Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

1. Increasing a firm's outstanding equity will increase firm leverage.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

2. Minimizing the cost of a firm's financing activities also maximizes the total value of the

firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

3. When calculating free cash flow, it is important to include interest and principal

payments.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does

not affect real investment policy.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

5. The enterprise value of a firm is the value of equity minus the value of debt.

A) True

B) False

Ans: B

Page 1

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

6. A financial restructuring can change the value of a firm's real assets, such as plant and

equipment.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

7. M&M Proposition 2 states that the required rate of return on a firm's stock is related to

the debt-to-equity ratio.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

8. M&M Proposition 1 states that the capital structure of a firm does not affect the

required rate of return on a firm's assets, while M&M Proposition 2 shows that the

required rate of return on firm's equity does change with capital structure decisions.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

9. If a firm has debt and pays taxes, the present value of the tax shield is the amount of

debt outstanding times the tax rate.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

10. Under the M&M assumptions with taxes, the value of the firm with debt is the value of

the firm without debt plus the present value of the interest tax shield.

A) True

B) False

Ans: A

Page 2

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

11. With no debt, the WACC is the cost of equity plus the required rate of return on the

firm's underlying assets.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

12. Issuing debt is less expensive than issuing stock.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital

structure.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

14. Direct-bankruptcy costs are considered transactions costs and occur when a firm must

navigate the bankruptcy process.

A) True

B) False

Ans: A

Page 3

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

15. When a firm gets closer to financial distress causing expected bankruptcy costs to

increase, lenders will often charge the firm a lower interest rate in order to reduce the

chance of an actual bankruptcy occurring.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

16. Direct bankruptcy costs are considered small when compared to indirect costs.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

17. Indirect bankruptcy costs include changes in customer and supplier behavior that

negatively affect the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

18. Unlike direct bankruptcy costs, indirect costs are not considered transactions costs.

A) True

B) False

Ans: B

Page 4

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

19. Indirect bankruptcy costs will often increase when a firm is in financial stress and may

even push the company into bankruptcy.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

20. More debt in the capital structure provides managers with an incentive to maximize

cash flows, but also makes them want to take on negative NPV projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

21. Dividends reduce the value of lender claims, and this is why bondholders often limit the

firm's ability to distribute cash to equity holders.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

22. Borrowing money and paying out a special dividend to shareholders is an example of

the asset substitution problem.

A) True

B) False

Ans: B

Page 5

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

23. When a firm is in financial distress, stockholders would like to overinvest in positive

NPV projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

24. Without debt in the capital structure, there are no asset substitution or underinvestment

problems.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

25. The trade-off theory of capital structure states that leverage is increased until the

marginal cost of debt is equal to the marginal benefit.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

26. Under the pecking order theory, debt is factually the cheapest source of funds due to the

interest tax shield.

A) True

B) False

Ans: B

Page 6

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

27. Firms have a difficult time selling equity when in financial distress.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

28. Industries with large amounts of tangible assets often use little debt.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

29. More profitable firms have less debt, which supports the trade-off theory.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Easy

30. Managers often focus on cash flows, but reported accounting earnings are a better

indicator of the firm's economic health.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO for Appendix

Level of Difficulty: Medium

31. An operating lease is treated like a purchase for accounting purposes.

A) True

B) False

Ans: B

Page 7

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

32. A firm's capital structure is the mix of financial securities used to finance its activities

and can include all of the following except

A) stock.

B) bonds.

C) equity options.

D) preferred stock.

Ans: C

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

33. The optimal capital structure of a firm

A) minimizes the cost of financing a firm's projects.

B) minimizes interest payments to creditors.

C) maximizes firm value.

D) both a and c.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

34. M&M Proposition 1 assumes all of the following except that

A) there are no taxes.

B) there are no costs to acquiring information.

C) there are no transactions costs.

D) the real investment policy of the firm is affected by its capital structure decisions.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

35. A firm's enterprise value is given by

A) the value of equity plus the value of debt.

B) the value of equity minus the value of debt.

C) the value of equity minus the value of debt plus the value of future projects.

D) none of the above.

Ans: A

Page 8

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

36. A financial restructuring

A) will not change the value of a firm's real assets under M&M Proposition 1.

B) includes financial transactions that change the capital structure of the firm.

C) means that a firm has issued equity to retire debt.

D) both a and b.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

37. The weighted average cost of capital (WACC) includes

A) the required return on equity and required return on underlying firm assets.

B) the cost of any debt and the cost of equity.

C) the cost of any debt and required return on underlying firm assets.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

38. M&M Proposition 2 states that the cost of a firm's common stock is related to

A) the debt-to-equity ratio.

B) the required rate of return on the firm's underlying assets.

