Q&A Hero

Q: Briefly explain what the empirical evidence suggests about financial managers' actions as they relate to the capital structure theory.

Q: Under what conditions are shareholders likely to incur agency costs when managers make capital budgeting decisions?

Q: Cheshire Corporation is now financed 100% with equity. The cost of equity is 15%. Cheshire is considering a proposal to borrow enough money at 7% to buy back half of its common stock. It would then be financed 50% with debt and 50% with equity. Assume that this does not affect the cost of equity. Cheshire's tax rate is 40%. What is Cheshire's cost of capital without and with the stock repurchase?

Q: Adams Inc. expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Bellingham Inc. also expects EBIT of $50 million if there is a recession, $100 million if the economy is normal, and $150 million if the economy expands. Adams is financed entirely with equity while Bellingham is financed 50% with debt at 10%. Adams has $200 million in equity; Bellingham is financed with $100 million of debt and $100 million of equity. The tax rate is 30%. Both firms pay out all available earnings as dividends. If there is a recession, compare dividends and total distributions to investors for each company.

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

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

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

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

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

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

Q: The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial leverage increases.

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

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

Q: Investors require a higher return on common stock investments if a firm uses less leverage.

Q: Which of the following is part of a firm's financial structure but NOT a component of its capital structure? A) Retained earnings B) Mortgage bonds C) Accounts payable D) Both A and C

Q: Newbury Inc. has retained $2 million in earnings this year. It can borrow up $1.5 million at a rate of 8% and sell the same amount of new stock at a cost of 17%. Newbury cost of common equity without selling any new stock is 16%. If Newbury's capital budget is $2.5 million, pecking order theory says management will use: A) $1.5 million in debt and $1 million in retained earnings. B) $2 million in retained earnings and $o.5 million in debt. C) $833,333 each from retained earnings, new debt and new stock. D) $1.5 million in debt and $1 million in new stock.

Q: The most acceptable view of capital structure, according to the text, is that the weighted average cost of capital: A) first falls with moderate levels of leverage and then increases as a firm's leverage becomes high. B) does not change with leverage. C) increases proportionately with increases in leverage. D) increases with moderate amounts of leverage and then falls.

Q: Lowell Corporation and Lawrence Corporation each have EBIT of $4 million. Lowell has no debt and no interest expense; Lawrence has $2 million in debt at a before-tax rate of 8%. The tax rate is 40%. How much cash does each firm return to its investors. A) Lowell $2,400,000, Lawrence $2,144,000 B) Lowell $2,400,000, Lawrence $2,240,000 C) Lowell $2,400,000, Lawrence $2,464,000 D) Lowell $2,400,000, Lawrence $2,304,000

Q: Chelsea Corporation's cost of equity is 16% and it is 100% equity financed. If it can borrow enough money at 10% to buy back half of its stock, what would would happen to the cost of equity be under the original assumptions of the Modigliani and Miller Capital Structure Theorem. A) It would remain at 16%. B) t would rise to 22%. C) It would fall to 11%. D) It would fall to 13%.

Q: With taxes, but in the absence of financial distress costs, the optimal capital structure would be: A) 100% equity. B) 50% debt, 50% equity. C) 100% debt. D) completely insensitive to the mix of debt and equity.

Q: The Modigliani and Miller Capital Structure Theorem, in its original form, assumes: A) there are no transactions costs. B) there are no taxes. C) investors can borrow money at the same rate as the firm. D) all of the above.

Q: Capital Structure Theory in general assumes that? A) A firm's value is determined by capitalizing (discounting) the firm's expected net income by the firm's cost of equity. B) A firm's cost of capital rises as a firm uses more financial leverage. C) A firm's value is determined by discounting the firm's expected cash flows by the WACC. D) A firm's cash flows will grow indefinitely at a constant rate.

Q: The Tradeoff Theory view of capital structure management says that the cost of capital curve is: A) a straight line. B) v-shaped. C) s-shaped. D) saucer-shaped.

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

Q: The theory that managers may prefer internal sources of funds to the lowest cost source of funds is known as: A) the Modigliani and Miller Proposition. B) tradeoff theory. C) financial stress avoidance theory. D) pecking order theory.

