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: pecking order theory 37. According to the net operating income approach (with no taxes), the use of a greater degree of financial leverage might result in an increase in earnings and dividends but will have no effect on the firm's cost of common equity.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: sinking fund 45. Agency costs tend to occur in business organizations when ownership and management control are confined to the same individuals.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: static trade-off theory 59. The pecking order theory of capital structure indicates that firms prefer to finance investment opportunities with external financial capital first, then with internally generated funds.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: target debt ratios 36. According to the pecking order theory of capital structure, when external funding is needed, common stock will be used to raise the funds.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

1. Financial structure includes long-term and short-term sources of funds.

ANSWER: True DIFFICULTY: Easy KEYWORDS

: debt capacity 43. Monitoring costs are higher for a firm with a high debt-to-equity ratio.

ANSWER: True DIFFICULTY: Easy KEYWORDS

: financial structure 2. Financial structure design determines how permanent financing should be utilized.

ANSWER: True DIFFICULTY: Easy KEYWORDS

: indifference level of EBIT 62. High coverage ratios, compared with a standard, imply unused debt capacity.

ANSWER: True DIFFICULTY: Easy KEYWORDS

: static trade-off theory 49. The nature of a firm's assets has a major influence on the types of financial capital a firm uses.

ANSWER: True DIFFICULTY: Easy KEYWORDS

: EBIT-EPS analysis 31. One danger of EBIT-EPS analysis is that it ignores the implicit cost of debt financing.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income approach 6. According to the net operating income approach to valuation, the total cost of debt financing is the coupon rate.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: capital costs 17. According to the independence hypothesis, the cost of debt consists of an explicit return to the bondholder and an implicit cost reflected in the increased return to equity.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: temporary capital, permanent capital 4. The net income theory of capital structure holds that the price of a share is increased by moderate increases in a firm's use of debt capital.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: uncommitted earnings per share 16. Capital costs, like other costs, potentially reduce the size of the cash dividend that can be paid.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

A(n) ________ cash flows come from the cash flows of underlying financial securities. A) general obligation security's B) revenue bond's C) asset-backed security's D) double-barreled bond's

Answer: C

The cash flows of a collateralized debt obligation are usually divided into how many different branches? A) 2 B) 3 C) 4 D) 6

Answer: C

Treasury securities that are semiannual coupon bonds with original maturities of between 1 and 10 years are called: A) Treasury bonds. B) Treasury bills. C) Treasury notes. D) TIPS.

Answer: C

Treasury securities that are standard coupon bonds where the outstanding principal is adjusted for inflation are called: A) Treasury notes. B) Treasury bonds. C) TIPS. D) Treasury bills.

Answer: C

What kind of corporate debt can be secured by any specified assets? A) Mortgage bonds B) Notes C) Asset-backed bonds D) Debentures

Answer: C

What kind of corporate debt has a maturity of less than 10 years? A) Asset-backed bonds B) Debentures C) Notes D) Mortgage bonds

Answer: C

What kind of unsecured corporate debt has a maturity of less than 10 years? A) Mortgage bonds B) Asset-backed bonds C) Debentures D) Notes

Answer: C

When banks resecuritize other asset-backed securities, the new asset-backed security is known as a: A) mortgage-backed security. B) double-barreled security. C) collateralized debt obligation. D) resecuritized security.

Answer: C

A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%? A. 7.73% B. 10.00% C. 10.75% D. 12.50% E. None of these.

A firm has a total value of $500,000 and debt valued at $300,000. What is the weighted average cost of capital if the after tax cost of debt is 9% and the cost of equity is 14%? A. 7.98% B. 10.875% C. 11.000% D. 12.125% E. It is impossible to determine WACC without debt and equity betas.

A firm has debt of $7,000, equity of $12,000, a leveraged value of $8,900, a cost of debt of 7%, a cost of equity of 14%, and a tax rate of 30%. What is the firm's weighted average cost of capital? A. 8.45% B. 9.90% C. 10.65% D. 12.50% E. 14.00%

A firm has debt of $90,000, equity of $140,000, a leveraged value of $100,000, a cost of debt of 6%, a cost of equity of 12%, and a tax rate of 40%. What is the firm's weighted average cost of capital? A. 8.15% B. 8.40% C. 8.70% D. 9.30% E. None of these

What kind of corporate debt must be secured by real property? A) Mortgage bonds B) Notes C) Asset-backed bonds D) Debentures

Answer: A

If the lessor borrows the majority of the purchase price of a leased asset, the lease is called a: A. leveraged lease. B. sale-and-leaseback arrangement. C. capital lease. D. nonrecourse lease. E. bargain purchase lease.

A. leveraged lease.

A manager should attempt to maximize the value of the firm by: A. changing the capital structure if and only if the value of the firm increases. B. changing the capital structure if and only if the value of the firm increases to the benefit of inside management. C. changing the capital structure if and only if the value of the firm increases only to the benefits of the debtholders. D.changing the capital structure if and only if the value of the firm increases although it decreases the stockholders' value. E. changing the capital structure if and only if the value of the firm increases and stockholder wealth is constant.

A very large firm has a debt beta of zero. If the cost of equity is 10%, and the risk-free rate is 3%, the cost of debt is: A. 3%. B. 6%. C. 11%. D. 15%. E. It is impossible to tell without the expected market return.

A very large firm has a debt beta of zero. If the cost of equity is 11%, and the risk-free rate is 5%, the cost of debt is: A. 5%. B. 6%. C. 11%. D. 15%. E. It is impossible to tell without the expected market return.

In order to value a project which is not scale enhancing you need to: A typically calculate the equity cost of capital using the risk adjusted beta of another firm in the industry . before calculating the WACC. B.typically increase the beta of another firm in the same line of business and then calculate the discount rate using the SML. C. typically you can simply apply your current cost of capital. D. discount at the market rate of return since the project will diversify the firm to the market. E typically calculate the equity cost of capital using the risk adjusted beta of another firm in another . industry before calculating the WACC.

MM Proposition I with taxes supports the theory that: A. there is a positive linear relationship between the amount of debt in a levered firm and its value. 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 weighted average cost of capital increases as the debt-equity ratio of the firm rises.

MM Proposition II with taxes: A. has the same general implications as MM Proposition II without taxes. B. reveals how the interest tax shield relates to the value of a firm. C. supports the argument that business risk is determined by the capital structure employed by a firm. D. supports the argument that the cost of equity decreases as the debt-equity ratio increases. E. reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.

The APV method to value a project should be used when the: A. project's level of debt is known over the life of the project. B. project's target debt to value ratio is constant over the life of the project. C. project's debt financing is unknown over the life of the project. D Both project's level of debt is known over the life of the project; and project's target debt to value ratio . is constant over the life of the project. E Both project's target debt to value ratio is constant over the life of the project; and project's debt . financing is unknown over the life of the project.

The Modigliani-Miller Proposition I without taxes states: A. a firm cannot change the total value of its outstanding securities by changing its capital structure proportions. B. when new projects are added to the firm the firm value is the sum of the old value plus the new. C.managers can make correct corporate decisions that will satisfy all shareholders if they select projects that maximize value. D. the determination of value must consider the timing and risk of the cash flows. E. None of these.

The Simpson Corp. is planning construction of a new plant. The initial cost of the investment is $5 million. Efficiencies from the new plant are expected to reduce costs by $620,000 forever. The corporation has a total value of $400 million and has outstanding debt of $150 million. What is the NPV of the project if the firm has an after tax cost of debt of 5% and a cost equity of 8%? A. $4,018,181 B. $4,434,748 C. $5,000,000 D. $9,018,181 E. None of these is the correct NPV.

The Webster Corp. is planning construction of a new shipping depot for its single manufacturing plant. The initial cost of the investment is $1 million. Efficiencies from the new depot are expected to reduce costs by $100,000 forever. The corporation has a total value of $60 million and has outstanding debt of $40 million. What is the NPV of the project if the firm has an after tax cost of debt of 6% and a cost equity of 9%? A. $428,571 B. $444,459 C. $565,547 D. $1,000,000 E. None of these is the correct NPV

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

The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as: A. MM Proposition I with no tax. B. MM Proposition II with no tax. C. MM Proposition I with tax. D. MM Proposition II with tax. E. static theory proposition.

The reason that MM Proposition I does not hold in the presence of corporate taxation is because: A. levered firms pay less taxes compared with identical unlevered firms. B. bondholders require higher rates of return compared with stockholders. C. earnings per share are no longer relevant with taxes. D. dividends are no longer relevant with taxes. E. All of these.

The tax savings of the firm derived from the deductibility of interest expense is called the: A. interest tax shield. B. depreciable basis. C. financing umbrella. D. current yield. E. tax-loss carry forward savings.

The term (B x rb) gives the: A. cost of debt interest payments per year. B. cost of equity dividend payments per year. C. unit cost of debt. D. unit cost of equity. E. weighted average cost of capital.

The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: A. homemade leverage. B. dividend recapture. C. the weighted average cost of capital. D. private debt placement. E. personal offset.

Thompson & Thomson is an all equity firm that has 500,000 shares of stock outstanding. The company is in the process of borrowing $8 million at 9% interest to repurchase 200,000 shares of the outstanding stock. What is the value of this firm if you ignore taxes? A. $20.0 million B. $20.8 million C. $21.0 million D. $21.2 million E. $21.3 million

Your firm has a $250,000 bond issue outstanding. These bonds have a 7% coupon, pay interest semiannually, and have a current market price equal to 103% of face value. What is the amount of the annual interest tax shield given a tax rate of 35%? A. $6,125 B. $6,309 C. $9,500 D. $17,500 E. $18,025

A. MM Proposition I with no tax.

A manager should attempt to maximize the value of the firm by changing the capital structure if and only if the value of the firm increases: A. as a result of the change. B. to the sole benefit of the managers. C. to the sole benefit of the debtholders. D. while also decreasing shareholder value. E. while holding stockholder value constant.

A. as a result of the change.

A. has the same general implications as MM Proposition II without taxes.

A. homemade leverage.

A. interest tax shield.

The reason that MM Proposition I does not hold in the presence of corporate taxation is because: A. levered firms pay less taxes compared with identical unlevered firms. B. bondholders require higher rates of return than stockholders do. C. earnings per share are no longer relevant with taxes. D. dividends become a tax shield. E. debt is more expensive than equity.

A. levered firms pay less taxes compared with identical unlevered firms.

A. there is a positive linear relationship between the amount of debt in a levered firm and its value.

Which one of these characteristics does not apply to a financial lease? A. The lease is usually not fully amortized. B. The lessee is responsible for the maintenance of the leased assets. C. Generally, the lease cannot be cancelled. D. The lessee usually has the right to renew the lease on expiration. E. The lessee must pay all of the lease payments.

A. The lease is usually not fully amortized.

In the presence of corporate taxes, riskless cash flows should be discounted at the: A. aftertax riskless rate of interest. B. aftertax cost of firm debt. C. pretax riskless rate of interest. D. pretax cost of firm debt. E. market rate of interest.

A. aftertax riskless rate of interest.

A leveraged lease typically involves a non-recourse loan which means that in the case of default the: A. lease payments go directly to the lender. B. the lessee obtains a first lien on the leased assets. C. lessor is obligated to fulfill the terms of both the lease and the loan. D. lessee assumes the loan obligation in exchange for the title to the leased assets. E. lease is automatically cancelled.

A. lease payments go directly to the lender.

: EBIT-EPS approach Use the following information to

ANSWER questions 101-104. Your firm is trying to determine whether it should finance a project requiring $800,000 with new common stock or with debt. The firm is faced with the following financing alternatives: I: Issue new common stock. Sale price of the common stock is expected to be $40 per share. II: Issue new bonds with a coupon rate of 12%. The firm has a marginal tax rate of 34%, the company currently has 40,000 shares of common stock outstanding, and $90,000 face value of 10% debt outstanding. 101. Total shares outstanding will be: a. 20,000 under alternative I and zero under alternative II. b. 40,000 under alternative I and 60,000 under alternative II. c. 60,000 under alternative I and 40,000 under alternative II. d. 60,000 under both alternative I and alternative II. @ANSWER: c DIFFICULTY: Moderate KEYWORDS

: capital structure management 13. Investors require a higher return on common stock investments if a firm uses less leverage.

