Questions Chapter 17
1) Which of the following statements are true as a firm approaches bankruptcy?
I. Stockholders will try to push the firm into bankruptcy as rapidly as possible.
II. Bondholders will attempt to push the firm into bankruptcy to prevent their position from
deteriorating.
III. It will be harder to retain company personnel.
IV. Indirect bankruptcy costs such as opportunity costs will tend to decrease.
[A] I and IV only
[B] II and III only
[C] I, II, and III only
[D] II, III, and IV only
[E] I, II, III, and IV
[A] :If stockholders have the most to lose, why would they push a firm into bankruptcy?
Review section 17.5.
[B] :You are correct!
[C] :If stockholders have the most to lose, why would they push a firm into bankruptcy?
Review section 17.5.
[D] :Wouldn’t indirect bankruptcy costs increase as a firm approaches bankruptcy? Review
section 17.5.
[E] :If stockholders have the most to lose, why would they push a firm into bankruptcy?
Review section 17.5.
2) The target capital structure is the debt-to-equity ratio that maximizes the:
[A] value of the firm.
[B] firm's weighted average cost of capital.
[C] market price of the firm's preferred stock.
[D] current earnings per share.
[E] market value of the firm's bonds.
[A] :You are correct!
[B] :When the WACC is maximized, firm value is minimized. Does this sound optimal?
Review section 17.6.
[C] :Why would you want to maximize the value of preferred stock instead of common
stock? Review section 17.6.
[D] :This won't necessarily maximize the market value of the firm. Review section 17.6.
[E] :Why would you want to maximize the value of bonds instead of common stock?
Review section 17.6.
3) According to the extended pie model, the value of all of the claims against a firm's cash
flows is not affected by capital structure, but the relative values of claims within the pie
change as the amount of debt financing is increased.
[A] True
[B] False
www.sudanpoint.com/mba
[A] :You are correct!
[B] :The pie doesn't grow, but the relative claims within the pie shift as financial leverage
shifts. Review section 17.7.
4) When a firm files for bankruptcy, the firm often must hire appraisers to determine the fair
value of the firm's assets. This is an example of a direct cost of bankruptcy.
[A] True
[B] False
[A] :You are correct!
[B] :Direct costs are costs that are directly associated with the bankruptcy process, so
appraisal fees would qualify as direct costs. Review section 17.5.
5) The equity risk that arises from the nature of the firm's operating activities is called _____
risk.
[A] business
[B] systematic
[C] unsystematic
[D] financial
[E] diversifiable
[A] :You are correct!
[B] :This term does not match the definition given. Review section 17.3.
[C] :This term does not match the definition given. Review section 17.3.
[D] :This term does not match the definition given. Review section 17.3.
[E] :This term does not match the definition given. Review section 17.3.
6) _____ risk arises from decisions that affect the left-hand side of the balance sheet; while
_____ risk arises from decisions that affect the right-hand side of the balance sheet.
[A] Systematic; financial
[B] Business; financial
[C] Unsystematic; systematic
[D] Business; diversifiable
[E] Systematic; unsystematic
[A] :Systematic risk depends on both business risk and financial risk. Review section 17.3.
[B] :You are correct!
[C] :At a minimum, unsystematic risk is not of concern. Review section 17.3.
[D] :The first part of this response is correct but the second part is incorrect. Review
section 17.3.
[E] :At a minimum, unsystematic risk is not of concern. Review section 17.3.
www.sudanpoint.com/mba
7) Which of the following statements are correct concerning observed capital structures in
the U.S.?
I. On average, firms in the U.S. are fairly heavily leveraged.
II. On average, it appears that U.S. firms do not use the interest tax shield to its fullest.
III. On average, there are very few industries in the U.S. for which total debt exceeds total
equity.
IV. On average, electric utilities and cable companies are some of the most highly
leveraged firms in the U.S.
[A] I and III only
[B] II and IV only
[C] II, III, and IV only
[D] I, II, and III only
[E] I, II, III, and IV
[A] :At least one of these choices is incorrect. Review section 17.8.
[B] :Correct, but there is at least one more correct option. Review section 17.8.
[C] :You are correct!
[D] :At least one of these choices is incorrect. Review section 17.8.
[E] :At least one of these choices is incorrect. Review section 17.8.
8) The Brassy Co. has expected EBIT of $910, debt with a face and market value of $2,000
paying an 8.5 percent annual coupon, and an unlevered cost of capital of 12 percent. If the
tax rate is 34 percent, what is the value of the firm?
[A] $3,258
[B] $3,685
[C] $5,685
[D] $6,325
[E] $7,005
[A] :You need to review this computation in section 17.4.
[B] :You need to review this computation in section 17.4.
[C] :You are correct!
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
9) All else equal, which one of the following is a correct statement?
[A] The business risk of a firm increases when it takes on a risky project.
[B] The business risk of a firm increases when it takes on more debt.
[C] The financial risk of a firm decreases when it takes on a risky project.
[D] The financial risk of a firm increases when it takes on more equity.
[E] The higher the business risk for a firm, the higher the financial risk as well.
[A] :You are correct!
[B] :This would increase financial risk, not business risk. Review section 17.3.
[C] :This would increase business risk, not decrease financial risk. Review section 17.3.
www.sudanpoint.com/mba
[D] :As the firm’s debt/equity ratio decreases, the financial risk of the firm declines as well.
Review section 17.3.
[E] :Financial risk is affected only by changes in the right-hand side of the balance sheet
while business risk is affected by the left-hand side. Review section 17.3.
10) _____ suggests that value-maximizing financial managers will employ capital structures
composed of that mix of debt and equity for which the interest tax shield is equal to the cost
associated with the probability of financial distress.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] The static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :If M&&M I with taxes holds, managers should employ as much debt as possible.
Review sections 17.4 and 17.6.
[B] :With no taxes, the firm's market value does not depend on the amount of debt in the
capital structure. Review sections 17.3 and 17.6.
[C] :You are correct!
[D] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and
17.6.
[E] :This relates to the cost of equity, not the value of the firm. Review sections 17.4 and
17.6.
11) _____ suggests that value-maximizing financial managers will employ capital structures
composed almost entirely of debt.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] The static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :You are correct!
[B] :With no taxes, the firm's market value does not depend on the amount of debt in the
capital structure. Review sections 17.3 and 17.4.
[C] :What about financial distress costs? Review section 17.6.
[D] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and
17.4.
[E] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and
17.4.
12) Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a
financially distressed firm.
[A] True
www.sudanpoint.com/mba
[B] False
[A] :You are correct!
[B] :This is the textbook definition of an indirect cost. Review section 17.5.
13) Below the breakeven EBIT, increased financial leverage will _____, all else equal.
Assume there are no taxes.
[A] increase EPS
[B] decrease EPS
[C] not affect EPS
[D] either increase or decrease EPS but you can’t tell which
[E] increase EBIT and EPS.
[A] :Remember, you are considering the case below the breakeven EBIT. Review section
17.2.
[B] :You are correct!
[C] :EPS will be affected in this case. How? Review section 17.2.
[D] :We can be certain which of these two will occur. Review section 17.2.
[E] :At a minimum, EPS will decrease. Review section 17.2.
14) According to the static theory of capital structure, because financial distress costs exist
there is an optimal capital structure.
[A] True
[B] False
[A] :You are correct!
[B] :This point occurs where the costs of increased financial distress that come from adding
debt are exactly offset by the increased tax benefits of debt. Review section 17.6.
15) You are a secured creditor in a Chapter 11 bankruptcy. Listed below, in chronological
order, are the steps in a bankruptcy proceeding. Just prior to which step would you expect
to have to document the strength of your claim on the firm's assets?
[A] The corporation files a bankruptcy petition.
[B] The petition is approved or denied by a federal judge.
[C] Creditors are divided into classes.
[D] The court confirms the bankruptcy plan.
