Q&A Hero

Q: Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its debt ratio on the horizontal axis. Then you plotted a similar curve for Firm V. The curve for firm U resembled a shallow "U," while that for Firm V resembled a sharp "V." Both firms have debt ratios that cause their WACCs to be minimized. Other things held constant, it would be easier for Firm V than for Firm U to maintain a steady dividend in the face of varying investment opportunities and earnings from year to year. a. True b. False

Q: Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock prices decline. Your firm's earnings, investment opportunities, and capital structure do not change. If the firm follows the residual dividend model, then its dividend payout ratio would increase. a. True b. False

Q: If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares. a. True b. False

Q: If a firm pays out all of its earnings as dividends and its stockholders then elect to have all of their dividends reinvested, the company should reconsider its dividend policy and possibly move to a lower dividend payout ratio. a. True b. False

Q: There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would have been paid as dividends to buy stock on the open market. Under the other type, the company issues new stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who choose to reinvest their dividends. a. True b. False

Q: One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest. a. True b. False

Q: If on January 3 a company declares a dividend of $1.50 per share, payable on January 31 to holders of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is the ex-dividend date. a. True b. False

Q: If on January 3 a company declares a dividend of $1.50 per share, payable on January 31 then the price of the stock should drop by approximately $1.50 on January 31. a. True b. False

Q: If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy. a. True b. False

Q: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm's debt ratio, the lower its payout ratio will be, other things held constant. a. True b. False

Q: If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm's investment opportunities, the lower its payout ratio will be, other things held constant. a. True b. False

Q: If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can have an important effect on its stock price and cost of equity. a. True b. False

Q: Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument. a. True b. False

Q: Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy. a. True b. False

Q: If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs. a. True b. False

Q: One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant. a. True b. False

Q: Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk. a. True b. False

Q: It has been argued that investors prefer high-payout companies because dividends are more certain (less risky) than the capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that this argument is incorrect, and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most dividends are reinvested in stocks, hence are exposed to the same risks as reinvested earnings. a. True b. False

Q: The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, if the tax rate on dividends is high relative to that on capital gains, then individuals with low taxable incomes should favor stocks with low payouts and high-income individuals should favor high-payout companies. a. True b. False

Q: The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in dividend payout ratios. a. True b. False

Q: The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock, other things held constant. a. True b. False

Q: A "reverse split" reduces the number of shares outstanding. a. True b. False

Q: A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's stock price. a. True b. False

Q: If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio. a. True b. False

Q: Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on its cost of capital, but it does affect its stock price. a. True b. False

Q: Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on either its cost of capital or its stock price. a. True b. False

Q: Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be. a. True b. False

Q: The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price. a. True b. False

Q: Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital. a. True b. False

Q: Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. a. True b. False

Q: Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory. a. True b. False

Q: Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt. a. True b. False

Q: The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing. a. True b. False

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

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

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

Q: If a firm borrows money, it is using financial leverage. a. True b. False

Q: A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes. a. True b. False

Q: Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt. a. True b. False

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

Q: You were hired as the CFO of a new company that was founded by three professors at your university. The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch. The issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per phone will be $250.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other data, are shown below. How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU? 0% Debt, U 60% Debt, L Expected unit sales (Q) 33,500 33,500 Price per phone (P) $250.00 $250.00 Fixed costs (F) $1,000,000 $1,000,000 Variable cost/unit (V) $200.00 $200.00 Required investment $2,500,000 $2,500,000 % Debt 0.00% 60.00% Debt, $ $0 $1,500,000 Equity, $ $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 25.00% 25.00% u200b a. 14.92% b. 19.13% c. 17.40% d. 21.04% e. 20.85%

Q: Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per share (DPS), and its tax rate is 25%. The company is considering issuing $3,000,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 1.05. However, the CFO believes the beta would rise to 1.25 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.) a. $34.47 b. $31.92 c. $33.20 d. $35.43 e. $26.81

Q: Dyson Inc. currently finances with 20.0% debt (i.e., wd = 20%), but its new CFO is considering changing the capital structure so wd = 62.5% by issuing additional bonds and using the proceeds to repurchase and retire common shares so the percentage of common equity in the capital structure (wc) = 1 wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity? Do not round your intermediate calculations. (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.) Risk-free rate, rRF5.00% Tax rate, T 25% Market risk prem, RPM6.00% Current wd20% Current beta, bL11.60 Target wd62.5% u200b a. 9.18% b. 10.93% c. 11.39% d. 11.48% e. 9.64%

Q: Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 61.0% debt (wd) by issuing bonds and using the proceeds to repurchase and retire some common shares so the percentage of common equity in the capital structure (wc) = 1 wd. Given the data shown below, by how much would this recapitalization change the firm's cost of equity, i.e., what is rL - rU? Do not round your intermediate calculations. Risk-free rate, rRF5.50% Tax rate, T 25% Market risk prem, RPM3.00% Current wd0% Current beta, bU1.75 Target wd61.0% u200b a. 4.31% b. 5.23% c. 7.08% d. 6.77% e. 6.16%