Q: The inclusion of financial distress costs in firm valuation: A) acknowledges that a firm is insulated from the impact of high debt financing. B) provides a rationale for a saucer-shaped cost of capital curve. C) eliminates conflicts between bondholders and stockholders. D) causes the cost of capital to rise in a linear fashion as more debt is added to the capital structure.

Q: Capital structure theory suggests that companies may put the interests of ________ ahead of the interests of ________. A) Potential stockholders, existing stockholders B) Stockholders, bondholders C) There are no potential conflicts t arising from the way a firm manages its capital structure. D) Existing shareholders, IRS

Q: If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt? A) The tax shield effect of debt will result in a lower cost of equity. B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress). C) A firm's common stock price will not be affected by the amount of debt a firm uses. D) Too much common equity increases the probability of bankruptcy.

Q: The Tradeoff theory of capital structure suggests that if a firm moves from zero debt in its capital structure to moderate usage of debt, the result is an increase in a firm's: A) stock price. B) cost of equity. C) dividend payout. D) both A and C.

Q: Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes, but not bankruptcy costs? A) Increased usage of financial leverage will increase a firm's composite cost of capital indefinitely. B) Increased usage of financial leverage will lower a firm's composite cost of capital indefinitely. C) Increased usage of financial leverage will not affect a firm's composite cost of capital. D) Increased usage of operating leverage will increase a firm's composite cost of capital indefinitely.

Q: Which of the following is consistent with the original formulation of the Modigliani and Miller Capital Structure Theorem? A) A firm's composite cost of capital decreases as financial leverage is used. B) A firm's common stock price falls as financial leverage is used. C) A firm's composite cost of capital and common stock price are unaffected by the amount of financial leverage used by the firm. D) A firm's composite cost of capital increases as operating leverage is used. E) A firm's common stock price rises as operating leverage is used.

Q: Which of the following is a reasonable conclusion from the Tradeoff theory of capital structure? A) A high debt ratio will result in a maximum price of a firm's common stock. B) A firm's common stock price will not be affected by the amount of debt a firm uses. C) A low debt ratio will result in a maximum price for a firm's common stock. D) Modest levels of debt have a more favorable impact on a firm's average cost of capital and stock price than no debt.

Q: Which of the following is consistent with the Tradeoff theory of capital structure? A) The cost of capital continuously decreases as the firm's debt ratio increases. B) The cost of capital remains constant as the firm's debt ratio increases. C) The cost of capital continuously increases as the firm's debt ratio increases. D) There is an optimal level of debt financing. E) Capital structure does not affect a firm's cost of capital.

Q: The tradeoff theory of capital structure management assumes: A) no corporate income taxes. B) cost of equity remains constant with an increase in financial leverage. C) firms might fail. D) none of the above.

Q: An optimal capital structure is achieved: A) when a firm's expected profits are maximized. B) when a firm's expected EPS are maximized. C) when a firm's expected stock price is maximized. D) when a firm's break-even point is achieved.

Q: From the information below, select the optimal capital structure for Mountain High Corp. A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50 B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90 C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20 D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40 E) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00

Q: An optimal capital structure is achieved: A) when a firm's expected profits are maximized. B) when a firm's expected EPS are maximized. C) when a firm's break-even point is achieved. D) when a firm's weighted average cost of capital is minimized.

Q: Optimal capital structure is: A) the funding mix that will maximize the company's common stock price. B) the mix of all items that appear on the right-hand side of the company's balance sheet. C) the mix of funds that will minimize the firm's beta. D) the mix of securities that will maximize EPS.

Q: The original form of the Modigliani and Miller Capital Structure Theorem A) ignores the effect of taxes. B) ignores the relationship between firm value and cost of capital. C) ignores transaction costs. D) both A and C are true.

Q: When the impact of taxes is considered, as the firm takes on more debt A) there will be no change in total cash flows. B) both taxes and total cash flow to stockholders and bondholders will decrease. C) cash flows will increase because taxes will decrease. D) the weighted average cost of capital will increase.

Q: Which of the following is the most important factor that affects a firm's financing mix? A) The amount of EPS B) The amount of operating income C) The number of shares that are outstanding D) The predictability of cash flows

Q: The inclusion of bankruptcy risk in firm valuation: A) acknowledges that a firm has an upper limit to debt financing. B) causes cost of capital curve to be linear. C) causes the cost of capital curve to be downward sloping regardless of capital structure. D) has no consequences for practical management of capital structure policy.

