FI 410 Test 2

C) homemade leverage

When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it is referred to as ________. A) outside debt B) retained earnings C) homemade leverage D) payout ratio

C) rE = rU + (D / E) × rU

Which of the following equations would NOT be appropriate to use in a firm with risky debt? A) rE = rU + (D / E) × (rU - rD) B) rU = rD + (D / E) × (rU - rD) C) rE = rU + (D / E) × rU D) rU = [E / (E + D)]rE +[D / (E + D)]rD

B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.

Which of the following statements is FALSE? A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firmʹs equity. B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation. C) We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of capital. D) The total market value of the firmʹs securities is equal to the market value of its assets, whether the firm is unlevered or levered.

D) $25

With perfect capital markets, what is the market price per share of Lutherʹs stock after the share repurchase? A) $20 B) $24 C) $15 D) $25

C) $25 billion

With perfect capital markets, what is the market value of Lutherʹs equity after the share repurchase? A) $15 billion B) $10 billion C) $25 billion D) $20 billion

B) 202%

A firm requires an investment of $25,000 and will return $36,500 after 1 year. If the firm borrows $20,000 at 7%, what is the return on levered equity? A) 162% B) 202% C) 242% D) 283%

A) 13%

A firm requires an investment of $30,000 and borrows $15,000 at 7%. If the return on equity is 19%, what is the firmʹs pretax WACC? A) 13% B) 6.5% C) 15.6% D) 18.2%

D) 15.3%

A firm requires an investment of $30,000 and borrows $7500 at 7%. If the return on equity is 18%, what is the firmʹs pretax WACC? A) 7.6% B) 18.3% C) 21.4% D) 15.3%

C) 16.3%

A firm requires an investment of $36,000 and borrows $12,000 at 9%. If the return on equity is 20%, what is the firmʹs pretax WACC? A) 8.2% B) 19.6% C) 16.3% D) 22.9%

A) 11.2%

A firm requires an investment of $60,000 and borrows $20,000 at 8%. If the return on equity is 14% and the tax rate is 30%, what is the firmʹs WACC? A) 11.2% B) 9.0% C) 13.4% D) 22.4%

B) 13.9%

A firm requires an investment of $60,000 and borrows $30,000 at 9%. If the return on equity is 22% and the tax rate is 35%, what is the firmʹs WACC? A) 11.1% B) 13.9% C) 16.7% D) 27.9%

C) $21,818.18

A firm will give a one-time cash flow of $24,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets? A) $17,454.55 B) $26,181.82 C) $21,818.18 D) more information needed

A) $20,000

A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets? A) $20,000 B) $16,000 C) $24,000 D) more information needed

C) managers

Asymmetric information implies that ________ may have better information about a firmʹs cash flows than other stakeholders. A) debt holders B) suppliers C) managers D) creditors

A) levered equity

Equity in a firm with debt is called ________. A) levered equity B) risk-free equity C) unlevered equity D) preferred equity

B) unlevered equity

Equity in a firm with no debt is called ________. A) levered equity B) unlevered equity C) risk-free equity D) preferred equity

B) perfect capital market

Investment cash flows are independent of financing choices in a ________. A) market with frictions B) perfect capital market C) setting with frictions in investment returns D) firm with leverage

C) increase

Leverage can ________ a firmʹs expected earnings per share, but does not necessarily increase the share price. A) decrease B) dilute C) increase D) never change

C) probability of financial distress

One of the factors that determine the present value (PV) of financial distress costs is ________. A) costs of unpaid interest arrears B) loss of dividend payments C) probability of financial distress D) employee compensation

D) 10.28%

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is weak? A) 8.0% B) -37.5% C) -58.6% D) 10.28%

A) 8.0%

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company uses no leverage, what is expected return to equity holders? A) 8.0% B) 11.6% C) 9.33% D) 30.0%

B) $32,407.40

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. What is the value of the company if the demand is as expected? $35,000 A) $23,148.15 B) $32,407.40 C) $41,666.67 D) Cannot be determined with the information given.

