Professional Documents
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16-1
Chapter 16 - Financial Leverage and Capital Structure Policy
B. issue
C. direct bankruptcy 11. The proposition that a firm borrows up to the
D. indirect bankruptcy point where the marginal benefit of the interest tax
E. unlevered shield derived from increased debt is just equal to
Refer to section 16.5 the marginal expense of the resulting increase in
financial distress costs is called:
AACSB: N/A A. the static theory of capital structure.
Bloom's: Knowledge
Difficulty: Basic B. M&M Proposition I.
Learning Objective: 16-3 C. M&M Proposition II.
Section: 16.5
Topic: Bankruptcy costs D. the capital asset pricing model.
E. the open markets theorem.
Refer to section 16.6
9. The costs incurred by a business in an effort to
avoid bankruptcy are classified as _____ costs. AACSB: N/A
A. flotation Bloom's: Knowledge
B. direct bankruptcy Difficulty: Basic
Learning Objective: 16-2
C. indirect bankruptcy Section: 16.6
D. financial solvency Topic: Static theory of capital structure
AACSB: N/A
13. A business firm ceases to exist as a Bloom's: Knowledge
Difficulty: Basic
going concern as a result of which one of the Learning Objective: 16-3
following? Section: 16.10
Topic: Absolute priority rule
A. divestiture
B. share repurchase 16. A firm should select the capital structure that:
C. liquidation A. produces the highest cost of capital.
D. reorganization B. maximizes the value of the firm.
E. capital restructuring C. minimizes taxes.
Refer to section 16.10 D. is fully unlevered.
E. equates the value of debt with the value of equity.
AACSB: N/A Refer to section 16.1
Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 16-3 AACSB: N/A
Section: 16.10 Bloom's: Knowledge
Topic: Liquidation Difficulty: Basic
Learning Objective: 16-1
14. Edwards Farm Products was unable to meet its Section: 16.1
Topic: Capital structure
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 17. The value of a firm is maximized when the:
underwent is known as a: A. cost of equity is maximized.
A. merger. B. tax rate is zero.
B. repurchase program. C. levered cost of capital is maximized.
C. liquidation. D. weighted average cost of capital is minimized.
D. reorganization. E. debt-equity ratio is minimized.
E. divestiture. Refer to section 16.1
Refer to section 16.10
AACSB: N/A
Bloom's: Knowledge
AACSB: N/A
Difficulty: Basic
Bloom's: Knowledge
Learning Objective: 16-1
Difficulty: Basic
Section: 16.1
Learning Objective: 16-3
Topic: Firm value
Section: 16.10
Topic: Reorganization
18. The optimal capital structure has been achieved
when the:
15. The absolute priority rule determines: A. debt-equity ratio is equal to 1.
A. when a firm must be declared officially B. weight of equity is equal to the weight of debt.
16-3
Chapter 16 - Financial Leverage and Capital Structure Policy
19. AA Tours is comparing two capital structures to 21. Which one of the following statements is correct
determine how to best finance its operations. The concerning the relationship between a levered and
first option consists of all equity financing. The an unlevered capital structure? Assume there are no
second option is based on a debt-equity ratio of taxes.
0.45. What should AA Tours do if its expected A. At the break-even point, there is no advantage to
earnings before interest and taxes (EBIT) are less debt.
than the break-even level? Assume there are no B. The earnings per share will equal zero when
taxes. EBIT is zero for a levered firm.
A. select the leverage option because the debt- C. The advantages of leverage are inversely related
equity ratio is less than 0.50 to the level of EBIT.
B. select the leverage option since the expected D. The use of leverage at any level of EBIT
EBIT is less than the break-even level increases the EPS.
C. select the unlevered option since the debt-equity E. EPS are more sensitive to changes in EBIT when
ratio is less than 0.50 a firm is unlevered.
D. select the unlevered option since the expected Refer to section 16.2
EBIT is less than the break-even level
E. cannot be determined from the information AACSB: N/A
provided Bloom's: Knowledge
Difficulty: Basic
Refer to section 16.2 Learning Objective: 16-1
Section: 16.2
Topic: Break-even point
AACSB: N/A
Bloom's: Comprehension 22. Jessica invested in Quantro stock when the firm
Difficulty: Basic
Learning Objective: 16-1 was unlevered. Since then, Quantro has changed its
Section: 16.2 capital structure and now has a debt-equity ratio of
Topic: Financial leverage
0.30. To unlever her position, Jessica needs to:
20. You have computed the break-even point A. borrow some money and purchase additional
between a levered and an unlevered capital shares of Quantro stock.
structure. Assume there are no taxes. At the break- B. maintain her current equity position as the debt
even level, the: of the firm did not affect her personally.