[E] Payments are made to creditors and shareholders.
[A] :Your chronology is not quite correct. Review section 17.9.
[B] :Your chronology is not quite correct. Review section 17.9.
[C] :You are correct!
[D] :Your chronology is not quite correct. Review section 17.9.
[E] :Your chronology is not quite correct. Review section 17.9.
www.sudanpoint.com/mba
16) The fastest form of bankruptcy is likely to be a prepackaged filing.
[A] True
[B] False
[A] :You are correct!
[B] :With this type of filing, a reorganization plan and the bankruptcy filing are generally
filed at about the same time, expediting the process. Review section 17.9.
17) Which of the following statements concerning leverage are correct?
I. Shareholders can offset the financial leverage of a firm through the use of homemade
leverage.
II. The effect of financial leverage depends on a company’s earnings before interest and
taxes.
III. The use of leverage by a firm does not affect the earnings per share.
IV. Homemade leverage involves the use of personal borrowing or personal lending.
[A] I and III only
[B] II and IV only
[C] I, III, and IV only
[D] I, II, and IV only
[E] I, II, III, and IV
[A] :Doesn’t interest expense affect net income? Review section 17.2.
[B] :Correct, but there is at least one more correct choice. Review section 17.2.
[C] :Doesn’t interest expense affect net income? Review section 17.2.
[D] :You are correct!
[E] :At least one of these options is incorrect. Review section 17.2.
18) Business risk declines as the systematic risk of a firm's assets increases.
[A] True
[B] False
[A] :Business risk increases as the systematic risk increases. Review section 17.3.
[B] :You are correct!
19) When a firm defaults on a legal obligation,:
[A] it is called a business failure.
[B] the firm is in legal bankruptcy.
[C] the firm is in technical insolvency.
[D] the firm is in accounting insolvency.
[E] the firm is in violation of protective covenants.
www.sudanpoint.com/mba
[A] :A business failure occurs when the firm actually goes out of business. That is not the
case here. Review section 17.9.
[B] :Bankruptcy is a legal proceeding that does not necessarily result from the firm
defaulting on a legal obligation. Review section 17.9.
[C] :You are correct!
[D] :Accounting insolvency occurs when the book value of the liabilities exceeds the book
value of the assets. Review section 17.9.
[E] :Protective covenants are not an issue here. Review section 17.9.
20) A firm has an unlevered cost of capital of 10 percent, a cost of debt of 9 percent, and a
tax rate of 34 percent. If it desires a cost of equity of 14 percent, what must its target
debt/equity ratio be?
[A] 2.49
[B] 3.89
[C] 4.68
[D] 5.14
[E] 6.06
[A] :Use M&&M II with taxes to determine this. Review section 17.4.
[B] :Use M&&M II with taxes to determine this. Review section 17.4.
[C] :Use M&&M II with taxes to determine this. Review section 17.4.
[D] :Use M&&M II with taxes to determine this. Review section 17.4.
[E] :You are correct!
21) Which one of the following statements is correct?
[A] The capital structure of a firm does not matter even when taxes are considered.
[B] Firms with substantial tax shields from other sources such as depreciation will benefit
the most from leverage.
[C] Firms in lower tax brackets will tend to benefit more from increases in financial leverage.
[D] The financial structure that minimizes WACC is the one that will minimize the value of
the firm.
[E] Relatively speaking, a firm with mostly tangible assets that can be sold without great
loss in value will have an incentive to borrow more.
[A] :The capital structure does matter once taxes are considered. Review section 17.4.
[B] :These firms will benefit less because of their other tax shields. Review section 17.6.
[C] :The benefit decreases as the tax rate decreases. Review section 17.6.
[D] :Minimizing WACC maximizes the value. Review section 17.6.
[E] :You are correct!
22) All else equal, which one of the following statements is true concerning the interest tax
shield of a firm that has positive earnings before interest and taxes?
[A] The higher the corporate tax rate, the less valuable the interest tax shield.
www.sudanpoint.com/mba
[B] If the firm dramatically increases its depreciation expense it may have more of a need
for an interest tax shield.
[C] The present value of the interest tax shield is the amount of debt multiplied by the
corporate tax rate.
[D] The interest tax shield increases as a firm reduces its level of debt outstanding.
[E] Since the interest tax shield is valuable for a firm, the firm would rather pay a high
coupon rate on its bonds than a low coupon rate.
[A] :The higher the corporate tax rate, the more valuable the interest tax shield. Review
section 17.4.
[B] :Since depreciation and interest are both tax deductible, raising one may make the firm
less able to utilize the tax benefits of the other. Review section 17.4.
[C] :You are correct!
[D] :Since interest expense increases with debt, so does the interest tax shield. Review
section 17.4.
[E] :Even though the interest tax shield is a benefit, firms would rather pay a lower interest
rate, all else equal. Review section 17.4.
23) Which one of the following actions would result in an increase in the debt-to-equity
ratio? (Assume there are no flotation costs.)
[A] A firm issues common stock and uses the proceeds to repurchase an equal amount of
preferred stock.
[B] A firm issues preferred stock and uses the proceeds to repurchase an equal amount of
bonds.
[C] A firm with positive additions to retained earnings uses the cash it generates to retire
existing debt.
[D] A firm uses excess cash to repurchase common stock in an amount equal to additions
to retained earnings for the year.
[E] A firm issues bonds and uses the proceeds to purchase short-term assets.
[A] :This increases the percentage of common stock in the capital structure but it
decreases the percentage of preferred stock by an equivalent amount. Review section 17.1.
[B] :This increases the percentage of preferred stock in the capital structure but it
decreases the percentage of debt by an equivalent amount. Review section 17.1.
[C] :In this case retained earnings increase and debt decreases by the same dollar
amount. Review section 17.1.
[D] :In this case retained earnings increase and common stock decreases by the same
dollar amount. Review section 17.1.
[E] :You are correct!
24) The Wrangler Co. has expected EBIT of $9,250, debt with a face and market value of
$14,000 carrying a 9 percent annual coupon, and an unlevered cost of capital of 12
percent. If the tax rate is 39 percent, what is the value of the firm?
[A] $47,021
[B] $52,481
[C] $55,635
[D] $58,525
www.sudanpoint.com/mba
[E] $65,600
[A] :This is the value of the unlevered firm. Now what about the debt? Review section 17.4.
[B] :You are correct!
[C] :You need to review this computation in section 17.4.
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
25) Which one of the following describes a correct priority of claims in a bankruptcy
liquidation?
[A] Wages, government tax claims, consumer claims, preferred stockholders
[B] Government tax claims, bankruptcy expenses, unsecured creditors, preferred
stockholders
[C] Bankruptcy expenses, consumer claims, unsecured creditors, government tax claims
[D] Government tax claims, unsecured creditors, preferred stockholders, bankruptcy
expenses
[E] Bankruptcy expenses, wages, unsecured creditors, preferred stockholders
[A] :Consumer claims usually have priority over government tax claims. Review section
17.9.
[B] :Bankruptcy expenses usually have priority over government tax claims. Review section
17.9.
[C] :Government tax claims usually have priority over unsecured creditors. Review section
17.9.
[D] :Bankruptcy expenses usually have priority over these other three claims. Review
section 17.9.
[E] :You are correct!
26) Which of the following statements are correct regarding financial leverage?
I. Whenever a firm's debt increases faster than its equity, financial leverage increases.
II. Leverage is most beneficial when EBIT is relatively high.
III. Increasing financial leverage will always increase the ROE and EPS of stockholders.
IV. The level of financial leverage that produces the highest firm value is the one most
beneficial to stockholders.
[A] I and III only
[B] II and IV only
[C] I and II only
[D] I, II, and IV only
[E] I, II, III, and IV
[A] :At least one of these options is incorrect. Review section 17.2.
[B] :Consider the definition of financial leverage to find one more correct option. Review
section 17.2.