ANSWER: False DIFFICULTY: Easy KEYWORDS

: comparative leverage ratio analysis 47. The firm's financial structure is the same as its capital structure.

ANSWER: False DIFFICULTY: Easy KEYWORDS

: independence hypothesis 18. The independence hypothesis is also known as the net income hypothesis.

ANSWER: False DIFFICULTY: Easy KEYWORDS

: EBIT-EPS analysis 32. The two most common types of leverage ratios are balance sheet leverage ratios and sources and uses leverage ratios.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: EBIT-EPS analysis 42. Debt capacity is the minimum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: agency costs 46. Comparative leverage ratio analysis does not involve the use of industry norms.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: common equity ratios 34. Debt capacity is the maximum proportion of debt that the firm can include in its capital structure without increasing its tax liability.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: debt capacity 35. Based on the results of a study reviewed in the text, the single most important influence on target debt ratios is the advice of investment bankers.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 24. The independence hypothesis suggests that the cost of equity decreases as financial leverage increases.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: explicit costs, implicit costs 28. One benefit from using fixed cost securities is the reduced variability in the EPS stream.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: financial leverage 11. Because preferred stock dividends are not tax-deductible, they are not a source of financial leverage.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: financial structure 48. The static trade-off theory of capital structure takes into account the monitoring and agency costs associated with debt usage.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: financial structure design 3. Real assets should be financed with temporary capital due to the short-term nature of depreciation expense.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: fixed cost securities 29. The free cash flow theory of capital structure gives a theoretical solution as to how much financial leverage a firm should have.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: free cash flow theory 30. Because there are no fixed financing costs, a common stock plan line in an EBIT-EPS analysis chart will have a steeper slope than will a bond-plan line.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: free cash flow theory 61. The indifference level of EBIT based on uncommitted EPS will always be less than that based on EPS.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: implicit cost of debt 39. The dependence hypothesis or NI approach (with no taxes) suggests that the greater use of debt financing, in regard to common equity financing, will have an unfavorable effect on the price of the company's common stock.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 52. The net operating income theory of capital structure maintains that debt has a single cost referred to as its explicit cost of capital.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 20. According to the independence hypothesis, earnings and dividends are expected to fall as financial leverage increases.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 22. The dependence hypothesis states that as debt usage increases, a firm's cost of debt capital increases.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 25. The dependence hypothesis suggests that the cost of equity decreases as financial leverage increases.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: interest tax shield 41. The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial leverage regardless of the financing plan chosen by the financial manager.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: market conditions, financial policy 65. Debt capacity is the maximum proportion of debt that the firm can include in its capital structure and still maintain a lower EPS.

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: net income approach 10. An increase in financial leverage will increase earnings before income and taxes (EBIT).

ANSWER: False DIFFICULTY: Moderate KEYWORDS

: capital structure management 51. An integral part of the independence hypothesis of capital structure is that the cost of common equity will increase at precisely the same rate as any increase in earnings and dividends.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: coverage ratios, debt capacity 63. Empirical evidence indicates that firms use target debt ratios influenced primarily by the firm's internal management and staff analysts.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: debt capacity 58. The static trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes that the benefit is offset by costs associated with debt financing.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: debt financing 27. The real cost of debt is the sum of explicit and implicit costs.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 23. The dependence hypothesis is also called the net income approach to valuation.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 26. Other things the same, the use of debt financing reduces the firm's total tax bill, resulting in a higher total market value.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 40. The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of the debt and the firm's marginal tax rate.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 9. Under the net income approach to valuation, the explicit and implicit cost of debt are one and the same.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis, cost of capital, leverage 56. The moderate position of capital structure theory indicates that there is a range of capital structures, rather than a single capital structure, that is optimal.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: financial capital 50. The objective of capital-structure management can be viewed as the endeavor to find the financing mix that will minimize the firm's composite cost of capital.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: financial leverage 12. The objective of capital structure management is to maximize the market value of the firm's equity.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 19. The independence hypothesis suggests that the total market value of the firm's outstanding securities is unaffected by its capital structure.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 21. The major implication of the independence hypothesis is that one capital structure is as good as any other.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: leverage ratios 33. The common equity ratios of large retail firms seem to differ statistically from those of major steel producers.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: moderate position of capital structure 57. Debt capacity is the maximum level of debt that the firm can include in its capital structure and still maintain its minimum composite cost of capital.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: monitoring costs 44. A sinking fund is a real cash reserve that is used to provide for the orderly and early retirement of the principal amount of the bond issue.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net income approach 8. According to the dependence hypothesis of debt financing, the cost of common equity is constant regardless of the debt financing level.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net income theory 5. According to the net operating income approach to valuation, the market value of the firm's common stock is a residual of total market value.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net income theory 54. The net operating income theory of capital structure maintains that a greater degree of financial leverage might result in higher earnings and dividends.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income approach 38. The implicit cost of debt takes into consideration the change in the cost of common equity brought on by using additional debt.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income approach 7. According to the net income approach to valuation, the cost of capital will be lower the more debt financing is used.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income theory 15. Uncommitted earnings per share is never greater than earnings per share (EPS).

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income theory 53. The net income theory of capital structure indicates that the firm's composite cost of capital and its common stock price will be affected by the firm's use of financial leverage, regardless of how little the firm uses debt.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: net operating income theory 55. The dependence hypothesis of capital structure suggests that the use of more leverage will lower the cost of capital.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: pecking order theory 60. The free cash flow theory of capital structure indicates how debt can be used to control managerial behavior.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: stock returns, leverage 14. According to the net operating income theory, a firm does not have an optimal capital structure.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: target debt ratios 64. When market conditions change abruptly, company financial policies and decisions must adapt to the new conditions; otherwise, the firm will be faced with a lower level of cash flow generation and increased risk of financial distress.

ANSWER: True DIFFICULTY: Moderate KEYWORDS

: independence theory, common stock price 74. Which theory of capital structure rests upon the net operating income approach to valuation? a. The independence theory b. The moderate position theory c. The dependence theory d. The capital accumulation theory

ANSWER: a DIFFICULTY: Easy KEYWORDS

: EBIT-EPS approach 138. Lever Brothers has a debt ratio (debt to assets) of 40%. Management is wondering if its current capital structure is too conservative. Lever Brothers's present EBIT is $3 million, and profits available to common shareholders are $1,560,000, with 342,857 shares of common stock outstanding. If the firm were to instead have a debt ratio of 60%, additional interest expense would cause profits available to stockholders to decline to $1,440,000, but only 228,571 common shares would be outstanding. What is the difference in EPS at a debt ratio of 60% versus 40%? a. $1.75 b. $2.00 c. $3.25 d. $4.50

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: capital structure management 94. The EBIT-EPS indifference point: a. identifies the EBIT level at which the EPS will be the same regardless of the financing plan. b. identifies the point at which the analysis can use EBIT and EPS interchangeably. c. identifies the level of earnings at which the management is indifferent about the payments of dividends. d. none of the above.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: debt financing 126. Which of the following statements is correct? a. Firms whose sales are very stable are more likely to rely on debt financing than firms whose sales are very sensitive to changes in economic circumstances. b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing. c. Firms with a high operating leverage are more likely to rely on debt financing. d. Firms operating in risky industries will have greater leverage.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: financing mix 86. The level of EBIT that will equate EPS between two different financing plans is called the: a. indifference point. b. optimal capital plan. c. break-even point. d. both a and c. e. all of the above.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: indifference level of EBIT 104. EPS at the indifference level of EBIT is: a. $3.17. b. $4.80. c. $5.27. d. $5.90.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: moderate position of capital structure 99. Monitoring costs that arise due to capital structure management: a. help to reduce the conflict between stockholders and creditors. b. are ultimately borne by the debt holders. c. are borne by preferred stockholders. d. none of the above.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 116. The moderate position (theory) of capital structure suggests that if a firm moves from zero debt in its capital structure to moderate usage of debt, the result is an increase in a firm's: a. stock price. b. cost of equity. c. dividend payout. d. both a & c. e. all of the above.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: net income approach 69. According to the net operating income theory of firm valuation, an increase in ____________ will increase the cost of common equity. a. dividends per share b. market price per share c. earnings available to common stockholders d. both a and c

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: net operating income approach 91. Optimal capital structure is: a. the mix of permanent sources of funds used by the firm in a manner that will maximize the company's common stock price. b. the mix of all items that appear on the right-hand side of the company's balance sheet. c. the mix of funds that will minimize the firm's beta. d. the mix of securities that will maximize EPS.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 122. The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital: a. first falls with moderate levels of leverage and then increases as a firm's leverage becomes high. b. does not change with leverage. c. increases proportionately with increases in leverage. d. increases with moderate amounts of leverage and then falls.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 93. Basic tools of capital structure management include: a. EBIT-EPS analysis. b. comparative profitability ratios. c. capital budgeting techniques. d. none of the above.

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: weighted average cost of capital 123. An increase in the ____________ is likely to encourage a corporation to increase its debt ratio. a. corporate tax rate b. personal tax rate c. company's degree of operating leverage d. expected cost of bankruptcy

ANSWER: a DIFFICULTY: Moderate KEYWORDS

: EBIT-EPS approach 139. Lever Brothers has a debt ratio (debt to assets) of 60%. Management is wondering if its current capital structure is too aggressive. Lever Brothers's present EBIT is $3 million, and profits available to common shareholders are $1,440,000, with 228,571 shares of common stock outstanding. If the firm were to instead have a debt ratio of 20%, reduced interest expense would cause profits available to stockholders to increase to $1,680,000, but 457,143 common shares would be outstanding. What is the difference in EPS at a debt ratio of 20% versus 60%? a. $-1.76 b. $-2.63 c. $-3.14 d. $-4.37

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: EBIT-EPS approach, indifference point 95. In equation form, the relationship between financial and capital structure can be expressed by: financial structure - ____________________ = capital structure a. equity b. current liabilities c. long-term debt d. none of the above

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: bankruptcy risk 111. Which of the following is the most typical natural conflict that could lead to agency costs in managing a firm's capital structure? a. Potential stockholders versus existing stockholders b. Stockholders versus bondholders c. There are no potential conflicts that could lead to agency costs in managing a firm's capital structure d. Existing shareholders and the IRS

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: bankruptcy risk 68. According to the net income approach to valuation, as the use of debt financing increases, the cost of capital _________ while the cost of equity _______________. a. remains constant; decreases b. decreases; remains constant c. remains constant; increases d. increases; increases

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: capital structure 102. The total interest obligation will be: a. $105,000 under alternative I and $9,000 under alternative II. b. $9,000 under alternative I and $105,000 under alternative II. c. zero under alternative I and $96,000 under alternative II. d. $105,000 under both alternative I and alternative II.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: capital structure components 73. The independence theory assumes that a firm's debt usage does not influence: a. common stock price. b. explicit costs. c. implicit costs. d. both b and c. e. all of the above.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: capital structure management, costs 100. A firm is analyzing two different capital structures for financing a new asset that will cost $100,000. The effects of the two structures on the firm's balance sheet are described below. Plan A: finance with 50% debt New asset $100,000 Debt $50,000 Common equity $50,000 Total $100,000 Plan B: finance with 70% debt New asset $100,000 Debt $70,000 Common equity $30,000 Total $100,000 Based on the information provided, we can conclude that: a. if the firm chooses Plan A, then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan B. b. if the firm chooses Plan B, then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan A. c. if the firm chooses Plan A, then any changes in the firm's EBIT will lead to the same fluctuations in the firm's EPS as will occur if the firm chooses Plan B. d. if the firm chooses Plan B, then any changes in the firm's EBIT will lead to smaller fluctuations in the firm's EPS than if the firm chooses Plan A.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 89. Sinking fund payments are made to the: a. banks. b. bond trustee. c. bondholder. d. board of directors.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: independence hypothesis 128. The dependence hypothesis assumes which of the following? a. A firm's value is determined by capitalizing (discounting) the firm's expected operating income by the firm's CAPM. b. A firm's value is determined by capitalizing (discounting) the firm's expected net income stream. c. A firm's cost of capital rises as a firm uses more financial leverage. d. A firm's cost of capital decreases as a firm uses more financial leverage.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: independence hypothesis approach 133. Castle Corp. generated $2 million in operating income from sales of $20 million during the latest fiscal year. The firm's interest expense was $500,000, and the corporate income tax rate was 40%. Investors require a rate of return of 18%. Using the dependence hypothesis approach to valuation, what is the market value of Castle? a. $9.6 million b. $8.3 million c. $7.2 million d. $6.5 million e. $5.1 million

