Parrino Ch.16 Capital Structure Policy Test Bank

Fundamentals of Corporate Finance, 5e (Parrino)

Chapter 16 Capital Structure Policy

1) A higher proportion of debt indicates a lower degree of financial leverage.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

2) Minimizing the cost of a firm's financing activities also maximizes the overall value of the firm.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

3) When calculating free cash flow, it is important to include interest and principal payments.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

4) M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses does not affect real investment policy of the firm.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

5) The enterprise value of a firm is the value of equity minus the value of debt.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

6) A financial restructuring will have some effect on the value of a firm's real assets, such as plant and equipment.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

7) M&M Proposition 2 states that the required rate of return on a firm's common stock is directly related to the debt-to-equity ratio.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

8) M&M Proposition 1 states that the capital structure of a firm does not affect the required rate of return on a firm's assets, while M&M Proposition 2 shows that the required rate of return on firm's equity does change with capital structure decisions.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

9) Under the M&M assumptions with taxes, the value of a firm with debt is the value of the firm without debt plus the present value of the interest tax shield.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

10) With no debt, the WACC is the cost of equity plus the required rate of return on the firm's underlying assets.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

11) If a firm has debt and pays taxes, the present value of the tax shield is the amount of debt outstanding times the tax rate.

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

12) Issuing debt is usually less expensive than issuing stock.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

13) Bankruptcy and agency costs both act as limits on the amount of debt in the capital structure.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

14) Direct bankruptcy costs are considered transactions costs and occur when a firm must navigate the bankruptcy process.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

15) When a firm gets closer to financial distress causing expected bankruptcy costs to increase, lenders will often charge the firm a lower interest rate in order to reduce the chance of an actual bankruptcy occurring.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

16) Direct bankruptcy costs are considered small when compared to indirect bankruptcy costs.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

17) Indirect bankruptcy costs include changes in customer and supplier behavior that negatively affect the firm.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

18) Unlike direct bankruptcy costs, indirect costs are not considered transaction costs.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

19) Indirect bankruptcy costs will often increase when a firm is in financial distress and it may even push the company into bankruptcy.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

20) More debt in a firm's capital structure provides managers with an incentive to maximize cash flows, but also makes them want to take on negative NPV projects.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

21) Dividends reduce the value of lender claims, and this is why bondholders often limit a firm's ability to distribute cash to equity holders.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

22) Borrowing money and paying out a special dividend to shareholders is an example of the asset substitution problem.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

23) When a firm is in financial distress, stockholders would like the manager to overinvest in positive NPV projects.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

24) When the firm uses no debt in financing activities, there will not be any asset substitution or underinvestment problems.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

25) The trade-off theory of capital structure states that leverage should be increased until the marginal cost of debt is equal to the marginal benefit.

Learning Objective: LO 2, 3

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

26) Under the pecking order theory, debt is the cheapest source of financing due to the interest tax shield.

Learning Objective: LO 3

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

27) The pecking order theory says that instead of trying to achieve a specified target capital structure, firms use the cheapest form of capital available at any given time.

Learning Objective: LO 3

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

28) Firms have a difficult time selling equity when they are in financial distress.

Learning Objective: LO 3

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

29) Industries with large amounts of tangible assets typically use little debt.

Learning Objective: LO 3

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

30) More profitable firms have less debt, which supports the trade-off theory.

Learning Objective: LO 3

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

31) Managers often focus on cash flows, but reported accounting earnings are a better indicator of a firm's economic health.

Learning Objective: LO 4

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

32) An operating lease is treated like a purchase for accounting purposes.

Learning Objective: LO Appendix

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

33) A firm's capital structure is the mix of financial securities used to finance its activities and can include all of the following EXCEPT:

A) common stock.

B) bonds.

C) equity options.

D) preferred stock.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

34) The optimal capital structure of a firm:

A) minimizes the cost of financing the firm's projects.

B) minimizes interest payments to creditors.

C) maximizes overall value of the firm.

D) minimizes the cost of financing the firm's projects and maximizes overall value of the firm.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

35) M&M Proposition 1 assumes all of the following EXCEPT that:

A) there are no taxes.

B) there are no costs to acquire information.

C) there are no transactions costs.

