Week 5 - Chapter 16 - Capital Structure I - Choosing the Debt/Equity Mix

Question 1

1) The firm’s capital structure refers to:
A) the way a firm invests its assets.
B) the amount of equity or capital in the firm.
C) the amount of dividends a firm pays.
D) the way in which a firm’s assets are financed.
E) how much cash the firm holds.

Answer 1

D) the way in which a firm’s assets are financed.

Question 2

A general rule for managers to follow is to set the firm’s capital structure such that:

A) the firm’s value is minimized.
B) the firm’s value is maximized.
C) the firm’s bondholders are made well off.
D) the firms suppliers of raw materials are satisfied.
E) the firms dividend payout is maximized.

Answer 2

B) the firm’s value is maximized.

Question 3

A levered firm is a company that:

A) is financed by common stock.
B) has some debt in the capital structure.
C) has all equity in the capital structure.
D) has no debt in the capital structure.

Answer 3

B) has some debt in the capital structure.

Question 4

A manager should attempt to maximize the value of the firm by:

A) changing the capital structure if and only if the value of the firm decreases.
B) changing the capital structure if and only if the value of the firm increases to the
benefit of the stockholders.
C) changing the capital structure if and only if the value of the firm increases only to the
benefits the debt holders.
D) changing the capital structure if and only if the value of the firm increases although it
decreases the stockholders’ value.
E) changing the capital structure if and only if the value of the firm increases and
stockholder wealth is constant

Answer 4

B) changing the capital structure if and only if the value of the firm increases to the
benefit of the stockholders.

Question 5

The unlevered cost of capital is:

A) the cost of capital for a firm with no equity in its capital structure.
B) the cost of capital for a firm with no debt in its capital structure.
C) the interest tax shield times pretax net income.
D) the cost of preferred stock for a firm with equal parts debt and common stock in its
capital structure.
E) equal to the profit margin for a firm with some debt in its capital structure.

Answer 5

B) the cost of capital for a firm with no debt in its capital structure.

Question 6

The effect of financial leverage depends on the operating earnings of the company. Which of
the following is not true?

A) Below the indifference or break-even point in EBIT the non-levered structure is
superior.

B) Financial leverage increases the slope of the EPS line.

C) Above the indifference or break-even point the increase in EPS for all equity plans is
less than debt-equity plans.

D) Above the indifference or break-even point the increase in EPS for all equity plans is
greater than debt-equity plans.

E) The rate of return on operating assets is unaffected by leverage.

Answer 6

D) Above the indifference or break-even point the increase in EPS for all equity plans is
greater than debt-equity plans.

Question 7

In the absence of taxes, the capital structure chosen by a firm doesn’t matter because of:

A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leverage.

Answer 7

E) homemade leverage.

Question 8

The Modigliani-Miller Proposition I without taxes states:

A) A firm cannot change the total value of its outstanding securities by changing its
capital structure proportions.
B) When new projects are added to the firm the firm value is the sum of the old value
plus the new.
C) Managers can make correct corporate decisions that will satisfy all shareholders if
they select projects that maximize value.
D) The determination of value must consider the timing and risk of the cash flows.

Answer 8

A) A firm cannot change the total value of its outstanding securities by changing its
capital structure proportions

Question 9

A key assumption of MMs Proposition I (no taxes) is:

A) that financial leverage increases risk.
B) that individuals can borrow on their own account at rates less than the firm.
C) that individuals must be able to borrow on their own account at rates equal to the
firm.
D) managers are acting to maximize the value of the firm

Answer 9

C) that individuals must be able to borrow on their own account at rates equal to the
firm.

Question 10

The use of personal borrowing to change the overall amount of financial leverage to which
an individual is exposed is called:

A) homemade leverage.
B) dividend recapture.
C) the weighted average cost of capital.
D) private debt placement.

Answer 10

A) homemade leverage.

Question 11

In an EPS- EBIT graphical relationship, the slope of the debt ray is steeper than the equity
ray. The debt ray has a lower intercept because:

A) more shares are outstanding for the same level of EBIT.
B) the break-even point is higher with debt.
C) a fixed interest charge must be paid even at low earnings.
D) the amount of interest per share has only a positive effect on the intercept.
E) the higher the interest rate the greater the slope.

Answer 11

C) a fixed interest charge must be paid even at low earnings.

Question 12

In an EPS-EBIT graphical relationship, the debt ray and equity cross. At this point, the equity
and debt are:

A) equivalent with respect to EPS but above and below this point equity is always
superior.
B) at breakeven in EPS but above this point debt increases EPS via leverage and
decreases EPS below this point.
C) equal but away from breakeven equity is better as fewer shares are outstanding.
D) at breakeven and MM Proposition II states that debt is the better choice.
E) at breakeven and debt is the better choice below breakeven because small payments
can be made.

Answer 12

B) at breakeven in EPS but above this point debt increases EPS via leverage and
decreases EPS below this point.

Question 13

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for
high levels of EBIT 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
less shares.
C) interest payments on the debt stay fixed, leaving more income to be distributed over
less shares.
D) interest payments on the debt stay fixed, leaving less income to be distributed over
more shares.
E) interest payments on the debt stay fixed, leaving more income to be distributed over
more shares.

