CH12 TB Brigham 2ce - M/C with answers PDF

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CHAPTER 12—CAPITAL STRUCTURE DECISIONS TRUE/FALSE 1. Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt. ANS: T PTS: 1 OBJ: (12.1) Bankruptcy costs

DIF: EASY

REF: 360

2. A firm’s business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses. ANS: F PTS: 1 OBJ: (12.2) Business risk

DIF: EASY

REF: 361–362

3. Financial risk refers to the extra risk shareholders bear as a result of using debt as compared with the risk they would bear if no debt were used. ANS: T PTS: 1 OBJ: (12.2) Financial risk

DIF: EASY

REF: 364–366

4. A firm’s financial risk has identifiable market risk and diversifiable risk components. ANS: F PTS: 1 OBJ: (12.2) Financial risk

DIF: EASY

REF: 364–366

5. A firm’s capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows. ANS: T PTS: 1 OBJ: (12.2) Financial risk

DIF: EASY

REF: 364–366

6. Whenever a firm borrows money, it is using financial leverage. ANS: T PTS: 1 OBJ: (12.2) Financial leverage

DIF: EASY

REF: 362–364

7. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant. ANS: F PTS: 1 OBJ: (12.2) Use of financial leverage

DIF: EASY

REF: 362–364

8. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage affects only EBIT. ANS: F PTS: 1 DIF: EASY OBJ: (12.2) Operating and financial leverage

REF: 362–364

9. The benefit of an interest tax shield is captured by the equity holders, not the debtholders.

ANS: T PTS: 1 OBJ: (12.3) Interest tax shield

DIF: EASY

REF: 370–371

10. In a world with no taxes, MM shows that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased. ANS: T PTS: 1 OBJ: (12.3) Taxes and capital structure

DIF: EASY

REF: 370–371

11. According to MM, in a world without taxes, the optimal capital structure for a firm is approximately 100% debt financing. ANS: F PTS: 1 OBJ: (12.3) Taxes and capital structure

DIF: EASY

REF: 370–371

12. MM shows that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt. ANS: T PTS: 1 OBJ: (12.3) MM models

DIF: EASY

REF: 372–375

13. MM shows that in a world without taxes, a firm’s value is not affected by its capital structure. ANS: T PTS: 1 OBJ: (12.3) MM models

DIF: EASY

REF: 372–375

14. The Miller model begins with the MM model with taxes and then adds personal taxes. ANS: T PTS: 1 OBJ: (12.4) Miller model

DIF: EASY

REF: 375

15. The Miller model begins with the MM model without corporate taxes and then adds personal taxes. ANS: F PTS: 1 OBJ: (12.4) Miller model

DIF: EASY

REF: 375

16. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient. ANS: T PTS: 1 OBJ: (12.6) Financial leverage

DIF: EASY

REF: 380

17. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing. ANS: T PTS: 1 OBJ: (12.6) Trade-off theory

DIF: EASY

REF: 377–381

18. Financial distress, agency costs, and direct and indirect bankruptcy costs affect a firm’s target capital structure. ANS: T PTS: 1 OBJ: (12.1) Capital structure issues

DIF: MEDIUM

REF: 359–361

19. The bankruptcy risk produces an ambiguous effect on agency costs. ANS: T PTS: 1 OBJ: (12.1) Agency costs

DIF: MEDIUM

REF: 359–361

20. If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X. ANS: T PTS: 1 OBJ: (12.2) Use of debt in financing

DIF: MEDIUM

REF: 362–365

21. Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms’ expected EBITs could actually be identical. ANS: F PTS: 1 OBJ: (12.2) Financial leverage

DIF: MEDIUM

REF: 362–365

22. Although they operate in different industries, two firms have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk. ANS: F PTS: 1 OBJ: (12.2) Business risk

DIF: MEDIUM

REF: 364–365

23. It is possible that two firms could have identical financial and operating leverage yet have different degrees of risk as measured by the variability of EPS. ANS: T If one firm’s sales and earnings were more volatile than those of the other, it could have greater EPS variability in spite of identical financial and operating leverage. PTS: 1 DIF: MEDIUM REF: 362–365 OBJ: (12.2) Operating and financial leverage 24. If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal. ANS: T PTS: 1 OBJ: (12.3) Bankruptcy costs

DIF: MEDIUM

REF: 370–374

25. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes. ANS: T PTS: 1 OBJ: (12.3) MM models