D) the real investment policy of a firm is affected by its capital structure decisions.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

36) A firm's enterprise value is given as:

A) the market value of equity plus the market value of debt.

B) the market value of equity minus the market value of debt.

C) the market value of equity minus the market value of debt plus the market value of future projects.

D) the market value of equity plus the market value of future projects plus the market value of debt.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

37) A financial restructuring:

A) will not change the value of a firm's real assets under M&M Proposition 1.

B) includes financial transactions that change the capital structure of the firm.

C) means that a firm has issued equity to retire debt.

D) Both A and B.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

38) The weighted average cost of capital (WACC) includes:

A) the required return on equity and required return on underlying firm assets.

B) the cost of any long-term debt and the cost of equity.

C) the cost of any long-term debt and required return on underlying firm assets.

D) the required return on equity only.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

39) M&M Proposition 2 states that the cost of a firm's common stock is directly related to:

A) the debt-to-equity ratio.

B) the required rate of return on the firm's underlying assets.

C) the return of the market index.

D) the debt-to-equity ratio and the required rate of return on the firm's underlying assets.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

40) According to M&M Proposition 2, the cost of a firm's equity:

A) increases as the debt-to-equity ratio increases.

B) decreases as the debt-to-equity ratio decreases.

C) increases as the cost of debt increases.

D) decreases as the required rate of return on the firm's underlying assets increases.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

41) Financial risk:

A) refers to the effect that a firm's financing decisions have on the riskiness of the cash flows that the stockholders will receive.

B) increases a firm's business risk.

C) decreases a firm's business risk.

D) is related to how debt affects the business decisions of a firm.

Learning Objective: LO 1

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

42) Which one of the following considerations are NOT a concern of managers when they make capital structure decisions?

A) Financial flexibility

B) Net income risk

C) Systematic risk

D) Earnings impact

Learning Objective: LO 4

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

43) What control implications do a firm's capital structure decisions have?

A) Issuing too much equity as to cause financial distress

B) only impacts debt financing

C) only impacts equity financing

D) Dilution issues

Learning Objective: LO 4

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

44) Which of the following is a reason financial policy might matter?

A) More important for firms exempt from paying corporate income taxes than firms that pay corporate taxes.

B) Can affect transaction costs, but not information costs.

C) Can affect information costs, but not transaction costs.

D) Capital structure choices can affect firm's real investment decisions, such as R&D and PP&E.

Learning Objective: LO 1

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

45) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much is Dynamo worth today?

A) $1,765

B) $1,500

C) $2,143

D) $1,900

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

46) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much are your cash flows today? (Round the answer to two decimal places.)

A) $12.38

B) $15

C) $4.50

D) $150

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

47) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity and use the debt proceeds to pay a special dividend to stockholders, how much debt should they issue?

A) $321

B) $375

C) $600

D) $225

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

48) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. How much does Dynamo currently pay as interest, and how much will it have to pay after the restructuring in the prior problem, assuming that the cost of debt is constant?

A) $42 and $26.25

B) $26.25 and $42

C) $160 and $37.50

D) $37.50 and $60

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

49) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, how much of the special dividend do you receive, and how much do you receive in regular dividends per year after the restructuring according to M&M Proposition 1?

A) $15 and $60

B) $60 and $15

C) $10.80 and $22.50

D) $22.50 and $10.80

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

50) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, what transaction do you need to take in order to undo the restructuring according to M&M Proposition 1?

A) Sell $22.50 of stock

B) Sell $10.80 worth of stock

C) Buy $22.50 worth of debt

D) Buy $10.80 worth of debt

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

51) Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the debt. You currently own 10 percent of the stock. If Dynamo wishes to change its capital structure from 75 percent to 60 percent equity, according to M&M Proposition 1, what are the interest payments that you receive after you undo the restructuring, and what are your total cash flows? (Do not round intermediate calculations. (Round the final answer to two decimal places.)

A) $1.58 and $12.38

B) $23.55 and $75

C) $1.125 and $12.38

D) $23.55 and $12.38

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

52) Cadmium Electronics Inc. currently has a capital structure that is 40 percent debt and 60 percent equity. If the firm's cost of equity is 12 percent, the cost of debt is 8 percent, the risk-free rate is 3 percent and the firm pays no tax, what is the appropriate WACC?