[C] :Why is option IV not correct? Isn’t the highest firm value the most beneficial to
stockholders? Review section 17.2.
[D] :You are correct!
www.sudanpoint.com/mba
[E] :Refer to table 17.4 in the textbook to determine which one of these four options is
incorrect. Review section 17.2.
27) The unlevered cost of capital for Red Ryder Original BBs, Inc. is 12 percent. Debt costs
run 8 percent before-tax for the firm. Assuming a capital structure of 25 percent debt and 75
percent equity, what is the cost of equity? The tax rate is 34 percent.
[A] 11.0 percent
[B] 12.6 percent
[C] 12.9 percent
[D] 13.4 percent
[E] 13.8 percent
[A] :You need to review this computation in section 17.4.
[B] :You need to review this computation in section 17.4.
[C] :You are correct!
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
28) All else equal, which of the following claims to a firm's cash flows will tend to increase
with decreases in the debt-to-equity ratio assuming there are taxes?
I. the government's claim in the form of taxes
II. the claims from bankruptcy costs
III. the claims of stockholders
IV. the claims of bondholders
[A] I and III only
[B] I and IV only
[C] II and IV only
[D] I, II, and III only
[E] I, II, and IV only
[A] :You are correct!
[B] :At least one of these choices is incorrect. Review section 17.7.
[C] :At least one of these choices is incorrect. Review section 17.7.
[D] :At least one of these choices is incorrect. Review section 17.7.
[E] :At least one of these choices is incorrect. Review section 17.7.
29) Which one of the following correctly describes the value of an unlevered firm under
M&&M Proposition I with corporate taxes?
[A] VU = EBIT / [RU X (1 - TC)]
[B] VU = [EBIT + (1 - TC)] / RU
[C] VU = [EBIT X (1 + TC) X (D/E)] / RU
[D] VU = [EBIT X (1 - TC) X (D/E)] / RU
[E] VU = [EBIT X (1 - TC)] / RU
www.sudanpoint.com/mba
[A] :You need to review this proposition in section 17.4.
[B] :You need to review this proposition in section 17.4.
[C] :You need to review this proposition in section 17.4.
[D] :You need to review this proposition in section 17.4.
[E] :You are correct!
30) A firm that wishes to proceed with a straight liquidation will file under Chapter 7 of the
Federal Bankruptcy Reform Act of 1978.
[A] True
[B] False
[A] :You are correct!
[B] :While Chapter 11 is a reorganization, Chapter 7 is a "straight" liquidation. Review
section 17.9.
31) According to the M&&M propositions without taxes, there is an optimal amount of
leverage for a firm.
[A] True
[B] False
[A] :According to M&&M II without taxes, the WACC remains unchanged as the debt-toequity ratio increases, meaning capital structure is irrelevant. Review section 17.3.
[B] :You are correct!
32) When choosing a capital structure, the objective of the firm should be to choose:
[A] the one that maximizes the current value of the firm's bonds.
[B] the one that minimizes the value of the firm.
[C] the one that minimizes the firm's WACC.
[D] the one that results in the largest interest tax shield.
[E] any capital structure since capital structure is always irrelevant.
[A] :What is the goal of the financial manager of a firm? Review chapter 1.
[B] :Why should the financial manager minimize the value of the firm? Review section 17.6.
[C] :You are correct!
[D] :This calls for large amounts of debt. What about the associated financial distress
costs? Review section 17.6.
[E] :This statement is not correct once taxes and the costs of financial distress are
considered. Review section 17.6.
33) All else equal, which one of the following will alter the capital structure of a firm?
[A] A firm sells bonds and uses the proceeds to buy back stock.
www.sudanpoint.com/mba
[B] A firm refunds a bond issue by issuing new bonds.
[C] A firm uses the proceeds of a sale of bonds to pay off bank debt.
[D] A firm pays all of its earnings out to stockholders in the form of dividends, retaining
nothing.
[E] A firm makes an interest payment on its bonds.
[A] :You are correct!
[B] :If the values of the two bond issues are the same there will be no change in the capital
structure. There is a better choice. Review section 17.1.
[C] :Since this swaps one form of debt for another, there will be no change in the capital
structure. There is a better choice. Review section 17.1.
[D] :This leaves both debt and equity unchanged so there will be no change in the capital
structure. Review section 17.1.
[E] :This does not alter the amount of debt or equity outstanding so there will be no change
in the capital structure. Review section 17.1.
34) The main lesson to be learned from the M&&M theory of capital structure is that:
[A] a firm can affect its value by changing its capital structure.
[B] the size of a pie is determined by how many slices it has.
[C] the WACC increases as financial leverage decreases.
[D] a firm's capital structure should be one hundred percent equity.
[E] the value of a firm is determined by its total cash flows.
[A] :Capital structure changes just cut the pie into more slices, it doesn’t alter the size of
the pie. Review section 17.7.
[B] :The size of the pie does not change. Review section 17.7.
[C] :This is not the main lesson to be learned from M&&M. Review section 17.7.
[D] :This is not one of the conclusions of the M&&M models. Review section 17.7.
[E] :You are correct!
35) Which one of the following individuals has NOT acquired a marketed claim against RDJ
corporation?
[A] John purchased 250 shares of RDJ common stock.
[B] Tom acquired rights allowing him to purchase 50 shares of RDJ common stock.
[C] Suzie just won a lawsuit against RDJ.
[D] Susan recently purchased 200 shares of preferred stock in RDJ Corporation.
[E] Jim purchased a long-term bond issued by RDJ.
[A] :This is a marketed claim. Review section 17.7.
[B] :This is a marketed claim. Review section 17.7.
[C] :You are correct!
[D] :This is a marketed claim. Review section 17.7.
[E] :This is a marketed claim. Review section 17.7.
36) The optimal capital structure is that mixture of debt and equity which:
www.sudanpoint.com/mba
I. maximizes the value of the firm.
II. minimizes the firm's weighted average cost of capital.
III. maximizes the market price of the firm's bonds.
[A] I only
[B] III only
[C] I and II only
[D] I and III only
[E] I, II, and III
[A] :Correct, but there is at least one more correct option. Review section 17.6.
[B] :What is the goal of the financial manager of a firm? Review chapter 1.
[C] :You are correct!
[D] :At least one of these choices is incorrect. Review section 17.6.
[E] :At least one of these choices is incorrect. Review section 17.6.
37) Suppose you draw a graph illustrating M&&M Proposition II. Let the vertical axis
represent the cost of capital and the firm's debt-to-equity ratio represent the horizontal axis;
then if the slope of the line representing the firm's WACC has a negative slope, we must be
incorporating taxes into the analysis.
[A] True
[B] False
[A] :You are correct!
[B] :According to M&&M II with taxes, as the leverage of a firm increases, its WACC
decreases. Review section 17.4.
38) According to M&&M Proposition II without taxes, a firm's cost of equity is a function of
which of the following factors?
I. the required rate of return on the firm's assets
II. the firm's debt/equity ratio
III. the firm's cost of debt
[A] II only
[B] I and II only
[C] I and III only
[D] II and III only
[E] I, II, and III
[A] :There is at least one more correct option. Review section 17.3.
[B] :Why doesn't the cost of debt matter? Review section 17.3.
[C] :Why doesn't the debt/equity ratio matter? Review section 17.3.
[D] :Why doesn't the required return on the firm's assets matter? Review section 17.3.
[E] :You are correct!
39) Which one of the following is considered an indirect bankruptcy cost?
www.sudanpoint.com/mba
[A] the cost of the extra insurance a bankruptcy court may require a firm to carry on its
assets
[B] the cost a firm must pay to the court when filing its bankruptcy petition
[C] the cost of any appraisals a bankruptcy court requires a firm to obtain
[D] the fee the firm pays its lawyer to draw up the bankruptcy petition
[E] the cost of projects in progress that are terminated in order to preserve cash to prevent
a bankruptcy
[A] :This is a direct bankruptcy cost. Review section 17.5.