C) the return of the market index.

D) a and b.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

39. According to M&M Proposition 2, the cost of a firm's equity

A) increases with the debt-to-equity ratio.

B) decreases with the debt-to-equity ratio.

C) increases and then falls with the debt-to-equity ratio.

D) decreases and then increases with the debt-to-equity ratio.

Ans: A

Page 9

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

40. Financial risk

A) refers to the effect that a firm's financing decisions has on the riskiness to cash flows that

investors will receive.

B) increases a firm's business risk.

C) decreases a firm's business risk.

D) is related to how debt affects the business decisions of a firm.

Ans: A

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

41. Which of the following is a reason financial policy might matter?

A) Firms must pay corporate income taxes.

B) Capital structure choices can affect investment decisions, such as R&D and PP&E.

C) Issuing equity is expensive.

D) All of the above.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

42. The interest tax shield

A) does not affect the WACC.

B) makes it less costly to distribute cash to the security holder through interest payments

than through dividends.

C) is given by D × (1 – t).

D) b and c.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

43. In order to calculate the present value of debt tax savings, the _______ is used as the

discount rate.

A) WACC

B) risk-free rate

C) required rate of return on debt

D) none of the above

Ans: C

Page 10

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

44. Academic studies have estimated that the tax benefit of debt realized by firms is

approximately

A) 10% of firm value.

B) a 10% reduction in WACC.

C) a 10% reduction in the cost of debt

D) 10% of debt value.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

45. The use of debt financing

A) may cause a manager to take on riskier projects in order to make interest payments.

B) is more expensive than issuing equity due to the use of covenants.

C) allows managers to make discretionary interest payments.

D) limits the ability of managers to waste stockholder money.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

46. Which of these statements about direct bankruptcy costs is not true?

A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and

consultants.

B) Direct bankruptcy costs are less than indirect costs.

C) Suppliers requiring cash on delivery is part of a firm's direct bankruptcy costs.

D) Negotiating with lenders may help a firm reduce direct bankruptcy costs.

Ans: C

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

47. Which of these is not an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be honored.

B) Employees begin to leave the firm.

C) New accountants are brought in to help with the bankruptcy process.

D) A bankruptcy judge orders new projects to be halted.

Ans: C

Page 11

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

48. The use of debt financing

A) reduces agency costs between the stockholders and management by increasing the

amount of risk the managers take.

B) increases agency costs between the stockholders and management by limiting the amount

of risk the managers take.

C) increases agency costs since managers prefer to keep more retained earnings rather than

pay a dividend.

D) b and c.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

49. The asset substitution problem occurs when

A) managers substitute riskier assets for less risky ones to the detriment of bondholders.

B) managers substitute less risky assets for riskier ones to the detriment of bondholders.

C) managers substitute riskier assets for less risky ones to the detriment of equity holders.

D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

50. The underinvestment problem occurs in a financially distressed firm when

A) the value of investing in a positive-NPV project is likely to go to debt holders instead of

equity holders.

B) the value of investing in a positive-NPV project is likely to go to equity holders instead of

debt holders.

C) management invests in negative-NPV projects to reduce their own risk.

D) issuing equity becomes difficult due to increased risk.

Ans: A

Page 12

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

51. Which of the following supports the trade-off theory of capital structure?

A) Firms use cash on hand first, since issuing equity and debt is expensive.

B) A firm's capital structure is the result of past equity and debt issuance decisions.

C) Firms have a target capital structure.

D) a and b.

Ans: C

Use the following to answer questions 52-58:

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The

company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells

you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the

debt. You currently own 10 percent of the stock.

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

52. M&M Proposition 1: How much is Dynamo worth today?

A) $1,765

B) $1,500

C) $2,143

D) None of the above.

Ans: B

Feedback:

CF $150

V Firm = i = 0.1 = $1,500

Page 13

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

53. M&M Proposition 1: How much are your cash flows today?

A) $12.38

B) $15

C) $4.50

D) $150

Ans: A

Feedback:

Cash flows to shareholders = Cash flows – Interest payments

= $150 – ($1,500) × (0.25) × (0.07) = $123.75

Therefore, your 10% share = $123.75 × 0.1 = $12.375

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

54. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75

percent to 60 percent equity and use the debt proceeds to pay a special dividend to

shareholders, how much debt should they issue?

A) $321

B) $375

C) $600

D) $225

Ans: D

Feedback:

Debt today = 0.25 × $1,500 = $375

Debt after restructuring = 0.40 × $1,500 = $600

Total debt issuance = $600 – $375 = $225

Page 14

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

55. M&M Proposition 1: How much does Dynamo currently pay in interest, and how

much will it have to pay after the restructuring in the prior problem, assuming that the

cost of debt is constant?

