Chapter 16 Multiple Choice

1. A capital restructuring occurs when a firm: 

A. Changes its debt-equity ratio without changing its total assets.
B. Reduces both its debt and its equity while maintaining a constant debt-equity ratio.
C. Changes its level of debt without changing its total equity.
D. Refinances its debt at a lower rate of interest.

2. The extent to which a firm relies on debt is referred to as: 

A. Homemade leverage.
B. The target ratio.
C. Business leverage.
D. Financial leverage.

3. The weighted average cost of capital can also be defined as the: 

A. Market weighted cost of equity financing.
B. Rate of return based on net book value.
C. Required return on a firm's overall assets.
D. Basis of M&M Proposition I.

4. The cost of equity capital, based on M&M Proposition II, can be defined as: 
A. RE = RD + (RA - RD) (D/E).
B. RE = RA + (RA - RD) (D/E).
C. RE = RA + (RD - RA) (E/D).
D. RE = RD - (RD - RA) (D/E).

5. The theory that a change in the capital structure weights is exactly offset by the change in the cost of
equity is known as: 
A. Homemade leverage.
B. Financial leverage.
C. The targeted capital structure theory.
D. M&M Proposition II.

6. The fact that individual investors can alter the amount of financial leverage to which they are exposed
is referred to as: 
A. Capital structure targeting.
B. Adjusting the business risk.
C. Homemade leverage.
D. M&M Proposition II.

7. The static theory of capital structure states that firms borrow up to the point where the tax benefit of
one additional dollar of debt is equal to the marginal cost of: 
A. Sales.
B. Financial distress.
C. Leverage.
D. Financial capital.

8. The option of keeping a financially distressed firm as an operating concern is called a(n): 
A. reorganization.
B. Acquisition.
C. Merger.
D. Technical solvency.
9. The procedure for liquidating a corporation is outlined in: 
A. The BNA Act.
B. The Canadian Constitution.
C. Chapter 11.
D. The Bankruptcy and Insolvency Act.

10. The absolute priority rule establishes the order in which: 

A. Firms are liquidated by the bankruptcy courts.

B. Reorganization events must occur.
C. Bankruptcy cases are heard by the courts.
D.  Claims are paid in a bankruptcy proceeding.
 

11. Which of the following is true about the WACC? 

A. The WACC is the appropriate discount rate for all new projects of the firm.
B. The value of the firm will be maximized when the WACC is minimized.
C. The WACC is virtually impossible to calculate for a firm with multiple divisions.
D. Since discount rates and firm value move in the same direction, minimizing the WACC will minimize the
value of the firm.

12. When choosing a capital structure, the objective of the firm should be to: 
A. Choose the one that maximizes the current value of the firm's bonds.
B.  Choose the one that minimizes the firm's WACC.
C. Choose the one that results in the largest interest tax shield.
D. Choose any capital structure since it is always irrelevant.

13. The optimal capital structure is the mixture of debt and equity which:
I. Maximizes the value of the firm.
II. Minimizes the firm's weighted average cost of capital.
III. Maximizes the market price of the firm's bonds. 
A. I only
B. I and II only
C. I and III only
D. I, II, and III

14. Which of the following is NOT accurate regarding financial leverage? 

A. Whenever a firm's debt increases faster than its equity, financial leverage increases.
B. Leverage is most beneficial when EBIT is relatively high.
C. Increasing financial leverage will always increase the EPS for stockholders.
D. The level of financial leverage that produces the highest firm value is the one most beneficial to
stockholders.
 

15. All else the same, the financial leverage of a firm will _________________. 
A. decrease as the firm's retained earnings account grows
B. increase by the amount of equity it issues in a given year
C. decrease if the firm has negative net income
D. decrease as the firm uses debt to fund expansion projects

If I have debt we can advantage… right hand side of the BS will grow

 16. Suppose you work for the CFO of Danforth, Inc. He believes sales and operating income will be
sharply higher each year for the foreseeable future. If he seeks to maximize earnings per share, he should
_____________. (Assume there are no taxes.) 
A. increase the firm's debt to equity ratio
B. increase the firm's debt to equity ratio if the firm's EBIT will remain below the break-even (comparing
levered to unlevered) level of EBIT
C. decrease the firm's debt to equity ratio
D. decrease the firm's debt to equity ratio if the firm's EBIT will remain below the break-even (comparing
levered to unlevered) level of EBIT