A. firm is just earning enough to pay for the cost of C. sell some shares of Quantro stock and hold the
the debt. proceeds in cash.
B. firm's earnings before interest and taxes are equal D. sell some shares of Quantro stock and loan out
16-4
Chapter 16 - Financial Leverage and Capital Structure Policy
that:
AACSB: N/A
Bloom's: Knowledge A. a firm's weighted average cost of capital
Difficulty: Basic decreases as the firm's debt-equity ratio increases.
Learning Objective: 16-1
Section: 16.3 B. the value of a firm is inversely related to the
Topic: M&M Proposition II amount of leverage used by the firm.
28. The business risk of a firm: C. the value of an unlevered firm is equal to the
A. depends on the firm's level of unsystematic risk. value of a levered firm plus the value of the interest
B. is inversely related to the required return on the tax shield.
firm's assets. D. a firm's cost of capital is the same regardless of
C. is dependent upon the relative weights of the the mix of debt and equity used by the firm.
debt and equity used to finance the firm. E. a firm's cost of equity increases as the debt-
D. has a positive relationship with the firm's cost of equity ratio of the firm decreases.
equity. Refer to section 16.4
E. has no relationship with the required return on a
firm's assets according to M&M Proposition II. AACSB: N/A
Bloom's: Comprehension
Refer to section 16.3 Difficulty: Basic
Learning Objective: 16-2
Section: 16.4
AACSB: N/A Topic: M&M Proposition I with taxes
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 16-1
Section: 16.3 31. M&M Proposition I with taxes is based on the
Topic: Business risk concept that:
A. the optimal capital structure is the one that is
29. Which of the following statements related to totally financed with equity.
financial risk are correct? B. the capital structure of a firm does not matter
I. Financial risk is the risk associated with the use of because investors can use homemade leverage.
debt financing. C. a firm's WACC is unaffected by a change in the
II. As financial risk increases so too does the cost of firm's capital structure.
equity. D. the value of a firm increases as the firm's debt
III. Financial risk is wholly dependent upon the increases because of the interest tax shield.
financial policy of a firm. E. the cost of equity increases as the debt-equity
IV. Financial risk is the risk that is inherent in a ratio of a firm increases.
firm's operations. Refer to section 16.4
A. I and III only
B. II and IV only AACSB: N/A
Bloom's: Comprehension
C. II and III only Difficulty: Basic
D. I, II, and III only Learning Objective: 16-2
Section: 16.4
E. I, II, III, and IV Topic: M&M Proposition I with taxes
Refer to section 16.3
32. M&M Proposition II with taxes:
A. has the same general implications as M&M
AACSB: N/A
Bloom's: Comprehension Proposition II without taxes.
Difficulty: Basic B. states that a firm's capital structure is irrelevant.
Learning Objective: 16-1
Section: 16.3 C. supports the argument that business risk is
Topic: Financial risk determined by the capital structure decision.
30. M&M Proposition I with tax supports the theory D. supports the argument that the cost of equity
16-6
Chapter 16 - Financial Leverage and Capital Structure Policy
decreases as the debt-equity ratio increases. A. the required rate of return on assets rises when
E. concludes that the capital structure decision is debt is added to the capital structure.
irrelevant to the value of a firm. B. the value of an unlevered firm is equal to the
Refer to section 16.4 value of a levered firm.
C. the net cost of debt to a firm is generally less
AACSB: N/A than the cost of equity.
Bloom's: Comprehension D. the cost of debt is equal to the cost of equity for a
Difficulty: Basic
Learning Objective: 16-2 levered firm.
Section: 16.4 E. firms prefer equity financing over debt financing.
Topic: M&M Proposition II with taxes
Refer to section 16.4
33. The present value of the interest tax shield is AACSB: N/A
expressed as: Bloom's: Comprehension
Difficulty: Basic
A. (TC D)/RA. Learning Objective: 16-2
Section: 16.4
B. VU + (TC D). Topic: Interest tax shield
C. [EBIT (TC D)]/RU.
36. Based on M&M Proposition II with taxes, the
D. [EBIT (TC D)]/RA.
weighted average cost of capital:
E. Tc D. A. is equal to the aftertax cost of debt.
Refer to section 16.4 B. has a linear relationship with the cost of equity
capital.
AACSB: N/A C. is unaffected by the tax rate.
Bloom's: Knowledge
Difficulty: Basic D. decreases as the debt-equity ratio increases.