A) $42 and $26.25

B) $26.25 and $42

C) $160 and $37.50

D) $37.50 and $60

Ans: B

Feedback:

Debt today = 0.25 × $1500 = $375

Interest payment on debt before restructuring = $375 × 0.07 = $26.25

Total debt after restructuring =0 .4 × $1,500 = $600

Interest payment on debt after restructuring = 0.07 × $600 = $42

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

56. M&M Proposition 1: How much of the special dividend do you receive, and how

much do you receive in regular dividends per annum after the restructuring?

A) $15 and $60

B) $60 and $15

C) $10.80 and $22.50

D) $22.50 and $10.80

Ans: D

Feedback:

Portion of special dividend received = 0.10 × $225 = $22.50

Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80

Note: $42 = Interest payment on debt after restructuring

Page 15

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

57. M&M Proposition 1: According to M&M Proposition 1, what transaction do you

need to take in order to undo the restructuring?

A) Sell $22.50 of stock.

B) Sell $10.80 worth of stock.

C) Buy $22.50 worth of debt.

D) Buy $10.80 worth of debt.

Ans: C

Feedback:

M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy

that much of the new debt issuance.

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

58. M&M Proposition 1: What are the interest payments that you receive after you undo

the restructuring, and what are your total cash flows?

A) $1.58 and $12.38

B) $23.55 and $75

C) $1.125 and $12.38

D) None of the above.

Ans: A

Feedback:

Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 =

$1.58 in interest payments. Since you will receive $10.80 in dividends after the

restructuring, your total cash flows are $1.58 + $10.80 = $12.38, the same as before the

restructuring!

Page 16

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

59. M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40%

debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the

risk-free rate is 3%, what is the appropriate WACC?

A) 8.4%

B) 9.6%

C) 10.4%

D) 9.2%

Ans: C

Feedback:

WACC = xDebt kDebt + xEquity kEquity = (0.40 ×.08) + (0.60 × 0.12) = 0.104

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

60. M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If

the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate

WACC?

A) 9%

B) 10%

C) 11%

D) None of the above.

Ans: C

Feedback:

Using the debt-to-equity ratio, you can solve for the percentage of the capital structure

that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1

and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity

percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2/3) ×

0.13 = 0.11.

Page 17

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

61. M&M Proposition 2: Swirlpool, Inc., has a WACC of 11%, a cost of debt of 8%, and a

cost of equity of 12%. What must the debt-to-equity ratio be?

A) 1/2

B) 1/4

C) 1/6

D) None of the above.

Ans: D

Feedback:

WACC = xDebt kDebt + xEquity kEquity

= xDebt × 0.08 + xEquity × 0.12 = 11%

Also, D + E = 1 by definition. Therefore, substituting gives you:

xDebt × 0.8 + (1 – xDebt) × 0.12 = 0.11.

Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E

is 1/3.

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

62. M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70%

equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal

corporate income tax rate is 35%. What is the appropriate WACC?

A) 8.17%

B) 6.35%

C) 8.80%

D) 7.44%

Ans: A

Feedback:

WACC with taxes = xDebt kDebt pretax (1 – t) + xEquity kEquity

= 0.30 ×.06×(1 – 0.35) + 0.70 × 0.10 = 0.0817

Page 18

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

63. M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in

outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the

appropriate WACC?

A) 6%

B) 8%

C) 9%

D) 10%

Ans: D

Feedback:

WACC = xDebt kDebt + xEquity kEquity

= (300/1200) × 0.07 + (900/1200) × 0.11 = 0.10

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

64. M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost

of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the

firm is financed with equity?

A) 50%

B) 60%

C) 70%

D) None of the above

Ans: B

Feedback:

WACC

= 0.085 = (1 – xEquity)kDebt (1 – t) + xEquity kEquity

= (1 – xEquity) × 0.05 × (1 – 0.35) + xEquity × 0.12

Solving for xEquity gives you 0.60

Page 19

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

65. M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12%

and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the

required rate of return on their equity?

A) 12.15%

B) 13.15%

C) 14.15%

D) None of the above

Ans: B

Feedback:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (1/5)(0.12 – 0.0625) = 0.1315

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

66. M&M Proposition 2: Using the information for Bellamee from Question 64, what is

its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases

the required rate of return on their debt to 7%?

A) 14%

B) 14.25%

C) 14.50%

D) 15%

Ans: A

Feedback:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (2/5)(0.12 – .07) = 0.14

Use the following to answer questions 67-69:

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and

SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%.

Assume that the COGS only includes the marginal costs of selling a computer. Banana is

considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its

capital structure.

Page 20

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

67. M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are

variable with the added debt?

