Intermediate Financial Management Ch. 16; Capital Structure Decisions

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

False

. Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT

False

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

False

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.

False

The MM model is the same as the Miller model, but with zero corporate taxes.

False

The Miller model begins with the MM model without corporate taxes and then adds personal taxes

False

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

False

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk.

False

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

False

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used

Financial Risk

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X.

True

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

True

A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows.

True

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

True

If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

True

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

True

The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes

True

The Miller model begins with the MM model with corporate taxes and then adds personal taxes.

True

The trade-off theory states that the capital structure decision involves a tradeoff between the costs and benefits of debt financing.

True

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

True

Whenever a firm borrows money, it is using financial leverage.

True

Which of the following statements bestdescribes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____. a. stock price. b. cost of equity. c. cost of debt. d. cost of preferred stock. e. earnings per share (EPS).

a

Companies HD and LD have identical tax rates, total assets, and return on invested capital (ROIC), and their ROIC exceeds their after-tax cost of debt, (1-T) rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? a. Company HD has a lower ROA than Company LD. b. Company HD has a lower ROE than Company LD. c. The two companies have the same ROA. d. The two companies have the same ROE. e. Company HD has a higher net income than Company LD.

a

The major contribution of the Miller model is that it demonstrates that a. personal taxes decrease the value of using corporate debt. b. financial distress and agency costs reduce the value of using corporate debt. c. equity costs increase with financial leverage. d. debt costs increase with financial leverage. e. personal taxes increase the value of using corporate debt.

a

Which of the following statements is CORRECT? a. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. b. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. c. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. d. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt. e. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.

a

Which of the following statements is CORRECT? a. The factors that affect a firm's business risk are affected by industry characteristics and economic conditions. Unfortunately, these factors are generally beyond the control of the firm's management. b. One of the benefits to a firm of being at or near its target capital structure is that this eliminates any risk of bankruptcy. c. A firm's financial risk can be minimized by diversification. d. The amount of debt in its capital structure can under no circumstances affect a company's business risk. e. A firm's business risk is determined solely by the financial characteristics of its industry.

a

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new low. e. An increase in costs incurred when filing for bankruptcy.

a

. Based on the information below for Benson Corporation, what is the optimal capital structure? a. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. b. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. c. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. d. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00. e. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

b

Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan? a. The company's earnings per share would decline. b. The company's cost of equity would increase. c. The company's ROA would increase. d. The company's ROE would decline. e. The company's net income would increase.

b

Which of the following statements is CORRECT? a. If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. b. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. c. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) d. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. e. Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

b

If debt financing is used, which of the following is CORRECT? a. The percentage change in net operating income will be equal to a given percentage change in net income. b. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. c. The percentage change in net income will be greater than the percentage change in net operating income. d. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. e. The percentage change in net operating income will be greater than a given percentage change in net income.

c

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations. a. Sales price variability. b. The extent to which operating costs are fixed. c. The extent to which interest rates on the firm's debt fluctuate. d. Input price variability. e. Demand variability.

c

Which of the following statements concerning capital structure theory is NOTCORRECT? a. Under MM with zero taxes, financial leverage has no effect on a firm's value. b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt. c. Under MM with corporate taxes, rsincreases with leverage, and this increase exactly offsets the tax benefits of debt financing. d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsLis a function of rsU. e. The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

c

Which of the following statements is CORRECT? a. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. b. Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC. c. Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC. d. Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity. e. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

c

Which of the following statements is CORRECT? a. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. b. The capital structure that minimizes the required return on equity also maximizes the stock price. c. The capital structure that minimizes the WACC also maximizes the price per share of common stock. d. The capital structure that gives the firm the best credit rating also maximizes the stock price. e. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.

c

Barette Consulting currently has no debt in its capital structure, has $500 million of total assets, and its basic earning power is 15%. The CFO is contemplating a recapitalization where it will issue debt at a cost of 10% and use the proceeds to buy back shares of the company's common stock, paying book value. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would remain unchanged. b. The basic earning power ratio would decline. c. The basic earning power ratio would increase. d. The ROE would increase. e. The ROA would increase.

d

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? a. The costs that would be incurred in the event of bankruptcy increase. b. Management believes that the firm's stock has become overvalued. c. Its degree of operating leverage increases. d. The corporate tax rate increases. e. Its sales become less stable over time.

d

The firm's target capital structure should be consistent with which of the following statements? a. Minimize the cost of debt (rd). b. Obtain the highest possible bond rating. c. Minimize the cost of equity (rs). d. Minimize the weighted average cost of capital (WACC). e. Maximize the earnings per share (EPS).

d

Which of the following statements is CORRECT, holding other things constant? a. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. b. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. c. An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure. d. An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure. e. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.

d

Which of the following statements is CORRECT? a. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. b. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. c. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. d. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC. e. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

d

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will a. normally lead to a decrease in its business risk. b. normally lead to a decrease in the standard deviation of its expected EBIT. c. normally lead to a decrease in the variability of its expected EPS. d. normally lead to a reduction in its fixed assets turnover ratio. e. normally lead to an increase in its fixed assets turnover ratio.

d

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. If the plan reduces the WACC, the stock price is also likely to decline. b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. c. If the plan does increase the EPS, the stock price will automatically increase at the same rate. d. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

e

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? a. An increase in the personal tax rate. b. An increase in the company's operating leverage. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new high. e. An increase in the corporate tax rate.

e

Which of the following statements is CORRECT? a. A change in the personal tax rate should not affect firms' capital structure decisions. b. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. c. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. d. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation. e. If corporate tax rates were decreasedwhile other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

e

Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. b. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC. d. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. e. The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

e

Which of the following statements is CORRECT? a. There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. b. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. c. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. d. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing. e. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

e

Which of these items will not generally be affected by an increase in the debt ratio? a. Total risk. b. Financial risk. c. Market risk. d. The firm's beta. e. Business risk.

e