A) 8.4%

B) 9.6%

C) 10.4%

D) 9.2%

Learning Objective: LO 1, 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

53) Gangland Water Guns, Inc. has a debt-to-equity ratio of 0.5. If the firm's cost of debt is 7 percent, its cost of equity is 13 percent and it pays no tax, what is its WACC?

A) 9%

B) 10%

C) 11%

D) 12%

Learning Objective: LO 1, 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

54) Swirlpool, Inc. has a WACC of 11 percent, cost of debt of 8 percent, and a cost of equity of 12%. What must the debt-to-equity ratio be if the firm pays no tax?

A) 1/2

B) 1/4

C) 1/6

D) 1/3

Learning Objective: LO 1

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

55) Melba's Toast has a capital structure with 30 percent debt and 70 percent equity. Its pretax cost of debt is 6 percent, and its cost of equity is 10 percent. The firm's marginal corporate income tax rate is 35 percent. What is the appropriate WACC?

A) 8.17%

B) 6.35%

C) 8.80%

D) 7.44%

Learning Objective: LO 1, 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

56) A firm has $300 million in outstanding debt and $900 million in outstanding equity. Its cost of equity is 11 percent, its cost of debt is 7 percent, and it pays no tax. What is the WACC?

A) 6%

B) 8%

C) 9%

D) 10%

Learning Objective: LO 1, 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

57) A firm has a WACC of 8.5 percent, a pretax cost of debt of 5 percent, a cost of equity of 12 percent, and a marginal corporate income tax rate is of 35 percent. About what percent of the firm's capital structure is financed with equity?

A) 50%

B) 60%

C) 70%

D) 80%

Learning Objective: LO 1, 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

58) Bellamee, Inc. has a required rate of return on its assets of 12 percent and a cost of debt of 6.25 percent. Its current debt-to-equity ratio is 1/5. What is the required rate of return on its equity?

A) 12.15%

B) 13.15%

C) 14.15%

D) 15.15%

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

59) Bellamee, Inc. has a required rate of return on its assets of 12 percent and a cost of debt of 6.25 percent. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7 percent?

A) 14.00%

B) 14.25%

C) 14.50%

D) 15.00%

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

60) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. What percent of the firm's costs are fixed, and what percent of costs are variable with the added debt? (Round the percentage answer to two decimal places.)

A) 27.9% and 72.1%

B) 72.1% and 27.9%

C) 25.23 and 74.77%

D) 74.77% and 25.23%

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

61) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. What is the net income of Banana without and with the debt?

A) $500 and $484.20

B) $484.20 and $500

C) $500 and $465

D) $490 and $500

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

62) Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and SG&A of $100. The required rate of return on its equity is 14 percent, and the risk-free rate is 5 percent. Assume that the COGS only include the marginal costs of selling a computer. Banana is considering adding $700 worth of debt with a coupon rate of 5 percent and an YTM of 7.9 percent to its capital structure. Suppose, revenues fall by $300, due to a decrease in the selling price, what is the percent change in net income with and without the debt? Assume that the total variable production costs remain the same. (Round the answer to one decimal place.)

A) 64.5% and 60%

B) 60.0% and 64.5%

C) 59.2% and 40.8%

D) 40.8% and 59.2%

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

63) Suppose a firm has a cost of equity of 12 percent, a D/E ratio of 1/6, and the YTM on its bonds is 7.5 percent. The risk-free rate is currently 3 percent. What is the current required rate of return on its assets and equity if the D/E ratio is changed to 1/3? (Round the answer to one decimal place of percentage.)

A) 11.36% and 13.25%

B) 11.36% and 8.25%

C) 13.25% and 11.36%

D) 11.36% and 12.65%

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

64) Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35 percent tax bracket. The appropriate discount rate for its cash flows is 12 percent. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders. Using the perpetuity valuation model, calculate the value of the firm without debt in the capital structure. Assume that the pretax annual cash flows are perpetual. Round to the nearest dollar.

A) $350

B) $650

C) $2,917

D) $5,417

Learning Objective: LO 1

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

65) Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35 percent tax bracket. The appropriate discount rate for its cash flows is 12 percent. Suppose the firm issues a $1,500 bond and uses these proceeds to pay a one-time special dividend to stockholders What is Millennium's value after the debt issuance? Assume that the pretax annual cash flows are perpetual.