C) the value of the firmʹs unlevered equity

The U in the equation above represents ________. A) the value of the firmʹs equity B) the market value of the firmʹs assets C) the value of the firmʹs unlevered equity D) the value of the firmʹs debt

A) good

The use of leverage as a way to signal ________ information to investors is known as the signaling theory of debt. A) good B) bad C) random D) none of the above

C) 17.8%

A firm has a market value of equity of $40,000 . It borrows $8000 at 7%. If the unlevered cost of equity is 16%, what is the firmʹs cost of equity capital? A) 8.9% B) 21.4% C) 17.8% D) 24.9%

A) 80%

A firm requires an investment of $18,000 and will return $25,000 after one year. If the firm borrows $10,000 at 6%, what is the return on levered equity? A) 80% B) 64% C) 96% D) 112%

A) 9.20%

A firm requires an investment of $30,000 and borrows $20,000 at 9%. If the return on equity is 15% and the tax rate is 30%, what is the firmʹs WACC? A) 9.20% B) 7.36% C) 11.04% D) 18.40 %

A) increases

In a setting where there is no risk that a firm will default, leverage ________ the risk of equity. A) increases B) decreases C) does not change D) cannot say for sure

C) $25.83 million

Suppose a project financed via an issue of debt requires five annual interest payments of $18 million each year. If the tax rate is 35% and the cost of debt is 7%, what is the value of the interest rate tax shield? A) $20.66 million B) $31.00 million C) $25.83 million D) $51.66 million

A) $20 billion

The market value of Lutherʹs non-cash assets is closest to ________. A) $20 billion B) $19 billion C) $25 billion D) $24 billion

B) $29.12 million

3) Suppose a project financed via an issue of debt requires six annual interest payments of $18 million each year. If the tax rate is 35% and the cost of debt is 8%, what is the value of the interest rate tax shield? A) $23.30 million B) $29.12 million C) $34.95 million D) $58.25 million

C) debt-to-value

A firmʹs ________ ratio is the fraction of the firmʹs total value that corresponds to debt. A) debt-to-equity B) equity-to-debt C) debt-to-value D) liability

C) $6.00

According to MM Proposition I, the stock price for Firm X is closest to ________. A) $8.00 B) $24.00 C) $6.00 D) $12.00

B) 1.0 billion

After the repurchase, how many shares will Luther have outstanding? A) 0.75 billion B) 1.0 billion C) 1.1 billion D) 1.2 billion

D) conflicts of interest exist between stakeholders

Agency costs arise when ________. A) there are high labor costs B) input costs are higher than interest costs C) interest costs exceed dividend payments D) conflicts of interest exist between stakeholders

D) interest payments have first priority

By adding leverage, the returns on a firm are split between debt holders and equity holders, but equity holder risk increases because ________. A) interest payments can be rolled over B) dividends are paid first C) debt and equity have equal priority D) interest payments have first priority

B) the new shares are sold at a fair price

In general, issuing equity may not dilute the ownership of existing shareholders if ________. A) the value of new shares is equal to the value of debt B) the new shares are sold at a fair price C) the firm has no debt financing D) the firm uses debt conservatively

A) may face little threat of being fired

Managerial entrenchment means that managers ________ and run the firm for their own best interests. A) may face little threat of being fired B) are overseen by equity holders C) are overseen by debt holders D) are well compensated

B) the levered cost of preferred equity

The following equation: X= E/(E+ D) rE + D/(E+D) rD can be used to calculate all of the following EXCEPT ________. A) the cost of capital for a firmʹs assets B) the levered cost of preferred equity C) the unlevered cost of equity D) the weighted average cost of capital

C) costs of hiring legal experts, appraisers, and auctioneers

A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy include ________. A) dividend payments B) raw material costs C) costs of hiring legal experts, appraisers, and auctioneers D) taxes

D) firm value

A financial manager makes a choice of the amount and source of capital based on how the choice will impact the ________. A) revenue B) face value of bonds C) depreciation D) firm value