Learning Objective: 16-2 E. is equal to RU (1 - TC).
Section: 16.4
Topic: PV of interest tax shield Refer to section 16.4
34. The interest tax shield has no value when a firm
AACSB: N/A
has a: Bloom's: Knowledge
I. tax rate of zero. Difficulty: Basic
Learning Objective: 16-2
II. debt-equity ratio of 1. Section: 16.4
III. zero debt. Topic: M&M Proposition II with taxes
IV. zero leverage.
A. I and III only
37. Bankruptcy:
B. II and IV only
A. creates value for a firm.
C. I, III, and IV only
B. transfers value from shareholders to bondholders.
D. II, III, and IV only
C. technically occurs when total equity equals total
E. I, II, and IV only
debt.
Refer to section 16.4
D. costs are limited to legal and administrative fees.
E. is an inexpensive means of reorganizing a firm.
AACSB: N/A Refer to section 16.5
Bloom's: Comprehension
Difficulty: Basic
Learning Objective: 16-2
Section: 16.4 AACSB: N/A
Topic: Interest tax shield Bloom's: Knowledge
Difficulty: Basic
Learning Objective: 16-3
Section: 16.5
35. The interest tax shield is a key reason why: Topic: Bankruptcy
16-7
Chapter 16 - Financial Leverage and Capital Structure Policy
AACSB: N/A
45. Which form of financing do firms prefer to use Bloom's: Knowledge
Difficulty: Basic
first according to the pecking-order theory? Learning Objective: 16-2
A. regular debt Section: 16.9
Topic: Capital structure
B. convertible debt
C. common stock 48. In general, the capital structures used by U.S.
D. preferred stock firms:
E. internal funds A. tend to overweigh debt in relation to equity.
Refer to section 16.8 B. generally result in debt-equity ratios between
0.45 and 0.60.
AACSB: N/A C. are fairly standard for all SIC codes.
Bloom's: Knowledge D. tend to be those which maximize the use of the
Difficulty: Basic
Learning Objective: 16-2 firm's available tax shelters.
Section: 16.8 E. vary significantly across industries.
Topic: Pecking-order theory
Refer to section 16.9
46. Which of the following are correct according to
pecking-order theory? AACSB: N/A
I. Firms stockpile internally-generated cash. Bloom's: Knowledge
Difficulty: Basic
II. There is an inverse relationship between a firm's Learning Objective: 16-2
profit level and its debt level. Section: 16.9
Topic: Capital structure
III. Firms avoid external debt at all costs.
IV. A firm's capital structure is dictated by its need
for external financing. 49. A firm is technically insolvent when:
A. I and III only A. it has a negative book value.
16-9
Chapter 16 - Financial Leverage and Capital Structure Policy
54. Kelso Electric is debating between a leveraged 5,000 shares of stock outstanding at a market price
and an unleveraged capital structure. The all equity of $15 a share. The firm's management has decided
capital structure would consist of 40,000 shares of to issue $30,000 worth of debt and use the funds to
stock. The debt and equity option would consist of repurchase shares of the outstanding stock. The
25,000 shares of stock plus $280,000 of debt with interest rate on the debt will be 10 percent. What are
an interest rate of 7 percent. What is the break-even the earnings per share at the break-even level of
level of earnings before interest and taxes between earnings before interest and taxes? Ignore taxes.
these two options? Ignore taxes. A. $1.46
A. $42,208 B. $1.50
B. $44,141 C. $1.67
C. $46,333 D. $1.88
D. $49,667 E. $1.94
E. $52,267 Number of shares repurchased = $30,000/$15 =
EBIT/40,000 = [EBIT - ($280,000 0.07)]/25,000; 2,000
EBIT = $52,267 EBIT/5,000 = [EBIT - ($30,000 .0.10)]/(5,000 -
2,000); EBIT = $7,500
AACSB: Analytic EPS = [$7,500 - ($30,000 0.10)]/(5,000 - 2,000);
Bloom's: Application EPS = $1.50
Difficulty: Basic
Learning Objective: 16-1
Section: 16.2
Topic: Break-even EBIT AACSB: Analytic
Bloom's: Application
Difficulty: Basic
Learning Objective: 16-1
55. Holly's is currently an all equity firm that has Section: 16.2
Topic: Break-even EPS
9,000 shares of stock outstanding at a market price
of $42 a share. The firm has decided to leverage its
operations by issuing $120,000 of debt at an interest 57. Miller's Dry Goods is an all equity firm with
rate of 9.5 percent. This new debt will be used to 45,000 shares of stock outstanding at a market price
repurchase shares of the outstanding stock. The of $50 a share. The company's earnings before
restructuring is expected to increase the earnings interest and taxes are $128,000. Miller's has decided
per share. What is the minimum level of earnings to add leverage to its financial operations by issuing
before interest and taxes that the firm is expecting? $250,000 of debt at 8 percent interest. The debt will
