Chapter 12 - Capital Structure Decisions PDF

Preview

Summary

: s: e:CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 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. a. Trueb. Fals e ANSWER: Fals e A firm’s financial risk has identifiable market risk ...

Description

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 1. 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. a. True b. Fals e ANSWER: Fals e 2. A firm’s financial risk has identifiable market risk and diversifiable risk components. a. True b. Fals e ANSWER: Fals e 3. 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. a. True b. Fals e ANSWER: Fals e 4. 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. a. True b. Fals e ANSWER: Fals e 5. 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. a. True b. Fals e ANSWER: True 6. According to MM, in a world without taxes, the optimal capital structure for a firm is approximately 100% debt financing. a. True b. Fals e ANSWER: Fals e Copyright Cengage Learning. Powered by Cognero.

Page 1

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 7. MM shows that in a world without taxes, a firm’s value is not affected by its capital structure. a. True b. Fals e ANSWER: True 8. The Miller model begins with the MM model with taxes and then adds personal taxes. a. True b. Fals e ANSWER: True 9. The Miller model begins with the MM model without corporate taxes and then adds personal taxes. a. True b. Fals e ANSWER: Fals e 10. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient. a. True b. Fals e ANSWER: True 11. The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing. a. True b. Fals e ANSWER: True 12. Financial distress, agency costs, and direct and indirect bankruptcy costs affect a firm’s target capital structure. a. True b. Fals e ANSWER: True 13. The bankruptcy risk produces an ambiguous effect on agency costs. a. True b. Fals e ANSWER: True Copyright Cengage Learning. Powered by Cognero.

Page 2

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 14. 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. a. True b. Fals e ANSWER: True 15. 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. a. True b. Fals e ANSWER: Fals e 16. 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. a. True b. Fals e ANSWER: Fals e 17. 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. a. True b. Fals e ANSWER: True 18. 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. a. True b. Fals e ANSWER: True 19. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes. a. True b. Fals e ANSWER: True 20. The MM model is the same as the Miller model, but with zero corporate taxes. a. True b. Fals Copyright Cengage Learning. Powered by Cognero.

Page 3

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS e ANSWER: Fals e 21. A firm’s financial policy drives its equity beta. a. True b. Fals e ANSWER: True 22. The MM model employs the concept of arbitrage to develop its theory. a. True b. Fals e ANSWER: True 23. The presence of personal taxes completely eliminates the benefits of debt financing. a. True b. Fals e ANSWER: Fals e 24. Firms having positive prospects try to raise new equity capital by selling new stocks. a. True b. Fals e ANSWER: Fals e 25. 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. a. True b. Fals e ANSWER: True 26. 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. a. True b. Fals e ANSWER: Fals e 27. On which of the following items will an increase in the debt ratio generally have no effect? Copyright Cengage Learning. Powered by Cognero.

Page 4

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS a. business risk b. total risk c. financial risk d. market risk ANSWER: a 28. 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 ANSWER: d 29. 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 ANSWER: a 30. 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 ANSWER: b 31. 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. ANSWER: d 32. 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. Copyright Cengage Learning. Powered by Cognero.

Page 5

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 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. ANSWER: d 33. 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 ANSWER: c 34. 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. ANSWER: b 35. 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. ANSWER: a 36. 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. Copyright Cengage Learning. Powered by Cognero.

Page 6

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 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. ANSWER: d 37. 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) ANSWER: d 38. 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. ANSWER: b 39. 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 ANSWER: d 40. 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. ANSWER: d Copyright Cengage Learning. Powered by Cognero.

Page 7

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS 41. 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. ANSWER: d 42. 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. ANSWER: d 43. 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. ANSWER: c 44. 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. ANSWER: b 45. 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. Copyright Cengage Learning. Powered by Cognero.

Page 8

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS d. SML is negatively sloped. ANSWER: a 46. 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. ANSWER: c 47. 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. ANSWER: a 48. 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 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. d.Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing. ANSWER: d 49. Which statement concerning the MM extension with growth is incorrect? a. The value of a growing tax shield is greater than the value of a constant tax shield. b.For a given D/E, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions. c. For a given D/E, the WACC is less than the WACC under MM’s original (with tax) assumptions. d.The total value of the firm increases with the amount of debt. ANSWER: c 50. What is likely to happen in the MM model with a high risk of bankruptcy? a. It requires almost 100% debt financing. b. Valuable projects are foregone to preserve cash. c. Wasteful expenditures are often found. d. Management buys back shares from the open market. Copyright Cengage Learning. Powered by Cognero.

Page 9

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS ANSWER: b 51. Which of the following statements is correct? a. 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. b.The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share. d.If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. ANSWER: b 52. Which of the following statements is correct? a. The capital structure that maximizes the common share price is also the capital structure that minimizes the WACC. b.The capital structure that maximizes the common share price is also the capital structure that maximizes earnings per share. c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company’s WACC. d.Increasing personal tax rate but decreasing corporate tax rate would encourage companies to increase their debt ratios. ANSWER: a 53. Which of the following statements is correct? a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. b.There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions. c. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else is equal. d.If a firm’s after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. ANSWER: a 54. The CFO of Google believes that its greatest strategic goal is to maintain flexibility. To achieve this goal, which of the following financial structures is in place at Google? a. Google has issued significantly more long-term debt than equity (common shares) because debt has a significantly lower after-tax cost. b.Google has issued significantly more equity (common shares) to avoid the restrictions that debt would imposed through restrictive covenants. c. Google holds large amounts of cash and short-term investments in spite of the opportunity loss resulting from low investment earnings. d.Google maintains a dividend payout ratio in line with other firms in the industry to ensure that its common shares are attractive to investors. Copyright Cengage Learning. Powered by Cognero.

Page 10

Name :

Clas s:

Dat e:

CHAPTER 12 - CAPITAL STRUCTURE DECISIONS ANSWER: c 55. Which of the following statements is correct? a. If corporate tax rates were decreased while other things were held constant, and if the Modigliani–Miller tax-adjusted trade-off theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. b.A change in the personal tax rate should not affect firms’ capital structure decisions. c. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and factors such as sales variability, cost variability, and operating leverage. d.The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WA...