Chapter 13 - Test Bank - Static
Student: ______
1. A new board of directors of the BMP Corporation is considering a capital restructuring as currently BMP uses no-debt financing. The board is considering issuing $3 400 000 of debt and using the funds to retire one quarter of 160 000 shares that the company currently has outstanding. The interest rate on debt is 8.30% per annum. Calculate the break-even level of earnings before interest and taxes (EBIT) between both capital structure options.
A. $282 200
B. $375 326
C. $1 128 800
D. $2 550 000
2. The corporate tax rate is 37%. The MaPol Company has a $100 million debenture issue outstanding with a coupon rate of 6.84% per annum. Face value of one debenture is $10 000 and investors require a 7% return on debentures with similar credit rating. What is the present value of the tax shield?
A. $7 000 000
B. $30 160 000
C. $25 300 800
D. $37 000 000
3. The BaPol Company has a cost of equity of 14% and a weighted average cost of capital of 13.02%. What is the company's cost of debt, if BaPol Company maintains the debt−equity ratio of 0.44? Consider that there are no taxes.
A. 17.59%
B. 13.48%
C. 16.68%
D. 10.80%
4. Janus International is an all-equity company. You are given the following information for Janus International: EBIT = $880 000 forever Corporate tax rate = 25% Cost of equity = 12% The company is in the process of issuing $1 000 000 of bonds at par that carry a 11.50% annual coupon. What is the levered value of the firm?
A. $5 750 000
B. $6 655 250
C. $8 000 000
D. $5 528 750
5. If we observe capital structures across the industries in Australia, what industry typically has the highest debt–equity ratios, excluding banks?
A. Gold mining
B. Property trusts
C. Capital goods
D. Utilities
6. Financial risk is defined as the:
A. equity risk that comes from the capital structure of a firm.
B. risk associated with a firm's level of surplus cash.
C. probability that a firm's weighted average cost of capital (WACC) will increase.
D. credit risk associated with the firm's borrowing.
7. The legal and administrative costs of liquidation are called _____ bankruptcy costs.
A. static
B. sunk
C. direct
D. indirect
8. Liquidation is best defined as:
A. the termination of a going concern.
B. a legal process for revising the capital structure of a firm.
C. the process of closing a business due to the inability to meet financial obligations.
D. a legal proceeding for liquidating or reorganising a business.
9. A firm's optimal capital structure:
A. is generally a mix of 40% debt and 60% equity.
B. exists when the debt–equity ratio is 0.50.
C. is found by locating the mix of debt and equity which causes the earnings per share to equal exactly $1.
D. is the debt–equity ratio that results in the lowest possible weighted average cost of capital.
10. Assume that you are comparing two firms that are identical, with one exception. Firm A is an all–equity firm and firm B has a debt–equity ratio of 0.60. All things being equal, firm A will:
A. have lower EPS than firm B when the level of EBIT is relatively low.
B. have lower EPS than firm B when the level of earnings before interest and taxes (EBIT) is relatively high.
C. always have higher EPS than firm B, since it has no interest expense.
D. generate a higher EBIT, but lower net income than firm B.
11. You are comparing two financial policies. The first is all equity. The second involves the use of $2 million of debt. The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT) is $450 000. Given this, it is accurate to say that leverage _____ beneficial to the firm when EBIT is $325 000 and _____ beneficial when EBIT is $625 000.
A. is; is not
B. The answer cannot be determined based on the information provided.
C. is not; is
D. is; is
12. Less Debt Inc. just revised its capital structure such that the firm's debt–equity ratio decreased from 0.80 to 0.40. Those individual investors who prefer the old capital structure:
A. should loan out funds equivalent to the amount invested in Less Debt.
B. should sell half of their equity holdings and invest in cash.
C. can replicate that structure by reducing their debt and doubling their investment in the firm.
D. can replicate that structure by increasing their use of homemade leverage.
13. Taylor & Taylor has positive earnings before interest and taxes (EBIT). Given this, which one of the following statements related to the interest tax shield is correct?
