Chapter 7 Quiz

Firm A and Firm B are identical except that A is incorporated while B is an unlimited liability partnership. Both have assets worth $500,000 ($500K) funded with a debt ratio of 40 percent. Suppose that the assets suddenly become worthless. What is the maximum possible loss to the equityholders of each company? Firm A: $200K; Firm B: $300K Firm A: $500K; Firm B: $500K Firm A: $500K; Firm B: $200K Firm A: $300K; Firm B: $500K

Firm A: $300K; Firm B: $500K

The change in a firm's retained earnings is: the difference between the market price of the stock and the book value. the difference between the net income earned and the dividends paid during a year. the amount of directly contributed equity capital in excess of par value. the amount of cash that the firm has saved up.

the difference between the net income earned and the dividends paid during a year.

The following are characteristics of preferred stock except it pays fixed dividends. has voting rights. pays fixed dividends and can demand payments of cumulative dividends. can demand payments of cumulative dividends.

has voting rights.

Preference in position among creditors when it comes to repayment is called: securitization. time preference. seniority. absolute return.

seniority.

Eurobonds are almost always denominated in euros. True False

False

For every dollar of operating income paid out as equity income, the shareholder realizes 1/(1 - TP). (1 - TpE) (1 - TC). (1 - Tp). (1 - Tc).

(1 - TpE) (1 - TC).

The market value of equity equals: (Market price) × (# of authorized shares). (Par value) × (# of shares outstanding). (Market price) × (# of treasury shares). (Market price) × (# of shares outstanding).

(Market price) × (# of shares outstanding).

Assume the following data for U&P Company: Debt (D) = $100 million; Equity (E) = $300 million; rD = 6%; rE = 12%; and TC = 30%. Calculate the after-tax weighted average cost of capital (WACC): 9.45 percent 10.05 percent 15 percent 10.5 percent

10.05 percent

A firm has a debt-to-equity ratio of 1. If it had no debt, its cost of equity would be 12 percent. Its cost of debt is 9 percent. What is its cost of equity if there are no taxes? 18 percent 15 percent 16 percent 21 percent

15 percent

The M&M Company is financed by $10 million in debt (market value) and $40 million in equity (market value). The cost of debt is 10 percent and the cost of equity is 20 percent. Calculate the weighted average cost of capital, assuming no taxes. 20 percent 12 percent 18 percent 10 percent

18 percent

A firm uses $30 million of debt, $10 million of preferred stock, and $60 million of common equity to finance its assets. If the before-tax cost of debt is 8 percent, the cost of preferred stock is 10 percent, and the cost of common equity is 15 percent, calculate the weighted average cost of capital for the firm assuming a tax rate of 35 percent. 10.84 percent 11.56 percent 12.40 percent 19.27 percent

19.27 percent

Given are the following data: Cost of debt = rD = 6%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50 percent debt and 50 percent equity. Calculate the after-tax weighted average cost of capital (WACC). 5.9 percent 8 percent 9 percent 7.1 percent

8 percent

The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5 percent and the cost of equity is 10 percent. Calculate the weighted average cost of capital. (Assume no taxes.) 15 percent 7 percent 8 percent 10 percent

8 percent

Which of the following is not a sensible reason for a firm to rely on internal funds? A new bond issue may drive the firm's debt ratio too high. Equity issues are generally expensive. Financial markets interpret the issuance of equity unfavorably. All of these are sensible reasons to rely on internal funds.

All of these are sensible reasons to rely on internal funds.

As a provider of funds to a corporation, owning which of the following corporate securities will give you the most control rights? Long-term bond Short-term bank loan Common stock Preferred stock

Common stock

Which of the following are not usually regarded as investment funds? Insurance companies Hedge funds Mutual funds Pension funds

Insurance companies

Recently, which of the following sources of funds has played the greatest role in the financing of U.S. nonfinancial firms? Net equity issues Internal funds Net borrowing All of the sources were approximately the same.

Internal funds

Why does MM Proposition I not hold in the presence of corporate taxes? Levered firms pay lower taxes when compared with identical unlevered firms. Earnings per share are no longer relevant with taxes. Dividends are no longer relevant with taxes. Bondholders require higher rates of return compared with stockholders.

Levered firms pay lower taxes when compared with identical unlevered firms.

When completing a large debt issue, financial managers of large firms will usually consider the following question(s): Should the firm issue fixed- or floating-rate debt? Should the firm borrow in foreign currency? Should the firm borrow short term or long term? Should the firm borrow short term or long term? Should the firm issue fixed- or floating-rate debt? Should the firm borrow in foreign currency?

Should the firm borrow short term or long term? Should the firm issue fixed- or floating-rate debt? Should the firm borrow in foreign currency?

The capital structure of the firm can be defined as: The firm's mix of different debt securities. The market imperfection that the firm's mangers can exploit. The firm's mix of different debt securities, the firm's mix of different securities used to finance assets, and the market imperfection that the firm's managers can exploit. The firm's mix of different securities used to finance assets.

The firm's mix of different securities used to finance assets.

