Chapter 16 Corfin Test Banks

Chapter 16 Financial Leverage and Capital Structure Policy
1. All else equal, higher financial leverage decreases a firm's break-even EBIT.
Ans: False Level: Basic Subject: Financial Leverage Type: Concepts
2. Business risk declines as the systematic risk of a firm's assets increases.
Ans: False Level: Basic Subject: Business Risk Type: Concepts
3. Business risk is a positive function of the systematic risk of a firm's assets.
Ans: True Level: Basic Subject: Business Risk Type: Concepts
4. Ignoring financial distress costs, borrowing money decreases the value of the firm by increasing the firm's
tax liability.
Ans: False Level: Basic Subject: Interest Tax Shield Type: Concepts
5. Suppose we wish to draw a graph illustrating M&M Proposition II. Let the vertical axis represent the cost
of capital and the firm's debt-to-equity ratio represent the horizontal axis; then if the slope of the line
representing the firm's WACC has a negative slope, we must be incorporating taxes into the analysis.
Ans: True Level: Basic Subject: M&M Proposition II Type: Concepts
6. Direct bankruptcy costs are those costs that are directly associated with bankruptcy, such as legal and
administrative costs.
Ans: True Level: Basic Subject: Bankruptcy Costs Type: Concepts
7. Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a financially
distressed firm.
8. It has been observed that, when firms get into financial trouble, they often find it difficult to attract and
retain high-quality employees. The additional costs incurred in this situation would be considered direct
bankruptcy costs.
Ans: False Level: Basic Subject: Bankruptcy Costs Type: Concepts
9. When a firm files for bankruptcy, the firm often must hire appraisers to determine the fair value of the
firm's assets. This is an example of a direct cost of bankruptcy.
10. According to the static theory of capital structure, value-maximizing financial managers will borrow to the
point where the firm's business risk is just equal to its financial risk.
Ans: False Level: Basic Subject: Capital Structure Theories Type: Concepts
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11. If the static theory of capital structure is true, then the optimal level of debt for a given firm increases as its
marginal tax rate increases and decreases as the costs of financial distress increase.
Ans: True Level: Basic Subject: Capital Structure Theories Type: Concepts
12. In order to avoid bankruptcy, management sometimes seeks to work with creditors. One method of
restructuring debt involves composition, which involves a reduction in the amount of the payment to be
made.
Ans: True Level: Basic Subject: Agreements to Avoid Bankruptcy Type: Concepts
13. The use of personal borrowing to change the overall amount of financial leverage to which the individual is
exposed is called:
A) Homemade leverage.
B) Dividend recapture.
C) The weighted average cost of capital.
D) Private debt placement.
E) A privileged subscription offer.
Ans: A Level: Basic Subject: Homemade Leverage Type: Definitions
14. The proposition that the value of the firm is independent of its capital structure is called:
A) The Capital Asset Pricing Model.
B) M&M Proposition I (without taxes).
C) M&M Proposition II.
D) The Law of One Price.
E) The Efficient Markets Hypothesis.
Ans: B Level: Basic Subject: M&M Proposition I Type: Definitions
15. The proposition that the cost of equity is a positive linear function of capital structure is called:
A) The Capital Asset Pricing Model.
B) M&M Proposition I.
D) The Law of One Price.
E) The Efficient Markets Hypothesis.
Ans: C Level: Basic Subject: M&M Proposition II Type: Definitions
16. The equity risk derived from the firm's operating activities is called ____________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) financial
Ans: D Level: Basic Subject: Business Risk Type: Definitions

17. The equity risk derived from the firm's capital structure policy is called ___________ risk.
A) market
B) systematic
C) extrinsic
D) business
E) financial
Ans: E Level: Basic Subject: Financial Risk Type: Definitions
18. The tax savings of the firm derived from the deductibility of interest expense is called the:
A) Interest tax shield.
B) Depreciable basis.
C) Financing umbrella.
D) Current yield.
E) Tax-loss carry-forward savings.
Ans: A Level: Basic Subject: Interest Tax Shield Type: Definitions
19. 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
Ans: B Level: Basic Subject: Unlevered Cost Of Capital Type: Definitions
20. The explicit costs associated with corporate default, such as legal expenses, are the ________ of the firm.
A) flotation costs
B) default beta coefficients
C) direct bankruptcy costs
D) indirect bankruptcy costs
E) default risk premia
Ans: C Level: Basic Subject: Direct Bankruptcy Costs Type: Definitions
21. The implicit costs associated with corporate default, such as lost sales, are the __________ of the firm.
A) flotation costs
E) default risk premia
Ans: D Level: Basic Subject: Indirect Bankruptcy Costs Type: Definitions

22. The explicit and implicit costs associated with corporate default are the ___________ of the firm.
A) flotation costs
E) financial distress costs
Ans: E Level: Basic Subject: Financial Distress Costs Type: Definitions
23. 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 the:
A) Static Theory of Capital Structure.
B) M&M Proposition I.
D) Capital Asset Pricing Model.
E) Open Markets Theorem.
Ans: A Level: Basic Subject: Static Theory Of Capital Structure Type: Definitions
24. The legal proceeding for liquidating or reorganizing a firm operating in default is called a:
A) Tender offer.
B) Bankruptcy.
C) Merger.
D) Takeover.
E) Proxy fight.
Ans: B Level: Basic Subject: Bankruptcy Type: Definitions
25. A firm that has negative net worth is said to be:

A) Experiencing a business failure.
B) In legal bankruptcy.
C) Experiencing technical insolvency.
D) Experiencing accounting insolvency.
E) In bankruptcy reorganization.
Ans: D Level: Basic Subject: Accounting Insolvency Type: Definitions
26. The complete termination of the firm as a going business concern is called a ______________.
A) merger
B) repurchase program
C) liquidation
D) reorganization
E) divestiture
Ans: C Level: Basic Subject: Liquidation Type: Definitions

27. The financial restructuring of a failing firm to attempt to continue operations as a going concern is called a
________________.
A) merger
B) repurchase program
C) liquidation
D) reorganization
E) divestiture
Ans: D Level: Basic Subject: Reorganization Type: Definitions
28. A capital restructuring occurs when a firm:

A) Increases its debt-equity ratio while maintaining a constant debt-to-asset ratio.
B) Changes its debt-equity ratio without changing its total assets.
C) Reduces both its debt and its equity while maintaining a constant debt-equity ratio.
D) Changes its level of debt without changing its total equity.
E) Refinances its debt at a lower rate of interest.
Ans: B Level: Basic Subject: Capital Restructuring Type: Definitions
29. The extent to which a firm relies on debt is referred to as:

B) The target ratio.
C) Business leverage.
D) Proposition I.
E) Financial leverage.
Ans: E Level: Basic Subject: Financial Leverage Type: Definitions
30. 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) Adjusted homemade leverage rate of return.
D) Required return on a firm's overall assets.
E) Basis of M&M Proposition I.
Ans: D Level: Basic Subject: Required Return On Assets Type: Definitions
31. 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) (E/D).
C) RE = RA + (RA - RD) (D/E).
D) RE = RA + (RD - RA) (E/D).
E) RE = RD - (RD - RA) (D/E).
Ans: C Level: Basic Subject: M&M Proposition II Type: Definitions

