Chapter 16 Financial Leverage and Capital Structure
1. 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 borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
D. Best defined as an increase in a firm's debt-equity ratio.
E. The term used to describe the capital structure of a levered firm.
2. Which one of the following states that the value of a firm is unrelated to the firm's capital structure?
A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
3. Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?
A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
4. 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
5. Which one of the following is the equity risk related to a firm's capital structure policy?
A. market
B. systematic
C. extrinsic
D. business
E. financial
6. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings?
A. Interest tax shield
B. Interest credit
C. Financing shield
D. Current tax yield
E. tax-loss interest
7. The unlevered cost of capital refers to the cost of capital for a(n):
A. Private entity.
B. all-equity firm.
C. Governmental entity.
D. Private individual.
E. Corporate shareholder.
8. 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
9. 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
10. By definition, which of the following costs are included in the term "financial distress costs"?I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed, but not bankrupt IV. Indirect costs related to being financially distressed, but not bankrupt
A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV
11. The proposition that a firm 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.
C. M & M Proposition II.
D. The capital asset pricing model.
E. The open markets theorem.
12. Which one of the following is the legal proceeding under which an insolvent firm can be reorganized?
A. Restructure process
B. bankruptcy
C. Forced merger
D. Legal takeover
E. Rights offer
13. A business firm ceases to exist as a going concern as a result of which one of the following?
A. divestiture
B. Share repurchase
C. liquidation
D. reorganization
E. Capital restructuring
14. 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 firm underwent is known as a:
A. merger.
B. Repurchase program.
C. liquidation.
D. reorganization.
E. divestiture.
15. 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.
16. 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.
17. The value of a firm is maximized when the:
A. Cost of equity is maximized.
B. Tax rate is zero.
C. Levered cost of capital is maximized.
D. Weighted average cost of capital is minimized.
E. debt-equity ratio is minimized.
18. 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 pre-tax 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.
19. AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.
A. Select the leverage option because the debt-equity ratio is less than 0.50
B. Select the leverage option since the expected EBIT is less than the break-even level
C. Select the unlevered option since the debt-equity ratio is less than 0.50
D. Select the unlevered option since the expected EBIT is less than the break-even level
E. Cannot be determined from the information provided
20. You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the:
A. Firm is just earning enough to pay for the cost of the debt.
B. Firm'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. Firm has a debt-equity ratio of .50.
21. Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no 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.
22. Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to:
A. Borrow some money and purchase additional shares of Quantro stock.
B. Maintain her current equity position as the debt of the firm did not affect her personally.
C. Sell some shares of Quantro stock and hold the proceeds in cash.
D. Sell some shares of Quantro stock and loan out the sale proceeds.
E. Create a personal debt-equity ratio of 0.30.
23. Which one of the following makes the capital structure of a firm 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
24. M & M 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. The debt-equity ratio of a firm is completely irrelevant.
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. Homemade leverage is irrelevant.
25. 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. Static theory proposition.
26. Which of the following statements are correct in relation to M & M Proposition II with no taxes?I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt-equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I and IV only
27. M & M Proposition II is the proposition that:
A. The capital structure of a firm has no effect on the firm's value.
B. The cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate.
C. A firm'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 a firm's assets.
E. The size of the pie does not depend on how the pie is sliced.
28. The business risk of a firm:
A. Depends on the firm's level of unsystematic risk.
B. Is inversely related to the required return on the firm's assets.
C. Is dependent upon the relative weights of the debt and equity used to finance the firm.
D. Has a positive relationship with the firm's cost of equity.
E. Has no relationship with the required return on a firm's assets according to M & M Proposition II.
29. Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations.
A. I and III only
B. II and IV only
C. II and III only
D. I, II, and III only
E. I, II, III, and IV
30. M & M Proposition I with tax supports the theory that:
A. A firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.
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 cost of equity increases as the debt-equity ratio of the firm decreases.
31. 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. The capital structure of a firm does not matter because investors can use homemade leverage.
C. A firm's WACC is unaffected by a change in the firm's capital structure.
D. The value of a firm increases as the firm's debt increases because of the interest tax shield.
E. The cost of equity increases as the debt-equity ratio of a firm increases.
32. M & M Proposition II with taxes:
A. Has the same general implications as M & M Proposition II without taxes.
B. States that a firm's capital structure is irrelevant.
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.
33. The present value of the interest tax shield is expressed as:
A. (TC × D)/RA.
B. VU + (TC × D).
C. [EBIT × (TC × D)]/RU.
D. [EBIT × (TC × D)]/RA.
E. Tc × D.
34. The interest tax shield has no value when a firm has a: I. Tax rate of zero. II. debt-equity ratio of 1. III. Zero debt. IV. Zero leverage.
A. I and III only
B. II and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, and IV only
35. 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.
36. Based on M & M Proposition II 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).
37. Bankruptcy:
A. Creates value for a firm.
B. Transfers value from shareholders to bondholders.
C. Technically occurs when total equity equals total debt.
D. Costs are limited to legal and administrative fees.
E. Is an inexpensive means of reorganizing a firm.
38. Which one of the following is a direct bankruptcy cost?
A. company CEO's time spent in bankruptcy court
B. Maintaining 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 fees to prepare bankruptcy reports
39. If a firm 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 firm will exceed the value of the firm if it were unlevered.
C. Value of the firm is minimized.
D. Value of the firm is equal to VL + TC × D.
E. debt-equity ratio is equal to 1.0.
40. Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?
A. Exceptionally high depreciation expenses
B. Very low marginal tax rate
C. Substantial tax shields from other sources
D. Low probabilities of financial distress
E. Minimal taxable income
41. The capital structure that maximizes the value of a firm 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 value of the unlevered firm.
42. The optimal capital structure:
A. Will be the same for all firms in the same industry.
B. Will remain constant over time unless the firm 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.
43. The static theory of capital structure advocates that the optimal capital structure for a firm:
A. Is dependent on a constant debt-equity ratio over time.
B. Remains fixed over time.
C. Is independent of the firm's tax rate.
D. Is independent of the firm's weighted average cost of capital.
E. Equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.
44. The basic lesson of M & M Theory is that the value of a firm is dependent upon:
A. The firm's capital structure.
B. The total cash flow of the firm.
C. Minimizing the marketed claims.
D. The amount of marketed claims to that firm.
E. Size of the stockholders' claims.
45. Which form of financing do firms 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
46. Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing.
A. I and III only
B. II and IV only
C. I, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV
47. Corporations in the U.S. Tend to:
A. Minimize taxes.
B. Underutilize debt.
C. Rely less on equity financing than they should.
D. Have relatively similar debt-equity ratios across industry lines.
E. Rely more heavily on debt than on equity as the major source of financing.
48. In general, the capital structures used by U.S. firms:
A. Tend to overweigh debt in relation to equity.
B. Generally result in debt-equity ratios between 0.45 and 0.60.
C. Are fairly standard for all SIC codes.
D. Tend to be those which maximize the use of the firm's available tax shelters.
E. Vary significantly across industries.
49. A firm is technically insolvent when:
A. It has a negative book value.
B. Total debt exceeds total equity.
C. It is unable to meet its financial obligations.
D. It files for bankruptcy protection.
E. The market value of its stock is less than its book value.
50. Which one of the following statements related to Chapter 7 bankruptcy is correct?
A. A firm in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern.
B. Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated.
C. Chapter 7 bankruptcies are always involuntary on the part of the firm.
D. Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy.
E. Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock are generally issued prior to the firm coming out of bankruptcy.
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