximizes the value of the debt.
E) maximizes the present value of the bankruptcy costs.
36) The optimal capital structure:
A) will be the same for all companies within the same industry.
B) will remain constant over time unless the company changes its primary operations.
C) will vary over time as taxes and market conditions change.
D) places more emphasis on operations than on financing.
E) is unaffected by changes in the financial markets.
37) The static theory of capital structure advocates that the optimal capital structure for a
company:
A) is highly dependent upon a constant debt-equity ratio over time.
B) remains fixed over time.
C) is independent of the company’s tax rate.
D) is independent of the company’s debt-equity ratio.
E) equates marginal tax savings from additional debt to the marginal increased bankruptcy costs
of that debt.
38) The basic lesson of M&M theory is that the value of a company is dependent upon:
A) the company’s capital structure.
B) the total cash flows of that company.
C) minimizing the marketed claims.
D) the amount of the company’s marketed claims.
E) size of the stockholders’ claims.
39) Which one of the following is a marketed claim against the cash flows of a company?
A) Tax payment to the IRS
B) Dividend payment to shareholders
C) Payment of employees’ wages
D) Payment for warranty work on a product produced by the company
E) Payment of legal claim against the company
40) The optimal capital structure of a company:
A) minimizes the company’s tax payments.
B) maximizes the value of that company’s marketed claims.
C) minimizes both the marketed and nonmarketed claims against that company.
D) eliminates all nonmarketed claims against that company.
E) equates the company’s marketed and nonmarketed claims.
41) Which form of financing do companies prefer to use first according to the pecking-order
theory?
A) Regular debt
B) Convertible debt
C) Common stock
D) Preferred stock
E) Internal funds
42) Which one of the following is correct according to pecking-order theory?
A) There is a direct relationship between a company’s profits and its debt levels.
B) Companies avoid external debt except as a last resort.
C) A company’s capital structure is independent of its need for external funding.
D) Companies stockpile internally generated cash.
E) Every company has an optimal capital structure.
43) With the exception of a few industries, most corporations in the U.S. tend to:
A) minimize taxes.
B) underutilize debt.
C) rely equally on debt and equity.
D) have relatively similar debt-equity ratios across industry lines.
E) rely more heavily on debt than on equity.
44) In general, the capital structures of U.S. firms:
A) tend to overweigh debt in relation to equity.
B) generally result in debt-equity ratios between .45 and .55.
C) are fairly standard for all SIC codes.
D) tend to exceed a debt-equity ratio of .45.
E) vary significantly across industries.
45) Edwards Farm Products was unable to meet its financial obligations and was forced into
using legal proceedings to restructure itself so that it could continue as a viable business. The
process this company underwent is known as a:
A) merger.
B) repurchase program.
C) liquidation.
D) reorganization.
E) divestiture.
46) Which one of these actions generally occurs first in a bankruptcy reorganization?
A) Filing proofs of claim
B) Dividing creditors into classes
C) Confirming the reorganization plan
D) Distributing cash, property, and securities to creditors
E) Submitting a reorganization plan
47) Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, how long
after a company firm files for bankruptcy protection do creditors have to wait before submitting
their own reorganization plan to the court?
A) 60 days
B) 45 days
C) 180 days
D) 12 months
E) 18 months
48) The absolute priority rule determines:
A) when a firm must be declared officially bankrupt.
B) how a distressed firm is reorganized.
C) which judge is assigned to a particular bankruptcy case.
D) how long a reorganized firm is allowed to remain under bankruptcy protection.
E) which parties receive payment first in a bankruptcy proceeding.