32. The theory that a change in the capital structure weights is exactly offset by the change in the cost of equity
is known as:
B) Financial leverage.
C) The targeted capital structure theory.
D) M&M Proposition I.
E) M&M Proposition II.
Ans: E Level: Basic Subject: M&M Proposition II Type: Definitions
33. 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) The static theory of capital structure.
D) Homemade leverage.
E) M&M Proposition II.
Ans: D Level: Basic Subject: Homemade Leverage Type: Definitions
34. 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) Equity.
C) Financial distress.
D) Leverage.
E) Financial capital.
Ans: C Level: Basic Subject: Static Theory Of Capital Structure Type: Definitions
35. The option of keeping a financially distressed firm as an operating concern is called a(n):
A) Liquidation.
B) Reorganization.
C) Acquisition.
D) Merger.
E) Technical solvency.
Ans: B Level: Basic Subject: Reorganization Type: Definitions
36. The procedure for liquidating a corporation is outlined in:

A) The Bankruptcy and Insolvency Act.
B) The BNA Act.
C) The Canadian Constitution.
D) Chapter 11.
E) The Small Business Reform Act.
Ans: A Level: Basic Subject: Bankruptcy and Insolvency Act Type: Definitions

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

A) Claims are paid in a bankruptcy proceeding.
B) Firms are liquidated by the bankruptcy courts.
C) Reorganization events must occur.
D) Bankruptcy cases are heard by the courts.
E) Judges are assigned to bankruptcy cases.
Ans: A Level: Basic Subject: Absolute Priority Rule Type: Definitions
38. 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 optimal capital structure is the one that maximizes the WACC.
C) The value of the firm will be maximized when the WACC is minimized.
D) The WACC is virtually impossible to calculate for a firm with multiple divisions.
E) Since discount rates and firm value move in the same direction, minimizing the WACC will
minimize the value of the firm.
Ans: C Level: Basic Subject: WACC Type: Concepts
39. 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 value of the firm.
C) Choose the one that minimizes the firm's WACC.
D) Choose the one that results in the largest interest tax shield.
E) Choose any capital structure since it is always irrelevant.
Ans: C Level: Basic Subject: Capital Structure Type: Concepts
40. 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) III only
C) I and II only
D) I and III only
E) I, II, and III
Ans: C Level: Basic Subject: Optimal Capital Structure Type: Concepts
41. 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) Investors can undo the effects of the firm's capital structure by using homemade leverage.
D) Increasing financial leverage will always increase the EPS for stockholders.
E) The level of financial leverage that produces the highest firm value is the one most beneficial to
stockholders.
Ans: D Level: Basic Subject: Financial Leverage Type: Concepts

42. All else the same, the financial leverage of a firm will _________________-.
A) decrease as the debt/equity ratio increases
B) decrease as the firm's retained earnings account grows
C) increase by the amount of equity it issues in a given year
D) decrease if the firm has negative net income
E) decrease as the firm uses debt to fund expansion projects
Ans: B Level: Basic Subject: Financial Leverage Type: Concepts
43. 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) not change the firm's debt to equity ratio
E) 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
Ans: E Level: Basic Subject: Financial Leverage Type: Concepts
44. 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) I only
B) II only
C) III only
D) I and II only
E) I, II, and III
Ans: A Level: Basic Subject: Financial Leverage & Capital Structure Type: Concepts
45. Which of the following statements regarding leverage is false?

A) The ultimate effect of leverage depends on the firm's EBIT.
B) If things go poorly for the firm, increased leverage provides greater returns to shareholders (as
measured by ROE and EPS).
C) As a firm levers up, shareholders are exposed to greater risk.
D) 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.
E) Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.
Ans: B Level: Basic Subject: Leverage Type: Concepts

46. Below the break-even EBIT, increased financial leverage will _______ EPS, all else the same. Assume
there are no taxes.
A) increase
B) decrease
C) not affect
D) either increase or decrease
E) increase EBIT but decrease
Ans: B Level: Basic Subject: Break-even EBIT Type: Concepts
47. 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 III only
B) I and IV only
C) II and IV only
D) I, II, and III only
E) I, II, and IV only
Ans: A Level: Basic Subject: Cash Flow & Leverage Type: Concepts
48. 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 value of the overall firm will not change as a result of a capital restructuring unless the NPV of
the restructuring is negative
E) The use of personal leverage by an investor to alter the degree of financial leverage of a firm is
called homemade leverage
Ans: E Level: Basic Subject: Homemade Leverage Type: Concepts
49. According to _________, the value of the firm is independent of its capital structure.
A) M&M Proposition I without taxes
B) M&M Proposition I with taxes
C) the static theory of capital structure
D) M&M Proposition II without taxes
E) M&M Proposition II with taxes
Ans: A Level: Basic Subject: M&M Proposition I Type: Concepts

50. 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 with taxes
B) M&M Proposition I without taxes
Ans: B Level: Basic Subject: M&M Proposition I Type: Concepts
51. _____________ implies that the firm should issue as much debt as possible.
Ans: A Level: Basic Subject: Capital Structure Theories Type: Concepts
52. 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) II and III only
E) I, II, and III
Ans: E Level: Basic Subject: M&M Proposition II Type: Concepts
53. 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) I, a firm's capital structure is relevant.
C) II, the cost of equity rises as the firm increases its use of debt financing.
D) II, the cost of equity depends on the firm's business risk but not its financial risk.
E) 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.
Ans: C Level: Basic Subject: M&M Without Taxes Type: Concepts

54. 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) I only
B) II only
C) III only
D) I and III only
E) II and III only
Ans: A Level: Basic Subject: M&M Without Taxes Type: Concepts
55. 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 the same as for an unlevered firm on the upside and lower on the downside.
D) The returns are greater than for an unlevered firm on the upside and lower on the downside.
E) The returns are the same as for an unlevered firm on the upside and greater on the downside.
Ans: D Level: Basic Subject: Levered Rates Of Return Type: Concepts
56. 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) I and II only
B) III only
C) I and III only
D) II and III only
E) I, II, and III
Ans: A Level: Basic Subject: Equity Beta Type: Concepts
57. A firm's systematic risk will ____________ as its debt/equity ratio __________.
A) increase; increases
B) decrease; decreases
C) remain unchanged; decreases
D) remain unchanged; increases
E) first increase, and then decrease; increases
Ans: A Level: Basic Subject: Business & Financial Risk Type: Concepts

58. __________ arises from decisions that affect the left-hand side of the balance sheet, while
________________ arises from decisions that affect the right-hand side of the balance sheet.
A) Systematic risk; financial risk
B) Business risk; financial risk
C) Unsystematic risk; systematic risk
D) Business risk; diversifiable risk
E) Systematic risk; unsystematic risk
Ans: B Level: Basic Subject: Business & Financial Risk Type: Concepts
59. Which of the following correctly completes this sentence: All else the same, _____________.
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
Ans: A Level: Basic Subject: Business & Financial Risk Type: Concepts
60. All else the same, which of the following is true about the interest tax shield of a firm with positive EBIT?
A) The higher the corporate tax rate, the less valuable the interest tax shield.
B) If the firm dramatically increases its depreciation expense, it may have more of a need for an interest
tax shield.
C) The interest tax shield becomes more valuable as the size of the debt load increases.
D) The interest tax shield increases as a firm reduces its level of outstanding debt.
E) Since the interest tax shield is valuable, the firm would rather pay a high coupon rate on its bonds
than a low coupon rate.
Ans: C Level: Basic Subject: Interest Tax Shield Type: Concepts
61. According to ___________, a firm's cost of equity increases with greater debt financing, but the WACC
remains unchanged.
Ans: D Level: Basic Subject: M&M Proposition II Type: Concepts
62. According to ___________, a firm's cost of equity increases with greater debt financing, and the WACC
decreases.
Ans: E Level: Basic Subject: M&M Proposition II Type: Concepts