Compared to normal bondholders, convertible bondholders have a greater interest in seeing the firm's stock price increase. True False

True

Dual-class shares are often created to give one group of owners more control rights over the company than another group. True False

True

LIBOR stands for London Interbank Offered Rate. True False

True

U.S. firms, in general, have been repurchasing shares and thus net equity issues have been negative. True False

True

The following are debts in disguise: accounts payable,leases, and underfunded pensions. accounts payable. leases. underfunded pensions.

accounts payable,leases, and underfunded pensions.

In the case of Google, which has issued Class A and Class B shares, both classes of shares have the same control rights and both classes of shares have different cash-flow rights. both classes of shares have the same cash-flow rights and both classes of shares have different control rights. both classes of shares have different cash-flow rights and both classes of shares have different control rights. both classes of shares have the same cash-flow rights and both classes of shares have the same control rights.

both classes of shares have the same cash-flow rights and both classes of shares have different control rights.

Capital structure is irrelevant if: capital markets are efficient, each investor can borrow/lend on the same terms as the firm, and there are no tax benefits to debt. capital markets are efficient. there are no tax benefits to debt. each investor can borrow/lend on the same terms as the firm.

capital markets are efficient, each investor can borrow/lend on the same terms as the firm, and there are no tax benefits to debt.

MM Proposition I with corporate taxes states that: capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield. firm value is maximized by using an all-equity capital structure. capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; and, by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value. by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value.

capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; and, by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value

A corporate bond that can be exchanged for a fixed number of shares of stock is called a convertible bond. warrant. callable bond. debenture.

convertible bond.

The cost of capital for a firm, rWACC, in a tax-free environment is: equal to the overall rate of return required on the levered firm. equal to the market value weighted average of the return on equity and the return on debt; equal to rA, the rate of return for that business risk class; and equal to the overall rate of return required on the levered firm. equal to rA, the rate of return for that business risk class. equal to the market value weighted average of the return on equity and the return on debt.

equal to the market value weighted average of the return on equity and the return on debt; equal to rA, the rate of return for that business risk class; and equal to the overall rate of return required on the levered firm.

Generally, managers of corporations prefer internally generated cash to finance their capital expenditures because: the costs of issuing new securities are high and the announcement of a new equity issue is usually bad news for investors. they can avoid the discipline of financial markets, the costs of issuing new securities are high, and the announcement of a new equity issue is usually bad news for investors. the costs of issuing new securities are high. they can avoid the discipline of financial markets.

hey can avoid the discipline of financial markets, the costs of issuing new securities are high, and the announcement of a new equity issue is usually bad news for investors.

The main advantage of debt financing for a firm is that: no SEC registration is required for bond issues, and unlevered firms have higher value than levered firms. interest expenses are tax deductible. unlevered firms have higher value than levered firms. no SEC registration is required for bond issues.

interest expenses are tax deductible.

If an individual wants to borrow with limited liability, he/she should: borrow on his/her own account. invest in the equity of a levered firm. invest in a risk-free asset like T-bills. invest in the equity of an unlevered firm.

invest in the equity of a levered firm.

If a firm is financed with both debt and equity, the firm's equity is known as: preferred equity. unlevered equity. levered equity. None of the options are correct.

levered equity.

If a bond is junior or subordinated, it: must give preference to senior creditors in the event of default. is secondary to equity. has been issued because the company is in default. has a higher priority status than specified creditors.

must give preference to senior creditors in the event of default.

According to the trade-off theory of capital structure, optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress. optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims. optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments. None of the options are correct.

optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.

When securities are sold by a firm, this is termed a(n): secondary transaction. open operation. OTC transaction. primary issue.

primary issue.

The following functions, provided by financial intermediaries, enable the smooth functioning of the economy: processing of payments, borrowing and lending, and pooling risks. processing of payments and borrowing and lending. pooling risks. processing of payments.

processing of payments, borrowing and lending, and pooling risks.

A grant of authority allowing someone else to vote shares of stock that you own is called: proxy voting. repurchase agreement. share repurchase. repurchase agreement and share repurchase.

proxy voting.

The trade-off theory of capital structure predicts that: rapidly growing firms should borrow more than mature firms. increasing leverage increases firm value, especially at high debt ratios. unprofitable firms should borrow more than profitable ones. safe firms should borrow more than risky ones.

safe firms should borrow more than risky ones.

MM Proposition II states that the required return on equity is a linear function of the firm's debt to equity ratio. the risk to equity increases with leverage. the expected return on equity is positively related to leverage. the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage.

the expected return on equity is positively related to leverage, the required return on equity is a linear function of the firm's debt to equity ratio, and the risk to equity increases with leverage.

Modigliani and Miller's Proposition I states that the market value of a firm's common stock is independent of its capital structure. the market value of any firm is independent of its capital structure. the market value of a firm's debt is independent of its capital structure. None of the options are correct.

the market value of any firm is independent of its capital structure.

When a firm has no debt, then such a firm is known as a(n): levered firm. unlevered firm and an all-equity firm. unlevered firm. all-equity firm.

unlevered firm and an all-equity