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: independence theory 119. Which of the following is consistent with the dependence hypothesis? a. Increased usage of financial leverage will increase a firm's composite cost of capital indefinitely. b. Increased usage of financial leverage will lower a firm's composite cost of capital indefinitely. c. Increased usage of financial leverage will not affect a firm's composite cost of capital. d. Increased usage of operating leverage will increase a firm's composite cost of capital indefinitely.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: indifference point 87. Which two ratios would be most helpful in managing a firm's capital structure? a. Balance sheet leverage ratios and profitability ratios b. Leverage ratios and coverage ratios c. Coverage ratios and liquidity ratios d. Coverage ratios and profitability ratios

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 117. What is the best argument against the dependence theory of capital structure? a. The tax shield effect of debt will result in a lower cost of equity. b. Increasing debt too much can result in a greater likelihood of firm failure (financial distress). c. A firm's common stock price will not be affected by the amount of debt a firm uses. d. Too much common equity increases the probability of bankruptcy.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: net operating income theory 70. The primary objective of capital structure management is to mix the _______ sources of funds obtained by a firm to minimize the cost of the company's __________. a. short-term; common stock b. permanent; common stock c. short-term; debt d. permanent; debt

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 108. The Goreman Corporation has a debt ratio of 33.33%, and it needs to raise $100,000 to expand. Management feels that an optimal debt ratio is 16.67%. Sales are currently $750,000, and the total assets turnover is 7.5. How should the expansion be financed so as to produce the desired debt ratio? a. Finance it all with debt. b. Finance it all with equity. c. Finance 20% with debt and 80% with equity. d. Finance 40% with debt and 60% with equity. e. Finance 50% with debt and 50% with equity.

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: projected earnings per share 135. Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock. If Zybeck issues common stock this year, what will projected EPS be next year? a. $2.10 b. $2.96 c. $2.33 d. $1.67

ANSWER: b DIFFICULTY: Moderate KEYWORDS

: dependence theory, common stock price 76. The net income approach to valuation relates to what theory on capital structure? a. The independence theory b. The moderate position theory c. The dependence theory d. The capital accumulation theory

ANSWER: c DIFFICULTY: Easy KEYWORDS

: EBIT-EPS approach 106. Typically, Delta, Inc. maintains $1 million in cash and marketable securities. The firm currently is expecting an economic recession and projects that its net cash flows from operations during the period will be $2.5 million. Delta expects annual interest and sinking fund payments will be $3 million during the period. If the recession occurs, Delta's cash balance at the end of the period will be: a. $6.5 million. b. $1 million. c. $500,000. d. $3.5 million.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

Bonds issued by a local entity, denominated in the local currency, traded in a local market, but purchased by foreigners are called: A) domestic bonds. B) Yankee bonds. C) Eurobonds. D) foreign bonds.

Answer: A

: EPS-EBIT approach 81. When deciding upon how much debt financing to employ, most practitioners would cite which of the following as the most important influence on the level of the debt ratio? a. Providing a borrowing reserve b. Maintaining desired bond rating c. Ability to adequately meet financing charges d. Exploiting advantages of financial leverage

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: agency costs 112. How can bondholders reduce potential conflicts with stockholders as related to capital structure? a. Pay out higher dividends. b. Increase management stock options. c. Require protective covenants in the bond indenture agreement. d. Require the firm to increase capital spending for new investments.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: capital structure 132. Baseline Corporation generated $2 million in operating income from sales of $20 million during the latest fiscal year. The firm's interest expense was $500,000, and the corporate income tax rate was 40%. Investors require a capitalization rate of 12%. Using the independence hypothesis approach to valuation, what is Baseline's market value? a. $18.6 million b. $17.1 million c. $16.7 million d. $15.4 million e. $14.3 million

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: cash balance 107. An optimal capital structure is achieved: a. when a firm's expected profits are maximized. b. when a firm's expected EPS are maximized. c. when a firm's expected stock price is maximized. d. when a firm's break-even point is achieved.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: debt capacity Multiple Choice 66. When the impact of taxes is considered with the net operating income approach to valuation, the value of the firm: a. increases at a debt-to-total value ratio of 40 percent. b. decreases by interest expense paid out. c. increases by the present value of the tax shield. d. decreases by the future value of cash flows.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: debt financing 127. The independence hypothesis assumes which of the following? a. A firm's value is determined by capitalizing (discounting) the firm's expected profits by the firm's CAPM. b. A firm's cost of capital rises as a firm uses more financial leverage. c. A firm's value is determined by capitalizing (discounting) the firm's expected net operating income stream. d. All of the above.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 97. If a firm chose to increase its debt ratio from 20% to 40%, what is the potential risk? a. The average cost of capital would most likely rise. b. The price of the firm's common stock would definitely decline. c. If economic forces cause a reduction of sales, the firm's EPS might decline. d. The firm's WACC might decline.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: dependence theory 118. Which of the following is consistent with the independence hypothesis? a. A firm's composite cost of capital decreases as financial leverage is used. b. A firm's common stock price falls as financial leverage is used. c. A firm's composite cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm. d. A firm's composite cost of capital increases as operating leverage is used. e. A firm's common stock price rises as operating leverage is used.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: financial leverage 79. Fluctuations in EBIT result in: a. fluctuations in EPS, which might be larger or smaller as financial leverage increases. b. smaller fluctuations in EPS, the greater the degree of financial leverage. c. greater fluctuations in EPS, the greater the degree of financial leverage. d. equal fluctuations in EPS, the greater the degree of financial leverage.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: financial structure, capital structure 96. Which of the following statements is true? a. The net operating income theory of capital structure maintains that the firm's composite cost of capital and its common stock price are dependent on the degree to which the firm chooses to use financial leverage. b. The net income theory of capital structure maintains that the firm's composite cost of capital and its common stock price are independent of the degree to which the firm chooses to use financial leverage. c. The dependence hypothesis of capital structure suggests that the explicit and implicit costs of debt are the same. d. All of the above statements are true.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: financing mix 131. A firm's capital structure consists of which of the following? a. The amount of debt that a firm utilizes b. The amount of debt and preferred stock that a firm utilizes c. The amount of debt, preferred stock, and common stock that a firm utilizes d. None of the above

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: independence theory, net operating income 75. Dependence theory assumes that as debt usage increases, _______ increases. a. explicit costs b. cost of debt c. common stock price d. both b and c

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: net operating income theory 83. The moderate view of capital structure management assumes: a. no corporate income taxes. b. cost of equity remains constant with an increase in financial leverage. c. firms might fail. d. none of the above.

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 72. Which of the following is part of a firm's financial structure but not a component of its capital structure? a. Retained earnings b. Mortgage bonds c. Accounts payable d. Both a and c

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 121. From the information below, select the optimal capital structure for Mountain High Corp. a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50 b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90 c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20 d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40 e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00

ANSWER: c DIFFICULTY: Moderate KEYWORDS

: bondholder protection 113. Which of the following is not a component of a firm's capital structure? a. Preferred stock b. Bonds c. Common stock d. Accounts payable e. Retained earnings

ANSWER: d DIFFICULTY: Moderate KEYWORDS

Packaging a portfolio of financial securities and issuing an asset-backed security backed by this portfolio is known as: A) asset securitization. B) revenue securitization. C) backup securitization. D) payment securitization.

Answer: A

: capital structure 114. Which of the following is consistent with the moderate view of capital structure theory? a. The cost of capital continuously decreases as the firm's debt ratio increases. b. The cost of capital remains constant as the firm's debt ratio increases. c. The cost of capital continuously increases as the firm's debt ratio increases. d. There is an optimal level of debt financing. e. Capital structure does not affect a firm's cost of capital.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: capital structure 125. Which of the following statements is correct? a. Firms whose sales are less sensitive to changes in the business cycle are more likely to rely on debt financing. b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing. c. Firms with a low operating leverage are more likely to rely on debt financing. d. Both a and c are correct.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: capital structure 88. The dependence hypothesis (no-tax case) suggests that the use of more debt will: a. lower the overall cost of capital. b. have no effect on the firm's cost of common equity. c. have a favorable effect on the company's common stock price. d. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: capital structure management 71. Which of the following is inconsistent with an optimal capital structure policy? a. Lower the blended cost of debt and equity. b. Maximize a firm's common stock price. c. Minimize the cost of capital. d. Maximize EPS.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: debt ratio 109. An optimal capital structure is achieved: a. when a firm's expected profits are maximized. b. when a firm's expected EPS are maximized. c. when a firm's break-even point is achieved. d. when a firm's weighted average cost of capital is minimized.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: debt ratio 124. As a general rule, the capital structure: a. maximizes expected EPS and also maximizes the price per share of common stock. b. minimizes the interest rate on debt and also maximizes the expected EPS. c. minimizes the required rate on equity and also maximizes the stock price. d. maximizes the price per share of common stock and also minimizes the weighted average cost of capital.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: debt ratio 98. The moderate position of capital structure theory indicates that: a. the tax shield on debt positively affects firm value, indicating that there is some benefit to financial leverage as opposed to an all-equity capitalization. b. the higher the firm's financial leverage, the higher the probability the firm will be unable to meet the financial obligations included in its debt contracts, which could ultimately lead to firm failure. c. there is a range of capital structures, rather than a single capital structure, that is optimal. d. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis approach 134. Farar, Inc. projects operating income of $4 million next year. The firm's income tax rate is 40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no debt. The firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not expected to generate an increase in income for two years. If Farar issues the bonds this year, what will projected EPS be next year? a. $1.53 b. $1.98 c. $2.33 d. $2.72 e. $3.12

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: dependence theory, net income approach 77. According to the moderate view of capital costs and financial leverage, as the use of debt financing increases: a. the cost of capital continuously decreases. b. the cost of capital remains constant. c. the cost of capital continuously increases. d. there is an optimal level of debt financing.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: financial leverage 80. When using an EPS-EBIT chart to evaluate a pure debt financing and pure equity financing plan, the debt financing plan line will have: a. a steeper slope than the equity financing plan line. b. a lower level of EBIT at EPS = 0. c. a smaller slope when less leverage is used. d. both a and c.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: indifference level of EBIT 105. Weaknesses of the EBIT-EPS analysis include: a. that it disregards the implicit costs of debt financing. b. that it ignores the effect of the specific financing decision on the firm's cost of common equity capital. c. that it considers only the level of the earnings stream and ignores the variability inherent in it. d. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: interest expense 103. The indifference level of EBIT is: a. $99,000. b. $66,600. c. $333,000. d. $297,000.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: moderate view of capital costs 78. Financial leverage is distinct from operating leverage since it accounts for the use of: a. debt. b. fixed operating costs. c. preferred stock. d. both a and c. e. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 130. Which of the following is the most important factor that affects a firm's financing mix? a. The amount of EPS b. The amount of operating income c. The number of shares that are outstanding d. Business risk

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 115. What is the central feature of the moderate view (theory) of capital structure? a. A high debt ratio will result in a maximum price of a firm's common stock. b. A firm's common stock price will not be affected by the amount of debt a firm uses. c. A low debt ratio will result in a maximum price for a firm's common stock. d. Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 84. The moderate view of capital structure management says that the cost of capital curve is: a. a straight line. b. v-shaped. c. s-shaped. d. saucer-shaped.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: moderate view of capital structure 85. The single most important factor that should influence a firm's financing mix is their: a. cost of debt. b. EPS. c. temporary capital. d. probability distribution of EBIT.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

Treasury securities that are semiannual-paying coupon bonds with maturities longer than 10 years are called: A) Treasury bonds. B) TIPS. C) Treasury bills. D) Treasury notes.