Q: The Modigliani and Miller Capital Structure Theorem, in its original form: A) uses unrealistic assumptions. B) provided important insights into capital structure policy. C) concludes that how a firm is financed is not important. D) all of the above.

Q: Bipolar Beverages total assets equal $360 million. The book value of Bipolar's equity is $180 million. The market value of Bipolar's equity is $ 250 million. The book value of the company's interest bearing debt is $120 million. Compute Bipolar's Debt Ratio and Debt to Value Ratio.

Q: Why is the Debt to Assets Ratio always higher than the Debt to Value ratio?

Q: What is meant by the terms "favorable" and "unfavorable" leverage?

Q: The Times Interest Earned Ratio measures a firm's ability to meet both interest payments and scheduled principal repayments.

Q: A firm's financial structure is defined by the Debt Ratio, while it's capital structure is defined by the Debt to Value ratio.

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

Q: How does the text distinguish between firm's financial structure and its capital structure? A) Financial structure includes only interest bearing debt B) Capital structure includes only non-interest bearing debt C) Financial structure uses market values of equity D) Capital structure includes only interest bearing debt

Q: Sprite Communications will erect 20 new transmission towers at a total cost of $15,000,000. The expansion will increase after-tax operating cash flows by $2.3 million dollars per year for the next 20 years. Sprite's WACC is 12%. To raise the $15,000,000, Sprite will need to issue new securities at a weighted average flotation cost of 12%. What is the NPV of the expansion?

Q: All capital projects incur flotation costs, no matter how they are financed.

Q: Flotation costs are usually ignored when computing the NPV of projects financed with newly issued securities.

Q: Flotation costs increase the amount of funds that must be raised to finance an investment.

Q: The cost of newly issued common stock is greater than the current cost common equity because of: A) capital gains taxes on retained earnings. B) flotation costs on newly issued common stock. C) capital gains taxes on newly issued common stock. D) all of the above

Q: As the size of a financing issue increases, the ________ usually decreases on a percentage basis. A) cost of equity B) flotation cost of the issue C) effective tax rate D) both A and B

Q: Larger issues of new common stock can cause ________ to increase. A) flotation costs B) the investor's required rate of return C) the stock price D) the tax rate

Q: When new capital must be raised for an expansion project, flotation costs should: A) be deducted from the operating cash flows. B) increase the initial investment outlay. C) be considered in recomputing the firm's overall WACC. D) be ignored.

Q: Stonehedge Dairy will expand its organic yogurt production capacity at a cost of $10,000,000. The expansion will increase after-tax operating cash by $1.4 million dollars per year for the next 20 years. Stonehedge's WACC is 10%. To raise the $10,000,000 Stonehedge will need to issue new securities at a weighted average flotation cost of 10%. What is the NPV of the expansion? A) $918,989 B) $807,878 C) $11,918,989 D) $1,918,989

Q: Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What is the total amount of capital that will need to be raised to finance the expansion project? A) $22,386,000 B) $20,000,000 C) $21,200.000 D) $21,413,276

Q: Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What rate should be used to discount the cash flows from the expansion project? A) 6.6% B) 6.0% C) 9.5% D) 16.1%

Q: Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. Compute Jen and Barry's weighted average flotation cost. A) 6.6% B) 6.0% C) 9.5% D) 16.1%

Q: Tantasqua Paper Products is composed of 3 divisions: industrial paper products, commercial paper products, and a forestry division which grows trees for wood pulp used in the paper-making process. Each of these divisions takes on a large number of projects with differing risk characteristics. Tantasqua now uses a single discount rate based on the company's WACC to evaluate all capital budgeting proposals. Discuss the advantages and disadvantages of switching to an approach based on separate discount rates for each division or even the risk level of each project.

Q: Tantasqua Paper Products is composed of 3 divisions: industrial paper products, commercial paper products, and a forestry division which grows trees for wood pulp used in the paper-making process. Each of these divisions takes on a large number of projects with differing risk characteristics. Tantasqua now uses a single discount rate based on the company's WACC to evaluate all capital budgeting proposals. Discuss the advantages and disadvantages of this approach.

