2) The target capital structure is the debt-to-equity ratio that maximizes the:

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1 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 [C] :If stockholders have the most to lose, why would they push a firm into bankruptcy? Review section [D] :Wouldn t indirect bankruptcy costs increase as a firm approaches bankruptcy? Review section [E] :If stockholders have the most to lose, why would they push a firm into bankruptcy? Review section ) 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. [B] :When the WACC is maximized, firm value is minimized. Does this sound optimal? Review section [C] :Why would you want to maximize the value of preferred stock instead of common stock? Review section [D] :This won't necessarily maximize the market value of the firm. Review section [E] :Why would you want to maximize the value of bonds instead of common stock? Review section ) 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

2 [B] :The pie doesn't grow, but the relative claims within the pie shift as financial leverage shifts. Review section ) 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] :Direct costs are costs that are directly associated with the bankruptcy process, so appraisal fees would qualify as direct costs. Review section ) 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 [B] :This term does not match the definition given. Review section [C] :This term does not match the definition given. Review section [D] :This term does not match the definition given. Review section [E] :This term does not match the definition given. Review section ) 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 [C] :At a minimum, unsystematic risk is not of concern. Review section [D] :The first part of this response is correct but the second part is incorrect. Review section [E] :At a minimum, unsystematic risk is not of concern. Review section 17.3.

3 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 [B] :Correct, but there is at least one more correct option. Review section [D] :At least one of these choices is incorrect. Review section [E] :At least one of these choices is incorrect. Review section ) 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 [B] :You need to review this computation in section [D] :You need to review this computation in section [E] :You need to review this computation in section ) 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. [B] :This would increase financial risk, not business risk. Review section [C] :This would increase business risk, not decrease financial risk. Review section 17.3.

4 [D] :As the firm s debt/equity ratio decreases, the financial risk of the firm declines as well. Review section [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 ) 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 [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 [D] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and [E] :This relates to the cost of equity, not the value of the firm. Review sections 17.4 and ) 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 [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 [C] :What about financial distress costs? Review section [D] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and [E] :This relates to the cost of equity, not the value of the firm. Review sections 17.3 and ) Indirect bankruptcy costs include the costs of avoiding a bankruptcy filing incurred by a financially distressed firm. [A] True

5 [B] :This is the textbook definition of an indirect cost. Review section ) 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 [C] :EPS will be affected in this case. How? Review section [D] :We can be certain which of these two will occur. Review section [E] :At a minimum, EPS will decrease. Review section ) According to the static theory of capital structure, because financial distress costs exist there is an optimal capital structure. [A] True [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 ) 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 [B] :Your chronology is not quite correct. Review section [D] :Your chronology is not quite correct. Review section [E] :Your chronology is not quite correct. Review section 17.9.

6 16) The fastest form of bankruptcy is likely to be a prepackaged filing. [A] True [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 ) 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 [B] :Correct, but there is at least one more correct choice. Review section [C] :Doesn t interest expense affect net income? Review section [D] :You are correct! [E] :At least one of these options is incorrect. Review section ) Business risk declines as the systematic risk of a firm's assets increases. [A] True [A] :Business risk increases as the systematic risk increases. Review section ) 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.

7 [A] :A business failure occurs when the firm actually goes out of business. That is not the case here. Review section [B] :Bankruptcy is a legal proceeding that does not necessarily result from the firm defaulting on a legal obligation. Review section [D] :Accounting insolvency occurs when the book value of the liabilities exceeds the book value of the assets. Review section [E] :Protective covenants are not an issue here. Review section ) 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 [B] :Use M&&M II with taxes to determine this. Review section [C] :Use M&&M II with taxes to determine this. Review section [D] :Use M&&M II with taxes to determine this. Review section [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 [B] :These firms will benefit less because of their other tax shields. Review section [C] :The benefit decreases as the tax rate decreases. Review section [D] :Minimizing WACC maximizes the value. Review section [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.