[B] :This is a direct bankruptcy cost. Review section 17.5.
[C] :This is a direct bankruptcy cost. Review section 17.5.
[D] :This is a direct bankruptcy cost. Review section 17.5.
[E] :You are correct!
40) A firm that has negative net worth is said to be:
[A] experiencing a business failure.
[B] in legal bankruptcy.
[C] experiencing technical insolvency.
[D] experiencing accounting insolvency.
[E] in Chapter 11, bankruptcy reorganization.
[A] :Having a negative net worth does not imply the firm will go out of business and must
be liquidated at a loss to creditors. Review section 17.9.
[B] :Bankruptcy is a legal process and does not necessarily result from a firm having
negative net worth. Review section 17.9.
[C] :Technical insolvency exists when a firm misses payment on a financial obligation. The
firm need not have negative net worth to do so. Review section 17.9.
[D] :You are correct!
[E] :A firm does not have to have a negative net worth to file bankruptcy, and vice-versa.
Review section 17.9.
41) Which of the following are true about bankruptcy and its costs?
I. If a firm is insolvent on an accounting basis, then an ensuing legal bankruptcy may end
with the bondholders not receiving all they are owed.
II. Direct bankruptcy costs include the legal and administrative costs incurred during the
bankruptcy process.
III. A firm faces technical insolvency if it is unable to meet its financial obligations.
IV. Direct bankruptcy costs are a disincentive to debt financing.
[A] I and II only
[B] I, II, and IV only
[C] I, III, and IV only
[D] II, III, and IV only
[E] I, II, III, and IV
[A] :Correct, but there is at least one more correct option. Review sections 17.5 and 17.9.
[B] :Option III is also correct. Review section 17.9.
www.sudanpoint.com/mba
[C] :Option II is also correct. Review section 17.5.
[D] :How can you pay all of your bills if your liabilities exceed your assets? Review section
17.9.
[E] :You are correct!
42) Business risk is a positive function of the systematic risk of a firm's assets.
[A] True
[B] False
[A] :You are correct!
[B] :Since business risk is the risk inherent in a firm's operations, this will be a positive
function of systematic risk. Review section 17.3.
43) An unlevered firm has an EBIT of $250,000, net income after tax of $175,000 and a
cost of capital of 12 percent. A levered firm with the same assets and operations has debt
with a face and market value of $1.25 million carrying an 8 percent annual coupon. What is
the value of the levered firm? The tax rate is 34 percent.
[A] $1,250,000
[B] $1,375,000
[C] $1,666,667
[D] $1,800,000
[E] $2,625,000
[A] :You need to review this computation in section 17.4.
[B] :This is the value of the unlevered firm. Now what about the debt? Review section 17.4.
[C] :You need to review this computation in section 17.4.
[D] :You are correct!
[E] :You need to review this computation in section 17.4.
44) Which of the following correctly describes the value of a levered firm under M&&M
Proposition I with corporate taxes?
[A] VL = VU + TC + D
[B] VL = VU X TC X D
[C] VL = VU - TC X D
[D] VL = VU + TC X D
[E] VL = VU X TC - D
[A] :You need to review this proposition in section 17.4.
[B] :You need to review this proposition in section 17.4.
[C] :You need to review this proposition in section 17.4.
[D] :You are correct!
[E] :You need to review this proposition in section 17.4.
www.sudanpoint.com/mba
45) _____ describes the situation in which a firm is having trouble meeting its financial
obligations.
[A] Technical bankruptcy
[B] Legal bankruptcy
[C] Financial distress
[D] Direct bankruptcy cost
[E] Business risk
[A] :Since the question does not state that the firm is in bankruptcy, there is a better choice.
Review section 17.5.
[B] :Since the question does not state that the firm is in bankruptcy, there is a better choice.
Review section 17.5.
[C] :You are correct!
[D] :Since the question does not state that the firm is in bankruptcy, there is a better
choice. Review section 17.5.
[E] :All firms face business risk while not all firms have trouble meeting their financial
obligations. Review section 17.5.
46) The equity risk that arises from the capital structure of the firm is called _____ risk.
[A] systematic
[B] business
[C] unsystematic
[D] financial
[E] diversifiable
[A] :This term does not match the definition given. Review section 17.3.
[B] :This term does not match the definition given. Review section 17.3.
[C] :This term does not match the definition given. Review section 17.3.
[D] :You are correct!
[E] :This term does not match the definition given. Review section 17.3.
47) Which of the following correctly describes M&&M Proposition II without taxes?
[A] RE = RA X (RA - RD) + (D/E)
[B] RE = RD + (RD - RA) X (D/E)
[C] RE = RD + (RA - RD) X (E/D)
[D] RE = RA + (RA - RD) X (E/D)
[E] RE = RA + (RA - RD) X (D/E)
[A] :You need to review this proposition in section 17.3.
[B] :You need to review this proposition in section 17.3.
[C] :You need to review this proposition in section 17.3.
[D] :You need to review this proposition in section 17.3.
[E] :You are correct!
www.sudanpoint.com/mba
48) Which of the following statements is (are) true regarding corporate borrowing when
EBIT is positive?
I. Increasing financial leverage increases the sensitivity of EPS and ROE to changes in
EBIT.
II. The effect of financial leverage depends on the company's EBIT, that is, leverage is
unfavorable when EBIT is relatively high, and leverage is favorable when EBIT is relatively
low.
III. High leverage decreases the returns to shareholders, as measured by ROE.
[A] I only
[B] II only
[C] III only
[D] I and II only
[E] I, II, and III
[A] :You are correct!
[B] :Actually, the reverse of this statement is true. Review section 17.2.
[C] :Leverage increases ROE. Review section 17.2.
[D] :One of these responses is incorrect. Review section 17.2.
[E] :At least one of these responses is incorrect. Review section 17.2.
49) The Brassy Co. has expected EBIT of $910, debt with a face and market value of
$2,000 paying an 8.5 percent annual coupon, and an unlevered cost of capital of 12
percent. If the tax rate is 34 percent, what is the value of the equity of Brassy Co.?
[A] $3,258
[B] $3,685
[C] $5,685
[D] $6,325
[E] $7,005
[A] :You need to review this computation in section 17.4.
[B] :You are correct!
[C] :You need to review this computation in section 17.4.
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
50) The Wrangler Co. has expected EBIT of $9,250 and debt with a face and market value
of $14,000 paying a 9 percent annual coupon. The market value of the firm is $58,525. If
the tax rate is 34 percent, what is the unlevered cost of capital for the firm?
[A] 9.00 percent
[B] 11.35 percent
[C] 12.12 percent
[D] 12.76 percent
[E] 12.99 percent
[A] :Use M&&M I with taxes to determine this. Review section 17.4.
www.sudanpoint.com/mba
[B] :You are correct!
[C] :Use M&&M I with taxes to determine this. Review section 17.4.
[D] :Use M&&M I with taxes to determine this. Review section 17.4.
[E] :Use M&&M I with taxes to determine this. Review section 17.4.
51) Direct bankruptcy costs are those costs that are directly associated with bankruptcy,
such as legal and administrative expenses.
[A] True
[B] False
[A] :You are correct!
[B] :This is the textbook definition of a direct cost. Review section 17.5.
52) Which one of the following correctly describes M&&M Proposition II with taxes?
[A] RE = RU + (RU - RD) X (D/E) X (1 - TC)
[B] RE = RD + (RD - RA) X (D/E) X (1 - TC)
[C] RE = RU X (RU - RA) + (D/E) X (1 + TC)
[D] RE = RU + (RU - RD) X (E/D) + (1 + TC)
[E] RE = RU + (RA - RD) X (E/D) + (1 - TC)
[A] :You are correct!
[B] :You need to review this proposition in section 17.4.
[C] :You need to review this proposition in section 17.4.