63. Which of the following correctly completes the following: M&M I with taxes shows
___________________________________.
A) the value of an unlevered firm exceeds the value of a levered firm by the present value of the interest
tax shield
B) a levered firm can increase its value by reducing debt
C) the optimal amount of leverage for a firm is not possible to determine
D) the value of a levered firm is equal to its aftertax EBIT discounted by the unlevered cost of capital
E) there is a linear relationship between the amount of debt in a levered firm and its value
Ans: E Level: Basic Subject: M&M I With Taxes Type: Concepts
64. 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
Ans: B Level: Basic Subject: Bankruptcy Type: Concepts
65. Which of the following is NOT true about bankruptcy and its costs?
A) As the debt/equity ratio falls, the probability that a firm will be able to meet the promised payments
on bonds decreases.
B) If a firm is economically bankrupt, then an ensuing legal bankruptcy will likely result in the
bondholders receiving less than what they are owed.
C) The amount of debt a firm can raise decreases as the probability of bankruptcy increases.
D) A firm is economically bankrupt when the value of its assets is less than the value of its debt.
E) Direct bankruptcy costs are a disincentive to debt financing.
Ans: A Level: Basic Subject: Bankruptcy Costs Type: Concepts
66. Which of the following would be considered an indirect bankruptcy cost?

A) The cost of the extra insurance the bankruptcy court requires the firm to carry on its assets.
B) The cost the firm must pay to the court when filing its bankruptcy petition.
C) The cost of the appraisals a firm must obtain on its assets by order of the bankruptcy court.
D) The fee the firm pays its lawyer to draw up the bankruptcy petition.
E) The cost to the firm of projects in-progress terminated in order to preserve cash.
Ans: E Level: Basic Subject: Direct Bankruptcy Costs Type: Concepts
67. When the value of a firm's assets exactly equals the value of its debt, the firm:
A) Is economically bankrupt.
B) Is technically insolvent.
C) Is legally bankrupt.
D) Is in liquidation.
E) Is in default.
Ans: A Level: Basic Subject: Financial Distress Type: Concepts

68. According to __________, a firm's cost of equity increases with greater debt financing, while the WACC
first decreases and then increases.
Ans: C Level: Basic Subject: Static Theory Of Capital Structure Type: Concepts
69. According to the static theory of capital structure, ____________________.

A) a firm's choice of assets and operations is fixed for all time
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
D) the optimal WACC is the same as it is in M&M with taxes
E) the value of the firm in M&M with taxes is overstated by the amount of financial distress costs
Ans: E Level: Basic Subject: Static Theory Type: Concepts
70. Of the following, all are conclusions that can be drawn from the capital structure puzzle EXCEPT:
A) In the framework of the static theory of capital structure, a firm can precisely identify its optimal
capital structure.
B) Firms with tax shields from other sources such as depreciation will benefit less from leverage.
C) Firms in lower tax brackets will tend to benefit less from increases in financial leverage.
D) The financial structure that minimizes WACC is the one that will maximize the value of the firm.
E) All else the same, firms with tangible, liquid assets will have an incentive to borrow more.
Ans: A Level: Basic Subject: Capital Structure Theories Type: Concepts
71. Which of the following individuals has NOT acquired a marketed claim against RDJ, Inc.?
A) John purchased 250 shares of RDJ common stock.
B) Tom acquired rights allowing him to purchase 50 shares of RDJ common stock.
C) First State Bank wrote an unsecured loan to RDJ.
D) Susan purchased 200 shares of RDJ preferred stock.
E) Jim purchased a long-term bond issued by RDJ.
Ans: C Level: Basic Subject: Marketable Claims Type: Concepts
72. Which of the following statements is/are true regarding observed capital structures?
I. There appears to be some connection between operating characteristics and capital structure
II. D/E ratios are significantly higher today than they were in the 1960s.
III. It appears that, for whatever reason, capital structures vary quite a bit across differing industry
groups
A) I only
B) III only
C) I and III only
D) I and II only
E) I, II, and III
Ans: E Level: Basic Subject: Observed Capital Structures Type: Concepts

73. In a(n) ______________ a business is liquidated, usually at a loss for the creditors.
A) violation of protective covenants
B) legal bankruptcy
C) technical insolvency
D) accounting insolvency
E) business failure
Ans: E Level: Basic Subject: Business Failure Type: Concepts
74. If a firm fails to make the required interest payments on its long-term bonds, it is said to be in:
A) Business failure.
B) Accounting failure.
C) Accounting insolvency.
D) Technical insolvency.
E) Economic failure.
Ans: D Level: Basic Subject: Technical Insolvency Type: Concepts
75. When a firm defaults on a legal obligation, ___________.

A) it is called a business failure
B) the firm is in legal bankruptcy
C) the firm is in technical insolvency
D) the firm is in accounting insolvency
E) the firm is in violation of protective covenants
Ans: C Level: Basic Subject: Technical Insolvency Type: Concepts
76. Of the following, __________ does NOT necessarily indicate financial distress.
A) business failure
B) legal bankruptcy
C) technical insolvency
D) accounting insolvency
E) an involuntary bankruptcy petition
Ans: D Level: Basic Subject: Accounting Insolvency Type: Concepts
77. You are a secured creditor in a bankruptcy liquidation. Listed below, in chronological order, are the steps
in the bankruptcy proceeding. Just prior to which step would you expect to have to document the strength
of your claim on the firm's assets?
A) The corporation files a bankruptcy petition
B) A trustee in bankruptcy is elected
C) Assets are liquidated and bankruptcy administration costs are paid
D) The proceeds are distributed among creditors
E) Residual payments are made to shareholders
Ans: D Level: Basic Subject: Bankruptcy Chronology Type: Concepts

78. Which of the following describes a correct priority of claims in a bankruptcy liquidation?
A) Wages, government tax claims, consumer claims, preferred stockholders
B) Government tax claims, bankruptcy expenses, unsecured creditors, preferred stockholders
C) Bankruptcy expenses, consumer claims, unsecured creditors, government tax claims
D) Government tax claims, unsecured creditors, preferred stockholders, bankruptcy expenses
E) Bankruptcy expenses, wages, unsecured creditors, preferred stockholders
Ans: E Level: Basic Subject: Bankruptcy Claims Priority Type: Concepts
79. Which of the following DOES not correctly rank the priority of claims of the parties to a corporate
bankruptcy? (Rank from strongest to weakest. )
A) Wages and salaries; consumer claims; unsecured creditors
B) Contributions to employee benefit plans; consumer claims; common stockholders
C) Government tax claims; preferred stockholders; unsecured creditors
D) Bankruptcy-related administrative expenses; wages and salaries; common stockholders
E) Wages and salaries; consumer claims; preferred stockholders
Ans: C Level: Basic Subject: Priority Of Claims Type: Concepts
80. Which of the following is true regarding bankruptcy?

