Question 1

When taxes are ignored,which of the following can be used to calculate the weighted-average cost of capital?

Accepted Answer

The weighted-average cost of capital (WACC) is calculated using the market values of all securities, not book values, and it considers the proportion of each type of capital (equity and debt) in the firm's capital structure.

Question 2

MM proposition I states that a firm's value is unaffected by its:

Accepted Answer

According to MM Proposition I, the value of a firm is solely determined by the investment decisions and has nothing to do with the way it is financed. In other words, a firm’s value is unaffected by the mixture of debt and equity. Theoretically, this means that the value of a firm should remain constant as long as its investment decisions remain the same, regardless of whether it raises capital by issuing stock or by borrowing money.

Question 3

The "trade-off theory" of capital structure suggests that:

Accepted Answer

The trade-off theory of capital structure suggests that firms with higher risk should use less debt. This is because higher levels of debt increase the financial risk of the firm, which may lead to bankruptcy in case of financial distress. Therefore, firms should balance the tax benefits of debt against the increased financial risk to determine their optimal capital structure.

Question 4

Based upon the "trade-off theory" of capital structure,what differences might you expect in the capital structure of a food producer and a defense contractor?

Accepted Answer

The trade-off theory suggests that firms balance the tax benefits of debt with the costs of potential financial distress. A food producer, typically having more stable and predictable cash flows, might be expected to have a higher debt-equity ratio compared to a defense contractor, which may face more variability and uncertainty in cash flows due to reliance on government contracts and geopolitical factors.

Question 5

What happens to an all-equity firm's EPS when $1 million of 20% debt is issued and proceeds used to repurchase two-thirds of the stock if operating income equals $1.5 million and EPS were $2 when the firm was all-equity-financed? Ignore taxes.

Accepted Answer

Before issuing debt and repurchasing stock:
- Operating income = $1.5 million
- EPS = $2.00

After issuing debt and repurchasing stock:
- Operating income stays the same at $1.5 million
- Debt amount = $1 million, with a 20% interest rate, will lead to $200,000 in interest payments
- Net income available to equity holders will now be $1.3 million ($1.5 million - $200,000 interest)
- Total shares outstanding reduced by two-thirds, so total shares outstanding is now one-third of the original amount
- EPS now is $5.20 ($1.3 million / (1/3 of original shares))

Question 6

A decrease in the possible range of percentage stock returns can be achieved by:

Accepted Answer

The possible range of percentage stock returns is directly affected by the level of financial leverage a firm bears. When a firm carries a high level of debt, the variation in the earnings will lead to an amplified response in the equity value. Hence, a decrease in a firm’s financial leverage contributes to a decrease in the possible range of percentage stock returns.

Question 7

An implicit cost of adding debt to the capital structure is that it:

Accepted Answer

The answer of An implicit cost of adding debt to...

Question 8

The reason that financial leverage increases shareholder risk is that there is:

Accepted Answer

Financial leverage refers to the use of debt to finance a company's operations. When a company takes on more debt, it reduces its equity, which means that shareholders have less of a buffer to absorb any losses. Therefore, if the company experiences financial difficulties, shareholders are more exposed to risk as there is less equity to absorb the operating risk. Choice A is incorrect because while more debt increases financial risk, it does not necessarily increase operating risk. Choice C is incorrect because less business risk to be spread around would actually decrease shareholder risk. Choice D is incorrect because financial risk and business risk are separate concepts and cannot be directly compared.

Question 9

According to MM,an increase in expected earnings per share can leave the share price unchanged if the:

Accepted Answer

According to Modigliani and Miller's (MM) theory, in a world without taxes, the value of a firm is not affected by its capital structure. Therefore, an increase in expected earnings per share (EPS) can leave the share price unchanged if the required return on equity increases. This is because the increase in required return on equity would offset the positive impact of higher EPS on the share price, keeping the valuation unchanged.

Question 10

Restructuring a firm involves changing the:

Accepted Answer

Restructuring a firm involves changing the mix of liabilities and equity to improve the financial health of the company.

Question 11

When taxes are considered,the value of a levered firm equals the value of the:

Accepted Answer

The answer of When taxes are considered,the value of a...

