Financial Management & Policy - Chapter 16

M&M Proposition 2, without taxes, is the proposition that:

**a company's cost of equity is a linear function with a slope equal to (RA − RD) -the capital structure of a company has no effect on that company's value -the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate -the cost of equity is equivalent to the required rate of return on assets -the size of the pie does not depend on how the pie is sliced

The symbol "RU" refers to the cost of capital for a(n) ______ while "RA" represents the:

**all-equity company; weighted average cost of capital -all-equity company; weighted average cost of capital -levered company; cost of capital for an all-equity company -levered company; weighted average cost of capital -unlevered company; average cost of equity

The unlevered cost of capital refers to the cost of capital for a(n):

**all-equity firm -corporate shareholder -private individual -private entity -governmental agency

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.

**at the break-even point, there is no advantage to debt -the earnings per share will equal zero when EBIT is zero for a levered firm -the advantages of leverage are inversely related to the level of EBIT -the use of leverage at any level of EBIT increases the EPS -EPS are more sensitive to changes in EBIT when a firm is unlevered

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Ignore taxes.

**at the break-even point, there is no advantage to debt -the earnings per share will equal zero when EBIT is zero for a levered firm -the advantages of leverage are inversely related to the level of EBIT -the use of leverage at any level of EBIT increases the EPS -EPS are more sensitive to changes in EBIT when a firm is unlevered

Which one of the following is the equity risk that is most related to the daily operations of a firm?

**business risk -systematic risk -financial risk -extrinsic risk -market risk

The optimal capital structure has been achieved when the:

**debt-equity ratio results in the lowest possible weighted average cost of capital -debt-equity ratio is equal to 1 -weight of equity is equal to the weight of debt -cost of equity is maximized given a pre-tax cost of debt -debt-equity ratio is such that the cost of debt exceeds the cost of equity

Based on M&M Proposition I with taxes, the weighted average cost of capital:

**decreases as the DE ratio increases -is equal to the aftertax cost of debt -has a linear relationship with the cost of equity capital -is unaffected by the tax rate -is equal to RU(1 − TC)

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs.

**direct bankruptcy -flotation -issue -indirect bankruptcy -unlevered

2.0 The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs.

**direct bankruptcy -unlevered -indirect bankruptcy -flotation -issue

Which one of the following is the equity risk related to a firm's capital structure policy?

**financial -market -systematic -extrinsic -business

You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the:

**firm is just earning enough to pay for the cost of debt -advantages of leverage exceed the disadvantages of leverage -EPS for the levered option are exactly double those of the unlevered option -firm has a DE ratio of 0.50 -firm's EBIT are equal to 0

By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt

**I, II, III, and IV -I only -III only -I and II only -III and IV only

The concept of homemade leverage is most associated with:

**M&M Proposition 1 with no tax -M&M Proposition 2 with no tax -M&M Proposition 1 with tax -M&M Proposition 2 with tax -the static theory proposition

Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?

**M&M Proposition 2 -CAPM -M&M Proposition 1 -law of one price -efficient markets hypothesis

Which one of the following states that the cost of equity capital is directly and proportionally related to capital structure?

**M&M Proposition 2 -static theory of capital structure -M&M Proposition 1 -homemade leverage -pecking-order theory

The value of a firm is maximized when the:

**WACC is minimized -cost of equity is maximized -tax rate equals the cost of capital -levered cost of capital is maximized -DE ratio is minimized

2.0 The value of a firm is maximized when the:

**WACC is minimized -tax rate is 0 -DE ratio is minimized -levered cost of capital is maximized -cost of equity is maximized

Assume you are reviewing a graph that plots earnings per share (EPS) against earnings before interest and taxes (EBIT). The steeper the slope of the plotted line the:

**greater the sensitivity of EPS to changes in EBIT -lower the impact of financial leverage -lower the DE ratio -higher the tax rate -lower the probability of a negative EPS

The business risk of a company:

**has a positive relationship with the company's cost of equity -depends on the company's level of unsystematic risk -is inversely related to the required return on the company's assets -is dependent upon the relative weights of the debt and equity used to finance the company -has no relationship with the required return on a company's assets according to M&M theory

Which one of the following makes the capital structure of a company irrelevant?

**homemade leverage -taxes -interest tax shield -100% dividend payout ratio -DE ratio that is greater than 0 but less than 1

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

**indirect bankruptcy -flotation -direct bankruptcy -financial solvency -capital structure

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings?

**interest tax shield -tax-loss interest -current tax yield -financing shield -interest credit

Which form of financing do companies prefer to use first according to the pecking-order theory?

**internal funds -regular debt -convertible debt -common stock -preferred stock

A firm should select the capital structure that:

**maximizes the value of the firm -produces the highest cost of capital -minimizes taxes -is fully unlevered -equates the value of debt with the value of equity

Which one of the following is a direct cost of bankruptcy?

**paying an outside accountant to prepare bankruptcy reports -bypassing a positive NPV project to avoid additional debt -investing in cash reserves -maintaining a debt-equity ratio that is lower than the optimal ratio -losing a key company employee

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a:

**reorganization -merger -repurchase program -liquidation -diverstiture

AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.

**select the unlevered option since the expected EBIT is less than the break-even level -select the leverage option because the debt-equity ratio is less than 0.50 -select the leverage option since the expected EBIT is less than the break-even level -cannot be determined from the information provided -select the unlevered option since the debt-equity ratio is less than 0.50

Jessica invested in QRT stock when the company was unlevered. Since then, QRT has changed its capital structure and now has a debt-equity ratio of .36. To unlever her position, Jessica needs to:

**sell 36 percent of her shares of QRT stock and loan out the sale proceeds -borrow some money and purchase additional shares of QRT stock -maintain her current equity position as the debt of the firm does not affect her personally -sell 36 percent of her shares of QRT stock and hold the proceeds in cash -create a personal debt-equity ratio of .36

2.0 Homemade leverage is:

**the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage -the incurrence of debt by a corporation in order to pay dividends to shareholders -the term used to describe the capital structure of a levered firm -the exclusive use of debt to fund a corporate expansion project -best defined as an increase in a firm's debt-equity ratio

Which one of these statements is correct?

**the optimal capital structure maximizes shareholder value -capital structure has no effect on shareholder value -the optimal capital structure occurs when the cost of equity is minimized -shareholder value is maximized when WACC is also maximized -unlevered firms have more value than levered firms when firms are profitable

Homemade leverage is:

**the use of personal borrowing to alter an individual's exposure to financial leverage -the incurrence of debt by a corporation in order to pay dividends to shareholders -the exclusive use of debt to fund a corporate expansion project -best defined as an increase in a company's debt level -the term used to describe the capital structure of a levered firm

With the exception of a few industries, most corporations in the U.S. tend to:

**underutilize debt -minimize taxes -rely equally on debt and equity -have relatively similar DE ratios across industry lines -rely more heavily on debt than on equity

The absolute priority rule determines:

**which parties receive payment first in a bankruptcy proceeding -when a firm must be declared officially bankrupt. -how a distressed firm is reorganized -which judge is assigned to a particular bankruptcy case -how long a reorganized firm is allowed to remain under bankruptcy protection