A) Liquidation frequently is converted into a reorganization.
B) In a prepack, creditors agree to a reorganization plan prior to the bankruptcy filing.
C) Firms cannot file bankruptcy to escape long-term leases on closed stores.
D) Creditors of the firm may not initiate bankruptcy proceedings.
E) A party other than the current firm management must take control of the firm before it comes out of
bankruptcy.
Ans: B Level: Basic Subject: Prepackaged Bankruptcy Type: Concepts
81. Which of the following are true when a firm is operating at its target capital structure point?
I. The WACC is at its minimum point.
II. The debt-equity ratio is equal to 1.
III. Shareholder value is maximized.
IV. The total value of the firm is maximized.
A) I and IV only
B) II and III only
C) I and III only
D) I, III, and IV only
E) I, II, III, and IV
Ans: D Level: Intermediate Subject: Target Capital Structure Type: Concepts
82. The value of a restructuring is equal to the net present value of the:
A) Resulting change in the total value of the firm.
B) Additional debt incurred minus the additional interest expense.
C) Debt outstanding minus the market value of the equity.
D) Net change in the total debt outstanding.
E) Change in the shareholders value minus the additional interest expense incurred.
Ans: A Level: Basic Subject: Restructuring Value Type: Concepts

83. Firm A has a debt-equity ratio of .5. Firm B has a debt-equity ratio of .8. All other features of these firms
are identical. The return on equity of Firm A is:
A) Equally as volatile as the return of equity of Firm B.
B) Less volatile than the return on equity of Firm B.
C) More volatile than the return on equity of Firm B.
D) Unaffected by the debt-equity ratio.
Ans: B Level: Intermediate Subject: Financial Leverage Type: Concepts
84. Which one of the following statements concerning financial leverage is correct?
A) Leverage is beneficial only when EBIT is relatively low.
B) EPS is decreased when leverage is used and the expected level of EBIT is achieved.
C) Financial leverage lowers the risk level of a firm.
D) The amount of financial leverage employed has a major effect on the value of the firm.
E) M&M Proposition I states that financial leverage is irrelevant to the value of a firm.
Ans: E Level: Basic Subject: Financial Leverage Type: Concepts
85. M&M Proposition I contends that:

A) The cost of equity is dependent upon the debt-ratio of the firm.
B) A firm's cost of equity varies with their cost of debt.
C) The total value of the firm remains constant regardless of the debt-equity mixture applied.
D) A firm's WACC also determines its cost of equity.
E) The cost of capital is a linear function with a positive slope.
Ans: C Level: Basic Subject: M&M Proposition I Type: Concepts
86. Which of the following apply to levered firms but not to unlevered firms?
I. Financial risk
II. Systematic risk
III. Business risk
IV. Interest tax shield
A) I only
B) I and IV only
C) II and III only
D) II, III, and IV only
E) I, II, and IV only
Ans: B Level: Intermediate Subject: Financial Risk Type: Concepts
87. M&M Proposition I with taxes states that the:

A) Debt-equity ratio does not affect the total value of a firm.
B) Cost of equity financing increases as the debt-equity ratio rises.
C) Value of a levered firm is equal to the present value of the interest tax shield plus the value of an
unlevered firm.
D) Required return on assets is determined by the level of financial risk.
E) Return on equity is dependent upon the marginal tax rate and the debt-equity ratio.
Ans: C Level: Basic Subject: M&M Proposition I With Taxes Type: Concepts

88. Which one of the following statements is true?

A) The total value of a firm decreases as debt is initially added to an all equity firm, if taxes are
considered.
B) The tax shield applies to both debt and equity financing.
C) The ideal capital structure minimizes the total tax liability.
D) Capital structure does matter when taxes are included.
E) The general conclusions of M&M Proposition II do not hold when taxes are considered.
Ans: D Level: Intermediate Subject: Tax Effects Type: Concepts
89. An individual investor who loans out part of their personal funds is in fact:
A) Offsetting part of the financial leverage of their investments.
B) Eliminating the business risk of their investments.
C) Increasing their total financial leverage.
D) Increasing their benefits from the interest tax shield.
E) Leveraging their investments.
Ans: A Level: Intermediate Subject: Homemade Leverage Type: Concepts
90. Firm A is levered. Firm B is unlevered. In all other aspects, Firms A and B are identical. There is no
depreciation expense. Considering taxes, Firm A will have _____ net income and _____ cash flow from
operations than will Firm B.
A) The same; the same
B) Lower; lower
C) Lower; higher
D) Higher; lower
E) Higher; higher
Ans: C Level: Intermediate Subject: Interest Tax Shield Type: Concepts
91. Which of the following are indirect costs of bankruptcy?

I. Loss of key employees
II. Foregone profitable projects due to debt restrictions
III. Loss created by sale of assets which was required to improve liquidity
IV. Accounting and legal fees incurred in the bankruptcy process
A) I and III only
B) I, II, and III only
C) I, III, and IV only
Ans: B Level: Intermediate Subject: Indirect Bankruptcy Costs Type: Concepts
92. Which one of the following groups is most apt to push a company towards filing bankruptcy once the firm
becomes financially distressed?
A) Executives
B) Employees
C) Stockholders
D) Secured bondholders
E) Suppliers
Ans: D Level: Intermediate Subject: Bankruptcy Type: Concepts

93. The cost of bankruptcy:

A) Includes only the direct costs associated with the actual bankruptcy filing.
B) At least partially offsets the benefits of the interest tax shield.
C) Is minimal due to the regulated processes that have been established under the Bankruptcy and
Insolvency Act.
D) Is not affected by the level of the debt-equity ratio.
E) Ignores all opportunity costs.
Ans: B Level: Intermediate Subject: Cost Of Bankruptcy Type: Concepts
94. Shareholders generally prefer that a distressed firm:

A) Undergo reorganization under the Bankruptcy and Insolvency Act because the common stock
generally recoups its value.
B) Undergo liquidation under the Bankruptcy and Insolvency Act because they have first priority over
the firm's assets.
C) Undergo reconstitution under the Bankruptcy and Insolvency Act because that option usually
minimizes shareholder loss.
D) Not declare bankruptcy because they are generally required to convert their shares into debt
securities.
E) Not declare bankruptcy since the common shares are often rendered worthless.
Ans: E Level: Intermediate Subject: Bankruptcy Type: Concepts
95. The optimal firm value is achieved when the:

A) Present value of the bankruptcy cost is minimized.
B) The interest tax shield on debt is maximized.
C) Weighted average cost of capital is minimized.
D) Debt-equity ratio is maximized.
E) Total net gain from leverage is equal to zero.
Ans: C Level: Basic Subject: Optimal Firm Value Type: Concepts
96. Which of the following statements concerning the actual value of a firm are correct?
I. The actual firm value is equal to the M&M Proposition I with tax value minus the financial distress
costs.
II. The actual value of a firm is equal to the value of the firm with no debt plus the present value of the
tax shield on debt minus the financial distress costs.
III. The actual value of a firm with debt is generally greater than the value of a firm without debt.
IV. The maximum value of a firm is at the point where the additional gain from leverage is just offset by
the additional financial distress cost.
A) II and III only
B) II and IV only
C) I and IV only
Ans: E Level: Intermediate Subject: Actual Firm Value Type: Concepts

97. The interest tax shield has more value when the amount of debt is _____ and the tax rate is:
A) Low; zero.
B) Low; high.
C) High; zero.
D) High; high.
E) Low; low.
Ans: D Level: Basic Subject: Interest Tax Shield Type: Concepts
98. Which of the following will affect the optimal level of debt for a firm?
I. Tax rate
II. Volatility of earnings
III. Nature of assets
IV. Accumulated tax losses
A) I and II only
B) I and IV only
C) I, II, and III only
D) I, III, and IV only
Ans: E Level: Intermediate Subject: Level Of Debt Type: Concepts
99. According to the absolute priority rule, which one of the following represents the correct order of
distributions in liquidation, starting with the highest priority first?
I. Employee wages
II. Government taxes
III. Administrative expenses of the bankruptcy
IV. Unsecured creditors
A) I, III, IV, II
B) II, III, I, IV
C) III, II, I, IV
D) III, I, II, IV
E) III, II, IV, I
Ans: D Level: Intermediate Subject: Bankruptcy Liquidation Type: Concepts
100. The financial management goal as it pertains to the capital structure of a firm is to operate at the point
where the debt-equity mix:
A) Creates the largest tax shield for the firm.
B) Maximizes the financial distress costs.
C) Maximizes the value of the firm
D) Minimizes the potential bankruptcy costs.
E) Minimizes the yield-to-maturity on debt.
Ans: C Level: Intermediate Subject: Financial Management Goal Type: Concepts