A) 27.9% and 72.1%

B) 72.1% and 27.9%

C) 25.23 and 74.77%

D) 74.77% and 25.23%

Ans: C

Feedback:

With the debt, fixed cost percentage is

(SG&A + Interest payments)/(SG&A + Interest payments + CGS) =

($100 + ($700)(0.05)) / ($100 + ($700)(0.05) + $400) = 25.23%.

Therefore, variable costs are $400 / ($100 + ($200)(0.05) + $400) or 74.77%.

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

68. M&M Proposition 2: What is the net income of Banana without and with the debt?

A) $500 and $484.2

B) $484.2 and $500

C) $500 and $465

D) $490 and $500

Ans: C

Feedback:

Without debt, net income is

$1000 – $400 – $100 = $500

With debt, net income is

$1000 – $400 – $100 – $35 = $165

Page 21

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

69. M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in

net income with and without the debt? Assume that the total variable productions costs

remain the same.

A) 64.5% and 60%

B) 60% and 64.5%

C) 59.2% and 40.8%

D) 40.8% and 59.2%

Ans: B

Feedback:

Without debt, the new net income is

$700 – $400 – $100 = $200

Therefore, the percent change is

($500 – $200) / $500 = 60%

With debt, the new net income is

$700 – $400 – $100 – $35 = $165

Therefore, the percent change is

($465 – $165) / $465 = 64.5%

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

70. M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the

YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current

required rate of return on its assets and equity if the D/E is changed to 1/3?

A) 11.35% and 13.25%

B) 11.35% and 8.25%

C) 13.25% and 11.35%

D) None of the above.

Ans: D

Feedback:

kcs

= kAssets + (D/E)(kAssets – kDebt)

12% = kAssets + (1/6)( kAssets – 7.5%)

Then, kAssets= 11.4%.

Note that if D/E changes, kAssets does not change.

The new cost of equity is then given by

kcs = 11.4% + (1/3)(11.4% – 7.5%) = 12.7%

Page 22

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

71. The benefits of debt: Packman Corporation has a reported EBIT of $500, which is

expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be

6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its

average tax rate is 20%, what are its after-tax earnings?

A) $238

B) $272

C) $259

D) None of the above.

Ans: A

Feedback:

After-tax earnings = (Earnings – Interest payments)×(1 – t)

= ($500 – $160) × (1 –.3)

= $238

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

72. The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its

average tax rate is 15%. By how much will this debt issuance reduce the firm's annual

tax liability?

A) $13,500

B) $22,500

C) $32,500

D) None of the above.

Ans: B

Feedback:

Tax shield = D × kDebt × t

= $1,000,000 × 0.09 × 0.25

= $22,500

Page 23

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

73. The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the

present value of the tax savings in perpetuity?

A) $11,025

B) $20,475

C) $350,000

D) $227,500

Ans: C

Feedback:

VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

Use the following to answer questions 74-75:

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket.

The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond

and uses these proceeds to pay a one-time special dividend to shareholders.

Reference: Ref 16-3

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

74. The cost of equity: What is its value without debt in the capital structure?

A) $350

B) $650

C) $2,917

D) $5,417

Ans: D

Feedback:

VFirm = [ CF × (1-t)] /i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417

Page 24

Reference: Ref 16-3

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

75. The cost of equity: What is Millennium's value after the debt issuance?

A) $5,417

B) $5,942

C) $6,392

D) None of the above.

Ans: B

Feedback:

PV of tax shield = $1,500 × 0.35 = $525

VFirm = VNo leverage+ PV of the tax shield = $5,417 + $525 = $5,942

Use the following to answer questions 76-79:

Suppose that UBM Corp has $100mm invested in 8% risk-free bonds that mature in one-year.

The firm also has $80mm in debt outstanding that will also mature in a year. UBM shareholders

are considering selling the $100mm in debt and investing in a project that has a 60% chance of

returning $200mm and a 40% chance of returning $2mm.

Reference: Ref 16-4

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

76. Agency costs: What will the equity value of UBM be in one-year without shareholders

taking on the project?

A) $100mm

B) $80mm

C) $20mm

D) $8mm

Ans: C

Feedback:

Value of risk-free debt owner – Value of bonds maturing = $20mm

Page 25

Learning Objective: LO 1

Level of Difficulty: Easy

1. Increasing a firm's outstanding equity will increase firm leverage.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

2. Minimizing the cost of a firm's financing activities also maximizes the total value of the

firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

3. When calculating free cash flow, it is important to include interest and principal

payments.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does

not affect real investment policy.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

5. The enterprise value of a firm is the value of equity minus the value of debt.

A) True

B) False

Ans: B

Page 1

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

6. A financial restructuring can change the value of a firm's real assets, such as plant and

equipment.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

7. M&M Proposition 2 states that the required rate of return on a firm's stock is related to

the debt-to-equity ratio.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

8. M&M Proposition 1 states that the capital structure of a firm does not affect the

required rate of return on a firm's assets, while M&M Proposition 2 shows that the

required rate of return on firm's equity does change with capital structure decisions.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

9. If a firm has debt and pays taxes, the present value of the tax shield is the amount of

debt outstanding times the tax rate.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Medium

10. Under the M&M assumptions with taxes, the value of the firm with debt is the value of

the firm without debt plus the present value of the interest tax shield.