8 [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 [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 [D] :Since interest expense increases with debt, so does the interest tax shield. Review section [E] :Even though the interest tax shield is a benefit, firms would rather pay a lower interest rate, all else equal. Review section ) 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 [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 [C] :In this case retained earnings increase and debt decreases by the same dollar amount. Review section [D] :In this case retained earnings increase and common stock decreases by the same dollar amount. Review section [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

9 [E] $65,600 [A] :This is the value of the unlevered firm. Now what about the debt? Review section [C] :You need to review this computation in section [D] :You need to review this computation in section [E] :You need to review this computation in section ) 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 [B] :Bankruptcy expenses usually have priority over government tax claims. Review section [C] :Government tax claims usually have priority over unsecured creditors. Review section [D] :Bankruptcy expenses usually have priority over these other three claims. Review section [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 [B] :Consider the definition of financial leverage to find one more correct option. Review section [C] :Why is option IV not correct? Isn t the highest firm value the most beneficial to stockholders? Review section [D] :You are correct!

10 [E] :Refer to table 17.4 in the textbook to determine which one of these four options is incorrect. Review section ) 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 [B] :You need to review this computation in section [D] :You need to review this computation in section [E] :You need to review this computation in section ) 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 [B] :At least one of these choices is incorrect. Review section [C] :At least one of these choices is incorrect. Review section [D] :At least one of these choices is incorrect. Review section [E] :At least one of these choices is incorrect. Review section ) Which one of the following correctly describes the value of an unlevered firm under M&&M Proposition I with corporate taxes? [A] V U = EBIT / [R U X (1 - T C )] [B] V U = [EBIT + (1 - T C )] / R U [C] V U = [EBIT X (1 + T C ) X (D/E)] / R U [D] V U = [EBIT X (1 - T C ) X (D/E)] / R U [E] V U = [EBIT X (1 - T C )] / R U

11 [A] :You need to review this proposition in section [B] :You need to review this proposition in section [C] :You need to review this proposition in section [D] :You need to review this proposition in section [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 [A] True [B] :While Chapter 11 is a reorganization, Chapter 7 is a "straight" liquidation. Review section ) According to the M&&M propositions without taxes, there is an optimal amount of leverage for a firm. [A] True [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 ) 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 [D] :This calls for large amounts of debt. What about the associated financial distress costs? Review section [E] :This statement is not correct once taxes and the costs of financial distress are considered. Review section ) 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.

12 [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. [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 [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 [D] :This leaves both debt and equity unchanged so there will be no change in the capital structure. Review section [E] :This does not alter the amount of debt or equity outstanding so there will be no change in the capital structure. Review section ) 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 [B] :The size of the pie does not change. Review section [C] :This is not the main lesson to be learned from M&&M. Review section [D] :This is not one of the conclusions of the M&&M models. Review section [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 [B] :This is a marketed claim. Review section [D] :This is a marketed claim. Review section [E] :This is a marketed claim. Review section ) The optimal capital structure is that mixture of debt and equity which:

13 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 [B] :What is the goal of the financial manager of a firm? Review chapter 1. [D] :At least one of these choices is incorrect. Review section [E] :At least one of these choices is incorrect. Review section ) 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] :According to M&&M II with taxes, as the leverage of a firm increases, its WACC decreases. Review section ) 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 [B] :Why doesn't the cost of debt matter? Review section [C] :Why doesn't the debt/equity ratio matter? Review section [D] :Why doesn't the required return on the firm's assets matter? Review section [E] :You are correct! 39) Which one of the following is considered an indirect bankruptcy cost?

14 [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 [B] :This is a direct bankruptcy cost. Review section [C] :This is a direct bankruptcy cost. Review section [D] :This is a direct bankruptcy cost. Review section [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 [B] :Bankruptcy is a legal process and does not necessarily result from a firm having negative net worth. Review section [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 [D] :You are correct! [E] :A firm does not have to have a negative net worth to file bankruptcy, and vice-versa. Review section ) 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 [B] :Option III is also correct. Review section 17.9.