101. An unlevered firm with a market value of $1 million has 50,000 shares outstanding. The firm restructures
itself by issuing 200 new par bonds with face value $1,000 and an 8% coupon. The firm uses the proceeds
to repurchase outstanding stock. In considering the newly levered versus formerly unlevered firm, what is
the break-even EBIT? Ignore taxes.
A) $25,000
B) $50,000
C) $75,000
D) $80,000
E) $95,000
Ans: D Level: Basic Subject: Break-even EBIT Type: Problems
102. An investor owns 500 shares of stock in a firm with a debt/equity ratio = 1.0. The investor prefers a
debt/equity ratio = 1.5. If the stock price is $2 per share, what should the investor do?
A) Borrow $500 and buy 250 new shares.
B) Borrow $1,500 and buy 750 new shares.
C) Borrow $2,500 and buy 1,250 new shares.
D) Sell 250 shares and lend $500.
E) Sell 25 shares and lend $50.
Ans: B Level: Basic Subject: Homemade Leverage Type: Problems
103. An investor owns 500 shares of stock in a firm with a debt/equity ratio = 1.0. The investor prefers an all-
equity firm. If the stock price is $2 per share, what should the investor do?
A) Borrow $500 and buy 250 new shares.
B) Borrow $1,500 and buy 750 new shares.
C) Borrow $2,500 and buy 1,250 new shares.
D) Sell 250 shares and lend $500.
E) Sell 25 shares and lend $50.
Ans: D Level: Basic Subject: Homemade Leverage Type: Problems
104. The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000 paying an 8.5%
annual coupon, and an unlevered cost of capital of 12%. If the tax rate is 34%, what is the value of the
Brassy's equity?
A) $3,258
B) $3,685
C) $5,685
D) $6,325
E) $7,005
Ans: B Level: Basic Subject: Value Of Equity Type: Problems
105. What is the cost of equity for a firm where the required return on assets is 14%, the cost of debt is 11%, and
the target debt/equity ratio is 0.5? Ignore taxes.
A) 11.0%
B) 12.5%
C) 14.0%
D) 15.5%
E) 16.0%
Ans: D Level: Basic Subject: Cost Of Equity Type: Problems

106. The unlevered cost of capital for Red Ryder, Inc. is 12%. Pretax debt costs are 8%. Assuming a debt
equity ratio of 0.33, what is the cost of equity? The tax rate is 34%.
A) 11.0%
B) 12.6%
C) 12.9%
D) 13.4%
E) 13.8%
Ans: C Level: Basic Subject: Cost Of Equity Type: Problems
107. ABC, Inc. has a debt/equity ratio = 1.2. The firm has a cost of equity of 12% and a cost of debt of 8%.
What will the cost of equity be if the target debt/equity ratio increases to 2.0 and the cost of debt does not
change? Ignore taxes.
A) 10.56%
B) 11.12%
C) 13.46%
D) 14.74%
E) 15.45%
Ans: C Level: Basic Subject: Cost Of Equity Type: Problems
108. RDJ Inc. has an asset beta of 0.95. Its current capital structure is 60% debt, 40% equity. What is the firm's
equity beta? Ignore taxes.
A) 0.380
B) 1.243
C) 1.583
D) 1.875
E) 2.375
Ans: E Level: Basic Subject: Equity Beta Type: Problems
109. Suppose a firm issues perpetual debt with a face and market value of $5,000 and a coupon rate of 12%. If
the firm is subject to a 40% tax rate and the appropriate discount rate is 10%, what is the present value of
the interest tax shield?
A) $1,667
B) $2,000
C) $2,400
D) $3,600
E) $6,000
Ans: C Level: Basic Subject: Present Value Of Tax Shield Type: Problems
110. An unlevered firm has aftertax net income = $125,000. The unlevered cost of capital is 13% and the
corporate tax rate is 34%. What is the value of this firm?
A) $594,102
B) $634,615
C) $729,654
D) $961,538
E) $1,051,591
Ans: D Level: Basic Subject: Value Of An Unlevered Firm Type: Problems

111. 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 million in debt to its capital structure. The coupon rate would be 8% and the
bonds would sell for par value. The firm's tax rate is 34%. How much will 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
Ans: C Level: Basic Subject: Value Of A Levered Firm Type: Problems
112. The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000 paying an 8.5%
annual coupon, and an unlevered cost of capital of 12%. If the tax rate is 34%, what is the value of the
firm?
A) $3,258
B) $3,685
C) $5,685
D) $6,325
E) $7,005
Ans: C Level: Basic Subject: Value Of A Levered Firm Type: Problems
113. An unlevered firm has an EBIT = $250,000, aftertax net income = $165,000, and a cost of capital of 12%.
A levered firm with the same assets and operations has $1.25 million in face value debt paying an 8%
annual coupon; the debt sells for par value in the marketplace. What is the value of the levered firm? The
tax rate is 34%.
A) $1,250,000
B) $1,375,000
C) $1,666,667
D) $1,800,000
E) $2,625,000
Ans: D Level: Basic Subject: Value Of A Levered Firm Type: Problems
114. The Wrangler Co. has expected EBIT = $9,250, debt with a face and market value of $14,000 paying a 9%
annual coupon, and an unlevered cost of capital of 12%. If the tax rate is 39%, what is the value of
Wrangler's equity?
A) $38,481
B) $52,481
C) $55,635
D) $58,525
E) $65,600
Ans: A Level: Basic Subject: Value Of Equity Type: Problems

115. The Wrangler Co. has expected EBIT = $9,250, and debt with a face and market value of $14,000 paying a
9% annual coupon. The market value of the firm is $58,525. If the tax rate is 34%, what is Wranger's
unlevered cost of capital?
A) 9.00%
B) 11.35%
C) 12.12%
D) 12.76%
E) 12.99%
Ans: B Level: Basic Subject: Unlevered Cost Of Capital Type: Problems
116. A firm has an unlevered cost of capital of 10%, a cost of debt of 9%, and a tax rate of 34%. If it desires a
cost of equity of 14%, what is its target debt/equity ratio?
A) 2.49
B) 3.89
C) 4.68
D) 5.14
E) 6.06
Ans: E Level: Basic Subject: Levered Cost Of Equity Type: Problems
117. The Brassy Co. has expected EBIT = $910, an unlevered cost of capital of 12%, and debt with a face and
market value of $2,000 paying an 8.5% annual coupon. If the tax rate is 34%, what is the WACC of Brassy
Co. ?
A) 10.56%
B) 11.12%
C) 13.25%
D) 13.64%
E) 14.45%
Ans: A Level: Basic Subject: Weighted Average Cost Of Capital Type: Problems
118. Given the following, what is the WACC? EBIT = $2 million; tax rate = 34%; market value and book value
of debt = $4 million; unlevered cost of capital = 14%; cost of debt = 9%.
A) 11.4%
B) 11.9%
C) 12.2%
D) 12.6%
E) 13.1%
Ans: C Level: Basic Subject: Weighted Average Cost Of Capital Type: Problems
Use the following to answer questions 119-123:
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 coupon rate N/A 8%

