Debt Policy 4

Question 1

The total market value (V) of the securities of a firm with both debt (D) and equity (E) is:
A. V = D - E
B. V = E - D
C. V = D * E
D. V = D + E

Answer 1

D. V = D + E

Question 2

Under what conditions would a policy of maximizing the value of the firm not the same as a policy of maximizing shareholders’ wealth?
A. If the issue of debt increases the probability of bankruptcy
B. If the firm issues debt for the first time
C. If the beta of equity is positive
D. If an issue of debt affects the market value of existing debt

Answer 2

D. If an issue of debt affects the market value of existing debt

Question 3

A policy of maximizing the value of the firm is the same as a policy of maximizing the shareholders’ wealth rests on two important assumptions. They are:
I) the firm can ignore dividend policy
II) the debt equity ratio of the firm does not change
III) an issue of new debt does not affect the market value of existing debt

A. I only
B. II only
C. III only
D. I and III only

Answer 3

D. I and III only

Question 4

Modigliani and Miller’s Proposition I states that:
A. The market value of any firm is independent of its capital structure
B. The market value of a firm’s debt is independent of its capital structure
C. The market value of a firm’s common stock is independent of its capital structure
D. None of the above

Answer 4

A. The market value of any firm is independent of its capital structure

Question 5

If firm U is unlevered and firm L is levered, then which of the following is true:
I) VU = EU
II) VL = EL + DL
III) VL = EU + DL

A. I only
B. I and II only
C. I, II, and III
D. III only

Answer 5

B. I and II only

Question 6

If an investor buys "a" proportion of an unlevered firm's (firm U) equity then his/her payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Answer 6

A. (a) * (profits)

Question 7

If an investor buys "a" proportion of an both debt and equity of a levered firm (firm L) then his/her payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Answer 7

A. (a) * (profits)

Question 8

If an investor buys "a" proportion of the equity of a levered firm (firm L) then his/her payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Answer 8

C. (a) * (profits - interest)

Question 9

The law of conservation of value implies that:
A. The value of a firm’s common stock is unchanged when debt is added to its capital structure
B. The value of any asset is preserved regardless of the nature of the claims against it
C. The value of a firm’s debt is unchanged when common stock is added to its capital structure
D. None of the above

Answer 9

B. The value of any asset is preserved regardless of the nature of the claims against it

Question 10

An investor can undo the effect of leverage on his/her own account by:
I) investing in the equity of a levered firm
II) by borrowing on his/her own account
III) by investing in risk-free debt like T-bills

A. I only
B. II only
C. III only
D. I and III above

Answer 10

D. I and III above

Question 11

“Value additivity” works for:
I) combining assets
II) splitting up of assets
III) mix of debt securities issued by the firm

A. I only
B. II only
C. I and II only
D. I, II, and III

Answer 11

D. I, II, and III

Question 12

Value additivity principal

Answer 12

When the value of a whole group of assets exactly equals the sum of the values of the individual assets that make up the group of assets. Or, the principle that the net present value of a set of independent projects is just the sum of the net present values of the individual projects.

Question 13

The law of conservation of value implies that:
I) the mix of senior and subordinated debt does not affect the value of the firm
II) the mix of convertible and non-convertible debt does not affect the value of the firm
III) the mix of common stock and the preferred stock does not affect the value of the firm

A. I only
B. II only
C. III only
D. I, II, and III

Answer 13

D. I, II, and III

Question 14

The main difference between preferred and common stock is that

Answer 14

preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company’s income, meaning they are paid dividends before common shareholders.

Question 15

Convertible debentures

Answer 15

are a type of debentures that can be converted into equity shares of the company. Non-convertible debentures are defined as the type of debentures that cannot be converted into equity shares of the company.

Question 16

Equity shares are

Answer 16

long-term financing sources for any company. These shares are issued to the general public and are non-redeemable in nature. Investors in such shares hold the right to vote, share profits and claim assets of a company.

Question 17

The law of conservation of value implies that:
I) the mix of common stock and preferred stock does not affect the value of the firm
II) the mix of long-term and short-term debt does not affect the value of the firm
III) the mix of secured and unsecured debt does not affect the value of the firm

A. I only
B. II only
C. III only
D. I, II, and III

Answer 17

D. I, II, and III

Question 18

Unsecured debt

Answer 18

has no collateral backing. Lenders issue funds in an unsecured loan based solely on the borrower’s creditworthiness and promise to repay. Secured debts are those for which the borrower puts up some asset as surety or collateral for the loan

Question 19

Capital structure is irrelevant if:
A. the capital markets are perfect
B. each investor holds a fully diversified portfolio
C. each investor holds the same proportion of debt and equity of the firm
D. all of the above

Answer 19

D. all of the above

Question 20

For a levered firm,
A.As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percent
B. As EBIT increases, the EPS increases by a larger percent
C. As EBIT increases, the EPS decreases
D. None of the above

Answer 20

B. As EBIT increases, the EPS increases by a larger percent

Question 21

For an all-equity firm,
A.As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percent
B. As EBIT increases, the EPS increases by a larger percent
C. As EBIT increases, the EPS decreases
D. None of the above