[D] :You need to review this proposition in section 17.4.
[E] :You need to review this proposition in section 17.4.
53) If a firm fails to meet the required interest payment on its long-term bonds, it is said to
be in:
[A] business failure.
[B] Chapter 11 bankruptcy.
[C] accounting insolvency.
[D] technical insolvency.
[E] Chapter 7 bankruptcy.
[A] :A business failure occurs when the firm actually goes out of business. That is not the
case here. Review section 17.9.
[B] :Bankruptcy is a legal proceeding that must be initiated, it is not automatically launched
when interest payments are missed. Review section 17.9.
[C] :Accounting insolvency occurs when the book value of the liabilities exceeds the book
value of the assets. That is not specifically addressed here. Review section 17.9.
[D] :You are correct!
[E] :Bankruptcy is a legal proceeding that must be initiated, it is not automatically launched
when interest payments are missed. Review section 17.9.
www.sudanpoint.com/mba
54) ABC, Inc. has a debt/equity ratio of 1.2. The firm has a cost of equity of 12 percent and
a cost of debt of 8 percent. What will the cost of equity be if the target capital structure
becomes 67 percent debt and 33 percent equity? The cost of debt does not change. Ignore
taxes.
[A] 10.56 percent
[B] 11.12 percent
[C] 13.52 percent
[D] 13.64 percent
[E] 14.45 percent
[A] :To find this, first use M&&M I without taxes to find the WACC. Did you get 9.82
percent? Then use M&&M I without taxes and the new debt/equity ratio to recompute the
cost of equity. Review section 17.4.
[B] :To find this, first use M&&M I without taxes to find the WACC. Did you get 9.82
percent? Then use M&&M I without taxes and the new debt/equity ratio to recompute the
cost of equity. Review section 17.4.
[C] :You are correct!
[D] :To find this, first use M&&M I without taxes to find the WACC. Did you get 9.82
percent? Then use M&&M I without taxes and the new debt/equity ratio to recompute the
cost of equity. Review section 17.4.
[E] :To find this, first use M&&M I without taxes to find the WACC. Did you get 9.82
percent? Then use M&&M I without taxes and the new debt/equity ratio to recompute the
cost of equity. Review section 17.4.
55) An unlevered firm has a net income after tax of $125,000. The unlevered cost of capital
is 13 percent and the corporate tax rate is 34 percent. What is the value of this firm?
[A] $594,102
[B] $634,615
[C] $729,654
[D] $961,538
[E] $1,051,591
[A] :You must first find EBIT. Did you get $189,394? You need to review this computation
in section 17.4.
[B] :You must first find EBIT. Did you get $189,394? You need to review this computation
in section 17.4.
[C] :You must first find EBIT. Did you get $189,394? You need to review this computation
in section 17.4.
[D] :You are correct!
[E] :You must first find EBIT. Did you get $189,394? You need to review this computation
in section 17.4.
56) Because investors can use homemade leverage to create any level of financial
leverage they desire, the capital structure of a firm does not matter to them.
www.sudanpoint.com/mba
[A] True
[B] False
[A] :You are correct!
[B] :By using homemade leverage, investors can create any level of financial leverage they
desire for themselves without the company's help. Review section 17.2.
57) M&&M Proposition I with taxes implies that:
[A] the value of an unlevered firm exceeds the value of a levered firm by the amount of the
present value of the interest tax shield.
[B] a levered firm can increase its value by reducing debt.
[C] the optimal amount of leverage for a firm is not possible to determine.
[D] the value of a levered firm is equal to after-tax EBIT discounted by the unlevered cost of
capital.
[E] there is a linear relationship between the amount of debt in a levered firm and its value.
[A] :The value of the levered firm exceeds the value of an unlevered firm. Why? Review
section 17.4.
[B] :According to M&&M I with taxes, adding debt always increases value up until the firm
has 100 percent debt. Review section 17.4.
[C] :When taxes are included, there is an optimal capital structure. Review section 17.4.
[D] :This statement is true for the value of an unlevered firm. Review section 17.4.
[E] :You are correct!
58) For a levered firm, the cost of equity, RE, is equal to the required return on the firm's
assets, RA.
[A] True
[B] False
[A] :A firm that is levered has debt, so its required return on assets will differ from its
required return on equity. Review section 17.3.
[B] :You are correct!
59) Which of the following are correct rankings of priorities if the claims are ranked from
strongest to weakest?
I. wages and salaries; consumer claims; unsecured creditors
II. contributions to employee benefit plans; consumer claims; common stockholders
III. government tax claims; preferred stockholders; unsecured creditors
IV. bankruptcy-related administrative expenses; wages and salaries; common stockholders
[A] I and II only
[B] III and IV only
[C] I, II, and IV only
[D] II, III, and IV only
[E] I, II, III, and IV
www.sudanpoint.com/mba
[A] :There is one more correct ranking. Review section 17.9.
[B] :One of these is an incorrect ranking. Review section 17.9.
[C] :You are correct!
[D] :One of these is an incorrect ranking. Review section 17.9.
[E] :One of these is an incorrect ranking. Review section 17.9.
60) A firm's systematic risk will _____ as its debt-to-equity ratio_____:
[A] increase; increases.
[B] decrease; increases.
[C] remain unchanged; decreases.
[D] remain unchanged; increases.
[E] not be affected; increases, but its unsystematic risk will increase.
[A] :You are correct!
[B] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio
rises? Review section 17.3.
[C] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio
falls? Review section 17.3.
[D] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio
rises? Review section 17.3.
[E] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio
rises? Review section 17.3.
61) Which one of the following formulas is associated with M&&M Proposition II without
taxes?
[A] VL = VU + TC X D
[B] RE = RU + (RU - RD) X (D/E) X (1 – TC)
[C] RE = RA + (RA - RD) X (D/E)
[D] VL = VU
[E] RE = RA
[A] :This is M&&M Proposition I with taxes. Review section 17.4.
[B] :This is M&&M Proposition II with taxes. Review section 17.4.
[C] :You are correct!
[D] :This is M&&M Proposition I without taxes. Review section 17.3.
[E] :This formula does not apply to any of the M&&M Propositions. Review section 17.3.
62) It has been observed that, when firms get into financial trouble, they often find it difficult
to attract and retain high-quality employees. The additional costs incurred in this situation
would be considered direct bankruptcy costs.
[A] True
[B] False
www.sudanpoint.com/mba
[A] :As a firm struggles to avoid bankruptcy, it incurs costs of avoiding a filing that are
called indirect costs. The inability to attract and retain quality employees is certainly an
indirect cost in this process. Review section 17.5.
[B] :You are correct!
63) The Brassy Co. has expected EBIT of $910, an unlevered cost of capital of 12 percent,
and debt with a face and market value of $2,000 paying an 8.5 percent annual coupon. If
the tax rate is 34 percent, what is the cost of equity of Brassy Co.?
[A] 12.99 percent
[B] 13.25 percent
[C] 13.76 percent
[D] 14.64 percent
[E] 18.45 percent
[A] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. Use this information plus M&&M II with taxes to find the cost of equity.
Review section 17.4.
[B] :You are correct!
[C] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. Use this information plus M&&M II with taxes to find the cost of equity.
Review section 17.4.
[D] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. Use this information plus M&&M II with taxes to find the cost of equity.
Review section 17.4.
[E] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. Use this information plus M&&M II with taxes to find the cost of equity.
Review section 17.4.
64) Assume there are no corporate or personal taxes. According to M&&M Proposition:
[A] I, the total value of the firm depends on how cash flows are divided up between
stockholders and bondholders.
[B] I, a firm's capital structure is relevant.
[C] II, the cost of equity rises as the firm increases its use of debt financing.
[D] II, the cost of equity depends on the firm's business risk but not its financial risk.
[E] I and II, as debt increases, the increase in the cost of equity is more than offset by the
lower cost of debt and the WACC falls.