There are no taxes. EBIT is expected to be $2.5 million, but could be as high as $3.5 million if an
economic expansion occurs, or as low as $2 million if a recession occurs. All values are market values.
119. How many shares are outstanding under the proposed capital structure?
A) 100,000
B) 200,000
C) 300,000
D) 400,000
E) 500,000
Ans: D Level: Basic Subject: Shares Outstanding Type: Problems
120. What is EPS under the current capital structure if there is a recession?
A) $3.33
B) $4.17
C) $5.00
D) $6.25
Ans: A Level: Basic Subject: EPS & Leverage Type: Problems
121. What is EPS during an expansion for the proposed capital structure?
A) $4.17
B) $5.00
C) $5.83
D) $6.00
E) $7.55
Ans: E Level: Basic Subject: EPS & Leverage Type: Problems
122. What is ROE for the proposed capital structure if the expected state occurs?
A) 16.7%
B) 16.7%
C) 20.0%
D) 22.4%
E) 23.3%
Ans: D Level: Basic Subject: ROE & Leverage Type: Problems
123. 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
Ans: A Level: Basic Subject: Break-even EBIT Type: Problems

Use the following to answer questions 124-130:
UNLEV has an expected perpetual EBIT = $4,000. The unlevered cost of capital = 15% and there are
20,000 shares of stock outstanding. The firm is considering issuing $8,800 in new par bonds to add
financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of
debt = 10% and the tax rate = 34%. There are no flotation costs.
124. Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. The stockholder prefers a
debt/equity ratio = 1.0. How could the stockholder use homemade leverage to achieve the restructuring
without the help of UNLEV? Assume there are no taxes.
A) The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B) The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C) The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D) The stockholder should lend $667 and sell 300 shares of UNLEV.
E) The stockholder should lend $1,337 and sell 667 shares of UNLEV.
Ans: A Level: Intermediate Subject: Homemade Leverage Type: Problems
125. Assume a stockholder owns 1,000 shares of UNLEV before the restructuring. Also assume UNLEV's
debt/equity ratio will be 0.493 after the restructuring. How could the stockholder use homemade leverage
to unlever her investment in the firm after the restructuring? Assume there are no taxes.
A) The stockholder should borrow $1,330 and buy 1,000 more shares of UNLEV.
B) The stockholder should borrow $2,660 and buy 1,000 more shares of UNLEV.
C) The stockholder should borrow $1,330 and buy 2,000 more shares of UNLEV.
D) The stockholder should lend $443 and sell 333 shares of UNLEV.
E) The stockholder should lend $1,337 and sell 667 shares of UNLEV.
Ans: D Level: Intermediate Subject: Homemade Leverage Type: Problems
126. What is the value of UNLEV before the restructuring? Assume there are no taxes.
A) $15,930
B) $17,600
C) $18,519
D) $26,667
E) $30,000
Ans: D Level: Intermediate Subject: Value Of An Unlevered Firm Type: Problems
127. What is the value of UNLEV before the restructuring?

A) $15,930
B) $17,600
C) $18,519
D) $26,667
E) $30,000
Ans: B Level: Intermediate Subject: Value Of An Unlevered Firm Type: Problems

128. What is the value of UNLEV after the restructuring?

A) $15,930
B) $17,600
C) $18,519
D) $20,592
E) $22,461
Ans: D Level: Intermediate Subject: Value Of A Levered Firm Type: Problems
129. What is the value of UNLEV's equity after the restructuring?

A) $11,792
B) $12,600
C) $12,819
D) $13,592
E) $16,461
Ans: A Level: Intermediate Subject: Value Of Equity Type: Problems
130. What is UNLEV's cost of equity after the restructuring? Assume the firm's market value is $20,592 after the
restructuring.
A) 14.8%
B) 17.5%
C) 18.4%
D) 20.0%
E) 22.5%
Ans: B Level: Intermediate Subject: Cost Of Equity With Taxes Type: Problems
131. The projected EBIT of a firm is $300,000. The firm currently has 100,000 shares of common stock
outstanding at a value of $18 per share. The firm has no debt. By how much will the ROE change if the
firm borrows $600,000 at 8% interest and uses the funds to repurchase shares of stock at the market price?
Ignore taxes.
A) -2.67%
B) 1.67%
C) 2.33%
D) 4.33%
E) 5.67%
Ans: D Level: Intermediate Subject: Capital Structure Type: Problems
132. ADA, Inc. currently has 20,000 shares of stock outstanding at a market value of $40 a share. The firm is
currently 100% financed with equity. ADA is considering a restructuring which will include issuing
$400,000 of bonds at par value with a coupon rate of 6%. What is the break-even EBIT?
A) $12,000
B) $24,000
C) $36,000
D) $48,000
E) $60,000
Ans: D Level: Intermediate Subject: Break-Even Ebit Type: Problems

133. A firm has a tax rate of 35%, an unlevered rate of return of 14%, total debt of $1,000, and an EBIT of
$300.00. What is the unlevered value of the firm?
A) $27
B) $393
C) $1,027
D) $1,393
E) $2,143
Ans: D Level: Intermediate Subject: Unlevered Debt Type: Problems
134. A firm has a 34% tax rate, EBIT of $400, total debt of $600, and an unlevered value of $1,000. What is the
value of the firm with debt?
A) $604
B) $816
C) $940
D) $1,136
E) $1,204
Ans: E Level: Intermediate Subject: M&M Proposition I With Taxes Type: Problems
135. A firm is worth $1,400, has a 35% tax rate, total debt of $600, an unlevered return of 15%, and a cost of
debt of 9%. What is the cost of equity?
A) 12.07%
B) 16.67%
C) 17.93%
D) 18.75%
E) 20.20%
Ans: C Level: Intermediate Subject: M&M Proposition II With Taxes Type: Problems
136. A firm has $500 in debt at a cost of 7%, a 34% tax rate, a total firm value of $1,100, and an unlevered
return of 14%. What is the WACC?
A) 9.24%
B) 9.74%
C) 9.88%
D) 10.67%
E) 11.84%
Ans: E Level: Intermediate Subject: Wacc Type: Problems
137. A firm has a debt-equity ratio of .40, a WACC of 16%, and a yield-to-maturity on its debt of 13%. Ignoring
taxes, what is the cost of equity?
A) 7.8%
B) 9.6%
C) 11.8%
D) 15.2%
E) 17.2%
Ans: E Level: Intermediate Subject: Cost Of Equity Type: Problems