A) 16.75%

A firm has a market value of equity of $30,000 . It borrows $7500 at 8%. If the unlevered cost of equity is 15%, what is the firmʹs cost of equity capital? A) 16.75% B) 6.70% C) 20.10% D) 23.45 %

B) 18.0%

A firm has a market value of equity of $30,000 . It borrows $7500 at 8%. If the unlevered cost of equity is 16%, what is the firmʹs cost of equity capital? A) 9.0% B) 18.0% C) 21.6% D) 25.2%

C) 43%

A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows $6000 at 7%, what is the return on levered equity? A) 35% B) 52% C) 43% D) 61%

B) $19,819.82

A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 11%, what is the levered value of the firm with perfect capital markets? A) $15,855.86 B) $19,819.82 C) $23,783.78 D) more information needed

B) tax shield benefit exceeds distress costs

As the level of debt increases the tax benefits of debt increase until ________. A) interest costs exceed dividend payments B) tax shield benefit exceeds distress costs C) raw material costs exceed dividend payments D) employee costs exceed interest expense

A) loss of customers and loss of suppliers

Aside from direct costs of bankruptcy, a firm may also incur other indirect costs such as ________. A) loss of customers and loss of suppliers B) loss of interest receipts C) loss of dividend receipts D) increase in raw material costs

B) 417

Assume that MMʹs perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your account will be the same as a $5,000 investment in Firm Y stock. The number of shares of Firm X stock you purchased is closest to ________. A) 100 B) 417 C) 1,650 D) 825

C) $2,500

Assume that MMʹs perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the payoff of your account will be the same as a $5,000 investment in Firm Y stock? A) $5,000 B) $0 C) $2,500 D) $4,000

B) 1,650

Assume that MMʹs perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm Y stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock. The number of shares of Firm Y stock you purchased is closest to ________. A) 425 B) 1,650 C) 2,000 D) 825

B) $5,000

Assume that MMʹs perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as Firm X. You have $5000 of your own money to invest and you plan on buying Firm Y stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock? A) $10,000 B) $5,000 C) $2,500 D) $0

A) 1.15 billion

Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding? A) 1.15 billion B) 1.2 billion C) 0.75 billion D) 1.1 billion

A) $22 billion

Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to employees valued at $2 billion. The market value of Lutherʹs non-cash assets is closest to ________. A) $22 billion B) $20 billion C) $25 billion D) $18 billion

B) low

Firms in industries such as real estate tend to have ________ distress costs because of a large proportion of tangible assets. A) high B) low C) unexpected D) varying

C) leverage increases the risk of the equity of the firm

It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm because ________. A) leverage decreases the risk of equity of the firm B) leverage changes the unlevered cost of equity C) leverage increases the risk of the equity of the firm D) cost of debt decreases in this setting

D) free cash flows

MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market value of the ________ generated by its assets. A) earnings after taxes B) earnings after interest C) cash flows after taxes D) free cash flows

A) consistent taxable income

Managers should make use of the interest tax shield if a firm has ________. A) consistent taxable income B) volatility in taxable income C) consistent dividend payments D) low tax rates

C) new shares, debt

Market timing means that managers may sell ________ when they believe the stock is over-valued and rely on ________ when the stock is undervalued. A) debt, shares B) debt, preferred stock C) new shares, debt D) debt, debt

B) ownership of managers may remain more concentrated

To reduce agency costs, issuing debt instead of equity provides incentives for managers to run a firm efficiently because ________. A) debt increases the funds available to managers to run the firm B) ownership of managers may remain more concentrated C) managers may take actions that benefit shareholders but harm creditors and lower the value of the firm D) shareholders prefer to decline new projects to save cash, even if their NPVs are positive

C) 9.33%

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is expected return to equity holders? Assume the demand is as expected. A) 8.0% B) 11.6% C) 9.33% D) 30.0%

B) 8.95%

Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of 8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if demand is strong? A) 8.0% B) 8.95% C) 28.6% D) 38.0%