A) $5,417

B) $5,942

C) $6,392

D) $6,512

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

66) The interest tax shield:

A) does not affect the WACC.

B) makes it less costly to distribute cash to investors through interest payments than through dividends.

C) is given as: D × (1 - t).

D) makes it less costly to distribute cash to investors through interest payments than through dividends, and is given as: D × (1 - t).

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

67) In order to calculate the present value of debt tax savings, the ________ is used as the discount rate.

A) WACC

B) risk-free rate

C) required rate of return on debt

D) market rate

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

68) Academic studies have estimated that the tax benefit of debt realized by firms is approximately:

A) 10% of firm value.

B) a 10% reduction in WACC.

C) a 10% reduction in the cost of debt.

D) 10% of debt value.

Learning Objective: LO 2

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

69) The use of debt financing:

A) causes a manager to take on riskier projects in order to make interest payments.

B) is more expensive than issuing equity due to the use of covenants.

C) allows managers to make discretionary interest payments.

D) limits the ability of managers to waste stockholders' money.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

70) Which of these statements about direct bankruptcy costs is NOT true?

A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and consultants.

B) Direct bankruptcy costs are less than indirect bankruptcy costs.

C) Direct bankruptcy costs include payments to suppliers on delivery.

D) Direct bankruptcy costs can be reduced by negotiating with lenders.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

71) Which of these is NOT an example of indirect bankruptcy costs?

A) A firm's customers become concerned about whether or not warranties will be honored.

B) Employees begin to leave the firm.

C) New accountants are brought in to help with the bankruptcy process.

D) A bankruptcy judge orders new projects to be halted.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

72) The use of debt financing:

A) reduces agency costs between the stockholders and management by increasing the amount of risk the managers take.

B) increases agency costs between the stockholders and management by limiting the amount of risk the managers take.

C) increases agency costs since managers prefer to keep less retained earnings to make dividend payments.

D) increases agency costs between the stockholders and management by limiting the amount of risk the managers take, and increases agency costs since managers prefer to keep more retained earnings to make dividend payments.

Learning Objective: LO 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

73) The asset substitution problem occurs when:

A) managers substitute more risky assets for less risky ones to the detriment of bondholders.

B) managers substitute less risky assets for more risky ones to the detriment of bondholders.

C) managers substitute more risky assets for less risky ones to the detriment of equity holders.

D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Learning Objective: LO 2

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

74) The underinvestment problem occurs in a financially distressed firm when:

A) the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders.

B) the value of investing in a positive NPV project is likely to go to equity holders instead of debt holders.

C) management invests in negative NPV projects to reduce their own risk.

D) issuing equity becomes difficult due to increased risk.

Learning Objective: LO 2

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

75) Packman Corporation has a reported EBIT of $500, which is expected to remain constant in perpetuity. The firm borrows $2,000, and its coupon rate is 8 percent. If the company's marginal tax rate is 30 percent and its average tax rate is 20 percent, what are its after-tax earnings?

A) $238

B) $272

C) $259

D) $290

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

76) A firm plans to issue $1 million worth of debt with a YTM of 9 percent. The debt is trading at par. The firm's marginal corporate tax rate is 25 percent, while its average tax rate is 15 percent. By how much will the new debt reduce the firm's annual tax liability?

A) $13,500

B) $22,500

C) $32,500

D) $43,500

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

77) A firm plans to issue $1 million worth of debt with a YTM of 9 percent. The debt is trading at par. The firm's marginal corporate tax rate is 35 percent. What is the present value of the tax savings if the debt never matures?

A) $11,025

B) $20,475

C) $350,000

D) $227,500

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

78) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM shareholders are considering selling $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What will the equity value of UBM be in one-year without stockholders taking on the project?

A) $100 million

B) $80 million

C) $20 million

D) $8 million

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

79) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What is the expected value of the bonds to the lenders if the stockholders sell the debt?

A) $100 million

B) $88.8 million

C) $48.8 million

D) $68.8 million

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

80) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. What is the expected value of the equity if the stockholders sell the debt?