[A] :The size of the pie does not change as the capital structure changes. Review section
17.3.
[B] :The value of the firm remains unchanged as debt is added to the capital structure.
Review section 17.3.
[C] :You are correct!
www.sudanpoint.com/mba
[D] :Since the cost of equity changes as the capital structure changes, the cost of equity
depends on the firm's financial risk. Review section 17.3.
[E] :The two offset one another exactly and the WACC remains unchanged as debt is
added. Review section 17.3.
65) According to _____, a firm's cost of equity rises with increases in the amount of debt but
the WACC decreases.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[B] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[C] :According to the static theory, the WACC first falls then rises as debt is added. Review
section 17.6.
[D] :The WACC does not change with changes in the amount of debt when there are no
taxes. Review section 17.3.
[E] :You are correct!
66) Given the following information, what is GEM Corporation's WACC? EBIT = $2 million;
tax rate = 34 percent; market value and book value of debt = $4 million; unlevered cost of
capital = 14 percent; cost of debt = 9 percent.
[A] 11.4 percent
[B] 11.9 percent
[C] 12.2 percent
[D] 12.6 percent
[E] 13.1 percent
[A] :You must first use M&&M I with taxes to find the total value of the firm to be $10.7886
million. Then, use M&&M II with taxes to find the cost of equity to be 15.94 percent. Finally,
find the WACC. Review section 17.4.
[B] :You must first use M&&M I with taxes to find the total value of the firm to be $10.7886
million. Then, use M&&M II with taxes to find the cost of equity to be 15.94 percent. Finally,
find the WACC. Review section 17.4.
[C] :You are correct!
[D] :You must first use M&&M I with taxes to find the total value of the firm to be $10.7886
million. Then, use M&&M II with taxes to find the cost of equity to be 15.94 percent. Finally,
find the WACC. Review section 17.4.
[E] :You must first use M&&M I with taxes to find the total value of the firm to be $10.7886
million. Then, use M&&M II with taxes to find the cost of equity to be 15.94 percent. Finally,
find the WACC. Review section 17.4.
67) The effect of financial leverage depends on a company's EBIT.
www.sudanpoint.com/mba
[A] True
[B] False
[A] :You are correct!
[B] :When EBIT is high, financial leverage is beneficial. Review section 17.2.
68) According to _____, a firm's cost of equity rises with increases in the amount of debt but
the WACC remains unchanged.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[B] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[C] :The WACC does not remain unchanged according to the static theory. Review section
17.6.
[D] :You are correct!
[E] :The WACC falls as debt increases when taxes are present. Review section 17.4.
69) According to the static theory of capital structure, value-maximizing financial managers
will borrow to the point where the firm's business risk is just equal to its financial risk.
[A] True
[B] False
[A] :The static theory states a firm should borrow up to the point where the tax benefit from
an extra dollar of debt is exactly equal to the costs of an increased probability of financial
distress. Review section 17.6.
[B] :You are correct!
70) The interest tax shield for a firm:
[A] is the tax benefit a firm derives from paying interest.
[B] will decrease as the corporate income tax rate is increased.
[C] is the yield-to-maturity on a firm's bonds multiplied by the market value of the bonds
outstanding and by the firm's tax rate.
[D] is equal to the coupon interest rate of the firm's debt.
[E] will be positive at all levels of EBIT.
[A] :You are correct!
[B] :The interest tax shield increases as the corporate tax rate is increased. Review section
17.4.
www.sudanpoint.com/mba
[C] :To compute the interest tax shield you need to know the par value of the bonds
outstanding and the coupon rate paid in addition to knowing the corporate tax rate. Review
section 17.4.
[D] :The coupon rate plays a major part in this calculation, but not the only part. Review
section 17.4.
[E] :If EBIT is negative, the interest expense will not create a tax benefit. Review section
17.4.
71) According to _____, a firm's cost of equity is a positive linear function of its degree of
leverage.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the dynamic theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition III with taxes
[A] :M&&M I does not relate to a firm's cost of equity. Review sections 17.3 and 17.4.
[B] :M&&M I does not relate to a firm's cost of equity. Review sections 17.3 and 17.4.
[C] :There is no such theory of capital structure. Review sections 17.3 and 17.4.
[D] :You are correct!
[E] :There is no such thing as M&&M Proposition III. Review section 17.4.
72) Suppose you draw a graph with EBIT on the horizontal axis and EPS on the vertical
axis. Which one of the following is true if you compare a levered firm versus an unlevered
firm using this graph? Assume there are no taxes.
[A] The levered firm has a lower intercept than the unlevered firm but we cannot say
anything about the slope.
[B] The levered firm has a lower intercept and a higher slope than does the unlevered firm.
[C] The levered firm has a higher intercept and a lower slope than does the unlevered firm.
[D] The unlevered firm has a higher intercept than the levered firm but we cannot say
anything about the slope.
[E] The unlevered firm has a lower intercept and a higher slope than does the levered firm.
[A] :This is correct regarding the intercept but not the slope. Review section 17.2.
[B] :You are correct!
[C] :This is incorrect regarding both the intercept and the slope. Review section 17.2.
[D] :This is correct regarding the intercept but not the slope. Review section 17.2.
[E] :The unlevered firm has a higher intercept and lower slope. Review section 17.2.
73) If the static theory of capital structure is true, then the optimal level of debt for a given
firm increases as its marginal tax rate increases and decreases as the costs of financial
distress increase.
[A] True
[B] False
www.sudanpoint.com/mba
[A] :You are correct!
[B] :As the tax rate increases, the present value of the tax shield increases on debt and the
optimal amount of debt increases. As the financial distress costs increase, the optimal level
of debt decreases. Review section 17.6.
74) Ignoring financial distress costs, borrowing money decreases the value of the firm by
increasing the firm's tax liability.
[A] True
[B] False
[A] :Borrowing money increases the present value of the firm's interest tax shield,
increasing the value of the firm. Review section 17.4.
[B] :You are correct!
75) The cost of debt is generally lower than the cost of equity; however, according to
_____, replacing equity with debt will not change the value of the firm because the savings
attributable to the lower cost of debt financing will be offset by the higher required return on
the remaining equity.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :When taxes are present, a firm's capital structure does impact its value. Review
section 17.4.
[B] :You are correct!
[C] :According to the static theory, capital structure does affect value. Review section 17.6.
[D] :M&&M II does not relate to the value of the firm. Review sections 17.3 and 17.4.
[E] :M&&M II does not relate to the value of the firm. Review sections 17.3 and 17.4.
76) Which of the following statements are true?
I. The total systematic risk of a firm's equity has two parts: business risk and financial risk.
II. The interest tax shield reduces the weighted average cost of capital (WACC) of a firm, all
else constant.
III. Most firms in the U.S. maintain relatively low debt-to-equity ratios.
IV. The costs of bankruptcy decrease the attractiveness of debt financing.
[A] I and III only
[B] II and IV only
[C] I, II, and III only
[D] II, III, and IV only
[E] I, II, III, and IV
www.sudanpoint.com/mba
[A] :Correct, but there is at least one more correct option. Review sections 17.4 and 17.5.
[B] :Correct, but there is at least one more correct option. Review sections 17.3 and 17.8.
[C] :If option IV is not correct, then why don’t firms rely solely on debt financing? Review
section 17.5.
[D] :Option I is also correct. Review section 17.3.
[E] :You are correct!
77) Which one of the following statements is correct concerning a bankruptcy
reorganization under Chapter 11 of the Federal Bankruptcy Reform Act of 1978?
[A] Only voluntary petitions can be filed for Chapter 11.
[B] A bankruptcy judge must accept all voluntary petitions for Chapter 11 bankruptcy.
[C] In most cases, a trustee is appointed to manage a firm that is in Chapter 11 bankruptcy.
[D] Everyone in a class must accept the reorganization plan for the plan to be approved.