DIF: MEDIUM

REF: 372–375

26. The MM model is the same as the Miller model, but with zero corporate taxes. ANS: F PTS: 1 OBJ: (12.3) MM models

DIF: MEDIUM

REF: 372–375

27. A firm’s financial policy drives its equity beta. ANS: T PTS: 1 OBJ: (12.3) Equity beta

DIF: MEDIUM

REF: 370–375

28. The MM model employs the concept of arbitrage to develop its theory. ANS: T PTS: 1 OBJ: (12.3) MM model

DIF: MEDIUM

REF: 367–370

29. The presence of personal taxes completely eliminates the benefits of debt financing. ANS: F PTS: 1 DIF: MEDIUM OBJ: (12.4) MM extension with personal taxes

REF: 375

30. As a firm approaches bankruptcy, the indirect costs of bankruptcy (e.g., financial distress) will tend to increase. ANS: T PTS: 1 OBJ: (12.5) Bankruptcy costs

DIF: MEDIUM

REF: 377–378

31. Firms having positive prospects try to raise new equity capital by selling new stocks. ANS: F PTS: 1 OBJ: (12.5) Signalling theory

DIF: MEDIUM

REF: 378–379

32. During a recession, companies with a significant portion of their capital structure in the form of debt (i.e., high leverage) often struggle to meet their legally binding interest obligations. ANS: T PTS: 1 OBJ: (Introduction) Financial leverage

DIF: EASY

REF: 358

33. During a recession, companies with a significant portion of their capital structure in the form of common share equity (i.e., low leverage) often struggle to provide a continuous stream of dividend income to their shareholders. ANS: F PTS: 1 OBJ: (Introduction) Financial leverage

DIF: EASY

REF: 358

MULTIPLE CHOICE 1. On which of the following items will an increase in the debt ratio generally have no effect? a. business risk b. total risk c. financial risk d. market risk ANS: A PTS: 1 OBJ: (12.2) Business risk

DIF: EASY BLM: Remember

REF: 361–362

2. Business risk is affected by a firm’s operations. Which of the following is NOT associated with (or does not contribute to) business risk? a. demand variability b. input price variability c. the extent to which operating costs are fixed d. the extent to which interest rates on the firm’s debt fluctuate ANS: D PTS: 1 OBJ: (12.2) Business risk

DIF: EASY BLM: Remember

REF: 361–362

3. Which event is likely to encourage a company to raise its target debt ratio, other things held constant? a. an increase in the corporate tax rate b. an increase in the personal tax rate c. an increase in the company’s operating leverage d. the company’s stock price hitting a new high ANS: A PTS: 1 OBJ: (12.2) Target debt ratio

DIF: EASY BLM: Understand

REF: 364–366

4. Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? a. an increase in costs incurred when filing for bankruptcy b. an increase in the corporate tax rate c. an increase in the personal tax rate d. the company’s stock price hitting a new low ANS: B PTS: 1 DIF: EASY OBJ: (12.2) Leverage and capital structure

REF: 364–366 BLM: Understand

5. Which of the following statements best describes WACC? a. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC. b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC. c. 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. d. 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. ANS: D PTS: 1 DIF: EASY OBJ: (12.2) Capital structure and WACC

REF: 364–366 BLM: Understand

6. Which of the following statements best describes capital structure? a. The capital structure that maximizes expected EPS also maximizes the price per share of common shares. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the required return on equity also maximizes the share price. d. The capital structure that minimizes the WACC also maximizes the price per share of common shares. ANS: D PTS: 1 OBJ: (12.3) Optimal capital structure

DIF: EASY BLM: Understand

REF: 370–374

7. Based on the information below, what is Ezzel Enterprises’ optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Common share price = $26.50 b. Debt = 50%; Equity = 50%; EPS = $3.05; Common share price = $28.90 c. Debt = 60%; Equity = 40%; EPS = $3.18; Common share price = $31.20 d. Debt = 80%; Equity = 20%; EPS = $3.42; Common share price = $30.40 ANS: C PTS: 1 OBJ: (12.3) Optimal capital structure

DIF: EASY BLM: Understand

REF: 370–374

8. Which statement best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt. ANS: B PTS: 1 OBJ: (12.3) Optimal capital structure

DIF: EASY BLM: Remember

REF: 370–374

9. Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company’s interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company’s CFO thinks the plan will not change total assets or operating income but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are correct, which of the following statements is correct? a. Since the proposed plan increases Volga’s financial risk, the company’s share price still might fall even if EPS increases. b. If the plan reduces the WACC, the share price is also likely to decline. c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. d. If the plan does increase the EPS, the share price will automatically increase at the same rate. ANS: A PTS: 1 OBJ: (12.3) Financial leverage and EPS

DIF: EASY BLM: Understand

REF: 370–374

10. Which statement best describes optimal capital structure? a. As a rule, the optimal capital structure is found by determining the debt–equity mix that maximizes expected EPS. b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. 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 common share price and minimizes the WACC. ANS: D REF: 370–374

