CHAPTER 13

        1.        ________ suggests that value-maximizing financial managers will employ capital structures composed of that mix of debt and equity for which the interest tax shield is equal to the cost associated with the probability of financial distress.

        A)        M&M Proposition I with taxes

        B)        M&M Proposition I without taxes

        C)    The static theory of capital structure

        D)        M&M Proposition II without taxes

        E)        M&M Proposition II with taxes

        2.        According to ________ , a firm's cost of equity rises with increases in the amount of debt while the WACC first falls and then rises as debt is added.

        A)        M&M Proposition I with taxes

        B)        M&M Proposition I without taxes

        C)    the static theory of capital structure

        D)        M&M Proposition II without taxes

        E)        M&M Proposition II with taxes

        3.     A firm has a WACC of 16%, a cost of debt of 10% and a cost of equity of 22%. The market value of the firm's equity is $200. What is the market value of the firm's debt? Ignore taxes.

        A)    $50

        B)    $100

        C)    $150

        D)    $200

        E)     $250

        4.     A firm with no debt has 200,000 shares outstanding valued at $20 each. Its cost of equity is 12%. The firm is considering adding $1,000,000 in debt to its capital structure. The coupon rate would be 8% and the firm's tax rate is 34%. What would the firm be worth after adding the debt?

        A)        $4.033 million

        B)        $4.180 million

        C)        $4.340 million

        D)        $4.660 million

        E)        $5.000 million

        5.        Which of the following correctly completes this sentence: All else equal, ___________.

        A)    the business risk of a firm increases when it takes on a risky project

        B)    the business risk of a firm increases when it takes on more debt

        C)    the financial risk of a firm decreases when it takes on a risky project

        D)    the financial risk of a firm increases when it takes on more equity

        E)     the higher the business risk for a firm, the higher the financial risk as well

        6.     A firm that is approaching bankruptcy will find that

        A)        stockholders will try to push the firm into bankruptcy as rapidly as possible

        B)        bondholders will attempt to push the firm into bankruptcy to prevent their position from deteriorating

        C)        stockholders will seek to protect the value of the assets of the firm as much as possible

        D)        direct bankruptcy costs such as filing fees will tend to diminish

        E)        indirect bankruptcy costs such as opportunity costs will tend to decrease

        7.     A firm has a WACC of 16%, a cost of debt of 10% and a cost of equity of 22%. The market value of the firm's debt is $200. What is the TOTAL market value of the firm? Ignore taxes.

        A)    $100

        B)    $200

        C)    $300

        D)    $400

        E)     $500

        8.        Based on M&M without taxes and with taxes, how much time should a financial manager spend analyzing the financial structure of their firm? Why? How about based on the static theory? Again, why?

        9.        What is the cost of equity for a firm for which the required return on assets (RA) is 14%, the cost of debt is 11%, and the target debt/equity ratio is .50? Ignore taxes.

        A)        11.0%

        B)        12.5%

        C)        14.0%

        D)        15.5%

        E)        16.0%

        10.        Which of the following is NOT a correct statement?

        A)    The total systematic risk of the firm's equity has two parts: business risk and financial risk

        B)    The interest tax shield is risk free

        C)        Financial risk comes from the bondholders taking control of the firm from the shareholders if the firm goes bankrupt

        D)    Most firms in the U.S. maintain relatively low debt-to-equity ratios

        E)     The costs of bankruptcy decrease the attractiveness of debt financing

        11.        Which of the following is true concerning the rates of return earned on shares of a levered firm in terms of the possible range of earnings? There are no taxes.

        A)    The rates do not differ from those of an unlevered firm

        B)    The rates are higher than an unlevered firm on the upside, but unchanged on the downside

        C)    The rates are unchanged from an unlevered firm on the upside, but lower on the downside

        D)    The rates are higher than an unlevered firm on the upside, but lower on the downside

        E)     The rates are unchanged from an unlevered firm on the upside, but higher on the downside

        12.        Business risk is a positive function of the systematic risk of a firm's assets.

        A)    True

        B)    False

        13.        According to ________ , a firm's cost of equity is a positive linear function of its degree of leverage.

        A)        M&M Proposition I with taxes

        B)        M&M Proposition I without taxes

        C)    the static theory of capital structure

        D)        M&M Proposition II without taxes

        E)        M&M Proposition III with taxes

Use the following to answer questions 14-15:

All values are market values, ignore tax effects.