D) $18.18 million

Suppose a project financed via an issue of debt requires five annual interest payments of $12 million each year. If the tax rate is 35% and the cost of debt is 5%, what is the value of the interest rate tax shield? A) 14.55 million B) $21.82 million C) $36.37 million D) $18.18 million

B) the market value of the firmʹs assets

The A in the equation above represents ________. A) the value of the firmʹs debt B) the market value of the firmʹs assets C) the value of the firmʹs equity D) the value of the firmʹs unlevered equity

A) the value of the firmʹs equity

The E in the equation above represents ________. A) the value of the firmʹs equity B) the value of the firmʹs debt C) the value of the firmʹs unlevered equity D) the market value of the firmʹs assets

A) a firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress

The Tradeoff Theory suggests that ________. A) a firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress B) with higher costs of financial distress, it is optimal for a firm to choose higher leverage C) differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain the differences in the use of leverage across industries D) there is no rational explanation for why firms choose debt levels that are too low to fully exploit the debt tax shield

C) retained earnings, debt, equity

The pecking order hypothesis states that managers will have a preference to fund investment by using ________, followed by ________, and will issue ________ as a last resort. A) debt, equity, retained earnings B) retained earnings, equity, debt C) retained earnings, debt, equity D) debt, retained earnings, equity

B) the costs of failure are borne largely by debt holders

The presence of a large amount of debt can encourage shareholders to take excessive risk because ________. A) equity holders are risk seeking by nature B) the costs of failure are borne largely by debt holders C) debt holders are risk seeking D) firm value increases with risk taking

A) likelihood that a firm will be unable to meet its debt commitments

The probability of financial distress depends on the ________. A) likelihood that a firm will be unable to meet its debt commitments B) chance that a firmʹs raw material costs will increase C) likelihood of dividend payments D) likelihood of asset growth

A) capital structure

The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its ________. A) capital structure B) dividend expense C) retained earnings D) paid out capital

A) financial distress

The tradeoff theory of optimal capital structure weighs the benefits of debt against the costs of ________. A) financial distress B) interest payments C) dividend reinvestment D) input factors

D) most of the gains from the investment accrue to debt holders

Under-investment problems refers to the problem that equity holders prefer not to invest in positive-NPV projects in highly levered firms because ________. A) future investments are contingent on debt financing B) projects are contingent on equity financing C) gains are evenly shared between all stakeholders D) most of the gains from the investment accrue to debt holders

C) that benefit shareholders at the expense of debt holders

When a firmʹs investment decisions have different consequences for the value of equity and the value of debt, managers may take actions ________. A) to increase debt values B) to decrease costs of distress C) that benefit shareholders at the expense of debt holders D) to reduce fixed costs

D) All of the above are considered.

Which of the following does a firm consider in the choice of securities issued? A) the tax consequences of the chosen security B) the transactions costs of the chosen security C) whether the chosen security will have a fair price in the market D) All of the above are considered.

A) All investors hold the efficient portfolio of assets.

Which of the following is NOT one of Modigliani and Millerʹs set of conditions referred to as perfect capital markets? A) All investors hold the efficient portfolio of assets. B) There are no taxes, transaction costs, or issuance costs associated with security trading. C) A firmʹs financing decisions neither change the cash flows generated by its investments, nor do they reveal new information about them. D) Investors and firms can trade the same set of securities at competitive market prices equal to the present value (PV) of their future cash flows.

D) As the amount of debt decreases, the debt becomes riskier because there is a chance the firm will default.

Which of the following statements is FALSE assuming a perfect market? A) The unlevered beta measures the market risk of a firmʹs business activities, ignoring any additional risk due to leverage. B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no cash and no debt. C) The unlevered beta measures the market risk of a firm without leverage, which is equivalent to the beta of the firmʹs assets. D) As the amount of debt decreases, the debt becomes riskier because there is a chance the firm will default.