15 [C] :Option II is also correct. Review section [D] :How can you pay all of your bills if your liabilities exceed your assets? Review section [E] :You are correct! 42) Business risk is a positive function of the systematic risk of a firm's assets. [A] True [B] :Since business risk is the risk inherent in a firm's operations, this will be a positive function of systematic risk. Review section ) 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 [B] :This is the value of the unlevered firm. Now what about the debt? Review section [C] :You need to review this computation in section [D] :You are correct! [E] :You need to review this computation in section ) Which of the following correctly describes the value of a levered firm under M&&M Proposition I with corporate taxes? [A] V L = V U + T C + D [B] V L = V U X T C X D [C] V L = V U - T C X D [D] V L = V U + T C X D [E] V L = V U X T C - D [A] :You need to review this proposition in section [B] :You need to review this proposition in section [C] :You need to review this proposition in section [D] :You are correct! [E] :You need to review this proposition in section 17.4.

16 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 [B] :Since the question does not state that the firm is in bankruptcy, there is a better choice. Review section [D] :Since the question does not state that the firm is in bankruptcy, there is a better choice. Review section [E] :All firms face business risk while not all firms have trouble meeting their financial obligations. Review section ) 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 [B] :This term does not match the definition given. Review section [C] :This term does not match the definition given. Review section [D] :You are correct! [E] :This term does not match the definition given. Review section ) Which of the following correctly describes M&&M Proposition II without taxes? [A] R E = R A X (R A - R D ) + (D/E) [B] R E = R D + (R D - R A ) X (D/E) [C] R E = R D + (R A - R D ) X (E/D) [D] R E = R A + (R A - R D ) X (E/D) [E] R E = R A + (R A - R D ) X (D/E) [A] :You need to review this proposition in section [B] :You need to review this proposition in section [C] :You need to review this proposition in section [D] :You need to review this proposition in section [E] :You are correct!

17 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 [B] :Actually, the reverse of this statement is true. Review section [C] :Leverage increases ROE. Review section [D] :One of these responses is incorrect. Review section [E] :At least one of these responses is incorrect. Review section ) 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 [C] :You need to review this computation in section [D] :You need to review this computation in section [E] :You need to review this computation in section ) 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] percent [C] percent [D] percent [E] percent [A] :Use M&&M I with taxes to determine this. Review section 17.4.

18 [C] :Use M&&M I with taxes to determine this. Review section [D] :Use M&&M I with taxes to determine this. Review section [E] :Use M&&M I with taxes to determine this. Review section ) Direct bankruptcy costs are those costs that are directly associated with bankruptcy, such as legal and administrative expenses. [A] True [B] :This is the textbook definition of a direct cost. Review section ) Which one of the following correctly describes M&&M Proposition II with taxes? [A] R E = R U + (R U - R D ) X (D/E) X (1 - T C ) [B] R E = R D + (R D - R A ) X (D/E) X (1 - T C ) [C] R E = R U X (R U - R A ) + (D/E) X (1 + T C ) [D] R E = R U + (R U - R D ) X (E/D) + (1 + T C ) [E] R E = R U + (R A - R D ) X (E/D) + (1 - T C ) [B] :You need to review this proposition in section [C] :You need to review this proposition in section [D] :You need to review this proposition in section [E] :You need to review this proposition in section ) 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 [B] :Bankruptcy is a legal proceeding that must be initiated, it is not automatically launched when interest payments are missed. Review section [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 [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.

19 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] percent [B] percent [C] percent [D] percent [E] 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 [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 [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 [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 ) 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 [B] :You must first find EBIT. Did you get $189,394? You need to review this computation in section [C] :You must first find EBIT. Did you get $189,394? You need to review this computation in section [D] :You are correct! [E] :You must first find EBIT. Did you get $189,394? You need to review this computation in section ) 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.