Q: Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $12.00, fixed costs for this operation are $300,000, and annual sales are 110,000 packs. The unit variable cost consists of a $3.00 royalty payment, VR , per pack to professors plus other variable costs of VO = $9.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant? Do not round your intermediate calculations. a. $1.77 b. $1.74 c. $1.72 d. $1.83 e. $2.22

Q: Your girlfriend plans to start a new company to make a new type of cat litter. Her father will finance the operation, but she will have to pay him back. You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity. The price per unit will be $10.00 regardless of how the firm is financed. The expected fixed and variable operating costs, along with other information, are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU? Do not round your intermediate calculations. 0% Debt, U 60% Debt, L Expected unit sales 275,000 275,000 Price per unit $10.00 $10.00 Fixed costs $1,000,000 $1,000,000 Variable cost/unit $3.50 $3.50 Required investment $2,500,000 $2,500,000 Shares issued at $10/share 250,000 100,000 % Debt 0.00% 60.00% Debt, $ $0 $1,500,000 Equity, $ $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 25.00% 25.00% u200b a. $2.42 b. $2.78 c. $1.94 d. $2.18 e. $2.06

Q: You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Both companies are small, so they are not subject to the interest deduction limitation. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROEHigher - ROELower? Do not round your intermediate calculations. Operating Data Other Data Capital $4,000 Higher wd60% ROIC = EBIT(1 T)/Capital 13.00% Higher interest rate 13% Tax rate 25% Lower wd10% Lower interest rate 9% u200b a. 3.72% b. 4.18% c. 4.77% d. 3.93% e. 4.68%

Q: Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (wc) = 1 wd. Other things held constant, and based on the data below, if the firm increases the percentage of debt in its capital structure (wd) to 60.0%, by how much would the ROE change, i.e., what is ROENew - ROEOld? Do not round your intermediate calculations. Operating Data Other Data Capital $150,000 Old wd5% ROIC = EBIT (1 T)/Capital 30.00% Old interest rate 10% Tax rate 25% New wd60% New interest rate 12% u200b a. 31.23% b. 26.98% c. 30.32% d. 34.56% e. 26.07%

Q: Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Both companies are small, so they are not subject to the interest deduction limitation. Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA? Do not round your intermediate calculations. Applicable to Both Firms Firm A's Data Firm NA's Data Capital $155,000 wd50% wd0% EBIT $40,000 Int. rate 12% Int. rate 10% Tax rate 25% u200b a. 10.25% b. 12.01% c. 10.35% d. 12.12% e. 12.84%

Q: Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Both companies are small, so they are not subject to the interest deduction limitation. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD? Do not round your intermediate calculations. Applicable to Both Firms Firm HD's Data Firm LD's Data Capital $3,000,000 wd70% wd20% EBIT $470,000 Int. rate 12% Int. rate 10% Tax rate 25% u200b a. 5.62% b. 4.02% c. 6.69% d. 5.35% e. 5.09%

Q: You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate. Both companies are small, so they are not subject to the interest deduction limitation. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh EPSLow? Do not round your intermediate calculations. Applicable to Both Firms Firm High's Data Firm Low's Data Capital $3,000,000 wd70% wd20% EBIT $505,000 Shares 90,000 Shares 240,000 Tax rate 25% Int. rate 12% Int. rate 10% u200b a. $0.90 b. $0.57 c. $0.54 d. $0.75 e. $0.72

Q: As a consultant to First Responder Inc., you have obtained the following data (dollars in millions). The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 8.0%. What would the firm's total market value be if it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed, and then divide by (WACC - g). Do not round your intermediate calculations. Oper. income (EBIT) $800 Tax rate 25.0% New cost of equity (rs) 12.00% New wd20.0% Interest rate (rd) 8.00% u200b a. $4,444 b. $4,400 c. $5,111 d. $3,733 e. $4,667

Q: Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? Do not round your intermediate calculations. wd80% Orig cost of equity, rs10.0% wc20% New cost of equity = rs11.0% Interest rate new = rd8.0% Tax rate 25% u200b a. 3.33% b. 3.00% c. 2.55% d. 3.63% e. 2.40%

Q: El Capitan Foods has a capital structure of 45% debt and 55% equity, its tax rate is 25%, and its beta (leveraged) is 1.20. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU? a. 0.74 b. 0.58 c. 0.86 d. 0.77 e. 0.95

Q: A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $600,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the break-even formula, but include the required profit in the numerator.) a. 3,300 b. 4,400 c. 3,696 d. 5,412 e. 5,104

Q: Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,500 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)? a. 17,100 b. 15,300 c. 15,000 d. 12,750 e. 13,500

Q: Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE? Capital $150,000 Interest rate 8% Debt/Capital, book value 65% Tax rate 25% EBIT $25,000 u200b a. 18.67% b. 23.83% c. 21.62% d. 24.57% e. 21.13%