A) True

B) False

Ans: A

Page 2

Format: True/False

Learning Objective: LO 1

Level of Difficulty: Easy

11. With no debt, the WACC is the cost of equity plus the required rate of return on the

firm's underlying assets.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

12. Issuing debt is less expensive than issuing stock.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

13. Bankruptcy and agency costs both act as limits on the amount of debt in the capital

structure.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

14. Direct-bankruptcy costs are considered transactions costs and occur when a firm must

navigate the bankruptcy process.

A) True

B) False

Ans: A

Page 3

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

15. When a firm gets closer to financial distress causing expected bankruptcy costs to

increase, lenders will often charge the firm a lower interest rate in order to reduce the

chance of an actual bankruptcy occurring.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

16. Direct bankruptcy costs are considered small when compared to indirect costs.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

17. Indirect bankruptcy costs include changes in customer and supplier behavior that

negatively affect the firm.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

18. Unlike direct bankruptcy costs, indirect costs are not considered transactions costs.

A) True

B) False

Ans: B

Page 4

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

19. Indirect bankruptcy costs will often increase when a firm is in financial stress and may

even push the company into bankruptcy.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

20. More debt in the capital structure provides managers with an incentive to maximize

cash flows, but also makes them want to take on negative NPV projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

21. Dividends reduce the value of lender claims, and this is why bondholders often limit the

firm's ability to distribute cash to equity holders.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

22. Borrowing money and paying out a special dividend to shareholders is an example of

the asset substitution problem.

A) True

B) False

Ans: B

Page 5

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Easy

23. When a firm is in financial distress, stockholders would like to overinvest in positive

NPV projects.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 2

Level of Difficulty: Medium

24. Without debt in the capital structure, there are no asset substitution or underinvestment

problems.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

25. The trade-off theory of capital structure states that leverage is increased until the

marginal cost of debt is equal to the marginal benefit.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

26. Under the pecking order theory, debt is factually the cheapest source of funds due to the

interest tax shield.

A) True

B) False

Ans: B

Page 6

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Medium

27. Firms have a difficult time selling equity when in financial distress.

A) True

B) False

Ans: A

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

28. Industries with large amounts of tangible assets often use little debt.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 3

Level of Difficulty: Easy

29. More profitable firms have less debt, which supports the trade-off theory.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO 4

Level of Difficulty: Easy

30. Managers often focus on cash flows, but reported accounting earnings are a better

indicator of the firm's economic health.

A) True

B) False

Ans: B

Format: True/False

Learning Objective: LO for Appendix

Level of Difficulty: Medium

31. An operating lease is treated like a purchase for accounting purposes.

A) True

B) False

Ans: B

Page 7

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

32. A firm's capital structure is the mix of financial securities used to finance its activities

and can include all of the following except

A) stock.

B) bonds.

C) equity options.

D) preferred stock.

Ans: C

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

33. The optimal capital structure of a firm

A) minimizes the cost of financing a firm's projects.

B) minimizes interest payments to creditors.

C) maximizes firm value.

D) both a and c.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

34. M&M Proposition 1 assumes all of the following except that

A) there are no taxes.

B) there are no costs to acquiring information.

C) there are no transactions costs.

D) the real investment policy of the firm is affected by its capital structure decisions.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

35. A firm's enterprise value is given by

A) the value of equity plus the value of debt.

B) the value of equity minus the value of debt.

C) the value of equity minus the value of debt plus the value of future projects.

D) none of the above.

Ans: A

Page 8

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

36. A financial restructuring

A) will not change the value of a firm's real assets under M&M Proposition 1.

B) includes financial transactions that change the capital structure of the firm.

C) means that a firm has issued equity to retire debt.

D) both a and b.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

37. The weighted average cost of capital (WACC) includes

A) the required return on equity and required return on underlying firm assets.

B) the cost of any debt and the cost of equity.

C) the cost of any debt and required return on underlying firm assets.

D) none of the above.

Ans: B

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

38. M&M Proposition 2 states that the cost of a firm's common stock is related to

A) the debt-to-equity ratio.

B) the required rate of return on the firm's underlying assets.