17. Which of the following statements is/are true regarding corporate borrowing when EBIT is positive?
I. Increasing financial leverage increases the sensitivity of EPS and ROE to changes in EBIT
II. The effect of financial leverage depends on the company's EBIT, that is, leverage is unfavourable when
EBIT is relatively high, and leverage is favourable when EBIT is relatively low
III. High leverage decreases the returns to shareholders (as measured by ROE) 
A. II only
B. III only
C. I only
D. I, II, and III

18. Which of the following statements regarding leverage is false? 

A.  If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by
ROE and EPS).
B. As a firm levers up, shareholders are exposed to greater risk.
C. The benefits of leverage will not be as great in a firm with substantial accumulated losses or other types of
tax shields compared to a firm without many tax shields.
D. Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.

 19. Below the break-even EBIT, increased financial leverage will _______ EPS, all else the same. Assume
there are no taxes. 
A.decrease
B. not affect
C. either increase or decrease
D. increase EBIT but decrease
 
 
20. All else the same, which of the following claims on the cash flows of the firm will tend to increase with
decreases in the debt/equity ratio?
I. Taxes
II. Bankruptcy costs
III. Stockholder claims
IV. Bondholder claims 

A. I and IV only

B. II and IV only
C. I, II, and III only
D.I and III only
 
21. Which of the following statements is correct? 
A. Decisions regarding a firm's debt and equity can be called capital budgeting decisions
B. The asset beta is a measure of the unsystematic risk of a firm's assets
C. In a purely capital restructuring, the composition of the assets of the firm will change
D. The use of personal leverage by an investor to alter the degree of financial leverage of a firm is called
homemade leverage

22. According to _________, the value of the firm is independent of its capital structure. 
A. M&M Proposition I with taxes
B. the static theory of capital structure
C. M&M Proposition II without taxes
D.  M&M Proposition I without taxes

23. The cost of debt is generally lower than the cost of equity; however, according to __________,
replacing equity with debt will not change the value of the firm because the savings attributable to the
lower cost of debt financing will be offset by the higher required return on the remaining equity. 
A. M&M Proposition I without taxes
B. the static theory of capital structure
C. M&M Proposition II without taxes
D. M&M Proposition II with taxes

24. _____________ implies that the firm should issue as much debt as possible. 
A. M&M Proposition I without taxes
B. the static theory of capital structure
C. M&M Proposition II without taxes
D. M&M Proposition I with taxes
 

 
25. According to M&M Proposition II without taxes, a firm's cost of equity is a function of which of the
following factors?
I. The required rate of return on the firm's assets
II. The firm's debt/equity ratio
III. The firm's cost of debt 
A. II only
B. I and II only
C. I and III only
D. I, II, and III

26. Assume there are no corporate or personal taxes. According to M&M Proposition: 

A. I, the total value of the firm depends on how cash flows are divided up between stockholders and
bondholders.
B. II, the cost of equity rises as the firm increases its use of debt financing.
C. II, the cost of equity depends on the firm's business risk but not its financial risk.
D. I and II, as debt increases, the increase in the cost of equity is more than offset by the lower cost of debt and
the WACC falls.

27. Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by
its capital structure. Which of the following is true?
I. A firm's cost of equity depends on the firm's business and financial risks.
II. The value of the firm is dependent on its capital structure.
III. The cost of equity increases as the firm's leverage decreases. 

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

  28. Which of the following is true concerning the rate of return earned on shares of a levered firm in
terms of the possible range of earnings? There are no taxes. 
A. The returns do not differ from those of an unlevered firm.
B. The returns are greater than for an unlevered firm on the upside and equal on the downside.
C. The returns are greater than for an unlevered firm on the upside and lower on the downside.
D. The returns are the same as for an unlevered firm on the upside and greater on the downside.

 29. The equity beta of a firm depends on which of the following?

I. The firm's business risk.
II. The firm's financial policy.
III. The firm's advertising policy. 

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

30. A firm's systematic risk will ____________ as its debt/equity ratio __________. 

A. decrease; increases
B. remain unchanged; decreases
C. remain unchanged; increases
D.  increase; increases