Answer: A

: net operating income approach 67. The inclusion of bankruptcy risk in firm valuation: a. acknowledges that a firm has an upper limit to debt financing. b. provides a rationale for a linear cost of capital curve. c. is ignored in both the net operating income and the net income of cost of capital. d. both a and c. e. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 110. The inclusion of bankruptcy risk in firm valuation: a. acknowledges that a firm is insulted from the impact of high debt financing. b. provides a rationale for a saucer-shaped cost of capital curve. c. is ignored in the Independence Hypothesis. d. both b & c. e. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: optimal capital structure 92. Optimal capital structure is: a. the explicit cost of debt. b. the implicit cost of debt. c. the change in the cost of equity caused by the issuance of the debt. d. all of the above.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: return on equity 137. Lever Brothers has a debt ratio (debt to assets) of 20%. Management is wondering if its current capital structure is too conservative. Lever Brothers's present EBIT is $3 million, and profits available to common shareholders are $1,680,000, with 457,143 shares of common stock outstanding. If the firm were to instead have a debt ratio of 40%, additional interest expense would cause profits available to stockholders to decline to $1,560,000, but only 342,857 common shares would be outstanding. What is the difference in EPS at a debt ratio of 40% versus 20%? a. $2.12 b. $1.95 c. $1.16 d. $0.88

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: sinking fund payments 90. The net operating income approach (no-tax case) suggests that a 10% increase in earnings and dividends per share, caused by a change in the financing mix, will: a. cause the firm's cost of common equity to fall by some percentage less than 10. b. cause the firm's cost of common equity to rise by 10%. c. cause the firm's cost of common equity to rise by some percentage less than 10. d. cause no change in the cost of common equity.

ANSWER: d DIFFICULTY: Moderate KEYWORDS

: debt ratio 82. The Independence Hypothesis states that the use of a greater degree of leverage might result in greater: a. earnings. b. dividends. c. firm cost of common equity. d. both a & c. e. all of the above.

ANSWER: e DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 120. Which of the following statements is correct? a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. b. The optimal capital structure simultaneously maximizes EPS and minimizes the Capital Asset Pricing Model (CAPM). c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. e. Each of the statements above is false.

ANSWER: e DIFFICULTY: Moderate KEYWORDS

: dependence hypothesis 129. The moderate view of capital structure theory states that the cost of capital initially ____________ and then ____________ as the firm uses high amounts of debt. a. increases; remains the same b. decreases; remains the same c. remains the same; increases d. increases; increases e. decreases; increases

ANSWER: e DIFFICULTY: Moderate KEYWORDS

: projected earnings per share 136. Zybeck Corp. projects operating income of $4 million next year. The firm's income tax rate is 40%. Zybeck presently has 750,000 shares of common stock which have a market value of $10 per share, no preferred stock, and no debt. The firm is considering two alternatives to finance a new product: (a) the issuance of $6 million of 10% bonds, or (b) the issuance of 60,000 new shares of common stock at $10 per share. If Zybeck issues common stock this year, what will the firm's return on equity be next year? a. 16.7% b. 18.2% c. 22.1% d. 26.4% e. 29.6%

ANSWER: e DIFFICULTY: Moderate KEYWORDS

An asset-backed security backed by home mortgages is a: A) mortgage-backed security. B) primary home-backed security. C) bond-backed security. D) real estate-backed security.

Answer: A

Which of the following statements regarding municipal bonds is FALSE? A) A single municipal bond issue will often contain a number of different maturity dates. Such issues are often called multi-muni bonds because the bonds are scheduled to mature over a multiple number of years. B) Revenue bonds are where the local government pledges specific revenues generated by projects that were initially financed by the bond issue. C) Municipal bonds are sometimes also referred to as tax-exempt bonds. D) Bonds backed by the full faith and credit of a local government are known as general obligation bonds and are not as secure as bonds backed by the full faith and credit of the federal government.

Answer: A Explanation: A) A single municipal bond issue will often contain a number of different maturity dates. Such issues are often called serial bonds because the bonds are scheduled to mature over a multiple number of years.

Which of the following statements is FALSE? A) By including more covenants, issuers increase their costs of borrowing. B) Once bonds are issued, equity holders have an incentive to increase dividends at the expense of debt holders. C) Covenants may restrict the level of further indebtedness and specify that the issuer must maintain a minimum amount of working capital. D) If the covenants are designed to reduce agency costs by restricting management's ability to take negative NPV actions that exploit debt holders, then the reduction in the firm's borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants.

Answer: A Explanation: A) By including more covenants, issuers decrease their costs of borrowing.

Which of the following statements is FALSE? A) If the issuer fails to live up to any covenant, the issuer goes into bankruptcy. B) The stronger the covenants in the bond contract, the less likely the issuer will default on the bond, and so the lower the interest rate investors will require to buy the bond. C) Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. D) Bond agreements often contain covenants that restrict the ability of management to pay dividends.

Answer: A Explanation: A) If the issuer fails to live up to any covenant, the issuer goes into default.

Which of the following statements is FALSE? A) In the case of a Treasury note or Treasury bond offering, the stop-out yield determines the coupon of the bond and then all bidders pay the discounted value for the bond or note. B) All competitive bidders submit sealed bids in terms of yields and the amount of bonds they are willing to purchase. C) In the past, the Treasury has issued bonds with maturities of 30 years (often called long bonds) and 20 years. D) Noncompetitive bidders (usually individuals) just submit the amount of bonds they wish to purchase and are guaranteed to have their orders filled at the auction.

Answer: A Explanation: A) In the case of a Treasury note or Treasury bond offering, the stop-out yield determines the coupon of the bond and then all bidders pay the par value for the bond or note.

In January 2010, the U.S. Treasury issued a $1000 par, five-year, inflation-indexed note with a coupon of 5%. On the date of issue, the consumer price index (CPI) was 250. By January 2015, the CPI had decreased to 200. The coupon payment that was made in January 2015 is closest to: A) $20 B) $25 C) $30 D) $40

Answer: A Explanation: A) The CPI depreciated by 200/250 = 0.8. Consequently the principal amount of the bond decreases (for interest purposes) by this amount so the new principal = $1000 × 0.8 = $800. Therefore, with a 5% coupon and semiannual compounding this bond would pay $800 × .05/2 = $20

Asset securitization is the process of creating a(n): A) collateralized security. B) asset-backed security. C) municipal security. D) payment security.

Answer: B

The largest sector of the asset-backed security market is the ________ market. A) collateralized debt obligation B) mortgage-backed security C) real property-backed security D) double-barreled security

Answer: B

Rearden Metal has just issued a callable, $1000 par value, twenty-year, 8% coupon bond with semiannual coupon payments. The bond can be called at par in five years or anytime thereafter on a coupon payment date. If the bond is currently trading for $1040.79, then its yield to call is closest to: A) 3.8% B) 7.0% C) 7.6% D) 8.0%

Answer: B Explanation: B) PV = -1040.79, PMT = 80/2 = 40, FV = 1000, N = 5 × 2= 10, compute i = 3.509305 × 2 = 7.0186%

In January 2010, the U.S. Treasury issued a $1000 par, ten-year, inflation-indexed note with a coupon of 4%. On the date of issue, the consumer price index (CPI) was 200. By January 2020, the CPI had increased to 300. The coupon payment that was made in January 2020 is closest to: A) $20 B) $30 C) $40 D) $50

Answer: B Explanation: B) The CPI appreciated by 300/200 = 1.50. Consequently the principal amount of the bond increases by this amount so the new principal = $1000 × 1.5 = $1500. Therefore, with a 4% coupon and semiannual compounding this bond would pay $1500 × .04/2 = $30

In January 2010, the U.S. Treasury issued a $1000 par, five-year, inflation-indexed note with a coupon of 5%. On the date of issue, the consumer price index (CPI) was 250. By January 2015, the CPI had decreased to 200. The principal payment that was made in January 2015 is closest to: A) $800 B) $1000 C) $1250 D) $1500

Answer: B Explanation: B) The CPI depreciated by 200/250 = 0.8. Consequently the principal amount of the bond decreases (for interest purposes) by this amount so the new principal (for interest purposes) = $1000 × 0.8 = $800. However, in the event of depreciation with the CPI these bonds will repay par, which is $1000 in this case.

Which of the following statements is FALSE? A) Mortgage-backed securities, such as GNMAs, are pass-through securities. That is, each security is backed by an underlying portfolio or pool of mortgages. B) The Government National Mortgage Association (GNMA, or "Ginnie Mae") is an example of an enterprise; the Student Loan Marketing Association ("Sallie Mae") is an example of a government-sponsored agency. C) Sovereign debt is debt issued by national governments. D) Agency securities are issued by agencies of the U.S. government or by U.S. government sponsored enterprises.

Answer: B Explanation: B) The Government National Mortgage Association (GNMA, or "Ginnie Mae") is an example of an agency; the Student Loan Marketing Association ("Sallie Mae") is an example of a government-sponsored enterprise.

Which of the following statements is FALSE? A) Zero-coupon Treasury securities with maturities longer than one year also trade in the bond market. B) Treasury securities are initially sold to the public through dealers. C) Municipal bonds ("munis") are issued by state and local governments. D) Municipal bonds' distinguishing characteristic is that the income on municipal bonds is not taxable at the federal level.

Answer: B Explanation: B) Treasury securities are initially sold to the public through auction.

Which of the following statements is FALSE? A) Almost all bonds that are issued today are registered bonds. B) The trust company represents the bondholders and makes sure that the terms of the indenture are enforced. C) For private placements, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company. D) In the case of default, the trust company represents the bondholders' interests.

Answer: C Explanation: C) For public debt issue, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company.

Which of the following statements regarding private placements is FALSE? A) A private placement is a bond issue that does not trade on a public market but rather is sold to a small group of investors. B) Privately placed debt need not conform to the same standards as public debt; as a consequence, it can be tailored to the particular situation. C) In 1990, the U.S. Securities and Exchange Commission (SEC) issued Rule 144A, which significantly decreased the liquidity of certain privately placed debt. D) Because a private placement does not need to be registered, it is less costly to issue.

Answer: C Explanation: C) In 1990, the U.S. Securities and Exchange Commission (SEC) issued Rule 144A, which significantly increased the liquidity of certain privately placed debt.

Which of the following statements is FALSE? A) The registered bond system also facilitates tax collection because the government can easily keep track of all interest payments made. B) Asset backed bonds and mortgage bonds are secured debt: Specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy. C) Notes typically have longer maturities (more than ten years) than debentures. D) Although the word "bond" is commonly used to mean any kind of debt security, technically a corporate bond must be secured.

Answer: C Explanation: C) Notes typically have shorter maturities (less than ten years) than debentures.

Rearden Metal has just issued a callable, $1000 par value, twenty-year, 8% coupon bond with semiannual coupon payments. The bond can be called at par in five years or anytime thereafter on a coupon payment date. If the bond is currently trading for $1040.79, then its yield to maturity is closest to: A) 3.8% B) 7.0% C) 7.6% D) 8.0%

Answer: C Explanation: C) PV = -1040.79, PMT = 80/2 = 40, FV = 1000, N = 20 × 2 = 40, compute i = 3.800007 × 2 = 7.6%

Galt Industries has just issued a callable, $1000 par value, five-year, 6% coupon bond with semiannual coupon payments. The bond can be called at par in three years or anytime thereafter on a coupon payment date. If the bond is currently trading for $978.94, then its yield to maturity is closest to: A) 3.4% B) 6.0% C) 6.5% D) 6.8%

Answer: C Explanation: C) PV = -978.94, PMT = 60/2 = 30, FV = 1000, N = 5 × 2 = 10, compute i = 3.250048 × 2 = 6.5%

Which of the following statements is FALSE? A) With registered bonds, on each coupon payment date, the bond issuer consults its list of registered owners and mails each owner a check (or directly deposits the coupon payment into the owner's brokerage account). B) If a coupon bond is issued at a discount, it is called an original issue discount bond. C) The face value or principal amount of the bond is denominated in standard increments, most often $10,000. D) In a public offering, the indenture lays out the terms of the bond issue.

Answer: C Explanation: C) The face value or principal amount of the bond is denominated in standard increments, most often $1,000.