Answer 13

C) interest payments on the debt stay fixed, leaving more income to be distributed over
less shares.

Question 14

Financial leverage impacts the performance of the firm by:

A) increasing the volatility of the firm’s EBIT.
B) decreasing the volatility of the firm’s EBIT.
C) decreasing the volatility of the firm’s net income.
D) increasing the volatility of the firm’s net income.

Answer 14

D) increasing the volatility of the firm’s net income.

Question 15

The increase in risk to equity holders when financial leverage is introduced is evidenced by:

A) higher EPS as EBIT increases.
B) a higher variability of EPS with debt than all equity.
C) increased use of homemade leverage.
D) equivalence value between levered and unlevered firms in the presence of taxes

Answer 15

B) a higher variability of EPS with debt than all equity.

Question 16

Thompson & Thomson is an-all equity firm that has 500,000 shares of stock outstanding. The
company is in the process of borrowing $8 million at 9% interest to repurchase 200,000
shares of the outstanding stock. What is the value of this firm if you ignore taxes?

A) $20.0 million.
B) $20.8 million.
C) $21.0 million.
D) $21.2 million.
E) $21.3 million

Answer 16

A) $20.0 million.

Question 17

The capital structure chosen by a firm doesn’t matter because of:

A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leverage.

Answer 17

E) homemade leverage.

Question 18

18) MM Proposition I with no tax supports the argument that:

A) business risk determines the return on assets.
B) the cost of equity rises as leverage rises.
C) it is completely irrelevant how a firm arranges its finances.
D) a firm should borrow money to the point where the tax benefit from debt is equal to
the cost of the increased probability of financial distress.
E) financial risk is determined by the debt-equity ratio.

Answer 18

C) it is completely irrelevant how a firm arranges its finances.

Question 19

You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your
shares in this closely held, all-equity firm. The other shareholders have agreed to have the
firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of
this firm today if you ignore taxes?

A) $4.8 million.
B) $5.1 million.
C) $5.4 million.
D) $5.7 million.
E) $6.0 million.

Answer 19

E) $6.0 million.

Question 20

A firm has debt market value of $5,000, equity market value of $16,000, a leveraged market
value of $21,000, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What
is the firm’s weighted average cost of capital?

A) 7.29%.
B) 7.94%.
C) 8.87%.
D) 10.40%.
E) 11.05%.

Answer 20

D) 10.40%.

Question 21

The difference between a market value balance sheet and a book value balance sheet is that a
market value balance sheet:

A) places assets on the right hand side.
B) places liabilities on the left-hand side.
C) does not equate the right hand with the left-hand side.
D) lists items in terms of market values, not historical costs.
E) uses the market rate of return.

Answer 21

D) lists items in terms of market values, not historical costs.

Question 22

MM Proposition I with taxes supports the theory that:

A) there is a positive linear relationship between the amount of debt in a levered firm and
its value.
B) the value of a firm is inversely related to the amount of leverage used by the firm.
C) the value of an unlevered firm is equal to the value of a levered firm plus the value of
the interest tax shield.
D) a firm’s cost of capital is the same regardless of the mix of debt and equity used by
the firm.
E) a firm’s weighted average cost of capital increases as the debt-equity ratio of the firm
rises.

Answer 22

there is a positive linear relationship between the amount of debt in a levered firm and
its value.

Question 23

MM 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) the capital structure of the firm does not matter because investors can use homemade
leverage.
C) the firm is better off with debt based on the weighted average cost of capital.
D) the value of the firm increases as total debt increases because of the interest tax
shield.
E) the cost of equity increases as the debt-equity ratio of a firm increases.

Answer 23

D) the value of the firm increases as total debt increases because of the interest tax
shield.

Question 24

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 firm is equal to the value of a levered firm.
C) the net cost of debt to a firm is generally less than the cost of equity.
D) the cost of debt is equal to the cost of equity for a levered firm.
E) firms prefer equity financing over debt financing.

Answer 24

D) the cost of debt is equal to the cost of equity for a levered firm.

Question 25

The Montana Hills Co. has expected earnings before interest and taxes of $17,100, an
unlevered cost of capital of 12.4 percent, and debt with both a book and face value of
$25,000. The debt has an annual 6.2 percent coupon. If the tax rate is 34 percent, what is the
value of the firm?

A) $91,016.13
B) $137,903.23
C) $99,516.13
D) $106,666.67
E) $146,403.23

Answer 25

C) $99,516.13

Question 26

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an
unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt
that carries a 7% coupon. The debt is selling at par value. What is the value of this firm?

A) $9,900.
B) $10,852.
C) $11,748.
D) $12,054.
E) $12,700.

Question 27

A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is
considering a new capital structure with 60% debt. The interest rate on the debt would be 8%.
Assuming there are no taxes or other imperfections, its cost of equity with the new capital
structure would be:

A) 9%.
B) 14%.
C) 13%.
D) 10%.