138. The Addopa Co. has a projected annual EBIT of $5,000. The company is currently 100% equity financed
with a cost of equity of 14%. The tax rate is 34% and the cost of debt is 10%. What is the value of the firm
if they borrow $12,000?
A) $23,571
B) $24,771
C) $26,009
D) $27,651
E) $29,229
Ans: D Level: Intermediate Subject: Firm Value Type: Problems
139. A firm has 30,000 shares of stock outstanding, $450,000 in debt at a 9% rate, an EBIT of $112,000, and a
tax rate of 0%. What is the EPS?
A) $2.38
B) $2.51
C) $2.87
D) $3.36
E) $3.73
Ans: A Level: Intermediate Subject: EPS Type: Problems
140. McMillin Industries is currently 100% equity financed, has 25,000 shares outstanding at a price of $30 a
share, and produces an annual EBIT of $150,000. The firm is considering issuing $300,000 of debt and
repurchasing shares. The cost of debt is 12%. Ignore taxes. By how much will EPS change if the company
issues the debt and EBIT remains constant?
A) $.72
B) $.76
C) $1.54
D) $1.60
E) $1.72
Ans: D Level: Intermediate Subject: EPS Type: Problems
141. Lance owns 200 shares of ABC stock with a current market value of $10 a share. ABC has an annual EBIT
of $400,000 and a cost of debt of 8%. Currently, ABC is 100% equity financed with 100,000 shares
outstanding. ABC is going to a 25% debt capital structure by issuing debt and redeeming shares. Ignore
taxes. What does Lance have to do to return his capital structure position to approximately its original
position?
A) Sell 69 shares and loan the money at 8%.
B) Sell 187 shares and loan the money at 8%.
C) Borrow $1,870 and buy an additional 187 shares.
D) Borrow $690 at 8% and buy an additional 69 shares.
E) Sell 50 shares and loan the money at 8%.
Ans: B Level: Intermediate Subject: Homemade Leverage Type: Problems

142. A firm has total debt of $900 and total equity of $1,600. The cost of debt is 10% and the unlevered rate of
return is 13%. The tax rate is 34%. What is the cost of equity?
A) 12.29%
B) 12.69%
C) 13.88%
D) 14.11%
E) 14.69%
Ans: D Level: Intermediate Subject: M&M Proposition II With Taxes Type: Problems
143. Martha's Grapevines, Inc. has an EBIT of $46,000, no debt, a 34% tax rate, and a 15% cost of capital. What
will the value of the firm be if Martha's Grapevines issues $75,000 in debt?
A) $202,400
B) $227,900
C) $267,300
D) $291,100
E) $330,000
Ans: B Level: Intermediate Subject: M&M Proposition I With Taxes Type: Problems
144. The Tee Company has total assets of $20,000 and total debt of $8,000. The yield-to-maturity on its bonds is
9%. The cost of capital with no debt is 15%. The tax rate is 34%. What is the WACC?
A) 8.64%
B) 10.58%
C) 10.88%
D) 11.39%
E) 12.96%
Ans: E Level: Intermediate Subject: WACC Type: Problems
145. BK Inc. has a cost of debt of 10% and a WACC of 15%. The debt-equity ratio is .6. The tax rate is 35%.
What is the cost of equity?
A) 19.33%
B) 19.88%
C) 20.10%
D) 20.54%
E) 20.67%
Ans: C Level: Intermediate Subject: Cost Of Equity Type: Problems
146. LKP, Inc. has an unlevered cost of capital of 14%, a cost of debt of 9%, a 34% tax rate, and an EBIT of
$60,000. The company has $120,000 in total assets, no accounts payable, and $70,000 in total equity. What
is the value of LKP, Inc.?
A) $265,857
B) $271,009
C) $282,857
D) $291,009
E) $299,857
Ans: E Level: Intermediate Subject: M&M Proposition I With Taxes Type: Problems

147. A firm has earnings per share of $2.12 on 40,000 shares outstanding. The firm also has $360,000 in debt at
a cost of 9%. Ignore taxes. What is the EBIT?
A) $84,800
B) $91,600
C) $102,300
D) $117,200
E) $119,700
Ans: D Level: Intermediate Subject: EBIT Type: Problems
148. A firm is considering two separate capital structures. The first is an all equity plan consisting of 25,000
shares of stock. The second plan would consist of 10,000 shares of stock and $90,000 in debt at a cost of
8%. Ignore taxes. What is the break-even EBIT?
A) $12,000
B) $15,000
C) $18,000
D) $19,000
E) $21,000
Ans: A Level: Intermediate Subject: Break-Even EBIT Type: Problems
149. Kate's Dry Goods currently has 15,000 shares of stock outstanding. Kate would like to reduce the
outstanding shares by one-third by issuing debt and repurchasing stock. The firm has an EBIT of $8,400
and a cost of debt of 7%. How much debt does Kate have to issue to accomplish her goal if she wishes
EBIT to remain constant?
A) $32,000
B) $35,000
C) $37,000
D) $40,000
E) $42,000
Ans: D Level: Intermediate Subject: Break-Even EBIT Type: Problems
150. JoBo's is a 100% equity financed firm with a tax rate of 34% and a WACC of 13%. The company can
borrow money at a current rate of 8%. EBIT is $24,500 annually. What is the current cost of equity?
A) 8.58%
B) 10.72%
C) 12.67%
D) 13.00%
E) 13.33%
Ans: D Level: Intermediate Subject: Cost Of Equity Type: Problems
151. Explain homemade leverage and why it matters.

Ans: Homemade leverage is the ability of investors to alter their own financial leverage to achieve a
desired capital structure no matter the firm's capital structure choice. If investors can use homemade
leverage to create additional leverage or to undo existing leverage of the firm at their discretion, then
the actual capital structure decision of the firm itself becomes irrelevant.
Level: Intermediate Subject: Homemade Leverage Type: Essays

152. Given that rational investors are risk averse, the cost of debt will generally be lower than the cost of equity;
however, M&M Proposition I states that replacing equity with debt will not change the value of the firm.
Explain.
Ans: The student is asked to demonstrate his/her understanding of the basic M&M model. The astute
student will recognize that, in terms of logical consistency, M&M is "bulletproof"; i.e., given the
assumptions, you will arrive at M&M's conclusions -- period. Second, no one believes that the Case
I model accurately describes reality; rather, it provides a jumping off point from which we can
readily assess the importance of market "imperfections" such as taxes, bankruptcy costs, etc. One
would hope that the responses to this question reflect these aspects of the issue, as well as the basic
mechanics involved.
Level: Challenge Subject: M&M Proposition I Type: Essays
153. Describe some of the sources of business risk and financial risk. Do financial decision makers have the
ability to "trade off" one type of risk for the other?
Ans: Students should intuitively recognize that some of the observed variation in capital structures across
industries, for example, reflect differences in the nature of the industries themselves; i.e., business
risk. Similarly, intuition would suggest that firms with large capital requirements and stable cash
flows (e.g., electric utilities) are more likely to be willing to raise funds via large amounts of
borrowing. Alternatively, firms with lower tangible asset needs and highly uncertain cash flows
(e.g., small software companies) are more likely to employ equity.
Level: Challenge Subject: M&M Propositions Type: Essays
154. In each of the theories of capital structure, the cost of equity rises as the amount of debt increases. So why
don't financial managers use as little debt as possible to keep the cost of equity down? After all, isn't the
goal of the firm to maximize share value (and minimize shareholder costs)?
Ans: This question requires students to differentiate between the cost of equity and the weighted average
cost of capital. In fact, it gets to the essence of capital structure theory: the firm trades off higher
equity costs for lower debt costs. The shareholders benefit (to a point, according to the static theory)
because their investment in the firm is leveraged, enhancing the return on their investment. Thus,
even though the cost of equity rises, the overall cost of capital declines (again, up to a point
according to the static theory) and firm value rises.
Level: Challenge Subject: Cost Of Equity Type: Essays
155. According to the capital structure theories we examined, a firm benefits by having debt since the interest
expense is deductible for tax purposes, creating an interest tax shield).The interest tax shield, on the other
hand, increases in value the higher the coupon rate on the debt and the higher the tax rate) Ignoring
financial distress costs, shouldn't the firm then choose to pay as high a coupon rate as possible?
Ans: This odd question challenges the students to differentiate between tax benefits and after-tax costs.
The interest tax shield measures the benefits of having debt, but ignores the cost side) What matters
to the firm is the WACC, which is minimized by adding low-cost debt to the mix. As debt costs rise,
the after-tax cost of debt rises, the WACC rises, and the benefits of debt decline.
Level: Challenge Subject: Taxes And Interest Costs Type: Essays