PTS: 1 DIF: EASY | MEDIUM OBJ: (12.3) Optimal capital structure BLM: Remember

11. What should the firm’s target capital structure be set to do? a. Maximize the earnings per share (EPS). b. Minimize the cost of debt (rd). c. Minimize the cost of equity (rs). d. Minimize the weighted average cost of capital (WACC). ANS: D REF: 370–374

PTS: 1 DIF: EASY | MEDIUM OBJ: (12.3) Target capital structure BLM: Remember

12. Which of the following statements regarding risk, or the avoidance of risk, is correct? a. A firm’s business risk is determined solely by the financial characteristics of its industry. b. Risk due to industry characteristics is beyond the control of the firm’s management. c. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy.

d. A firm’s financial risk can be minimized by diversification. ANS: B PTS: 1 DIF: EASY | MEDIUM REF: 361–362 | 370–374 OBJ: (Comp: 12.2, 12.3) Business & fin. risk & cap. struc. BLM: Understand 13. Suppose a firm increases the operating leverage used to produce a given quantity of output. What will this normally lead to? a. a decrease in the standard deviation of its expected EBIT b. a decrease in its business risk c. a decrease in the variability of its expected EPS d. a reduction in its fixed assets turnover ratio ANS: D More operating leverage generally means a greater use of automation, which means more fixed assets. If fixed assets increase, but sales do not, then the fixed asset turnover (S/FA) will decline. PTS: 1 BLM: Understand

DIF: MEDIUM

REF: 362–364

OBJ: (12.2) Operating leverage

14. If debt financing is used, which of the following is correct? a. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. b. The percentage change in net operating income will be equal to a given percentage change in net income. c. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. d. The percentage change in net income will be greater than the percentage change in net operating income. ANS: D PTS: 1 OBJ: (12.2) Use of financial leverage

DIF: MEDIUM BLM: Understand

REF: 364–366

15. Which statement regarding debt is correct, other things held constant? a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs; hence, they tend to use relatively little debt. b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. c. An increase in the company’s degree of operating leverage is likely to encourage a company to use more debt in its capital structure. d. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. ANS: D PTS: 1 DIF: MEDIUM OBJ: (12.2) Leverage and capital structure

REF: 364–366 BLM: Understand

16. Other things held constant, which event is most likely to encourage a firm to increase the amount of debt in its capital structure? a. Its sales become less stable over time. b. The costs that would be incurred in the event of bankruptcy increase. c. Management believes that the firm’s stock has become overvalued. d. The corporate tax rate increases. ANS: D PTS: 1 DIF: MEDIUM OBJ: (12.2) Leverage and capital structure

REF: 364–366 BLM: Understand

17. Reynolds Resorts is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. What would also be likely to occur if the company goes ahead with the recapitalization plan? a. The company’s net income would increase. b. The company’s earnings per share would decline. c. The company’s cost of equity would increase. d. The company’s ROE would decline. ANS: C PTS: 1 DIF: MEDIUM OBJ: (12.2) Leverage and capital structure

REF: 364–366 BLM: Understand

18. In a perfect world of no taxes, which statement regarding MM propositions is true? a. According to proposition I, a firm is able to find its optimal capital structure. b. Proposition II implies that an increase in leverage raises the risk of equity and thereby the required return on equity. c. According to proposition II, changes in the capital mix of a firm will not affect the debt and equity values of the firm. d. Proposition I states that the total firm value critically depends on capital structure. ANS: B PTS: 1 OBJ: (12.3) MM model

DIF: MEDIUM BLM: Understand

REF: 372–375

19. In a perfect world of no taxes, what happens if the weighted average cost of capital (WACC) is unaffected by the capital structure? a. MM proposition I holds. b. MM proposition II holds. c. SML is positively sloped. d. SML is negatively sloped. ANS: A PTS: 1 OBJ: (12.3) MM model

DIF: MEDIUM BLM: Understand

REF: 372–375

20. With corporate taxes but no personal taxes, and without financial distress, what happens? a. An unlevered firm cannot benefit from increased leverage. b. Equity costs decrease with more debt financing. c. The optimal amount of leverage for a firm is 100% debt. d. Debt costs increase with financial leverage. ANS: C PTS: 1 OBJ: (12.3) MM model

DIF: MEDIUM BLM: Understand

REF: 372–375

21. What is the major contribution of the Miller model? a. It demonstrates that personal taxes decrease the value of using corporate debt. b. It demonstrates that financial distress and agency costs reduce the value of using corporate debt. c. It demonstrates that equity costs increase with financial leverage. d. It demonstrates that debt costs increase with financial leverage. ANS: A PTS: 1 OBJ: (12.4) Miller model

DIF: MEDIUM BLM: Remember

REF: 375–376

22. Which statement concerning capital structure theory is NOT true? a. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt. b. Under MM with zero taxes, financial leverage has no effect on a firm’s value. c. Under MM with corpo...