Bonds issued by a foreign company in a local market, intended for local investors, and denominated in the local currency are known as: A) domestic bonds. B) Yankee bonds. C) Eurobonds. D) foreign bonds.

Answer: D

Mortgages that do not meet certain credit criteria and have a high probability of default are know as ________ mortgages. A) prepayment B) pooled C) under-water D) subprime

Answer: D

Treasury securities that are pure discount bonds with original maturities ranging from a few days to 26 weeks are called: A) TIPS. B) Treasury bonds. C) Treasury notes. D) Treasury bills.

Answer: D

Which of the following does NOT issue asset-backed securities? A) Government National Mortgage Association B) Federal National Mortgage Association C) Student Loan Marketing Association D) Federal Reserve

Answer: D

Which of the following statements is FALSE? A) Global bonds combine the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously. B) In a leveraged buyout (LBO), a group of private investors purchases all the equity of a public corporation. C) A term loan is a bank loan that lasts for a specific term. D) Eurobonds are international bonds that are denominated in the local European currency of the country in which they are issued.

Answer: D Explanation: D) Eurobonds are international bonds that are not denominated in the local currency of the country in which they are issued.

Which of the following statements is FALSE? A) In the event of default, the assets not pledged as collateral for outstanding bonds cannot be used to pay off the holders of subordinated debentures until all more senior debt has been paid off. B) Because more than one debenture might be outstanding, the bondholder's priority in claiming assets in the event of default, known as the bond's seniority, is important. C) When a firm conducts a subsequent debenture issue that has lower priority than its outstanding debt, the new debt is known as a subordinated debenture. D) Most debenture issues contain clauses restricting the company from issuing new debt with equal or lower priority than existing debt.

Answer: D Explanation: D) Most debenture issues contain clauses restricting the company from issuing new debt with equal or higher priority than existing debt.

Galt Industries has just issued a callable, $1000 par value, five-year, 6% coupon bond with semiannual coupon payments. The bond can be called at par in three years or anytime thereafter on a coupon payment date. If the bond is currently trading for $978.94, then its yield to call is closest to: A) 3.4% B) 6.0% C) 6.5% D) 6.8%

Answer: D Explanation: D) PV = -978.94, PMT = 60/2 = 30, FV = 1000, N = 3 × 2 = 6, compute i = 3.393852 × 2 = 6.7877%

In January 2010, the U.S. Treasury issued a $1000 par, ten-year, inflation-indexed note with a coupon of 4%. On the date of issue, the consumer price index (CPI) was 200. By January 2020, the CPI had increased to 300. The principal payment that was made in January 2020 is closest to: A) $1000 B) $1020 C) $1030 D) $1500

Answer: D Explanation: D) The CPI appreciated by 300/200 = 1.50. Consequently the principal amount of the bond increases by this amount so the new principal = $1000 × 1.5 = $1500

Which of the following statements regarding the private debt market is FALSE? A) Private debt has the advantage that it avoids the cost of registration. B) Bank loans are an example of private debt, debt that is not publicly traded. C) Private debt has the disadvantage of being illiquid. D) The public debt market is larger than the private debt market.

Answer: D Explanation: D) The private debt market is larger than the public debt market.

A firm has a debt-to-equity ratio of .5. Its cost of equity is 22%, and its cost of debt is 16%. If the corporate tax rate is .40, what would the cost of equity be if the debt-to-equity ratio were 0? A. 14.00% B. 20.61% C. 21.07% D. 22.00% E. None of these.

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If the corporate tax rate is 25%, what would the cost of equity be if the debt-to-equity ratio were 0? A. 11.11% B. 12.57% C. 13.33% D. 16.00% E. None of these.

A firm should select the capital structure which: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. has no debt.

A general rule for managers to follow is to set the firm's capital structure such that: A. the firm's value is minimized. B. the firm's value is maximized. C. the firm's bondholders are made well off. D. the firms suppliers of raw materials are satisfied. E. the firms dividend payout is maximized.

A levered firm is a company that has: A. Accounts Payable as the only liability on the balance sheet. B. some debt in the capital structure. C. all equity in the capital structure. D. All of these. E. None of these.

Alexandria's Dance Studio is currently an all equity firm that has 60,000 shares of stock outstanding with a market price of $24 a share. The current cost of equity is 11% and the tax rate is 40%. Alexandria is considering adding $2 million of debt with a coupon rate of 7% to her capital structure. The debt will be sold at par value. What is the levered value of the equity? A. $.12 million B. $.24 million C. $1.12 million D. $2.24 million E. $2.84 million

Aspen's Distributors has a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt? A. 7.92% B. 8.10% C. 8.16% D. 8.84% E. 9.00%

Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on the assets is 11%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes? A. .60 B. .64 C. .72 D. .75 E. .80

Flotation costs are incorporated into the APV framework by: A. adding them into the all equity value of the project. B. subtracting them from the all equity value of the project. C. incorporating them into the WACC. D. disregarding them. E. None of these.

Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to her capital structure. The debt will be sold at par value. What is the levered value of the equity? A. $2.4 million B. $2.7 million C. $3.3 million D. $3.7 million E. $3.9 million

If a project's debt level is known over the life of the project, one should use A. WACC. B. APV. C. FTE. D. IRR. E. None of these.

In an EPS-EBI graphical relationship, the debt ray and equity ray cross. At this point the equity and debt are: A. equivalent with respect to EPS but above and below this point equity is always superior. B. at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point. C. equal but away from breakeven equity is better as fewer shares are outstanding. D. at breakeven and MM Proposition II states that debt is the better choice. E. at breakeven and debt is the better choice below breakeven because small payments can be made

In calculating the NPV using the flow-to-equity approach the discount rate is the: A. all equity cost of capital. B. cost of equity for the levered firm. C. all equity cost of capital minus the weighted average cost of debt. D. weighted average cost of capital. E. all equity cost of capital plus the weighted average cost of debt.

Longmont Inc. has a cost of equity of 12% and a pre-tax cost of debt of 6%. The required return on the assets is 10%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes? A. .45 B. .50 C. .55 D. .60 E. .65

Rosita's has a cost of equity of 13.8% and a pre-tax cost of debt of 8.5%. The debt-equity ratio is .60 and the tax rate is .34. What is Rosita's unlevered cost of capital? A. 8.83% B. 12.30% C. 13.97% D. 14.08% E. 14.60%

The APV method is comprised of the all equity NPV of a project and the NPV of financing effects. The four side effects are: A. tax subsidy of dividends, cost of issuing new securities, subsidy of financial distress and cost of debt financing. B. cost of issuing new securities, cost of financial distress, tax subsidy of debt and other subsidies to debt financing. C. cost of issuing new securities, cost of financial distress, tax subsidy of dividends and cost of debt financing. D. subsidy of financial distress, tax subsidy of debt, cost of other debt financing and cost of issuing new securities. E. None of these.

The WACC approach to valuation is not as useful as the APV approach in leveraged buyouts because: A. there is greater risk with a LBO. B. the capital structure is changing. C. there is no tax shield with the WACC. D. the value of the levered and unlevered firms are equal. E. the unlevered and levered cash flows are separated which cannot be used with the WACC approach.

The Winter Wear Company has expected earnings before interest and taxes of $2,100, an unlevered cost of capital of 14% and a tax rate of 34%. The company also has $2,800 of debt that carries a 7% coupon. The debt is selling at par value. What is the value of this firm? A. $9,900 B. $10,852 C. $11,748 D. $12,054 E. $12,700

The change in firm value in the presence of corporate taxes only is: A. positive as equityholders face a lower effective tax rate. B. positive as equityholders gain the tax shield on the debt interest. C. negative because of the increased risk of default and fewer shares outstanding. D. negative because of a reduction of equity outstanding. E. None of these.

The increase in risk to equityholders when financial leverage is introduced is evidenced by: A. higher EPS as EBIT increases. B. a higher variability of EPS with debt than all equity. C. increased use of homemade leverage. D. equivalence value between levered and unlevered firms in the presence of taxes. E. None of these.

The proposition that the value of the firm is independent of its capital structure is called: A. the capital asset pricing model. B. MM Proposition I. C. MM Proposition II. D. the law of one price. E. the efficient markets hypothesis.

The unlevered cost of capital is: A. the cost of capital for a firm with no equity in its capital structure. B. the cost of capital for a firm with no debt in its capital structure. C. the interest tax shield times pretax net income. D. the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure. E. equal to the profit margin for a firm with some debt in its capital structure.

The value of a corporation in a levered buyout is composed of which following four parts: A.unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value, and asset sales. B unlevered cash flows and interest tax shields during the debt paydown period, unlevered terminal value . and interest tax shields after the paydown period. C levered cash flows and interest tax shields during the debt paydown period, levered terminal value and . interesttaxshieldsafterthepaydownperiod. D levered cash flows and interest tax shields during the debt paydown period, unlevered terminal value . andinteresttaxshieldsafterthepaydownperiod. E. asset sales, unlevered cash flows during the paydown period, interest tax shields and unlevered terminal value.

To calculate the adjusted present value, one will: A. multiply the additional effects by the all equity project value. B. add the additional effects of financing to the all equity project value. C. divide the project's cash flow by the risk-free rate. D. divide the project's cash flow by the risk-adjusted rate. E. add the risk-free rate to the market portfolio when B equals 1.

The proposition that the value of the firm is independent of its capital structure is called: A. the capital asset pricing model. B. MM Proposition I (no taxes). C. MM Proposition II (no taxes). D. the law of one price. E. the efficient markets hypothesis.

B. MM Proposition I (no taxes).

15. The increase in risk to shareholders when financial leverage is introduced is best evidenced by: A. higher EPS as EBIT increases. B. a higher variability of EPS with debt than with all-equity financing. C. increased use of homemade leverage. D. the increase in taxes. E. decreasing earnings as EBIT increases.

B. a higher variability of EPS with debt than with all-equity financing.

MM Proposition I with taxes states that: A. capital structure does not affect firm value. B. increasing the debt-equity ratio increases firm value. C. firm value is maximized when the firm is all-equity financed. D. the cost of equity rises as the debt-equity ratio increases. E. the unlevered cost of equity is equal to RWacc.

B. increasing the debt-equity ratio increases firm value.

A firm should select the capital structure which: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. has no debt.

B. maximizes the value of the firm.

According to MM Proposition II with no taxes, the: A. return on assets is determined by financial risk. B. required return on equity is a linear function of the firm's debt-equity ratio. C. cost of equity in inversely related to the firm's debt-equity ratio. D. cost of debt must equal the cost of equity. E. required return on assets exceeds the weighted average cost of capital.

B. required return on equity is a linear function of the firm's debt-equity ratio.

A levered firm is a company that has: A. accounts payable as its only liability. B. some debt in its capital structure. C. an all-equity capital structure. D. a tax loss carry forward. E. taxable income.

B. some debt in its capital structure.

The unlevered cost of capital is: A. the cost of capital for a firm with no equity in its capital structure. B. the cost of capital for a firm with no debt in its capital structure. C. the interest tax shield times pretax net income. D. the cost of preferred stock for an all-equity firm. E. equal to the profit margin for a firm with some debt in its capital structure.

B. the cost of capital for a firm with no debt in its capital structure.

A general rule for managers to follow is to set the firm's capital structure such that the firm's: A. size is maximized. B. value is maximized C. bondholders are secured. D. suppliers of raw materials are satisfied. E. dividend payout is maximized.

B. value is maximized

For accounting purposes, which one of the following conditions would automatically cause a lease to be classified as a capital lease? A. The lessee can purchase the asset at fair market value at the end of the lease. B. The lease transfers ownership of the asset to the lessee by the end of the lease term. C. The lease term equals 60 percent of the asset's estimated economic life. D. The present value of the lease payments equals 76 percent of the asset's fair market value at lease inception. E. The lessor can renew the lease at the end of the lease term.