D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

Which of the following statements is FALSE? A) As long as a firmʹs choice of securities does not change the cash flows generated by its assets, the capital structure decision will not change the total value of the firm or the amount of capital it can raise. B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero and, therefore, should not change the value of a firm. C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front. D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his or her own portfolio.

D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of a firm.

Which of the following statements is FALSE? A) As long as investors can borrow or lend at the same interest rate as a firm, homemade leverage is a perfect substitute for the use of leverage by the firm. B) When investors use leverage in their own portfolios to adjust the leverage choice made by a firm, we say that they are using homemade leverage. C) The value of a firm is determined by the present value (PV) of the cash flows from its current and future investments. D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of a firm.

A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its cost of debt as the cost of capital for the project.

Which of the following statements is FALSE? A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated, and if the comparison firm is levered, then we can use its cost of debt as the cost of capital for the project. B) We can calculate the cost of capital of a firmʹs assets by computing the weighted average of the firmʹs equity and debt cost of capital, which we refer to as the firmʹs weighted average cost of capital. C) The portfolio of a firmʹs equity and debt replicates the returns we would earn if the firm were unlevered. D) When evaluating any potential investment project, we must use a discount rate that is appropriate given the risk of the projectʹs free cash flow.

A) Investors can alter the leverage choice of a firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage.

Which of the following statements is FALSE? A) Investors can alter the leverage choice of a firm to suit their personal tastes either by borrowing and reducing leverage or by holding bonds and adding more leverage. B) As per MM proposition II, the cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the debt-equity ratio. C) The MM propositions imply that the true role of a firm's financial policy is to deal with financial market imperfections such as taxes and transaction costs. D) In practice, we will find that capital structure can have an effect on a firm's value.

A) The Law of One Price implies that leverage will affect the total value of a firm under perfect capital market conditions.

Which of the following statements is FALSE? A) The Law of One Price implies that leverage will affect the total value of a firm under perfect capital market conditions. B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firmʹs security holders is equal to the total cash flow generated by the firmʹs assets. C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and equity, without altering the total cash flows of a firm. D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

B) By holding a portfolio of a firmʹs equity and its debt, we can replicate the cash flows from holding its levered equity.

Which of the following statements is FALSE? A) The levered equity return equals the unlevered return plus an extra ʺkickʺ due to leverage. B) By holding a portfolio of a firmʹs equity and its debt, we can replicate the cash flows from holding its levered equity. C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium that is proportional to the market value debt-equity ratio. D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its equity holders.

C) A projectʹs net present value (NPV) represents the value to the new investors of a firm created by the project.

Which of the following statements is FALSE? A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. B) The most common choices are financing through equity alone and financing through a combination of debt and equity. C) A projectʹs net present value (NPV) represents the value to the new investors of a firm created by the project. D) When corporations raise funds from outside investors, they must choose which type of security to issue.

A) When a firm borrows money to repurchase shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.

Which of the following statements is FALSE? A) When a firm borrows money to repurchase shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization. B) MM Proposition I applies to capital structure decisions made at any time during the life of a firm. C) By choosing positive-NPV projects that are worth more than their initial investment, a firm can enhance its value. D) The choice of capital structure does not change the value of a firm if the cost of equity is higher than the cost of debt.

B) With perfect capital markets, a firmʹs WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is unlevered.

Which of the following statements is FALSE? A) With no debt, the WACC is equal to the unlevered equity cost of capital. B) With perfect capital markets, a firmʹs WACC is dependent on its capital structure and is equal to its equity cost of capital only if the firm is unlevered. C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but the net effect is that the firmʹs WACC is unchanged. D) As debt has a lower cost of capital than equity, higher leverage lowers a firmʹs WACC.

A) Holding cash has the opposite effect of leverage on risk and return.

Which of the following statements is TRUE? A) Holding cash has the opposite effect of leverage on risk and return. B) We use the market value of a firmʹs net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firmʹs business assets. C) Since the WACC does not change with the use of leverage, the value of a firmʹs free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices. D) Even if a firmʹs capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firmʹs debt and equity.