Ignore taxes. be used to repurchase shares of stock. You own 400
A. $35,910 shares of Miller's stock. You also loan out funds at 8
B. $38,516 percent interest. How many shares of Miller's stock
C. $42,000 must you sell to offset the leverage that Miller's is
D. $44,141 assuming? Assume you loan out all of the funds you
E. $45,020 receive from the sale of stock. Ignore taxes.
EBIT/9,000 = [EBIT - ($120,000 0.095)]/[9,000 - A. 35.6 shares
($120,000/$42)]; EBIT = $35,910 B. 40.0 shares
C. 44.4 shares
AACSB: Analytic D. 47.5 shares
Bloom's: Application E. 50.1 shares
Difficulty: Basic
Learning Objective: 16-1 Miller's interest = $250,000 0.08 = $20,000
Section: 16.2 Miller's shares repurchased = $250,000/$50 = 5,000
Topic: Break-even EBIT
Miller's shares outstanding with debt = 45,000 -
56. Sewer's Paradise is an all equity firm that has 5,000 = 40,000
16-11
Chapter 16 - Financial Leverage and Capital Structure Policy
16-12
Chapter 16 - Financial Leverage and Capital Structure Policy
16-13
Chapter 16 - Financial Leverage and Capital Structure Policy
16-14
Chapter 16 - Financial Leverage and Capital Structure Policy
taxes, and the static theory. Briefly explain what the shareholders because they can use homemade
two graphs reveal about firm value and its cost of leverage to adjust their exposure to financial
capital under the three different theories. leverage to whatever level they prefer. Thus, Pete
The student should replicate and explain Figure can increase the debt-equity ratio of the firm if he
16.8 from the text. feels it is in the best interest of the firm to do so.
86. Based on the M&M propositions with and 88. In each of the theories of capital structure, the
without taxes, how much time should a financial cost of equity increases as the amount of debt
manager spend analyzing the capital structure of a increases. So why don't financial managers use as
firm? What if the analysis is based on the static little debt as possible to keep the cost of equity
theory? down? After all, aren't financial managers supposed
Under either M&M scenario, a financial manager to maximize the value of a firm?
should not spend time analyzing the firm's capital This question requires students to differentiate
structure. With no taxes, capital structure is between the cost of equity and the weighted average
irrelevant. With taxes, M&M says a firm will cost of capital. In fact, it gets to the essence of
maximize its value by using 100 percent debt. In capital structure theory: the firm trades off higher
both cases, the manager has nothing to decide. With equity costs for lower debt costs. The shareholders
the static theory, however, the manager must benefit (to a point, according to the static theory)
determine the optimal amount of debt and equity by because their investment in the firm is leveraged,
analyzing the tradeoff between the benefits of the enhancing the return on their investment. Thus,
interest tax shield versus the financial distress costs. even though the cost of equity rises, the overall cost
Finding the optimal capital structure is challenging of capital declines (again, up to a point according to
in this case. the static theory) and firm value rises.
Feedback: Refer to sections 16.3 and 16.4 Feedback: Refer to section 16.6
87. Pete is the CFO of Dexter International. He 89. Explain how a firm loses value during the
would like to increase the debt-equity ratio of the bankruptcy process from both a creditors and a
firm but is concerned that the firm's shareholders shareholders perspective.
may not be willing to accept additional financial The bankruptcy process is a legal proceeding that
leverage. Pete has come to you for advice. What is either liquidates or reorganizes a firm. Under either
your recommendation? situation, legal, accounting, and other administrative
The capital structure of the firm is irrelevant to the fees are incurred. These fees, which are frequently
16-19
Chapter 16 - Financial Leverage and Capital Structure Policy
quite substantial, must be paid out of the assets of $7.712195 = -70.97 percent
the firm, thereby reducing the value remaining for
the creditors and shareholders. In addition, the AACSB: Analytic
bankruptcy process generally transfers value from Bloom's: Analysis
Difficulty: Basic
the shareholders to the creditors based on the EOC #: 16-1
absolute priority rule. Learning Objective: 16-1
Section: 16.2
Topic: EBIT and leverage
Feedback: Refer to section 16.10