A) $175 million

B) $97.5 million

C) $51 million

D) $72 million

Learning Objective: LO 2

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

81) Suppose that UBM Corp. has invested $100 million in 8 percent risk-free bonds that mature in one-year. The firm also has $80 million in debt outstanding that will also mature in a year. UBM stockholders are considering selling the $100 million in debt and investing in a project that has a 60 percent chance of returning $200 million and a 40 percent chance of returning $2 million. Given the payoffs of the project, what does the percent chance of success need to be in order for the expected value of equity with the project to be equal to the expected value of equity without the project?

A) 1/3

B) 1/4

C) 1/5

D) 1/6

Learning Objective: LO 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

82) Suppose that JMK, Inc. has debt with a face value of $100 million and assets worth $70 million. The firm's management has identified a risk-free project that will require an initial outlay of $10 million and will return a NPV of $16 million. The firm currently has no cash. What would be the effect on stockholders' wealth if they took on this project?

A) -$10 million

B) $0 million

C) $26 million

D) $70 million

Learning Objective: LO 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

83) Which of the following supports the trade-off theory of capital structure?

A) Firms use cash on hand first, since issuing equity and debt is expensive.

B) A firm's capital structure is the result of past equity and debt issuance decisions.

C) Firms have a target capital structure that maximizes the value of firm.

D) Firms use cash on hand first, since issuing equity and debt is expensive, and a firm's capital structure is the result of past equity and debt issuance decisions.

Learning Objective: LO 3

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

84) A firm wishes to invest in a project that costs $150 million. It currently has $10 million in cash on hand and believes that it can raise $75 million in debt and $100 million in equity if needed. According to the pecking order theory of the capital structure, what percent of the project will be financed by debt?

A) 0%

B) 26.67%

C) 50%

D) 76.67%

Learning Objective: LO 3

Bloomcode: Application

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

85) Which of the following should a company consider when deciding to buy or lease an asset?

A) Transaction cost, but not information costs

B) Information costs, but not transaction costs

C) The effect of buy or lease decision on the firm's capital structure, but not its profitability

D) Taxes

Learning Objective: LO Appendix

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

86) Which of the following would arise if the lessee can have the incentive to use the asset more than the lessor would prefer?

A) Operating lease conflict

B) Capital lease conflict

C) Intensity of use conflict

D) Maintenance conflict

Learning Objective: LO Appendix

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

87) Which of the following arises when the lessee can have the incentive to use the asset more than the lessor would prefer?

A) Track the total services obtained from the asset and charge the lessee additional fees based on lack of usage.

B) Make a service contract available, but not mandatory.

C) Do not provide the lessee with the right to buy the asset when the lease expires.

D) Bundle the lease contract with a service contract.

Learning Objective: LO Appendix

Bloomcode: Knowledge

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

88) LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative, the company will only need the laser for 5 years. Assume LMNO's marginal tax rate is 30 percent.

Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed with a five-year balloon loan at 9 percent. The laser will be depreciated on straight line and have no salvage value. Maintenance on the laser is expected to be $1,200 per year.

Lease alternative: The company that manufactures the laser offers a 5-year leasing option with annual lease payments of $12,500. With this option, the lessor will be responsible for maintenance of the laser and will take it back after 5 years. The lease will be classified as an operating lease.

Which is the best option for LMNO Manufacturing? (Do not round the intermediate calculation. Round final answer to the nearest dollar.)

A) Purchase, the company will be $4,416 better off

B) Lease, the company will be $4,416 better off

C) Purchase, the company is $10,496 better off

D) Lease, the company is $10,496 better off

Learning Objective: LO Appendix

Bloomcode: Evaluation

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

89) One of the conditions that the M&M Propositions required was that the firm does not pay tax. Briefly discuss whether the introduction of taxes decreases or increases the value of the firm.

Learning Objective: LO 1

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

90) Briefly explain how an increase in the amount of debt that a firm has outstanding may actually decrease the agency costs caused by the conflict between managers and stockholders.

Learning Objective: LO 2

Bloomcode: Analysis

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

91) The pecking order theory of capital structure suggests that managers will choose to utilize retained earnings before issuing additional debt when financing new projects. Does that imply anything about the flotation costs of issuing new securities?

Learning Objective: LO 3

Bloomcode: Comprehension

AACSB: Analytic

IMA: Corporate Finance

AICPA: Global and Industry Perspectives

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