B. The lease transfers ownership of the asset to the lessee by the end of the lease term.

A lease with which one of these characteristics would not be qualified by the IRS? A. term of 25 years B. early balloon payments C. lessee option to purchase asset at fair market value at lease expiration D. no lease provision limiting the lessee' right to issue additional debt E. lessee granted first option to meet a competing outside renewal offer

B. early balloon payments

Assume the net present value of a lease relative to a purchase is $150. This indicates that the: A. purchase price is less than the reduction in optimal debt level if leasing. B. lease is preferred. C. optimal lease payment is $150 per period. D. net advantage of leasing is negative. E. lease provides an advantage only to the lessor.

B. lease is preferred.

When computing the incremental cash flows from leasing relative to purchasing, the: A. cost of the asset is a negative cash flow. B. lost depreciation tax benefit is a negative cash flow. C. pretax lease payment is a positive cash flow. D. lease payments are ignored. E. tax benefit of the lease payment is a negative cash flow.

B. lost depreciation tax benefit is a negative cash flow.

To meet IRS guidelines for leasing, the lease should: A. limit the lessee's right to issue debt or pay dividends while the lease is operative. B. offer renewal options only at fair market value. C. pay a very low rate of return to the lessor. D. transfer ownership of the asset at the end of the lease at below fair market value. E. have a term of 30 years or more.

B. offer renewal options only at fair market value.

When a lease must be recorded on the balance to meet FAS 13, the asset amount is set equal to the: A. amount of the lease payments due within the next 12 months. B. present value of the lease payments. C. amount of the lease payments due within the current fiscal year. D. present value of the lease payments due within the next 12 months. E. total sum of all of the remaining lease payments.

B. present value of the lease payments.

A firm has a debt-to-equity ratio of .60. Its cost of debt is 8%. Its overall cost of capital is 12%. What is its cost of equity if there are no taxes or other imperfections? A. 10.0% B. 13.5% C. 14.4% D. 18.0% E. None of these.

A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If there are no taxes or other imperfections, what would be its cost of equity if the debt-to-equity ratio were 0? A. 8% B. 10% C. 12% D. 14% E. 16%

A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 14%. Its cost of debt is 10%. What is its cost of equity if the corporate tax rate is 50%? A. 14.0% B. 16.0% C. 17.5% D. 21.0% E. None of these.

The acronym APV stands for: A. applied present value. B. all-purpose variable. C. accepted project verified. D. adjusted present value. E. applied projected value.

A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are no taxes or other imperfections, its cost of equity capital with the new capital structure would be _____. A. 9% B. 10% C. 13% D. 14% E. None of these.

A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is considering a new capital structure with 40% debt. The interest rate on the debt would be 4%. Assuming that the corporate tax rate is 34%, what would the cost of equity capital with the new capital structure be? A. 10.3% B. 11.0% C. 11.2% D. 13.9% E. None of these.

A firm is valued at $8 million and has debt of $2 million outstanding. The firm has an equity beta of 1.5 and a debt beta of .60. The beta of the overall firm is: A. 0.600. B. 1.155. C. 1.275. D. 1.500. E. None of these.

A key assumption of MM's Proposition I without taxes is: A. that financial leverage increases risk. B. that individuals can borrow on their own account at rates less than the firm. C. that individuals must be able to borrow on their own account at rates equal to the firm. D. managers are acting to maximize the value of the firm. E. All of these.

Alabaster Incorporated has a beta of 1.05, a cost of debt of 8% and a debt to value ratio of .7. The current risk free rate is 3% and the market rate of return is 12.5%. What is the company's cost of equity capital? A. 8.13% B. 10.25% C. 12.97% D. 13.13% E. 16.13%

Alabaster Incorporated has an equity cost of capital of 14%. The debt to value ratio is .6, the tax rate is 35%, and the cost of debt is 8%. What is the cost of equity if Alabaster was unlevered? A. 9.05% B. 10.55% C. 11.03% D. 12.55% E. None of these.

An unlevered firm has a cost of capital of 14% and earnings before interest and taxes of $150,000. A levered firm with the same operations and assets has both a book value and a face value of debt of $700,000 with a 7% annual coupon. The applicable tax rate is 35%. What is the value of the levered firm? A. $696,429 B. $907,679 C. $941,429 D. $1,184,929 E. $1,396,429

Brad's Boat Company, a company in the 40% tax bracket, has riskless debt in its capital structure which makes up 30% of the total capital structure, and equity is the other 70%. The beta of the assets for this business is .9 and the equity beta is: A. 0.54. B. 0.90. C. 1.13. D. 1.20. E. 1.49.

If the WACC is used in valuing a leveraged buyout, the: A. WACC remains constant because of the final target debt ratio desired. B. flotation costs must be added to the total UCF. C. WACC must be recalculated as the debt is repaid and the cost of capital changes. D. tax shields of debt are not available because the corporation is no longer publicly traded. E. None of these.

Joe's Leisure Time Sports is an unlevered firm with an after-tax net income of $86,000. The unlevered cost of capital is 10% and the tax rate is 34%. What is the value of this firm? A. $567,600 B. $781,818 C. $860,000 D. $946,000 E. $1,152,400

Juanita's Steak House has $12,000 of debt outstanding that is selling at par and has a coupon rate of 8%. The tax rate is 34%. What is the present value of the tax shield? A. $2,823 B. $2,887 C. $4,080 D. $4,500 E. $4,633

MM 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. it is completely irrelevant how a firm arranges its finances. 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. financial risk is determined by the debt-equity ratio.

MM Proposition II is the proposition that: A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm. 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 capital is a positive linear function of the firm's capital structure. D. the cost of equity is equivalent to the required return on the total assets of a firm. E. supports the argument that the size of the pie does not depend on how the pie is sliced.

Non-market or subsidized financing ________ the APV ___________. A. has no impact on; as the lower interest rate is offset by the lower discount rate B. decreases; by decreasing the NPV of the loan C. increases; by increasing the NPV of the loan D. has no impact on; as the tax deduction is not allowed with any government supported financing E. None of these

Reena Industries has $10,000 of debt outstanding that is selling at par and has a coupon rate of 7%. The tax rate is 34%. What is the present value of the tax shield? A. $2,800 B. $3,000 C. $3,400 D. $3,800 E. $7.000

The Felix Filter Corp. maintains a debt-equity ratio of .6. The cost of equity for Richardson Corp. is 16%, the cost of debt is 11% and the marginal tax rate is 30%. What is the weighted average cost of capital? A. 8.38% B. 11.02% C. 12.89% D. 13.00% E. 14.12%

The Montana Hills Co. has expected earnings before interest and taxes of $8,100, an unlevered cost of capital of 11%, and debt with both a book and face value of $12,000. The debt has an annual 8% coupon. The tax rate is 34%. What is the value of the firm? A. $48,600 B. $50,000 C. $52,680 D. $56,667 E. $60,600

The Spartan Co. has an unlevered cost of capital of 11%, a cost of debt of 8%, and a tax rate of 35%. What is the target debt-equity ratio if the targeted cost of equity is 12%? A. .44 B. .49 C. .51 D. .56 E. .62

The Telescoping Tube Company is planning to raise $2,500,000 in perpetual debt at 11% to finance part of their expansion. They have just received an offer from the Albanic County Board of Commissioners to raise the financing for them at 8% if they build in Albanic County. What is the total added value of debt financing to Telescoping Tube if their tax rate is 34% and Albanic raises it for them? A. $850,000 B. $1,200,000 C. $1,300,000 D. $1,650,000 E. There is no value to the scheme; Albanic is just conning Telescoping Tube into moving.

The Tip-Top Paving Co. has a beta of 1.11, a cost of debt of 11% and a debt to value ratio of .6. The current risk free rate is 9% and the market rate of return is 16.18%. What is the company's cost of equity capital? A. 7.97% B. 8.96% C. 16.97% D. 17.96% E. 26.96%

The Tip-Top Paving Co. has an equity cost of capital of 16.97%. The debt to value ratio is .6, the tax rate is 34%, and the cost of debt is 11%. What is the cost of equity if Tip-Top was unlevered? A. 0.08% B. 3.06% C. 14.0% D. 16.97% E. None of these.

The appropriate cost of debt to the firm is: A. the weighted cost of debt after tax. B. the levered equity rate. C. the market borrowing rate after tax. D. the coupon rate pre-tax. E. None of these.

The flow-to-equity (FTE) approach in capital budgeting is defined to be the: A. discounting all cash flows from a project at the overall cost of capital. B. scale enhancing discount process. C. discounting of the levered cash flows to the equity holders for a project at the required return on equity. D. dividends and capital gains that may flow to shareholders of any firm. E. discounting of the unlevered cash flows of a project from a levered firm at the WACC.

The flow-to-equity approach has been used by the firm to value their capital budgeting projects. The total investment cost at time 0 is $640,000. The company uses the flow-to-equity approach because they maintain a target debt to value ratio over project lives. The company has a debt to equity ratio of 0.5. The present value of the project including debt financing is $810,994. What is the relevant initial investment cost to use in determining the value of the project? A. $170,994 B. $267,628 C. $372,372 D. $543,366 E. $640,000

The flow-to-equity approach to capital budgeting is a three step process of: A calculating the levered cash flow, the cost of equity capital for a levered firm, then adding the interest . expensewhenthecashflowsarediscounted. B.calculating the unlevered cash flow, the cost of equity capital for a levered firm, and then discounting the unlevered cash flows. Ccalculating the levered cash flow after interest expense and taxes, the cost of equity capital for a levered . firm, and then discounting the levered cash flows by the cost of equity capital. Dcalculating the levered cash flow after interest expense and taxes, the cost of equity capital for a levered . firm, and then discounting the levered cash flows at the risk free rate. E. None of these.

The interest tax shield has no value for a firm when: I. the tax rate is equal to zero. II. the debt-equity ratio is exactly equal to 1. III. the firm is unlevered. IV. a firm elects 100% equity as its capital structure. 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

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.

The proposition that the cost of equity is a positive linear function of capital structure is called: A. the capital asset pricing model. B. MM Proposition I. C. MM Proposition II. D. the law of one price. E. the efficient markets hypothesis.

The weighted average cost of capital is determined by: A. multiplying the weighted average after tax cost of debt by the weighted average cost of equity. B. adding the weighted average before tax cost of debt to the weighted average cost of equity. C. adding the weighted average after tax cost of debt to the weighted average cost of equity. D. dividing the weighted average before tax cost of debt by the weighted average cost of equity. E. dividing the weighted average after tax cost of debt by the weighted average cost of equity.

Uptown Interior Designs is an all equity firm that has 40,000 shares of stock outstanding. The company has decided to borrow $1 million to buy out the shares of a deceased stockholder who holds 2,500 shares. What is the total value of this firm if you ignore taxes? A. $15.5 million B. $15.6 million C. $16.0 million D. $16.8 million E. $17.2 million

When comparing levered vs. unlevered capital structures, leverage works to increase EPS for high levels of EBIT because: A. interest payments on the debt vary with EBIT levels. B. interest payments on the debt stay fixed, leaving less income to be distributed over less shares. C. interest payments on the debt stay fixed, leaving more income to be distributed over less shares. D. interest payments on the debt stay fixed, leaving less income to be distributed over more shares. E. interest payments on the debt stay fixed, leaving more income to be distributed over more shares.

Which of the following statements are correct in relation to MM Proposition II with no taxes? I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt-equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises. A. I and III only B. II and IV only C. I and II only D. III and IV only E. I and IV only

Wild Flowers Express has a debt-equity ratio of .60. The pre-tax cost of debt is 9% while the unlevered cost of capital is 14%. What is the cost of equity if the tax rate is 34%? A. 7.52% B. 8.78% C. 15.98% D. 16.83% E. 17.30%

n an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because: A. more shares are outstanding for the same level of EBI. B. the break-even point is higher with debt. C. a fixed interest charge must be paid even at low earnings. D. the amount of interest per share has only a positive effect on the intercept. E. the higher the interest rate the greater the slope.

The proposition that the cost of equity is a positive linear function of capital structure is called: A. the capital asset pricing model. B. MM Proposition I (no taxes). C. MM Proposition II (no taxes). D. the law of one price. E. the efficient markets hypothesis.

C. MM Proposition II (no taxes).

MM Proposition II is the proposition that: A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm. B. the cost of levered equity depends solely on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity capital is a positive linear function of the firm's capital structure. D. the cost of equity is equivalent to the required return on the total assets of a levered firm. E. supports the argument that the size of the pie does not depend on how the pie is sliced.