C) the return of the market index.

D) a and b.

Ans: D

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

39. According to M&M Proposition 2, the cost of a firm's equity

A) increases with the debt-to-equity ratio.

B) decreases with the debt-to-equity ratio.

C) increases and then falls with the debt-to-equity ratio.

D) decreases and then increases with the debt-to-equity ratio.

Ans: A

Page 9

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

40. Financial risk

A) refers to the effect that a firm's financing decisions has on the riskiness to cash flows that

investors will receive.

B) increases a firm's business risk.

C) decreases a firm's business risk.

D) is related to how debt affects the business decisions of a firm.

Ans: A

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Easy

41. Which of the following is a reason financial policy might matter?

A) Firms must pay corporate income taxes.

B) Capital structure choices can affect investment decisions, such as R&D and PP&E.

C) Issuing equity is expensive.

D) All of the above.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

42. The interest tax shield

A) does not affect the WACC.

B) makes it less costly to distribute cash to the security holder through interest payments

than through dividends.

C) is given by D × (1 – t).

D) b and c.

Ans: B

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

43. In order to calculate the present value of debt tax savings, the _______ is used as the

discount rate.

A) WACC

B) risk-free rate

C) required rate of return on debt

D) none of the above

Ans: C

Page 10

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

44. Academic studies have estimated that the tax benefit of debt realized by firms is

approximately

A) 10% of firm value.

B) a 10% reduction in WACC.

C) a 10% reduction in the cost of debt

D) 10% of debt value.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Easy

45. The use of debt financing

A) may cause a manager to take on riskier projects in order to make interest payments.

B) is more expensive than issuing equity due to the use of covenants.

C) allows managers to make discretionary interest payments.

D) limits the ability of managers to waste stockholder money.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

46. Which of these statements about direct bankruptcy costs is not true?

A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and

consultants.

B) Direct bankruptcy costs are less than indirect costs.

C) Suppliers requiring cash on delivery is part of a firm's direct bankruptcy costs.

D) Negotiating with lenders may help a firm reduce direct bankruptcy costs.

Ans: C

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

47. Which of these is not an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be honored.

B) Employees begin to leave the firm.

C) New accountants are brought in to help with the bankruptcy process.

D) A bankruptcy judge orders new projects to be halted.

Ans: C

Page 11

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

48. The use of debt financing

A) reduces agency costs between the stockholders and management by increasing the

amount of risk the managers take.

B) increases agency costs between the stockholders and management by limiting the amount

of risk the managers take.

C) increases agency costs since managers prefer to keep more retained earnings rather than

pay a dividend.

D) b and c.

Ans: D

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

49. The asset substitution problem occurs when

A) managers substitute riskier assets for less risky ones to the detriment of bondholders.

B) managers substitute less risky assets for riskier ones to the detriment of bondholders.

C) managers substitute riskier assets for less risky ones to the detriment of equity holders.

D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Ans: A

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Medium

50. The underinvestment problem occurs in a financially distressed firm when

A) the value of investing in a positive-NPV project is likely to go to debt holders instead of

equity holders.

B) the value of investing in a positive-NPV project is likely to go to equity holders instead of

debt holders.

C) management invests in negative-NPV projects to reduce their own risk.

D) issuing equity becomes difficult due to increased risk.

Ans: A

Page 12

Format: Multiple Choice

Learning Objective: LO 3

Level of Difficulty: Medium

51. Which of the following supports the trade-off theory of capital structure?

A) Firms use cash on hand first, since issuing equity and debt is expensive.

B) A firm's capital structure is the result of past equity and debt issuance decisions.

C) Firms have a target capital structure.

D) a and b.

Ans: C

Use the following to answer questions 52-58:

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The

company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells

you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the

debt. You currently own 10 percent of the stock.

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

52. M&M Proposition 1: How much is Dynamo worth today?

A) $1,765

B) $1,500

C) $2,143

D) None of the above.

Ans: B

Feedback:

CF $150

V Firm = i = 0.1 = $1,500

Page 13

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

53. M&M Proposition 1: How much are your cash flows today?

A) $12.38

B) $15

C) $4.50

D) $150

Ans: A

Feedback:

Cash flows to shareholders = Cash flows – Interest payments

= $150 – ($1,500) × (0.25) × (0.07) = $123.75

Therefore, your 10% share = $123.75 × 0.1 = $12.375

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

54. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75

percent to 60 percent equity and use the debt proceeds to pay a special dividend to

shareholders, how much debt should they issue?

A) $321

B) $375

C) $600

D) $225

Ans: D

Feedback:

Debt today = 0.25 × $1,500 = $375

Debt after restructuring = 0.40 × $1,500 = $600

Total debt issuance = $600 – $375 = $225

Page 14

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

55. M&M Proposition 1: How much does Dynamo currently pay in interest, and how

much will it have to pay after the restructuring in the prior problem, assuming that the

cost of debt is constant?

