Chapter 13 Leverage and Capital Structure

Chapter 13 Leverage and Capital Structure Multiple Choice Questions The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as: A. M&M Proposition I. B. capital restructuring. C. homemade leverage. D. M&M Proposition II. E. financial risk management. Refer to section 13.2. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Homemade leverage Which one of the following statements matches M&M Proposition I? A. The cost of equity capital has a positive linear relationship with a firm's capital structure. B. The dividends paid by a firm determine the firm's value. C. The cost of equity capital varies in response to changes in a firm's capital structure. D. The value of a firm is independent of the firm's capital structure. E. The value of a firm is dependent on the firm's capital structure. Refer to section 13.3. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: M&M Proposition I Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure? A. Static theory of capital structure B. M&M Proposition I C. M&M Proposition II D. Homemade leverage theory E. WACC Refer to section 13.3. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: M&M Proposition II Which one of the following is the equity risk arising from the daily operations of a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk Refer to section 13.3. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.3 Topic: Business risk Which one of the following is the equity risk arising from the capital structure selected by a firm? A. Strategic risk B. Financial risk C. Liquidity risk D. Industry risk E. Business risk Refer to section 13.3. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.3 Topic: Financial risk Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship? A. Static theory of interest rates B. M&M Proposition I C. Financial risk D. Interest tax shield E. Homemade leverage Refer to section 13.4. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.4 Topic: Interest tax shield Which one of the following is a direct bankruptcy cost? A. Loss of customer goodwill resulting from a bankruptcy filing B. Legal and accounting fees related to a bankruptcy proceeding C. Management time spent on a bankruptcy proceeding D. Any financial distress cost E. Costs a firm spends trying to avoid bankruptcy Refer to section 13.5. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.5 Topic: Direct bankruptcy cost Which one of the following terms applies to the costs incurred by a firm which is trying to avoid filing for bankruptcy? A. Indirect bankruptcy costs B. Direct bankruptcy costs C. Static theory cost D. Optimal capital structure cost E. Reorganization costs Refer to section 13.5. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.5 Topic: Indirect bankruptcy cost Which one of the following terms is inclusive of both direct and indirect bankruptcy costs? A. Financial distress costs B. Capital structure costs C. Financial leverage D. Homemade leverage E. Cost of capital Refer to section 13.5. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.5 Topic: Financial distress costs Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt? A. M&M Proposition I, with taxes B. M&M Proposition II, with taxes C. M&M Proposition I, without taxes D. Homemade leverage proposition E. Static theory of capital structure Refer to section 13.6. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Static theory of capital structure Which one of the following best defines legal bankruptcy? A. Negotiating new payment terms with a firm's creditors B. A temporary technical insolvency C. A legal proceeding for liquidating or reorganizing a business D. The internal process of revising the capital structure of a firm E. The failure of a firm to meet its financial obligations in a timely manner Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Bankruptcy Which one of the following terms refers to the termination of a firm as a going concern? A. Insolvency B. Reorganization C. Chapter 11 bankruptcy D. Prepack E. Liquidation Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Liquidation Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation? A. Chapter 7 bankruptcy B. Liquidation C. Technical insolvency D. Accounting insolvency E. Reorganization Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Reorganization In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first? A. Technical insolvency definition B. Absolute priority rule C. Accounting insolvency definition D. Chapter 7 of the Federal Bankruptcy Reform Act of 1978 E. Securities and Exchange Commission Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Absolute priority rule Which one of the following is minimized when the value of a firm is maximized? A. Return on equity B. WACC C. Debt D. Taxes E. Bankruptcy costs Refer to section 13.1. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.1 Topic: Firm valuation Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms? A. The levered firm has higher EPS than the unlevered firm at the break-even point. B. The levered firm will have higher EPS than the unlevered firm at all levels of EBIT. C. The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT. D. The EPS for the unlevered firm will always exceed those of the levered firm. E. The unlevered firm will have higher EPS at relatively low levels of EBIT. Refer to section 13.2. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Financial leverage Which one of the following statements concerning financial leverage is correct? A. Financial leverage increases profits and decreases losses. B. Financial leverage has no effect on a firm's return on equity. C. Financial leverage refers to the use of common stock. D. Financial leverage magnifies both profits and losses. E. Increasing financial leverage will always decrease the earnings per share. Refer to section 13.2. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Financial leverage You are comparing two possible capital structures for a firm. The first option is an all-equity firm. The second option involves the use of $3.8 million of debt. The break-even point between these two financing options occurs when the earnings before interest and taxes (EBIT) are $428,000. Given this, you know that leverage is beneficial to the firm: A. whenever EBIT is less than $428,000. B. only when EBIT is $428,000. C. whenever EBIT exceeds $428,000. D. only if the debt is decreased by $428,000. E. only if the debt is increased by $428,000. Refer to section 13.2. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Financial leverage Which one of the following statements concerning financial leverage is correct? A. The benefits of leverage are unaffected by the amount of a firm's earnings. B. The use of leverage will always increase a firm's earnings per share. C. The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage. D. Changes in the capital structure of a firm will generally change the firm's earnings per share. E. Financial leverage is beneficial to a firm only when the firm has negative earnings. Refer to section 13.2. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Financial leverage T.L. C. Enterprises just revised its capital structure from a debt-equity ratio of 0.30 to a debtequity ratio of 0.45. The firm's shareholders who prefer the old capital structure should: A. sell some shares and hold the sale proceeds in cash. B. sell all of their shares and loan out the entire sale proceeds. C. do nothing. D. sell some shares and loan out the sale proceeds. E. borrow funds and purchase more shares. Refer to section 13.2. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.2 Topic: Homemade leverage Which one of the following statements is the core principle of M&M Proposition I, without taxes? A. A firm's cost of equity is directly related to the firm's debt-equity ratio. B. A firm's WACC is directly related to the firm's debt-equity ratio. C. The interest tax shield increases the value of a firm. D. The capital structure of a firm is totally irrelevant. E. Levered firms have greater value than unlevered firms. Refer to section 13.3. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: M&M I, no tax Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases? A. M&M Proposition I, without taxes B. M&M Proposition II, without taxes C. M&M Proposition I, with taxes D. Static theory of capital structure E. No theory suggests this. Refer to section 13.4. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.4 Topic: M&M I, with tax Which one of the following is an implication of M&M Proposition II, without taxes? A. A firm's optimal capital structure is 100 percent debt. B. WACC is unaffected by the capital structure of a firm. C. WACC decreases as the debt-equity ratio increases. D. A firm's capital structure is irrelevant. E. The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations. Refer to section 13.3. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: M&M II, without tax M&M Proposition II, without taxes, states that the: A. capital structure of a firm is highly relevant. B. weighted average cost of capital decreases as the debt-equity ratio decreases. C. cost of equity increases as a firm increases its debt-equity ratio. D. return on equity is equal to the return on assets multiplied by the debt-equity ratio. E. return on equity remains constant as the debt-equity ratio increases. Refer to section 13.3. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: M&M II, without tax The level of financial risk to which a firm is exposed is dependent upon the firm's: A. tax rate. B. debt-equity ratio. C. return on assets. D. level of earnings before interest and taxes. E. operational level of risk. Refer to section 13.3. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-01 Discuss the effect of financial leverage Section: 13.3 Topic: Financial risk Which one of the following represents the present value of the interest tax shield? A. D (1 - Tc) B. D/(1 - Tc) C. D/Tc D. D - D(Tc) E. TC D Refer to section 13.4. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.4 Topic: Interest tax shield Which of the following will increase the value of a levered firm according to M&M Proposition I, with taxes? I. decrease in the amount of the debt II. increase in the value of the unlevered firm III. decrease in the tax rate IV. increase in the interest rate on the debt A. II only B. I and IV only C. II and III only D. II and IV only E. II, III, and IV only Refer to section 13.4. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.4 Topic: M&M I, with tax Which of the following statements correctly relate to M&M Proposition I, with taxes? I. Debt decreases the value of a firm. II. The levered value of a firm exceeds the firm's unlevered value. III. The weighted average cost of capital (WACC) is constant. IV. The optimal capital structure is zero debt. A. I only B. II only C. II and III only D. I and IV only E. I, III, and IV only Refer to section 13.4. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.4 Topic: M&M I, with tax Which one of the following is an example of a direct bankruptcy cost? A. Operating at a debt-equity ratio that is less than the optimal ratio B. Reducing the dividend payout ratio as a means of increasing a firm's equity C. Forgoing a positive net present value project to conserve current cash D. Incurring legal fees for the preparation of bankruptcy filings E. Losing a key customer due to concerns over a firm's financial viability Refer to section 13.5. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.5 Topic: Direct bankruptcy cost The static theory of capital structure assumes a firm: A. maintains a constant debt-equity ratio. B. has an all-equity structure. C. is fixed in terms of its assets. D. pays no taxes. E. is operating at the point where financial distress costs are eliminated. Refer to section 13.6. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Static theory Which one of the following conditions exists at the point where a firm maximizes its value? A. The tax benefit from an additional dollar of debt is zero. B. Financial distress costs are equal to zero. C. The debt-equity ratio is 1.0. D. WACC is minimized. E. The cost of equity is minimized. Refer to section 13.6. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Optimal capital structure Which one of the following statements related to the static theory of capital structure is correct? A. A firm begins to lose value as soon as the first dollar of debt is incurred. B. The actual value of a firm continually rises in direct proportion to the increased use of debt. C. The linear function of a firm's value has a constant positive slope. D. A firm's value is maximized when a firm operates at its optimal debt level. E. The value of a firm will automatically decrease whenever the debt-equity ratio is decreased. Refer to section 13.6. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Static theory Which one of the following is correct based on the static theory of capital structure? A. A firm receives the greatest benefit from debt financing when its tax rate is relatively low. B. A debt-equity ratio of 1 is considered to be the optimal capital structure. C. The costs of financial distress decrease the value of a firm. D. The more debt a firm assumes, the greater the incentive to acquire even more debt until such time as the firm is financed with 100 percent debt. E. At the optimal level of debt a firm also optimizes its tax shield on debt. Refer to section 13.6. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Static theory Assume both corporate taxes and financial distress costs apply to a firm. Given this, the static theory of capital structure illustrates that: A. a firm's value and its weighted average cost of capital are inversely related. B. a firm's value and its tax rate are inversely related. C. the maximum value of a firm is obtained when a firm is financed solely with debt. D. the value of a firm rises as the interest rate on debt rises. E. the value of a firm rises as both the interest rate on debt and the tax rate rise. Refer to section 13.6. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-02 Analyze the impact of taxes and bankruptcy on capital structure choice Section: 13.6 Topic: Static theory When is a firm insolvent from an accounting perspective? A. When the firm is unable to meet its financial obligations in a timely manner B. When the firm's debt exceeds the value of the firm's equity C. When the firm has a negative net worth D. When the firm's revenues cease E. When the market value of the firm's equity equals zero Refer to section 13.8. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Accounting insolvency Peterboro recently defaulted on a bank loan. To avoid a bankruptcy proceeding, the bank agreed to a composition. This composition would do which one of the following? A. Forgive the loan payment in its entirety B. Extend the due date on the missed loan payment C. Reduce the amount of the loan payments so Peterboro can pay timely D. Transfer some of Peterboro's assets to the bank in lieu of the loan payment E. Transfer all the equity shares in Peterboro to the lending bank Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Composition Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming the absolute priority rule is followed? A. Claims by unsecured creditors B. Employee wages C. Government tax claims D. Contributions to employee retirement plans E. Bankruptcy administrative expenses Refer to section 13.8. Bloom's: Knowledge Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Absolute priority rule Which one of the following is a key provision of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005? A. Disallowance of bankruptcy prepacks B. Right granted to creditors to file their own reorganization plan once a firm is in bankruptcy for 18 months C. Disallowance of all management bonus payments while a firm is in bankruptcy D. Requirement that only creditors can file reorganization plans for a bankrupt firm E. Requirement for all Chapter 11 bankruptcies to be converted to Chapter 7 bankruptcies after 18 months Refer to section 13.8. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: BAPCA 2005 Which one of the following statements is correct? A. A prepack is a plan of liquidation used to distribute a firm's assets. B. Bankruptcy courts have "cram-down" powers. C. The absolute priority rule must be strictly followed in all bankruptcy proceedings. D. Creditors cannot force a firm into bankruptcy even though they might like to do so. E. A reorganization plan can only be approved if the firm's creditors all agree with the plan. Refer to section 13.8. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Bankruptcy A prepack: A. guarantees full payment to all creditors but lengthens the time span of the debt. B. is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan. C. protects the interests of both the current creditors and the existing shareholders. D. applies only if a firm files under Chapter 7 of the bankruptcy code. E. extends the time that a firm is protected by the bankruptcy process. Refer to section 13.8. Bloom's: Comprehension Difficulty: Basic Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Prepack Which one of the following statements is correct? A. All Chapter 7 bankruptcy filings must include a "workout" agreement. B. Firms must remain in bankruptcy for at least 18 months. C. Key employee retention plans (KERPS) are no longer legal. D. Labor contracts cannot be modified through the bankruptcy process. E. A firm can file for Chapter 11 bankruptcy even if the firm is solvent. Refer to section 13.8. Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 13-03 Identify the essentials of the bankruptcy process. Section: 13.8 Topic: Bankruptcy