20 [A] True [B] :By using homemade leverage, investors can create any level of financial leverage they desire for themselves without the company's help. Review section ) 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 [B] :According to M&&M I with taxes, adding debt always increases value up until the firm has 100 percent debt. Review section [C] :When taxes are included, there is an optimal capital structure. Review section [D] :This statement is true for the value of an unlevered firm. Review section [E] :You are correct! 58) For a levered firm, the cost of equity, R E, is equal to the required return on the firm's assets, R A. [A] True [A] :A firm that is levered has debt, so its required return on assets will differ from its required return on equity. Review section ) 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

21 [A] :There is one more correct ranking. Review section [B] :One of these is an incorrect ranking. Review section [D] :One of these is an incorrect ranking. Review section [E] :One of these is an incorrect ranking. Review section ) 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. [B] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio rises? Review section [C] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio falls? Review section [D] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio rises? Review section [E] :Is this consistent with what happens to a firm's cost of equity as the debt-to-equity ratio rises? Review section ) Which one of the following formulas is associated with M&&M Proposition II without taxes? [A] V L = V U + T C X D [B] R E = R U + (R U - R D ) X (D/E) X (1 T C ) [C] R E = R A + (R A - R D ) X (D/E) [D] V L = V U [E] R E = R A [A] :This is M&&M Proposition I with taxes. Review section [B] :This is M&&M Proposition II with taxes. Review section [D] :This is M&&M Proposition I without taxes. Review section [E] :This formula does not apply to any of the M&&M Propositions. Review section ) 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

22 [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 ) 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] percent [B] percent [C] percent [D] percent [E] 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 [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 [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 [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 ) 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 [B] :The value of the firm remains unchanged as debt is added to the capital structure. Review section 17.3.

23 [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 [E] :The two offset one another exactly and the WACC remains unchanged as debt is added. Review section ) 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 [B] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and [C] :According to the static theory, the WACC first falls then rises as debt is added. Review section [D] :The WACC does not change with changes in the amount of debt when there are no taxes. Review section [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 $ million. Then, use M&&M II with taxes to find the cost of equity to be percent. Finally, find the WACC. Review section [B] :You must first use M&&M I with taxes to find the total value of the firm to be $ million. Then, use M&&M II with taxes to find the cost of equity to be percent. Finally, find the WACC. Review section [D] :You must first use M&&M I with taxes to find the total value of the firm to be $ million. Then, use M&&M II with taxes to find the cost of equity to be percent. Finally, find the WACC. Review section [E] :You must first use M&&M I with taxes to find the total value of the firm to be $ million. Then, use M&&M II with taxes to find the cost of equity to be percent. Finally, find the WACC. Review section ) The effect of financial leverage depends on a company's EBIT.

24 [A] True [B] :When EBIT is high, financial leverage is beneficial. Review section ) 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 [B] :M&&M I does not relate to a firm's cost of capital. Review sections 17.3 and [C] :The WACC does not remain unchanged according to the static theory. Review section [D] :You are correct! [E] :The WACC falls as debt increases when taxes are present. Review section ) 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 [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 ) 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. [B] :The interest tax shield increases as the corporate tax rate is increased. Review section 17.4.

25 [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 [D] :The coupon rate plays a major part in this calculation, but not the only part. Review section [E] :If EBIT is negative, the interest expense will not create a tax benefit. Review section ) 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 [B] :M&&M I does not relate to a firm's cost of equity. Review sections 17.3 and [C] :There is no such theory of capital structure. Review sections 17.3 and [D] :You are correct! [E] :There is no such thing as M&&M Proposition III. Review section ) 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 [C] :This is incorrect regarding both the intercept and the slope. Review section [D] :This is correct regarding the intercept but not the slope. Review section [E] :The unlevered firm has a higher intercept and lower slope. Review section ) 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

26 [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 ) Ignoring financial distress costs, borrowing money decreases the value of the firm by increasing the firm's tax liability. [A] True [A] :Borrowing money increases the present value of the firm's interest tax shield, increasing the value of the firm. Review section ) 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 [C] :According to the static theory, capital structure does affect value. Review section [D] :M&&M II does not relate to the value of the firm. Review sections 17.3 and [E] :M&&M II does not relate to the value of the firm. Review sections 17.3 and ) 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