Question 12

According to MM II,as a firm's debt-equity ratio decreases:

Accepted Answer

According to MM II, a firm's debt-equity ratio doesn't affect its overall cost of capital. Therefore, the required rate of return on equity is independent of the firm's capital structure. Thus, the required rate of return on equity remains constant, and it doesn't change with the decrease in the debt-equity ratio of the firm.

Question 13

When debt is risky under MM II:

Accepted Answer

According to Modigliani and Miller's Proposition II, in a world with no taxes or bankruptcy costs, debt is irrelevant in determining the value of a firm. However, when debt becomes risky, it increases the likelihood of bankruptcy which leads to higher default costs. Equityholders are inherently holders of a residual claim and thus have a higher tolerance for risk. In order to mitigate risk, equityholders may shift more of the risk to bondholders by taking on safer projects or reducing dividend payouts. Therefore, option B is the correct answer.

Question 14

What is the maximum rate that can be paid on debt and maintain a 14% WACC with a 19% expected return on equity in a firm with a 60% debt-to-asset ratio? Ignore taxes.

Accepted Answer

WACC formula: WACC = (E/V x Re) + (D/V x Rd) x (1 - T)

Given, 
Debt-to-asset ratio (D/A) = 60%
Equity-to-asset ratio (E/A) = 40%
Expected return on equity (Re) = 19%
WACC = 14%

We need to find the maximum rate that can be paid on debt (Rd).

Putting the given values in the WACC formula, we get:

14% = (0.4 x 19%) + (0.6 x Rd)
14% = 7.6% + 0.6Rd
0.6Rd = 14% - 7.6%
0.6Rd = 6.4%
Rd = 6.4% / 0.6
Rd = 10.67%

Therefore, the maximum rate that can be paid on debt and maintain a 14% WACC with a 19% expected return on equity in a firm with a 60% debt-to-asset ratio is 10.67%.

Hence, the answer is (C).

Question 15

What is the return on equity for a firm with 15% return on assets,10% return on debt,and a .75 debt-equity ratio?

Accepted Answer

The return on equity is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier is calculated as 1 divided by the debt-equity ratio. In this case, the return on equity is 15% * (1 / 0.75) = 20%.

Question 16

According to MM,if individuals cannot obtain the same borrowing terms as firms,then:

Accepted Answer

According to MM, if individuals cannot obtain the same borrowing terms as firms, then capital structure may be relevant. This means that the way a firm chooses to finance its investments can affect the value of the firm and the returns earned by its investors. Therefore, capital structure decisions such as the use of debt or equity financing can impact returns for investors.

Question 17

A firm is currently expected to develop $2 EPS when operating income equals $4 million and interest expense equals $2 million.How low can operating income drop before EPS are reduced by half,to $1? Ignore taxes.

Accepted Answer

The firm currently has a net income of $2 million ($4 million operating income - $2 million interest expense) and EPS of $2.

To reduce EPS by half, the firm needs to have a net income of $1 million and assuming the interest expense remains constant at $2 million, the operating income required to achieve this net income is:

$1 million + $2 million = $3 million

Therefore, the operating income can drop to $3 million before EPS are reduced to $1.

Option B is the closest to the calculated amount, which makes it the best choice.

Question 18

A firm's capital structure is represented by its mix of:

Accepted Answer

Capital structure refers to the combination of a firm's debt and equity securities used to finance its operations. Therefore, it is represented by the mix of liabilities and equity. The assets and liabilities are separate components of a company's balance sheet, while equity represents the residual value of a company's assets after deducting liabilities.

Question 19

A decrease of debt in the capital structure tends to reduce a firm's EPS when the firm:

Accepted Answer

A decrease in debt reduces financial leverage, which can lower EPS if the firm is experiencing strong growth, as it may miss out on the benefits of leveraging debt to finance growth opportunities.

Question 20

What is the expected return on equity for a firm with a 14% expected return on assets that pays 9% on its debt,which totals 70% of assets?

Accepted Answer

The answer of What is the expected return on equity...

Quiz 16: Debt Policy