156. In a world of corporate taxes only, show that the WACC can be written as
WACC = RU[ 1 - TC(D/V)].
Ans: This is an exact statement of question 18 (a challenge question) from the end of the chapter. It
makes the student use the M&M propositions to derive the WACC).The student should begin with:
RE = RU + (RU - RD) D/E(1 - TC)
RA = REE/V + RDD/V(1 - TC)
From there, substituting RE into the RA equation leads to the final answer.
Level: Challenge Subject: WACC Type: Essays
157. Is there an easily identifiable debt/equity ratio that will maximize the value of a firm? Why or why not?
Ans: Students should explain that in a world with taxes, transaction costs, and financial distress costs,
there are both benefits and costs to higher debt loads, and there is no way to target exactly what the
ideal capital structure should be.
Level: Intermediate Subject: Capital Structure Theories Type: Essays
158. Based on M&M without taxes and with taxes, how much time should a financial manager spend analyzing
the capital structure of their firm? How about based on the static theory?
Ans: Under either M&M scenario, the financial manager should invest no time in analyzing the firm's
capital structure. With no taxes, capital structure is irrelevant. With taxes, M&M says a firm will
maximize its value by using 100% debt. In both cases, the manager has nothing 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 the interest tax shield versus financial distress costs. Ultimately,
finding the optimal capital structure is challenging in this case.
Level: Challenge Subject: Capital Structure Theories Type: Essays
159. Draw the following two graphs, one above the other: In the top graph, plot firm value on the vertical axis
and total debt on the horizontal. Use the graph to illustrate the value of a firm under M&M without taxes,
M&M with taxes, and the static theory of capital structure. On the lower graph, plot the WACC on the
vertical axis and the debt/equity ratio on the horizontal axis. Use the graph to illustrate the value of the
firm's WACC under M&M without taxes, M&M with taxes, and the static theory. Briefly explain what the
two graphs tell us about firm value and its cost of capital under the three different theories.
Ans: The student should replicate and explain Figure 16.8 from the text.
Level: Challenge Subject: Capital Structure Theories Type: Essays
160. Differentiate between (A) business failure, (B) legal bankruptcy, (C) technical insolvency, and (D)
accounting insolvency.
Ans: This a straightforward question requiring the student to know and understand the terminology in
section 16.9.
Level: Intermediate Subject: Financial Distress Type: Essays

161. What are the advantages for a firm using a prepackaged bankruptcy? Disadvantages?
Ans: A prepack allows a firm to minimize its stay in bankruptcy court, and should allow the firm to
minimize its bankruptcy costs as well. In either case, management is freed up to spend time on more
productive tasks, such as operating the firm. The negative side of a prepack is a little more difficult
to discern. Astute students will recognize that prepacks take time to negotiate, that is, they may save
time during bankruptcy, but they likely take more time up front than a straight bankruptcy filing.
Furthermore, it is also likely that the firm must give creditors a better deal in order to get them to
sign on to the bankruptcy agreement. If so, the firm may actually get better terms from its creditors
by going through with a full bankruptcy process.
Level: Challenge Subject: Prepackaged Bankruptcy Type: Essays
162. Explain why the optimal capital structure is one that maximizes the value of marketed claims and
minimizes the value of nonmarketed claims.
Ans: Marketed claims are claims the bondholders and shareholders have on a firm. Nonmarketed claims
include taxes, bankruptcy costs, and other similar items. The optimal capital structure should ensure
full payment of debt in a timely manner and provide the maximum return for shareholders.
Nonmarketed claims reduce the return to shareholders and thus, should be minimized.
Level: Intermediate Subject: Marketed And Nonmarketed Claims Type: Essays

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Chapter 16 Financial Leverage and Capital Structure Policy

Ans: False Level: Basic Subject: Financial Leverage Type: Concepts

2. Business risk declines as the systematic risk of a firm's assets increases.

Ans: False Level: Basic Subject: Business Risk Type: Concepts

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

Ans: True Level: Basic Subject: Business Risk Type: Concepts

Ans: True Level: Basic Subject: M&M Proposition II Type: Concepts

Ans: True Level: Basic Subject: Bankruptcy Costs Type: Concepts

Ans: True Level: Basic Subject: Bankruptcy Costs Type: Concepts

Ans: False Level: Basic Subject: Bankruptcy Costs Type: Concepts

Ans: True Level: Basic Subject: Bankruptcy Costs Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 1

Ans: A Level: Basic Subject: Homemade Leverage Type: Definitions

Ans: B Level: Basic Subject: M&M Proposition I Type: Definitions

Ans: C Level: Basic Subject: M&M Proposition II Type: Definitions

Ans: D Level: Basic Subject: Business Risk Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 2

Ans: E Level: Basic Subject: Financial Risk Type: Definitions

Ans: A Level: Basic Subject: Interest Tax Shield Type: Definitions

19. The unlevered cost of capital is _________________.

Ans: B Level: Basic Subject: Unlevered Cost Of Capital Type: Definitions

Ans: C Level: Basic Subject: Direct Bankruptcy Costs Type: Definitions

Ans: D Level: Basic Subject: Indirect Bankruptcy Costs Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 3

Ans: E Level: Basic Subject: Financial Distress Costs Type: Definitions

Ans: B Level: Basic Subject: Bankruptcy Type: Definitions

25. A firm that has negative net worth is said to be:

Ans: D Level: Basic Subject: Accounting Insolvency Type: Definitions

Ans: C Level: Basic Subject: Liquidation Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 4

Ans: D Level: Basic Subject: Reorganization Type: Definitions

28. A capital restructuring occurs when a firm:

Ans: B Level: Basic Subject: Capital Restructuring Type: Definitions

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

Ans: E Level: Basic Subject: Financial Leverage Type: Definitions

Ans: D Level: Basic Subject: Required Return On Assets Type: Definitions

Ans: C Level: Basic Subject: M&M Proposition II Type: Definitions

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 5

Ans: E Level: Basic Subject: M&M Proposition II Type: Definitions

Ans: D Level: Basic Subject: Homemade Leverage Type: Definitions

Ans: B Level: Basic Subject: Reorganization Type: Definitions

36. The procedure for liquidating a corporation is outlined in:

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 6

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

Ans: A Level: Basic Subject: Absolute Priority Rule Type: Definitions

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

Ans: C Level: Basic Subject: WACC Type: Concepts

Ans: C Level: Basic Subject: Capital Structure Type: Concepts

Ans: C Level: Basic Subject: Optimal Capital Structure Type: Concepts

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

Ans: D Level: Basic Subject: Financial Leverage Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 7

Ans: B Level: Basic Subject: Financial Leverage Type: Concepts

Ans: E Level: Basic Subject: Financial Leverage Type: Concepts

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

Ans: B Level: Basic Subject: Leverage Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 8

Ans: B Level: Basic Subject: Break-even EBIT Type: Concepts

48. Which of the following statements is correct?

Ans: E Level: Basic Subject: Homemade Leverage Type: Concepts

Ans: A Level: Basic Subject: M&M Proposition I Type: Concepts

Copyright © 2005 McGraw-Hill Ryerson Limited. Page 9

Ans: B Level: Basic Subject: M&M Proposition I Type: Concepts

Ans: A Level: Basic Subject: Capital Structure Theories Type: Concepts