        Current Cap. Structure        Proposed Cap. Structure

Assets      $15 million       $15 million

Debt $0    $6 million

Equity       $15 million       $9 million

Share Price        $25.00        $22.50

Shares Outstanding        600,000        ?

Bond Interest Rate 8%   8%

Coupon Rate        8%   8%

        Recession        Expected        Expansion

EBIT        $2.0 million       $2.5 million       $3.5 million

        14.        What is the break-even EPS for these two capital structures?

        A)        $2.40

        B)        $3.28

        C)        $4.25

        D)        $5.00

        E)        $8.75

        15.        What is the EPS under the current capital structure if there is a recession?

        A)        $3.33

        B)        $4.17

        C)        $5.00

        D)        $6.25

        E)        $7.50

        16.   If a firm fails to meet the required interest payment on its long-term bonds, it is said to be in ____________.

        A)        business failure

        B)        chapter 11 bankruptcy

        C)        accounting insolvency

        D)        technical insolvency

        E)        chapter 7 bankruptcy

Use the following to answer question 17:

Firm UNLEV generates perpetual after-tax cash flows of $4,000. The firm is currently unleveraged and has a cost of capital of 20%. There are 20,000 shares of stock outstanding. The firm is considering issuing new debt to add some financial leverage to the firm. The entire proceeds of the debt issue will be used to repurchase equity. The cost of debt is 10% and the debt will be sold at par. There are no flotation costs.

        17.        Assuming a tax rate of 34%, what is the value of UNLEV's equity after the restructuring if the firm issues $5,000 (both par and market value) worth of bonds and uses the proceeds to repurchase stock?

        A)        $5,000

        B)        $12,400

        C)        $16,700

        D)        $18,300

        E)        $21,700

        18.        According to the static theory of capital structure

        A)    a firm is fixed in terms of its assets and operations and it only considers possible changes in the benefits of financial distress

        B)    a firm will borrow up to the point where the benefit from an extra dollar of debt is just equal to the tax benefit associated with that debt

        C)    the value of the firm will differ from the M&M value without taxes by the gain from leverage, net of distress costs

        D)    the optimal WACC is the same as it is in M&M without taxes

        E)     the value of the firm in M&M with taxes is overstated by the loss in value due to possible financial distress

        19.        According to M&M proposition II without taxes, the equity risk that comes from the nature of the firm's operating activities can be identified as ______, a component of the cost of equity.

        A)    RA

        B)    RD

        C)    (RA -RD)

        D)    (RA -RD)´(D/E)

        E)     D/E

        20.   A firm has a WACC of 16%, a cost of debt of 10% and a cost of equity of 22%. What is the firm's debt-to-equity ratio? Ignore taxes.

        A)    0.25

        B)    0.50

        C)    0.75

        D)    1.00

        E)     1.25

Answer Key

        1.     C    

        2.     C    

        3.     D    

        4.     C    

        5.     A    

        6.     B     

        7.     D    

        8.        Under both M&Ms, the financial manager should invest no time in analyzing the financial structure of the firm. With no taxes, the degree of leverage doesn't matter because firm value is unaffected by the financial structure of the firm. With taxes, M&M says a firm will maximize its value by using 100% debt. Again, there is nothing for the financial manager to decide. With the static theory, however, the manager decides the optimal amount of debt and equity by analyzing the tradeoff between the benefits of more debt versus the cost of additional debt in the form of financial distress. Ultimately, finding the optimal capital structure is challenging in this case.

        9.     D    

        10.   B     

        11.   D    

        12.   A    

        13.   D    

        14.   A    

        15.   A    

        16.   D    

        17.   C    

        18.   E     

        19.   A