C. a firm's cost of equity capital is a positive linear function of the firm's capital structure.

13. In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray has a lower intercept because: A. more shares are outstanding for the same level of EBI. B. the break-even point is higher with debt. C. a fixed interest charge must be paid even at low earnings. D. the amount of interest per share has only a positive effect on the intercept. E. the break-even point is lower with debt.

C. a fixed interest charge must be paid even at low earnings.

A key underlying assumption of MM Proposition I without taxes is that: A. financial leverage increases risk. B. individuals can borrow at lower rates than corporations. C. individuals and corporations borrow at the same rate. D. managers always act to maximize the value of the firm. E. corporations are all-equity financed.

C. individuals and corporations borrow at the same rate.

MM 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. it is completely irrelevant how a firm arranges its finances. 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. financial risk is determined by the debt-equity ratio.

C. it is completely irrelevant how a firm arranges its finances.

Lyme Home has 3,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 8%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 30%? A. $52,000 B. $60,000 C. $62,500 D. $68,000 E. $72,000

MM Proposition I without taxes proposes that: A. the value of an unlevered firm exceeds that of a levered firm. B. there is one ideal capital structure for each firm. C. leverage does not affect the value of the firm. D. shareholder wealth is directly affected by the capital structure selected. E. the value of a levered firm exceeds that of an unlevered firm.

C. leverage does not affect the value of the firm.

When comparing levered versus unlevered capital structures, leverage works to increase EPS for high levels of EBIT because interest payments on the debt: A. vary with EBIT levels. B. stay fixed, leaving less income to be distributed over fewer shares. C. stay fixed, leaving more income to be distributed over fewer shares. D. stay fixed, leaving less income to be distributed over more shares. E. stay fixed, leaving more income to be distributed over more shares.

C. stay fixed, leaving more income to be distributed over fewer shares.

The interest tax shield has no value for a firm when: A. the firm's debt-equity ratio is exactly equal to 1. B. the firm's debt-equity ratio is exactly .5. C. the firm is unlevered. D. shareholders fully utilize homemade leverage. E. RWACC equals R0.

C. the firm is unlevered.

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

Reed Machinery just signed a capital lease agreement with a present value of $130,000. How would this lease first appear on Reed Machinery's balance sheet? A. Capital leases do not appear on the balance sheet. B. Assets under capital lease $260,000; Obligations under capital lease $260,000 C. Assets under capital lease $130,000; Obligations under capital lease $130,000 D. Assets under capital lease $260,000; Retained earnings committed to leases $260,000 E. Assets under capital lease $130,000; Retained earnings committed to leases $130,000

C. Assets under capital lease $130,000; Obligations under capital lease $130,000

The city of Plainview sold its maintenance facility in an all-cash transaction and used the proceeds to improve the city's financial position. The city then leased the building from the new owner on a non-cancellable basis. The city will be responsible for the maintenance and upkeep of the facility. These transactions illustrate: A. an operating lease. B. a leveraged lease. C. a sale and leaseback. D. a fully amortized lease. E. both an operating lease and a sale and leaseback.

C. a sale and leaseback.

Assume that both the lessor and the lessee have the same interest and tax rates and there are no transaction costs. Given this, the best lease agreement results in: A. a benefit for the lessor and a zero gain for the lessee. B. a benefit for the lessee and a zero gain for the lessor. C. an NPV of zero for both parties. D. a benefit for both parties. E. a loss for both parties.

C. an NPV of zero for both parties.

Which one of these can be ignored when valuing a purchase versus a lease? A. tax shield from depreciation B. investment outlay for the asset C. changes in operating costs related to the acquired asset D. lease payments E. taxes

C. changes in operating costs related to the acquired asset

One key reason why the IRS is concerned about the structure of lease contracts is because: A. firms that lease generally pay no taxes. B. leasing usually leads to bankruptcy. C. leases can be set up solely to avoid taxes. D. leasing leads to off-balance-sheet-financing. E. lease payments can never be deducted as a business expense.

C. leases can be set up solely to avoid taxes.

The appropriate discount rate that a lessee should use to value a financial lease is the: A. lessee's aftertax weighted average cost of capital. B. lessor's aftertax cost of borrowing. C. lessee's aftertax cost of secured borrowing. D. capitalization rate stated in the lease contract. E. current U.S. Treasury T-bill rate.

C. lessee's aftertax cost of secured borrowing.

In a direct lease arrangement, the owner of the asset is: A. either the lessee or the lessor. B. the lessee. C. the lessor. D. either the lessee or the manufacturer. E. the asset's manufacturer.

C. the lessor.

A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections? A. 10% B. 15% C. 18% D. 21% E. None of these.

A firm has debt of $5,000, equity of $16,000, a leveraged value of $8,900, a cost of debt of 8%, a cost of equity of 12%, and a tax rate of 34%. What is the firm's weighted average cost of capital? A. 7.29% B. 7.94% C. 8.87% D. 10.40% E. 11.05%

A firm is valued at $6 million and has debt of $2 million outstanding. The firm has an equity beta of 1.8 and a debt beta of .42. The beta of the overall firm is: A. 1.00. B. 1.11. C. 1.20. D. 1.34. E. It is impossible to determine with the information given.

Bryan invested in Bryco, Inc. stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to: A. borrow some money and purchase additional shares of Bryco stock. B. maintain his current position as the debt of the firm did not affect his personal leverage position. C. sell some shares of Bryco stock and hold the proceeds in cash. D.sell some shares of Bryco stock and loan it out such that he creates a personal debt-equity ratio equal to that of the firm. E. create a personal debt-equity ratio that is equal to exactly 50% of the debt-equity ratio of the firm.

Discounting the unlevered after tax cash flows by the _____ minus the ______ yields the ________. A. cost of capital for the unlevered firm; initial investment; adjusted present value B. cost of equity capital; initial investment; project NPV C. weighted cost of capital; fractional equity investment; project NPV D. cost of capital for the unlevered firm; initial investment; all-equity net present value E. None of these

Financial leverage impacts the performance of the firm by: A. maintaining the same level of volatility of the firm's EBIT. B. decreasing the volatility of the firm's EBIT. C. decreasing the volatility of the firm's net income. D. increasing the volatility of the firm's net income. E. None of these.

If a firm is unlevered and has a cost of equity capital of 12%, what would the cost of equity be if its debt- equity ratio became 2? The expected cost of debt is 8%. A. 14.0% B. 14.67% C. 16.0% D. 20.0% E. None of these.

In a leveraged buyout, the equity holders expect a successful buyout if: A. the firm generates enough cash to serve the debt in early years. B. the company can be taken public or sold in 3 to 7 years. C. the company is attractive to buyers as the buyout matures. D. All of these. E. None of these.

In a world of no corporate taxes if the use of leverage does not change the value of the levered firm relative to the unlevered firm is known as: A. MM Proposition III that the cost of stock is less than the cost of debt. B. MM Proposition I that leverage is invariant to market value. C. MM Proposition II that the cost of equity is always constant. D. MM Proposition I that the market value of the firm is invariant to the capital structure. E. MM Proposition III that there is no risk associated with leverage in a no tax world.

Jasmine's Boutique has 2,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 9%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 34%? A. $58,500 B. $60,100 C. $60,750 D. $61,200 E. $62,250

MM Proposition I with corporate taxes states that: A. capital structure can affect firm value. B. by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value. C. firm value is maximized at an all debt capital structure. D. All of these. E. None of these.

MM 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 the firm does not matter because investors can use homemade leverage. C. the firm is better off with debt based on the weighted average cost of capital. D. the value of the firm increases as total debt increases because of the interest tax shield. E. the cost of equity increases as the debt-equity ratio of a firm increases.

Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the firm's cost of equity? A. 13.25% B. 13.89% C. 13.92% D. 14.14% E. 14.25%

The BIM Corporation has decided to build a new facility for its R&D department. The cost of the facility is estimated to be $125 million. BIM wishes to finance this project using its traditional debt-equity ratio of 1.5. The issue cost of equity is 6% and the issue cost of debt is 1%. What is the total flotation cost? A. $0.75 million B. $1.29 million C. $3.19 million D. $3.75 million E. $8.75 million

The Backwoods Lumber Co. has a debt-equity ratio of .80. The firm's required return on assets is 12% and its cost of equity is 15.68%. What is the pre-tax cost of debt based on MM Proposition II with no taxes? A. 6.76% B. 7.00% C. 7.25% D. 7.40% E. 7.50%

The Delta Company has a capital structure of 30% risky debt with a β of 1.1 and 70% equity with a β of 1.4. Their current tax rate is 30%. What is the β for Delta Company? A. 0.95 B. 1.00 C. 1.10 D. 1.31 E. 1.40

The Free-Float Company, a company in the 36% tax bracket, has riskless debt in its capital structure which makes up 40% of the total capital structure, and equity is the other 60%. The beta of the assets for this business is .8 and the equity beta is: A. 0.53. B. 0.73. C. 0.80. D. 1.14. E. 1.47.

The TRIM Corporation has decided to build a new facility for its R&D department. The cost of the facility is estimated to be $150 million. TRIM wishes to finance this project using its traditional debt- equity ratio of 1.2. The issue cost of equity is 7% and the issue cost of debt is 2%. What is the total flotation cost? A. $3.00 million B. $5.59 million C. $6.75 million D. $6.41 million E. $10.5 million

The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11%, the tax rate is 34%, and the cost of equity for an all equity firm is 14%. What will be Tip-Top's cost of equity? A. 0.08% B. 3.06% C. 14.0% D. 16.97% E. None of these.

The acceptance of a capital budgeting project is usually evaluated on its own merits. That is, capital budgeting decisions are treated separately from capital structure decisions. In reality, these decisions may be highly interwoven. This may result in: A firms rejecting positive NPV, all equity projects because changing to a capital structure with debt will . always create negative NPV. B. never considering capital budgeting projects on their own merits. C corporate financial managers first checking with their investment bankers to determine the best type of . capitaltoraisebeforevaluingtheproject. Dfirms accepting some negative NPV all equity projects because changing the capital structure adds . enough positive leverage tax shield value to create a positive NPV. E.firms never changing the capital structure because all capital budgeting decisions will be subsumed by capital structure decisions.

The effect of financial leverage depends on the operating earnings of the company. Which of the following is not true? A. Below the indifference or break-even point in EBIT the non-levered structure is superior. B. Financial leverage increases the slope of the EPS line. C.Above the indifference or break-even point the increase in EPS for all equity structures is less than debt-equity structures. D.Above the indifference or break-even point the increase in EPS for all equity structures is greater than debt-equity structures. E. The rate of return on operating assets is unaffected by leverage.

The firm's capital structure refers to: A. the way a firm invests its assets. B. the amount of capital in the firm. C. the amount of dividends a firm pays. D. the mix of debt and equity used to finance the firm's assets. E. how much cash the firm holds.

The non-market rate financing impact on the APV is: A. calculated by Tc B because the tax shield depends only on the amount of financing. B. calculated by subtracting the all equity NPV from the FTE NPV. C. irrelevant because it is always less than the market financing rate. D. calculated by the NPV of the loan using both debt rates. E. None of these.

Using APV, the analysis can be tricky in examples of: A. tax subsidy to debt. B. interest subsidy. C. flotation costs. D. All of these. E. Both tax subsidy to debt; and flotation costs.

What are the three standard approaches to valuation under leverage? A. CAPM, SML, and CML B. APR, FTE, and CAPM C. APT, WACC, and CAPM D. APV, FTE, and WACC E. NPV, IRR, Payback

What is the cost of equity for a firm if the corporate tax rate is 40%? The firm has a debt-to-equity ratio of 1.5. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 10%. A. 17.4% B. 18.4% C. 19.6% D. 21.4% E. None of these.

Which of the following are guidelines for the three methods of capital budgeting with leverage? A. Use APV if project's level of debt is known over the life of the project. B. Use APV if project's level of debt is unknown over the life of the project. C. Use FTE or WACC if the firm's target debt-to-value ratio applies to the project over its life. DBoth use APV if project's level of debt is known over the life of the project; and use FTE or WACC if . the firm's target debt-to-value ratio applies to the project over its life. EBoth use APV if project's level of debt is unknown over the life of the project; and use FTE or WACC . if the firm's target debt-to-value ratio applies to the project over its life.