Q: You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $620,000. Other data for the firm are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU? 0% Debt, U 60% Debt, L Oper. income (EBIT) $620,000 $620,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Shares issued, $10/share 250,000 100,000 Interest rate NA 10.00% Tax rate 25% 25% u200b a. $1.50 b. $2.08 c. $1.91 d. $1.67 e. $1.58

Q: You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $180,000. The company is small, so it is not subject to the interest deduction limitation. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? Do not round your intermediate calculations. 0% Debt, U 60% Debt, L Oper. income (EBIT) $180,000 $180,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 25% 25% u200b a. 3.78% b. 3.15% c. 2.84% d. 4.10% e. 3.31%

Q: Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $250.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 33,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.) Machine A Machine B Price per phone (P) $250.00 $250.00 Fixed costs (F) $1,000,000 $2,000,000 Variable cost/unit (V) $200.00 $150.00 Expected unit sales (Q) 33,000 33,000 Required equity investment $2,500,000 $3,000,000 u200b a. 20.97% b. 15.77% c. 19.76% d. 16.29% e. 17.33%

Q: Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $23.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 40,000 units, how much higher or lower will the firm's expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with low fixed costs, i.e., what is EBITB - EBITA ? Machine A Machine B Price per mouse (P) $23.00 $23.00 Fixed costs (F) $100,000 $400,000 Variable cost/unit (V) $16.00 $8.00 Exp. unit sales (Q) 40,000 40,000 u200b a. $17,600 b. $18,400 c. $18,600 d. $18,000 e. $20,000

Q: Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $25.50 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the break-even points for Machines A and B? Do not round your intermediate calculations. (Hint: Find BEB - BEA) Machine A Machine B Price per pair (P) $25.50 $25.50 Fixed costs (F) $25,000 $100,000 Variable cost/unit (V) $7.00 $4.00 u200b a. 3,762 b. 3,135 c. 2,640 d. 3,564 e. 3,300

Q: Southwest U's campus book store sells course packs for $14 each. The variable cost per pack is $12, and at current annual sales of 49,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs? a. $25,300 b. $18,860 c. $27,140 d. $23,000 e. $27,600

Q: Southwest U's campus book store sells course packs for $16 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 63,000 packs. What are the pre-tax profits from sales of course packs? a. $281,970 b. $241,000 c. $216,900 d. $204,850 e. $219,310

Q: Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price would be set at 1.50 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,120,000. What sales volume would be required to break even, i.e., to have EBIT = zero? a. 32,853 b. 28,075 c. 28,373 d. 33,152 e. 29,867

Q: Longstreet Inc. has fixed operating costs of $670,000, variable costs of $2.75 per unit produced, and its product sells for $3.95 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs? a. 558,333 b. 491,333 c. 686,750 d. 653,250 e. 446,667

Q: Which of the following statements is CORRECT? a. Generally, debt ratios do not vary much among different industries, although they do vary among firms within a given industry. b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. c. Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to-equity ratios. d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. e. Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms' weighted average costs of capital.

Q: Which of the following statements is CORRECT? a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase. b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios. d. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.

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

Q: Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors capital (ROIC) exceed their after-tax costs of debt, rd(1 T). Which of the following statements is CORRECT? a. HD should have a higher return on assets (ROA) than LD. b. HD should have a higher times interest earned (TIE) ratio than LD. c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. d. Given that ROIC > rd(1 T), HD's stock price must exceed that of LD. e. Given that ROIC > rd(1 T), LD's stock price must exceed that of HD.

Q: Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors capital (ROIC) exceeds its after-tax cost of debt, rd(1 T). Which of the following statements is CORRECT? a. Company HD has a higher return on assets (ROA) than Company LD. b. Company HD has a higher times interest earned (TIE) ratio than Company LD. c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's. d. The two companies have the same ROE. e. Company HD's ROE would be higher if it had no debt.

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

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

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

Q: Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure? a. Its sales are projected to become less stable in the future. b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. c. Management believes that the firm's stock is currently overvalued. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. The corporate tax rate is increased.

Q: Which of the following statements is CORRECT, holding other things constant? a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt. b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations. d. An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged. e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.

Q: A major contribution of the Miller model is that it demonstrates, other things held constant, that a. personal taxes increase the value of using corporate debt. b. personal taxes lower the value of using corporate debt. c. personal taxes have no effect on the value of using corporate debt. d. financial distress and agency costs reduce the value of using corporate debt. e. debt costs increase with financial leverage.

Q: Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total investor-supplied capital, the size of the firm (i.e., total assets), and it would not affect the firm's return on investors capital (ROIC), which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? a. The company's net income would increase. b. The company's earnings per share would decline. c. The company's cost of equity would increase. d. The company's ROA would increase. e. The company's ROE would decline.

Q: Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT? a. The two companies have the same times interest earned (TIE) ratio. b. Firm L has a lower ROA than Firm U. c. Firm L has a lower ROE than Firm U. d. Firm L has the higher times interest earned (TIE) ratio. e. Firm L has a higher EBIT than Firm U.

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