A) $42 and $26.25

B) $26.25 and $42

C) $160 and $37.50

D) $37.50 and $60

Ans: B

Feedback:

Debt today = 0.25 × $1500 = $375

Interest payment on debt before restructuring = $375 × 0.07 = $26.25

Total debt after restructuring =0 .4 × $1,500 = $600

Interest payment on debt after restructuring = 0.07 × $600 = $42

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

56. M&M Proposition 1: How much of the special dividend do you receive, and how

much do you receive in regular dividends per annum after the restructuring?

A) $15 and $60

B) $60 and $15

C) $10.80 and $22.50

D) $22.50 and $10.80

Ans: D

Feedback:

Portion of special dividend received = 0.10 × $225 = $22.50

Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80

Note: $42 = Interest payment on debt after restructuring

Page 15

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

57. M&M Proposition 1: According to M&M Proposition 1, what transaction do you

need to take in order to undo the restructuring?

A) Sell $22.50 of stock.

B) Sell $10.80 worth of stock.

C) Buy $22.50 worth of debt.

D) Buy $10.80 worth of debt.

Ans: C

Feedback:

M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy

that much of the new debt issuance.

Reference: Ref 16-1

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

58. M&M Proposition 1: What are the interest payments that you receive after you undo

the restructuring, and what are your total cash flows?

A) $1.58 and $12.38

B) $23.55 and $75

C) $1.125 and $12.38

D) None of the above.

Ans: A

Feedback:

Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 =

$1.58 in interest payments. Since you will receive $10.80 in dividends after the

restructuring, your total cash flows are $1.58 + $10.80 = $12.38, the same as before the

restructuring!

Page 16

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

59. M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40%

debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the

risk-free rate is 3%, what is the appropriate WACC?

A) 8.4%

B) 9.6%

C) 10.4%

D) 9.2%

Ans: C

Feedback:

WACC = xDebt kDebt + xEquity kEquity = (0.40 ×.08) + (0.60 × 0.12) = 0.104

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

60. M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If

the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate

WACC?

A) 9%

B) 10%

C) 11%

D) None of the above.

Ans: C

Feedback:

Using the debt-to-equity ratio, you can solve for the percentage of the capital structure

that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1

and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity

percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2/3) ×

0.13 = 0.11.

Page 17

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

61. M&M Proposition 2: Swirlpool, Inc., has a WACC of 11%, a cost of debt of 8%, and a

cost of equity of 12%. What must the debt-to-equity ratio be?

A) 1/2

B) 1/4

C) 1/6

D) None of the above.

Ans: D

Feedback:

WACC = xDebt kDebt + xEquity kEquity

= xDebt × 0.08 + xEquity × 0.12 = 11%

Also, D + E = 1 by definition. Therefore, substituting gives you:

xDebt × 0.8 + (1 – xDebt) × 0.12 = 0.11.

Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E

is 1/3.

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

62. M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70%

equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal

corporate income tax rate is 35%. What is the appropriate WACC?

A) 8.17%

B) 6.35%

C) 8.80%

D) 7.44%

Ans: A

Feedback:

WACC with taxes = xDebt kDebt pretax (1 – t) + xEquity kEquity

= 0.30 ×.06×(1 – 0.35) + 0.70 × 0.10 = 0.0817

Page 18

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

63. M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in

outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the

appropriate WACC?

A) 6%

B) 8%

C) 9%

D) 10%

Ans: D

Feedback:

WACC = xDebt kDebt + xEquity kEquity

= (300/1200) × 0.07 + (900/1200) × 0.11 = 0.10

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

64. M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost

of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the

firm is financed with equity?

A) 50%

B) 60%

C) 70%

D) None of the above

Ans: B

Feedback:

WACC

= 0.085 = (1 – xEquity)kDebt (1 – t) + xEquity kEquity

= (1 – xEquity) × 0.05 × (1 – 0.35) + xEquity × 0.12

Solving for xEquity gives you 0.60

Page 19

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

65. M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12%

and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the

required rate of return on their equity?

A) 12.15%

B) 13.15%

C) 14.15%

D) None of the above

Ans: B

Feedback:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (1/5)(0.12 – 0.0625) = 0.1315

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

66. M&M Proposition 2: Using the information for Bellamee from Question 64, what is

its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases

the required rate of return on their debt to 7%?

A) 14%

B) 14.25%

C) 14.50%

D) 15%

Ans: A

Feedback:

kcs = kAssets + (D/E)(kAssets – kDebt)

= 0.12 + (2/5)(0.12 – .07) = 0.14

Use the following to answer questions 67-69:

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and

SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%.