Which of the following will tend to diminish the benefit of the interest tax shield given a progressive tax rate structure? I. A reduction in tax rates II. A large tax loss carryforward III. A large depreciation tax deduction IV. A sizeable increase in taxable income A. I and II only B. I and III only C. II and III only D. I, II, and III only E. I, II, III, and IV

Your firm has a debt-equity ratio of .60. Your pre-tax cost of debt is 6.0% and your required return on assets is 12%. What is your cost of equity if you ignore taxes? A. 9.00% B. 12.00% C. 14.50% D. 15.60% E. 16.10%

Your firm has a debt-equity ratio of .75. Your pre-tax cost of debt is 8.5% and your required return on assets is 15%. What is your cost of equity if you ignore taxes? A. 11.25% B. 12.21% C. 16.67% D. 19.88% E. 21.38%

labaster Incorporated wants to be levered at a debt to value ratio of .6. The cost of debt is 9%, the tax rate is 35%, and the cost of equity for an all equity firm is 12%. What will be Alabaster's cost of equity? A. 2.93% B. 10.45% C. 12.0% D. 14.93% E. None of these.

The effects of financial leverage depend on the operating earnings of the company. Based on this relationship, assume you graph the EPS and EBI for a firm, while ignoring taxes. Which one of these statements correctly states a relationship illustrated by the graph? A. Financial leverage decreases the slope of the EPS line. B. Below the break-even point unlevered structures have a lower EPS for every dollar of EBI than levered structures do. C. Above the break-even point the increase in EPS for unlevered structures is greater than that of levered structures for every dollar increase in EBI. D. Leverage only provides value above the break-even point. E. Above the break-even point, the unlevered structure is preferred.

D. Leverage only provides value above the break-even point.

Which one of the following will tend to increase the benefit of the interest tax shield given a progressive tax rate structure? A. a reduction in tax rates B. a large tax loss carryforward C. a large depreciation tax deduction D. a sizeable increase in taxable income E. a catastrophic loss

D. a sizeable increase in taxable income

The firm's capital structure refers to the: A. mix of current and fixed assets a firm holds. B. amount of capital invested in the firm. C. amount of dividends a firm pays. D. mix of debt and equity used to finance the firm's assets. E. amount of cash versus receivables the firm holds.

D. mix of debt and equity used to finance the firm's assets.

Bryan invested in Bryco stock when the firm was financed solely with equity. The firm now has a debt-equity ratio of .3. To maintain the same level of leverage he originally had, Bryan needs to: A. borrow some money and purchase additional shares of Bryco stock. B. maintain his current position in Bryco stock. C. sell some shares of Bryco stock and hold the proceeds in cash. D. sell some shares of Bryco stock and loan out the proceeds. E. sell half of his Bryco stock and invest the proceeds in risk-free securities.

D. sell some shares of Bryco stock and loan out the proceeds.

D. the value of the firm increases as total debt increases because of the interest tax shield.

Fresh Fish has assets valued at $1.2 million and equity of $.98 million. The firm wants to obtain new equipment via a capital lease. The equipment costs $200,000 and the present value of the lease payments is $175,000. With the lease, firm's balance sheet will show assets of ____and liabilities of ____. A. $1,375,000; $1,375,000 B. $1,400,000; $1,180,000 C. $1,400,000; $1,400,000 D. $1,375,000; $1,155,000 E. $1,400,000; $1,155,000

D. $1,375,000; $1,155,000

Why must some debt be eliminated when a firm enters a lease agreement? A. Lessors require an increase in equity to offset the lease obligation which is accomplished by replacing other current debt with equity. B. Lessors require lessees to reduce their debt to demonstrate ability to make the lease payments. C. FASB 13 requires a debt offset equal to the present value of the lease payments. D. Leases are all debt which causes an imbalance in the firm's debt-to-equity ratio. E. FASB 13 requires lease payments be offset by an equal decrease in debt payments.

D. Leases are all debt which causes an imbalance in the firm's debt-to-equity ratio.

Which one of these statements is false? A. Lenders are concerned about a firm's total liabilities including lease obligations. B. Debt displacement occurs with leasing. C. Less future debt can be raised for a growing firm when leasing occurs. D. Leasing allows the lessee to increase the benefits of debt capacity. E. If a firm uses operating leases, then it should think in terms of the liability-to-equity ratio rather than the debt-to-equity ratio.

D. Leasing allows the lessee to increase the benefits of debt capacity.

Sizzler's is considering either purchasing or leasing an asset that costs $28,000, has a 6-year life, and a zero salvage value. The firm has a 35 percent tax rate and a borrowing rate of 7 percent. The firm can lease the asset for five years with lease payments of $4,500 payable the first of each year. This lease would be classified as a(n): A. operating lease because the asset life is less than 10 years. B. operating lease because there is no cost reduction. C. leveraged lease because it is being financed with debt. D. capital lease because the lease term is greater than 75 percent of the economic life. E. sale and leaseback arrangement because Sizzler's obtains full use of the asset.

D. capital lease because the lease term is greater than 75 percent of the economic life.

If a lease is for 35 years the IRS will classify the lease as a: A. financial lease. B. operating lease. C. capital lease. D. conditional sale. E. sale and leaseback arrangement.

D. conditional sale.

FAS 13 sets forth four criteria for determining whether or not a lease must be classified as a capital lease. How many of these criteria must be met for capital lease classification? A. all four B. three C. two D. only one E. depends on the limit set by the lessee

D. only one

An operating lease generally: A. has a term that exceeds the economic life of the leased asset. B. is fully amortized. C. cannot be cancelled. D. requires the lessee to return the leased asset to the lessor if the lease is cancelled. E. requires the lessee to maintain the leased asset.

D. requires the lessee to return the leased asset to the lessor if the lease is cancelled.

The lease payment that the lessee sets as its bound is known as the: A. present value of the tax shields. B. reservation payment, LMIN. C. present value of operating savings. D. reservation payment, LMAX. E. reservation payment, LOPTIMAL.

D. reservation payment, LMAX.

If Alby's leases equipment directly from the equipment's manufacturer the lease must be a: A. leveraged lease. B. sales and leaseback arrangement. C. capital lease. D. sales-type lease. E. bargain lease.

D. sales-type lease.

Which one of the following is probably the best reason for leasing instead of buying? A. increased ROA B. circumvent expenditure controls C. 100 percent financing D. tax reduction E. increased uncertainty

D. tax reduction

A key difference between the APV, WACC, and FTE approaches to valuation is: A. how the unlevered cash flows are calculated. B. how the ratio of equity to debt is determined. C. how the initial investment is treated. D. whether terminal values are included or not. E. how debt effects are considered; i.e. the target debt to value ratio and the level of debt.

Although the three capital budgeting methods are equivalent, they all can have difficulties making computation impossible at times. The most useful methods or tools from a practical standpoint are: A. APV because debt levels are unknown in future years. B. WACC because projects have constant risk and target debt to value ratios. C.Flow-to-equity, because of constant risk and the knowledge that managers think in terms of optimal debt to equity ratios. D Both APV because debt levels are unknown in future years; and W ACC because projects have constant . risk and target debt to value ratios. EBoth WACC because projects have constant risk and target debt to value ratios; and Flow-to-equity, . because of constant risk and the knowledge that managers think in terms of optimal debt to equity ratios.

An appropriate guideline to adopt when determining the valuation formula to use is: A. never use the APV approach. B. use APV if the project is far different from scale enhancing. C. use WACC if the project is close to being scale enhancing. D. Both never use the APV approach; and use WACC if the project is close to being scale enhancing. E.Both use APV if the project is far different from scale enhancing; and use WACC if the project is close to being scale enhancing.

Anderson's Furniture Outlet has an unlevered cost of capital of 10%, a tax rate of 34%, and expected earnings before interest and taxes of $1,600. The company has $3,000 in bonds outstanding that have an 8% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity? A. 8.67% B. 9.34% C. 9.72% D. 9.99% E. 10.46%

Boutelle Homes has 4,000 bonds outstanding with a face value of $1,000 each and a coupon rate of 7%. The interest is paid semi-annually. What is the amount of the annual interest tax shield if the tax rate is 40%? A. $58,000 B. $60,000 C. $72,000 D. $98,000 E. $112,000

MM Proposition I without taxes is used to illustrate: A. the value of an unlevered firm equals that of a levered firm. B. that one capital structure is as good as another. C. leverage does not affect the value of the firm. D. capital structure changes have no effect on stockholders' welfare. E. All of these.

The Delta Company has a capital structure of 20% risky debt with a β of .9 and 80% equity with a β of 1.7. Their current tax rate is 34%. What is the β for Delta Company? A. 0.59 B. 0.82 C. 1.06 D. 1.49 E. 1.54

The capital structure chosen by a firm doesn't really matter because of: A. taxes. B. the interest tax shield. C. the relationship between dividends and earnings per share. D. the effects of leverage on the cost of equity. E. homemade leverage.

The cost of capital for a firm, R-WACC, in a zero tax environment is: A. equal to the expected earnings divided by market value of the unlevered firm. B. equal to the rate of return for that business risk class. C. equal to the overall rate of return required on the levered firm. D. is constant regardless of the amount of leverage. E. All of these.

Which capital budgeting tools, if properly used, will yield the same answer? A. WACC, IRR, and APV B. NPV, IRR, and APV C. NPV, APV and Flow to Debt D. NPV, APV and WACC E. APV, WACC, and Flow to Equity

You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes? A. $4.8 million B. $5.1 million C. $5.4 million D. $5.7 million E. $6.0 million

You own 30% of Westcoast, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $2 million to purchase your 2,000 shares of stock. What is the total value of this firm today if you ignore taxes? A. $4.58 million B. $5.08 million C. $5.40 million D. $5.76 million E. $6.67 million

Your firm has a pre-tax cost of debt of 7% and an unlevered cost of capital of 13%. Your tax rate is 35% and your cost of equity is 15.26%. What is your debt-equity ratio? A. .43 B. .49 C. .51 D. .54 E. .58

In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of: A. taxes. B. the interest tax shield. C. the relationship between dividends and earnings per share. D. the effects of leverage on the cost of equity. E. homemade leverage.

E. homemade leverage.

FAS 13, Accounting for Leases requires: A. all leases, of any type, be recorded on the lessee's balance sheet. B. capital leases be recorded in the footnotes or scheduled section of the lessees' financial statements. C. sale and leaseback arrangements be recorded on the lessee's balance sheet with all other leases recorded elsewhere in the financial statements. D. operating leases be recorded on the lessee's balance sheet as an asset and offsetting liability. E. all leases with bargain purchase price options to be recorded on the lessee's balance sheet.

E. all leases with bargain purchase price options to be recorded on the lessee's balance sheet.

A financial lease has which one of the following characteristics? A. lessor maintains leased asset B. no right of renewal C. cancellation clause D. lessor must make all lease payments E. fully amortized

E. fully amortized

Operating leases: A. appear as offsetting items on the lessee's balance sheet. B. are fully expensed at the time the lease is established. C. are not included in the lessee's financial reports. D. are treated the same as a purchase. E. must be disclosed in the lessee's annual report.

E. must be disclosed in the lessee's annual report.

Which of these are offered as key considerations in the lease versus purchase decision according to the research findings of Smith and Wakeman? A. price discrimination opportunities and debt displacement options B. cash flows and sensitivity to use and maintenance decisions. C. attracting clients with low prices and debt displacement D. cash flows and debt displacement E. price discrimination opportunities and sensitivity to use and maintenance decisions

E. price discrimination opportunities and sensitivity to use and maintenance decisions

In which one of these cases is a lease most beneficial to both parties? A. when the lessor's tax rate is lower than the lessee's . b. when the lessor's tax rate is equal to the lessee's C. when the lessor's tax rate is higher than the lessee's D. never, because a lease cannot be beneficial to both parties E. since leases always have a zero NPV the best the parties can do is to break even

b. when the lessor's tax rate is equal to the lessee's

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