[E] New shares of stock may be issued as a result of a Chapter 11 bankruptcy.
[A] :Involuntary petitions can be filed by creditors. Review section 17.9.
[B] :A judge can deny the petition. Review section 17.9.
[C] :In most cases, the management of the corporation continues to manage the firm.
Review section 17.9.
[D] :Only the majority of a class has to agree for the plan to be accepted. Review section
17.9.
[E] :You are correct!
78) The legal proceeding for liquidating or reorganizing a business is called:
[A] a lawsuit.
[B] accounting insolvency.
[C] technical insolvency.
[D] legal bankruptcy.
[E] business failure.
[A] :This term does not match this definition. Review section 17.9.
[B] :Accounting insolvency occurs when the book value of the liabilities exceeds the book
value of the assets. Review section 17.9.
[C] :Technical insolvency occurs when a firm is unable to meet its financial obligations.
Review section 17.9.
[D] :You are correct!
[E] :A business failure occurs when the firm actually goes out of business and ceases
operations. Review section 17.9.
79) Of the following, _____ would MOST likely lead to a Chapter 7 bankruptcy liquidation.
[A] the need to escape long-term leases on closed stores
[B] a prepackaged bankruptcy filing
[C] technical insolvency
[D] accounting insolvency
www.sudanpoint.com/mba
[E] financial distress
[A] :This is more likely to result in a Chapter 11 reorganization than a “straight” liquidation.
Review section 17.9.
[B] :Prepacks are Chapter 11 reorganizations, not a “straight” liquidation. Review section
17.9.
[C] :You are correct!
[D] :While this may result in a Chapter 11 reorganization, it is less likely to result in a
“straight” liquidation. There is a better choice. Review section 17.9.
[E] :While this may result in a Chapter 11 reorganization, it is less likely to result in a
“straight” liquidation. There is a better choice. Review section 17.9.
80) Which of the following is (are) true regarding observed capital structures?
I. Drug companies appear to use less debt than electric utility companies do.
II. It appears that many firms choose to pay substantial taxes rather than increase debt to
further benefit from the interest tax shield.
III. It appears that, for whatever reason, capital structures vary quite a bit across industry
groups.
[A] I only
[B] III only
[C] I and III only
[D] I and II only
[E] I, II, and III
[A] :Correct, but there is at least one more correct option. Review section 17.8.
[B] :Correct, but there is at least one more correct option. Review section 17.8.
[C] :Correct, but do firms really use their tax shelters to their fullest? Review section 17.8.
[D] :Correct, but do firms in different industries really have the same capital structures?
Review section 17.8.
[E] :You are correct!
81) All else equal, the financial leverage of a firm will:
[A] decrease as the amount of debt increases relative to equity.
[B] decrease as the firm's retained earnings account grows.
[C] increase by the amount of equity it issues in a given year.
[D] decrease if the firm has negative net income.
[E] decrease as the firm uses debt to fund expansion projects.
[A] :As debt increases, leverage increases. Review section 17.2.
[B] :You are correct!
[C] :Financial leverage decreases as equity is added to the capital structure. Review
section 17.2.
[D] :If a firm has negative net income, earnings retained will be negative and the proportion
of equity relative to debt will fall. Review section 17.2.
[E] :As debt increases, leverage increases. Review section 17.2.
www.sudanpoint.com/mba
82) _____ suggests that value-maximizing financial managers will look to the asset side of
the balance sheet to increase firm value, since the mix of debt and equity employed is
unlikely to affect firm value.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] The static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :If M&&M I with taxes holds, managers should employ as much debt as possible.
Review sections 17.3 and 17.4.
[B] :You are correct!
[C] :You need to review section 17.3.
[D] :This relates to the cost of equity, not the value of the firm. Review section 17.3.
[E] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and
17.4.
83) Based on M&&M II without taxes, what is the cost of equity for a firm with a required
return on assets of 14 percent, a cost of debt of 11 percent, and a target debt/equity ratio of
.50?
[A] 11.0 percent
[B] 12.5 percent
[C] 14.0 percent
[D] 15.5 percent
[E] 17.0 percent
[A] :You need to review this computation in section 17.3.
[B] :You need to review this computation in section 17.3.
[C] :You need to review this computation in section 17.3.
[D] :You are correct!
[E] :You need to review this computation in section 17.3.
84) Which of the following statements is (are) correct if there are no personal or corporate
income taxes and the overall cost of capital of a firm is unaffected by its capital structure?
I. A firm's cost of equity depends on the firm's business and financial risks.
II. The value of the firm is dependent on its capital structure.
III. The cost of equity increases as the firm's leverage decreases.
[A] I only
[B] II only
[C] III only
[D] I and III only
[E] II and III only
[A] :You are correct!
www.sudanpoint.com/mba
[B] :The value of the firm is not dependent on the capital structure when there are no taxes.
Review section 17.3.
[C] :The cost of equity increases as the firm's leverage increases. Review section 17.3.
[D] :At least one of these responses is incorrect. Review section 17.3.
[E] :At least one of these responses is incorrect. Review section 17.3.
85) A firm with no debt has 200,000 shares outstanding valued at $20 each. Its cost of
equity is 12 percent. The firm is considering adding $1,000,000 in debt to its capital
structure. The coupon rate would be 8 percent and the firm's tax rate is 34 percent. What
would the firm be worth after adding the debt?
[A] $4.033 million
[B] $4.180 million
[C] $4.340 million
[D] $4.660 million
[E] $5.000 million
[A] :You need to review this computation in section 17.4.
[B] :You need to review this computation in section 17.4.
[C] :You are correct!
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
86) Which one of the following is true concerning the rates of return earned on shares of a
levered firm in terms of the possible range of earnings? Assume there are no taxes.
[A] The rates do not differ from those of an unlevered firm.
[B] The rates are higher than an unlevered firm on the upside, but unchanged on the
downside.
[C] The rates are unchanged from an unlevered firm on the upside, but lower on the
downside.
[D] The rates are higher than an unlevered firm on the upside, but lower on the downside.
[E] The rates are unchanged from an unlevered firm on the upside, but higher on the
downside.
[A] :The rates earned do depend on the leverage of the firm. Review section 17.2.
[B] :Actually, leverage affects returns in both directions. Review section 17.2.
[C] :Actually, leverage affects returns in both directions. Review section 17.2.
[D] :You are correct!
[E] :Actually, leverage affects returns in both directions. Review section 17.2.
87) In a(n) _____ a business is terminated, usually with a loss to creditors.
[A] violation of protective covenants
[B] bankruptcy reorganization
[C] technical insolvency
[D] accounting insolvency
www.sudanpoint.com/mba
[E] business failure
[A] :Protective covenants are not an issue here. Review section 17.9.
[B] :Bankruptcy reorganization is a legal proceeding that does not result in termination of
the business. Review section 17.9.
[C] :Technical insolvency occurs when a firm is unable to meet its financial obligations.
Review section 17.9.
[D] :Accounting insolvency occurs when the book value of the liabilities exceeds the book
value of the assets. Review section 17.9.
[E] :You are correct!
88) According to _____, the value of the firm is independent of its capital structure.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :When taxes are present, a firm's capital structure does impact its value. Review
section 17.4.
[B] :You are correct!
[C] :According to the static theory, capital structure does affect value. Review section 17.6.
[D] :M&&M II does not relate to the value of the firm. Review sections 17.3 and 17.4.
[E] :M&&M II does not relate to the value of the firm. Review sections 17.3 and 17.4.
89) According to _____, a firm's cost of equity rises with increases in the amount of debt
while the WACC first falls and then rises as debt is added.
[A] M&&M Proposition I with taxes
[B] M&&M Proposition I without taxes
[C] the static theory of capital structure
[D] M&&M Proposition II without taxes
[E] M&&M Proposition II with taxes
[A] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[B] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and 17.4.
[C] :You are correct!
