FIN 4610 CH 16 40

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes. A. At the break-even point, there is no advantage to debt. B. The earnings per share will equal zero when EBIT is zero for a levered firm. C. The advantages of leverage are inversely related to the level of EBIT. D. The use of leverage at any level of EBIT increases the EPS. E. EPS are more sensitive to changes in EBIT when a firm is unlevered.

A. At the break-even point, there is no advantage to debt.

The concept of homemade leverage is most associated with: A. M&M Proposition I with no tax. B. M&M Proposition II with no tax. C. M&M Proposition I with tax. D. M&M Proposition II with tax. E. static theory proposition.

A. M&M Proposition I with no tax.

M&M Proposition I with tax supports the theory that: A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases. B. the value of a firm is inversely related to the amount of leverage used by the firm. C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. E. a firm's cost of equity increases as the debt-equity ratio of the firm decreases.

A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.

M&M Proposition II with taxes: A. has the same general implications as M&M Proposition II without taxes. B. states that a firm's capital structure is irrelevant. C. supports the argument that business risk is determined by the capital structure decision. D. supports the argument that the cost of equity decreases as the debt-equity ratio increases. E. concludes that the capital structure decision is irrelevant to the value of a firm.

A. has the same general implications as M&M Proposition II without taxes. B. states that a firm's capital structure is irrelevant.

Bankruptcy: A. creates value for a firm. B. transfers value from shareholders to bondholders. C. technically occurs when total equity equals total debt. D. costs are limited to legal and administrative fees. E. is an inexpensive means of reorganizing a firm.

B. transfers value from shareholders to bondholders.

If a firm has the optimal amount of debt, then the: A. direct financial distress costs must equal the present value of the interest tax shield. B. value of the levered firm will exceed the value of the firm if it were unlevered. C. value of the firm is minimized. D. value of the firm is equal to VL + TC D. E. debt-equity ratio is equal to 1.0.

B. value of the levered firm will exceed the value of the firm if it were unlevered.

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only

C. I, III, and IV only

M&M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity is a linear function with a slope equal to (RA - RD). D. the cost of equity is equivalent to the required rate of return on a firm's assets. E. the size of the pie does not depend on how the pie is sliced.

C. a firm's cost of equity is a linear function with a slope equal to (RA - RD).

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to: A. borrow some money and purchase additional shares of Quantro stock. B. maintain her current equity position as the debt of the firm did not affect her personally. C. sell some shares of Quantro stock and hold the proceeds in cash. D. sell some shares of Quantro stock and loan out the sale proceeds. E. create a personal debt-equity ratio of 0.30.

C. sell some shares of Quantro stock and hold the proceeds in cash.

M&M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. E. homemade leverage is irrelevant.

C. the debt-equity ratio of a firm is completely irrelevant.

The interest tax shield is a key reason why: A. the required rate of return on assets rises when debt is added to the capital structure. B. the value of an unlevered firm is equal to the value of a levered firm. C. the net cost of debt to a firm is generally less than the cost of equity. D. the cost of debt is equal to the cost of equity for a levered firm. E. firms prefer equity financing over debt financing.

C. the net cost of debt to a firm is generally less than the cost of equity.

Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations. A. I and III only B. II and IV only C. II and III only D. I, II, and III only E. I, II, III, and IV

D. I, II, and III only

Based on M&M Proposition II with taxes, the weighted average cost of capital: A. is equal to the aftertax cost of debt. B. has a linear relationship with the cost of equity capital. C. is unaffected by the tax rate. D. decreases as the debt-equity ratio increases. E. is equal to RU (1 - TC).

D. decreases as the debt-equity ratio increases.

The business risk of a firm: A. depends on the firm's level of unsystematic risk. B. is inversely related to the required return on the firm's assets. C. is dependent upon the relative weights of the debt and equity used to finance the firm. D. has a positive relationship with the firm's cost of equity. E. has no relationship with the required return on a firm's assets according to M&M Proposition II.

D. has a positive relationship with the firm's cost of equity.

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm? A. exceptionally high depreciation expenses B. very low marginal tax rate C. substantial tax shields from other sources D. low probabilities of financial distress E. minimal taxable income

D. low probabilities of financial distress

M&M Proposition I with taxes is based on the concept that: A. the optimal capital structure is the one that is totally financed with equity. B. the capital structure of a firm does not matter because investors can use homemade leverage. C. a firm's WACC is unaffected by a change in the firm's capital structure. D. the value of a firm increases as the firm's debt increases because of the interest tax shield. E. the cost of equity increases as the debt-equity ratio of a firm increases.

D. the value of a firm increases as the firm's debt increases because of the interest tax shield.

The present value of the interest tax shield is expressed as: A. (TC D)/RA. B. VU + (TC D). C. [EBIT (TC D)]/RU. D. [EBIT (TC D)]/RA. E. Tc D.

E. Tc D.

Which one of the following makes the capital structure of a firm irrelevant? A. taxes B. interest tax shield C. 100 percent dividend payout ratio D. debt-equity ratio that is greater than 0 but less than 1 E. homemade leverage

E. homemade leverage

Which one of the following is a direct bankruptcy cost? A. company CEO's time spent in bankruptcy court B. maintaining cash reserves C. maintaining a debt-equity ratio that is lower than the optimal ratio D. losing a key company employee E. paying an outside accountant fees to prepare bankruptcy reports

E. paying an outside accountant fees to prepare bankruptcy reports