Answer 21

A.As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS) increases by the same percent

Question 22

An EPS-Operating Income graph shows the trade-off between financing plans and:
I) Greater risk associated with debt financing, which is evidenced by the greater slope
II) Their break-even point
III) The minimum earnings needed to pay the debt financing for a given level of debt

A. I only
B. II only
C. III only
D. I, II, and III only

Answer 22

D. I, II, and III only

Question 23

According to the EPS-operating income graph, debt financing is preferred if the expected operating income is:
A. less than the break-even income
B. greater than the break-even income
C. equal to the break-even income

Answer 23

B. greater than the break-even income

Question 24

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of operating income because:
A. Interest payments on the debt vary with EBIT levels
B. Interest payments on the debt stay fixed leaving less income to be distributed over fewer shares
C. Interest payments on the debt stay fixed, leaving less income to be distributed over more shares
D. Interest payments on the debt stay fixed, leaving more income to be distributed over fewer number of
shares

Answer 24

D. Interest payments on the debt stay fixed, leaving more income to be distributed over less number of
shares

Question 25

In an EPS-Operating Income graphical relationship, the slope of the debt line is steeper than the equity line. The debt line has a negative value for intercept because:
A. The break-even point is higher with debt
B. A fixed interest charge must be paid even at low earnings
C. The amount of interest per share has only a positive effect on the intercept
D. The higher the interest rate the greater the slope

Answer 25

B. A fixed interest charge must be paid even at low earnings

Question 26

The effect of financial leverage on the performance of the firm depends on:
A. The rate of return on equity
B. The firm's level of operating income
C. The current market value of the debt
D. The rate of dividend growth

Answer 26

B. The firm’s level of operating income

Question 27

MM Proposition II states that:
A. The expected return on equity is positively related to leverage
B. The required return on equity is a linear function of the firm’s debt to equity ratio
C. The risk to equity increases with leverage
D. All of the above
E. None of the above

Answer 27

D. All of the above

Question 28

The cost of capital for a firm, rWACC, in a tax-free environment, is:
A. Equal to the expected EBIT divided by the market value of the unlevered firm
B. Equal to rA, the rate of return for that business risk class
C. Equal to the overall rate of return required on the levered firm
D. All of the above

Answer 28

D. All of the above

Question 29

For a levered firm, beta of equity (bE) is equal to:
A. bE = bA
B. bE = bA + (D/E) * [bA - bD]
C. bE = bA + (D/(D + E)) * [bA - bD]
D. None of the above

Answer 29

B. bE = bA + (D/E) * [bA - bD]

Question 30

For a levered firm, return on equity (rE) is equal to:
A. rE = rA
B. rE = rA + (D/E) * [rA - rB]
C. rE = rA + (D/(D + E)) * [rA - rB]
D. None of the above

Answer 30

B. rE = rA + (D/E) * [rA - rB]

Question 31

Generally, which of the following is true?
A. rD > rA > rE
B. rE > rD > rA
C. rE > rA > rD
D. None of the above is true

Answer 31

C. rE > rA > rD

Question 32

Generally, which of the following is true? (b = beta)
A. bD < bA < bE
B. bE < bA < bD
C. bA < bE < bD
D. None of the above is true

Answer 32

A. bD < bA < bE

Question 33

Generally, which of the following is true?
A. rE < rD < rA
B. rD < rA < rE
C. rE < rA < rD
D. None of the above is true

Answer 33

B. rD < rA < rE

Question 34

Which of the following is true?
A. bD > bA > bE
B. bE > bA > bD
C. bA > bE > bD
D. None of the above is true

Answer 34

B. bE > bA > bD

Question 35

If beta of debt is zero, then the relationship between equity beta and asset beta is given by:
A. equity beta = 1 + [(Beta of assets)/(debt-equity ratio)]
B. equity beta = (1 - Debt-equity ratio)(beta of assets)
C. equity beta = (1 + Debt-equity ratio)(beta of assets)
D. None of the above

Answer 35

C. equity beta = (1 + Debt-equity ratio)(beta of assets)

Question 36

Minimizing the weighted average cost of capital (WACC) is the same as:
A. Maximizing the market value of the firm
B. Maximizing the book value of the firm
C. Maximizing the profits of the firm
D. Maximizing the liquidating value of the firm

Answer 36

A. Maximizing the market value of the firm

Question 37

The after-tax weighted average cost of capital (WACC) is given by: (Corporate tax rate = TC )
A. WACC = (rD)(D/V) + (rE)(E/V)
B. WACC = (rD)(D/V) +[(rE )(E/V)/(1 - TC)]
C. WACC = [(rD)(D/V) + (rE)(E/V)]/(1 - TC)
D. WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)

Answer 37

D. WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)

Question 38

According to the graph of WACC for Union Pacific, the following is (are) true:
I) cost of equity is an increasing function of the debt-equity ratio.
II) cost of debt is an increasing function of the debt-equity ratio.
III) weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.
A. I only
B. I and II only
C. III only
D. I, II and III

Answer 38

D. I, II and III