Q: Using a firm's overall cost of capital to evaluate divisional projects can lead to the rejection of good investments in low-risk divisions and the acceptance of poor projects in high-risk divisions.

Q: The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged.

Q: The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class.

Q: Large firms are most likely to adjust for differences in the risk levels of investments taken on by different parts of the firm: A) by subjectively adjusting the company's WACC up or down. B) by estimating individual costs of capital for each individual project. C) by estimating individual costs of capital for each division or unit of the company. D) by identifying the specific sources of funding used by each division or unit.

Q: Which of the following is NOT a good reason to use divisional costs of capital? A) Divisional costs of capital require less time and effort to estimate than individual project costs of capital. B) Divisional costs of capital reduce the latitude of divisional managers in deciding which projects to accept. C) Divisional costs of capital reflect differences in the systematic risk of projects evaluated by different divisions. D) Divisional costs of capital may be estimated by comparing divisions to the most similar free standing companies which may have different capital structures.

Q: The "pure play" approach to estimating a divisions WACC involves: A) computing the value of the division if it were to be spun off as a separate company. B) comparisons to free standing firms with businesses similar to the division. C) "deleveraging" the division so that only the cost of equity is considered. D) using the company's WACC to estimate the value added by the division.

Q: Estimating a divisional cost of capital by comparing the division to a similar free-standing company is known as: A) Divisional Average Cost of Capital approach (DACC). B) Segmental Capital Structure approach. (SCS). C) the "pure play" approach. D) Project Specific Approach (PSA).

Q: Survey literature indicates that separate project costs of capital: A) are used by less than half of major companies. B) are used by more than 75% of major companies. C) are used by nearly all major companies. D) are almost never used by major companies.

Q: Lott Bros Developers evaluates a great many small to medium size projects each year. Some are riskier than others. Lott Bros should probably: A) allow individual project managers to estimate their own discount rates. B) try to identify the specific funding sources for each project. C) use the company's overall WACC for all projects. D) spend a great deal of time and money to estimate discount rates for each project.

Q: In theory using the same discount rate to evaluate all projects can lead to: A) rejection of low risk projects that should be accepted. B) acceptance of high risk projects that should be rejected. C) control of efforts by employees with a vested interested in a project to manipulate the discount rate. D) all of the above.

Q: Alio e Olio has restaurants throughout the United States, Canada, and Western Europe. It is considering a proposal to open several restaurants in major cities of India and China. A) Alio e Olio should use the company's overall WACC to evaluate all proposals. B) Alio e Olio should use a lower discount rate for new ventures to be sure it does not miss out on opportunities. C) Alio e Olio should evaluate projects in different regions at discount rates that reflect the risk inherent in those projects. D) Alio e Olio should adjust the discount rate for specific regions to reflect the specific sources of funding used.

Q: Plimoth Plantation's overall WACC is 11%. It has an opportunity to accept a project that involves nearly riskless cash flows, but will earn only 7%. This project will require a significant portion of the firm's capital. If Plimoth accepts this project, A) the value of the company will fall because it's WACC will fall. B) the value of the company will fall because it's average rate of return on investments will fall. C) the value of the company will rise because its WACC will fall. D) both it's average rate of return and its WACC should fall.

Q: Pilgrim's WACC is 12%. It has one opportunity to invest in a high risk project with an expected rate of return of 25%. It has another opportunity to lease a building to a government agency. The expected rate of return on the lease is 10%. A) Pilgrim should definitely accept the high risk project and reject the leasing arrangement. B) Ideally, Pilgrim would discount the cash flows from each project at a rate appropriate to its risk. C) Pilgrim should definitely accept both projects. D) Pilgrim should finance the lease with all debt and the high risk project with all equity.

Q: Why is it important to use market-based weights rather than balance sheet weights when estimating a company's weighted average cost of capital

Q: National Gridlock's capital structure consisted of $125 million of debt and $250 million of equity before it issued bonds to borrow an additional $125 million. The new funds will be used to finance infrastructure improvements and expansion. The company believes that the project will generate enough cash to retire 1/5 of the bonds each year. How do the borrowing and the repayment plan affect the discount rate(s) that should be used to evaluate this project.

Q: As the corporate tax rate increases, the cost of debt to a corporation increases.