Question 28

What is its cost of equity if there are no taxes or other imperfections? The firm has a debt-toequity ratio of 0.60. Its cost of debt is 8%. Its overall cost of capital is 12%

A) 18%.
B) 14.4%.
C) 10%.
D) 13.5%

Question 29

In a world of no corporate taxes if the use of leverage does not change the value of the
levered firm relative to the unlevered firm this is known as:

A) conservation of energy principle.
B) MM Proposition I that leverage is invariant to market value.
C) MM Proposition II that the cost of equity is always constant.
D) MM Proposition I that the market value of the firm is invariant to the capital
structure.
E) MM Proposition III that there is no risk associated with leverage in a no tax world

Question 30

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If
there are no taxes or other imperfections, what would be its cost of equity if the debt-toequity ratio were 0?

A) 8%.
B) 10%.
C) 12%.
D) 14%.
E) 16%.

Question 31

If a firm is unlevered and has a cost of equity capital of 12%, what would the cost of equity
be if the firm becomes levered at 2:1? The expected cost of debt would be 8%.

A) 14.67%.
B) 16.0%.
C) 20.0%.
D) 14.0%.

Question 32

A full-equity firm has a cost of equity of 15%. If the company issues debt such that the debtto-equity ratio is 1.2, what is its cost of equity if its cost of debt is 10% and there are no taxes
or other imperfections?

A) 21%.
B) 18%.
C) 15%.
D) 10%.

Question 33

The reason that MM Proposition I does not hold in the presence of corporate taxation is
because:

A) levered firms pay less taxes compared with identical unlevered firms.
B) bondholders require higher rates of return compared with stockholders.
C) earnings per share are no longer relevant with taxes.
D) dividends are no longer relevant with taxes.

Question 34

The Boston Firm is unlevered with assets of $30 million and EBIT of $6 million. If the firm’s
tax rate is 34%, calculate both its after-tax cash flow and its value, given a risk-adjusted
discount rate of 12%

A) $2,400,000; $30,000,000.
B) $2,400,000; $2,400,000.
C) $3,960,000; $33,000,000.
D) $3,960,000; $30,000,000.
E) $2,400,000; $33,000,000

Question 35

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm
is now utilizing debt in its capital structure. To unlever his position, Bryan needs to:

A) borrow some money and purchase additional shares of Bryco stock.
B) maintain his current position as the debt of the firm did not affect his personal
leverage position.
C) sell some shares of Bryco stock and hold the proceeds in cash.
D) sell some shares of Bryco stock and loan it out such that he creates a personal debtequity ratio equal to that of the firm.
E) create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio
of the firm

Question 36

The change in firm value due to infusion of debt in the presence of corporate taxes is:

A) positive as equity holders face a lower effective tax rate.
B) positive as equity holders gain the tax shield on the debt interest.
C) negative because of the increased risk of default and fewer shares outstanding.
D) negative because of a reduction of equity outstanding.

Question 37

A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is
considering a new capital structure with 40% debt. The interest rate on the debt would be 4%.
Assuming that the corporate tax rate is 34%, what is the cost of equity with the new capital
structure?

A) 10.32%.
B) 11.20%
C) 11.00%.
D) 13.95%.

Question 38

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If
the corporate tax rate is 0.25, what would its cost of equity be if the debt-to-equity ratio were
0?

A) 11.11%.
B) 12.57%.
C) 13.33%.
D) 16.00%.

Question 39

A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is 16%.
If the corporate tax rate is 0.40, what would its cost of equity be if the debt-to-equity ratio
were 0?

A) 22.00%.
B) 21.07%.
C) 14.00%.
D) 20.62%.

Question 40

What is its cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-toequity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt
is 12%.

A) 22.0%.
B) 18.4%.
C) 17.44.
D) 19.6%.

Question 41

A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its
cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%?

A) 10.0%.
B) 10.75%.
C) 12.50%.
D) 7.73%

Question 42

Assume the corporate tax rate is 50%. A firm has perpetual expected EBIT of $100. The firm
has no debt in its capital structure. Its cost of equity is 10%. What would be the value of the
firm if it issued $400 in perpetual debt?

A) $700.
B) $800.
C) $900.
D) $1,000.

Question 43

A full equity firm has 5,000 shares outstanding worth $7 each. They are planning on issuing
$10,000 of new perpetual debt at the 8% market rate of interest and using the proceeds to buy
up stock. The effective tax rate is 25%. What is the change in the share price if they make the
debt for equity exchange?

A) $.50 per share
B) $.20 per share
C) $.80 per share
D) $.16 per share

Question 44

44) The Hifalutin Co. has a perpetual EBIT of $3,000. It has no debt in its capital structure, and
its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding.
Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the
proceeds to buy up stock.
What will the stock price be after the recapitalization?

A) $40.
B) $35.
C) $45.
D) $50.

Question 45

The Hifalutin Co. has a perpetual EBIT of $3,000. It has no debt in its capital structure, and
its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding.
Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the
proceeds to buy up stock.
How many shares will be purchased?

A) 93.75 shares.
B) 66.67 shares.
C) 50.00 shares.
D) 83.33 shares