[D] :The WACC does not change with changes in the amount of debt when there are no
taxes. Review section 17.3.
[E] :The WACC falls as debt increases when taxes are present. Review section 17.4.
90) According to the static theory of capital structure:
[A] a firm is fixed in terms of its debt-equity ratio and only considers changes in its assets.
[B] a firm will borrow up to the point where the benefit from an extra dollar of debt is just
equal to the cost of the increased probability of financial distress.
www.sudanpoint.com/mba
[C] the value of the firm will differ from the M&&M value without taxes by the loss from
leverage, net of distress costs.
[D] the optimal level of debt is found when a firm is 100 percent financed by debt.
[E] the value of the unlevered firm in M&&M I with taxes is overstated by the loss in value
due to possible financial distress.
[A] :Just the opposite is true. Review section 17.6.
[B] :You are correct!
[C] :Leverage adds value to a firm. Review section 17.6.
[D] :What about financial distress costs? Review section 17.6.
[E] :This is correct for a levered firm. Review section 17.6.
91) According to M&&M Proposition I with taxes, the:
[A] WACC increases as leverage increases.
[B] unlevered value of the firm is equal to the levered value.
[C] present value of the tax shield can be expressed as “Tc X D”.
[D] capital structure of a firm is irrelevant.
[E] WACC remains constant as the debt-equity ratio changes.
[A] :WACC decreases as leverage increases. Review section 17.4.
[B] :This is true only if there are no taxes. Review section 17.4.
[C] :You are correct!
[D] :The capital structure is relevant when taxes are considered. Review section 17.4.
[E] :WACC decreases as the debt/equity ratio increases. Review section 17.4.
92) The Wrangler Co. has expected EBIT of $9,250, debt with a face and market value of
$14,000 paying a 9 percent annual coupon, and an unlevered cost of capital of 12 percent.
If the tax rate is 39 percent, what is the value of the equity of the firm?
[A] $38,481
[B] $52,481
[C] $55,635
[D] $58,525
[E] $65,600
[A] :You are correct!
[B] :This is the total firm value, now find the value of the equity only. Review section 17.4.
[C] :You need to review this computation in section 17.4.
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
93) Which one of the following statements is true concerning the weighted average cost of
capital (WACC)?
[A] WACC ignores taxes.
[B] The optimal capital structure is the one that maximizes the WACC.
www.sudanpoint.com/mba
[C] The value of a firm will be maximized when the WACC is minimized.
[D] WACC ignores the capital structure of a firm.
[E] Since discount rates and present values move in the same direction, minimizing the
WACC will minimize the value of the firm's cash flows.
[A] :WACC includes taxes. Review section 17.1.
[B] :The optimal capital structure results in the lowest possible WACC. Review section
17.1.
[C] :You are correct!
[D] :The weights in the WACC formula are based on the capital structure of a firm. Review
section 17.1.
[E] :Discount rates and present values move in opposite directions from one another.
Review section 17.1.
94) Which one of the following statements is correct?
[A] Decisions regarding a firm's debt and equity can be called capital budgeting decisions.
[B] The asset beta is a measure of the unsystematic risk of a firm's assets.
[C] In a pure capital restructuring, the composition of the assets of the firm will change.
[D] The value of the overall firm will not change as a result of a capital restructuring unless
the NPV of the restructuring is negative.
[E] The use of personal leverage by an investor to alter the degree of financial leverage to
which the investor is exposed is called homemade leverage.
[A] :Capital budgeting is the process of planning and managing a firm's investment in longterm assets. Review the introduction to chapter 17.
[B] :Betas always measure systematic risk. Review the end of chapter questions in chapter
17.
[C] :If only the capital structure is altered, how will assets change? Review the introduction
to chapter 17.
[D] :The value of the overall firm will change if the NPV of the restructuring is either
negative or positive. Review section 17.1.
[E] :You are correct!
95) When the value of a firm's assets equals the value of its debt (i.e., the firm's equity has
no value) the firm is in:
[A] economic bankruptcy.
[B] technical insolvency.
[C] legal bankruptcy.
[D] liquidation.
[E] default.
[A] :You are correct!
[B] :A firm in technical insolvency cannot meet its financial obligations, which is not
necessarily the case here. Review sections 17.5 and 17.9.
[C] :Bankruptcy is a legal process and is not necessarily related to the value of the firm's
assets versus the value of its debt. Review sections 17.5 and 17.9.
[D] :The firm is not necessarily in liquidation at this point. Review sections 17.5 and 17.9.
www.sudanpoint.com/mba
[E] :The firm is not necessarily in default at this point. Review sections 17.5 and 17.9.
96) In order to avoid bankruptcy, management sometimes seeks to work with creditors.
One method of restructuring debt involves composition, which involves a reduction in the
amount of the payment to be made.
[A] True
[B] False
[A] :You are correct!
[B] :This is one of the forms of voluntary restructuring that might occur. Review section
17.9.
97) Homemade leverage is the use of personal borrowing to change the overall amount of
financial leverage to which an individual is exposed.
[A] True
[B] False
[A] :You are correct!
[B] :This is the textbook definition of homemade leverage. Review section 17.2.
98) Which of the following statements regarding leverage are correct?
I. The ultimate effect of leverage depends on the firm's EBIT.
II. As a firm levers up, shareholders are exposed to more and more risk.
III. The benefits of leverage will not be as great in a firm with substantial accumulated
losses or other types of tax shields as for a firm without many tax shields.
IV. Beyond a certain point, the costs of financial distress outweigh the benefits of leverage.
[A] I and III only
[B] II and IV only
[C] II, III, and IV only
[D] I, II, and IV only
[E] I, II, III, and IV
[A] :Correct, but can’t the cost of financial distress sometimes outweigh the benefits of
leverage? Review section 17.2.
[B] :Correct, but consider this: How can you benefit from a tax deduction if you don’t owe
any tax? Review section 17.6.
[C] :Why is option I incorrect? Review section 17.2.
[D] :Correct, but consider this: How can you benefit from a tax deduction if you don’t owe
any tax? Review section 17.6.
[E] :You are correct!
www.sudanpoint.com/mba
99) A firm has 10,000 bonds outstanding, each with a face value of $1,000 and a coupon
payment of $55 every six months. If the corporate tax rate is 34 percent, what is the interest
tax shield each year?
[A] $187,000
[B] $374,000
[C] $748,000
[D] $976,000
[E] $1,240,000
[A] :Is this the tax shield for six months or for one year? Review section 17.4.
[B] :You are correct!
[C] :You need to review this computation in section 17.4.
[D] :You need to review this computation in section 17.4.
[E] :You need to review this computation in section 17.4.
100) The Brassy Co. has expected EBIT of $910, an unlevered cost of capital of 12 percent
and debt with a face and market value of $2,000 paying an 8.5 percent annual coupon. If
the tax rate is 34 percent, what is the WACC of Brassy Co.?
[A] 10.56 percent
[B] 11.12 percent
[C] 13.25 percent
[D] 13.64 percent
[E] 14.45 percent
[A] :You are correct!
[B] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. In addition, from M&&M II with taxes, the cost of equity must be 13.25
percent. Use this information plus the information given to find the WACC. Review section
17.4.
[C] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. In addition, from M&&M II with taxes, the cost of equity must be 13.25
percent. Use this information plus the information given to find the WACC. Review section
17.4.
[D] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. In addition, from M&&M II with taxes, the cost of equity must be 13.25
percent. Use this information plus the information given to find the WACC. Review section
17.4.
[E] :First, you must find the value of the levered firm using M&&M I with taxes. Did you get
$5,685? From this you know the market value of debt is $2,000 and the market value of
equity is $3,685. In addition, from M&&M II with taxes, the cost of equity must be 13.25
percent. Use this information plus the information given to find the WACC. Review section
17.4.
www.sudanpoint.com/mba
www.sudanpoint.com/mba