Assume that the COGS only includes the marginal costs of selling a computer. Banana is

considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its

capital structure.

Page 20

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

67. M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are

variable with the added debt?

A) 27.9% and 72.1%

B) 72.1% and 27.9%

C) 25.23 and 74.77%

D) 74.77% and 25.23%

Ans: C

Feedback:

With the debt, fixed cost percentage is

(SG&A + Interest payments)/(SG&A + Interest payments + CGS) =

($100 + ($700)(0.05)) / ($100 + ($700)(0.05) + $400) = 25.23%.

Therefore, variable costs are $400 / ($100 + ($200)(0.05) + $400) or 74.77%.

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

68. M&M Proposition 2: What is the net income of Banana without and with the debt?

A) $500 and $484.2

B) $484.2 and $500

C) $500 and $465

D) $490 and $500

Ans: C

Feedback:

Without debt, net income is

$1000 – $400 – $100 = $500

With debt, net income is

$1000 – $400 – $100 – $35 = $165

Page 21

Reference: Ref 16-2

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

69. M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in

net income with and without the debt? Assume that the total variable productions costs

remain the same.

A) 64.5% and 60%

B) 60% and 64.5%

C) 59.2% and 40.8%

D) 40.8% and 59.2%

Ans: B

Feedback:

Without debt, the new net income is

$700 – $400 – $100 = $200

Therefore, the percent change is

($500 – $200) / $500 = 60%

With debt, the new net income is

$700 – $400 – $100 – $35 = $165

Therefore, the percent change is

($465 – $165) / $465 = 64.5%

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

70. M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and the

YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current

required rate of return on its assets and equity if the D/E is changed to 1/3?

A) 11.35% and 13.25%

B) 11.35% and 8.25%

C) 13.25% and 11.35%

D) None of the above.

Ans: D

Feedback:

kcs

= kAssets + (D/E)(kAssets – kDebt)

12% = kAssets + (1/6)( kAssets – 7.5%)

Then, kAssets= 11.4%.

Note that if D/E changes, kAssets does not change.

The new cost of equity is then given by

kcs = 11.4% + (1/3)(11.4% – 7.5%) = 12.7%

Page 22

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

71. The benefits of debt: Packman Corporation has a reported EBIT of $500, which is

expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be

6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its

average tax rate is 20%, what are its after-tax earnings?

A) $238

B) $272

C) $259

D) None of the above.

Ans: A

Feedback:

After-tax earnings = (Earnings – Interest payments)×(1 – t)

= ($500 – $160) × (1 –.3)

= $238

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

72. The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its

average tax rate is 15%. By how much will this debt issuance reduce the firm's annual

tax liability?

A) $13,500

B) $22,500

C) $32,500

D) None of the above.

Ans: B

Feedback:

Tax shield = D × kDebt × t

= $1,000,000 × 0.09 × 0.25

= $22,500

Page 23

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

73. The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%.

The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the

present value of the tax savings in perpetuity?

A) $11,025

B) $20,475

C) $350,000

D) $227,500

Ans: C

Feedback:

VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

Use the following to answer questions 74-75:

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket.

The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond

and uses these proceeds to pay a one-time special dividend to shareholders.

Reference: Ref 16-3

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

74. The cost of equity: What is its value without debt in the capital structure?

A) $350

B) $650

C) $2,917

D) $5,417

Ans: D

Feedback:

VFirm = [ CF × (1-t)] /i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417

Page 24

Reference: Ref 16-3

Format: Multiple Choice

Learning Objective: LO 1

Level of Difficulty: Medium

75. The cost of equity: What is Millennium's value after the debt issuance?

A) $5,417

B) $5,942

C) $6,392

D) None of the above.

Ans: B

Feedback:

PV of tax shield = $1,500 × 0.35 = $525

VFirm = VNo leverage+ PV of the tax shield = $5,417 + $525 = $5,942

Use the following to answer questions 76-79:

Suppose that UBM Corp has $100mm invested in 8% risk-free bonds that mature in one-year.

The firm also has $80mm in debt outstanding that will also mature in a year. UBM shareholders

are considering selling the $100mm in debt and investing in a project that has a 60% chance of

returning $200mm and a 40% chance of returning $2mm.

Reference: Ref 16-4

Format: Multiple Choice

Learning Objective: LO 2

Level of Difficulty: Hard

76. Agency costs: What will the equity value of UBM be in one-year without shareholders

taking on the project?

A) $100mm

B) $80mm

C) $20mm

D) $8mm

Ans: C

Feedback:

Value of risk-free debt owner – Value of bonds maturing = $20mm

Page 25

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