A. The value of the interest tax shield is inversely related to the amount of financial leverage employed.
B. The present value of the tax shield is equal to TC x D.
C. The present value of the tax shield is equal to (TC− RD) D.
D. As EBIT increases, the value of the interest tax shield decreases.
14. M&M Proposition I, with taxes, states that the value of a levered (VL) firm is equal to:
A. VU− (TC − RD) x D
B. VU− (TC x D)
C. VU + (TC x D)
D. VU + (TC − RD) x D
15. The maximum firm value, according to the static theory of capital structure, occurs at a point where the:
A. value of the firm, as defined by M&M Proposition I, with tax, is exactly equal to the value of the firm, as defined by M&M Proposition I, without tax.
B. financial distress costs are equal to zero.
C. value of the firm equalises the costs of financial distress with the present value of the tax shield on debt.
D. value of the firm is equal to the value defined by M&M Proposition I, with tax.
16. Blue & Co. is an all-equity firm with a total market value of $230 000. The firm has 25 000 shares outstanding. Management is considering issuing $100 000 of debt at an interest rate of 7% and using the proceeds to repurchase shares. Management estimates that the economy will be fairly normal and thus the firm's earnings before interest and taxes (EBIT) will be $60 000. Ignore taxes. What are the anticipated earnings per share (EPS) if the debt is issued?
A. $3.82
B. $3.75
C. $3.46
D. $3.20
17. Bartlett Specialists is considering two different capital structures. The first option consists of 15 000 shares of stock. The second option consists of 9000 shares of stock plus $80 000 of debt at an interest rate of 7.5%. Ignore taxes. What is the break-even level of earnings before interest and taxes (EBIT) between these two options?
A. $19 400
B. $20 000
C. $18 600
D. $15 000
18. Deltona, USA is a development company that is currently financed with 100% equity. There are 15 000 shares outstanding at a market price of $50 a share. Deltona has earnings before interest and taxes (EBIT) of $20 000. The firm has decided to issue $250 000 of debt at a rate of 8% and use the proceeds to repurchase shares. Theresa owns 500 shares of Deltona and wants to use homemade leverage to offset the leverage used by Deltona. Theresa should:
A. buy an additional 150 shares.
B. sell 167 shares.
C. buy an additional 167 shares.
D. sell 133 shares.
19. Day 'n' Nite currently has 25 000 shares of stock outstanding and no debt. The price per share is $20. The firm is considering borrowing funds at 8% interest and using the proceeds to repurchase 5000 shares of stock. Ignore taxes. How much is the firm borrowing?
A. $180 000
B. $100 000
C. $165 000
D. $140 000
20. Brown's Department Store has a cost of equity of 19.1%, a pre–tax cost of debt of 8%, and a return on assets of 14%. Ignore taxes. What is the debt–equity ratio?
A. 0.70
B. 0.75
C. 0.85
D. 0.80
21. The use of borrowing by an individual to adjust his or her overall exposure to financial leverage is referred to as:
A. homemade leverage.
B. financial risk management.
C. M&M Proposition I.
D. M&M Proposition II.
22. TLC Enterprises just revised its capital structure from a debt–equity ratio of 0.30 to a debt–equity ratio of 0.45. The firm's shareholders who prefer the old capital structure should:
A. sell all of their shares and loan out the entire sale proceeds.
B. sell some shares and hold the sale proceeds in cash.
C. do nothing.
D. sell some shares and loan out the sale proceeds.
23. Which one of the following statements matches M&M Proposition I, without taxes?
A. The dividends paid by a firm determine the firm's value.
B. The cost of equity capital has a positive linear relationship with a firm's capital structure.
C. The cost of equity capital varies in response to changes in a firm's capital structure.
D. The value of a firm is independent of the firm's capital structure.
24. Which one of the following is the equity risk arising from the daily operations of a firm?
A. Industry risk
B. Business risk
C. Financial risk
D. Strategic risk
25. Which one of the following is the equity risk arising from the capital structure selected by a firm?
A. Industry risk
B. Business risk
C. Strategic risk
D. Financial risk
26. Which one of the following statements is the core principle of M&M Proposition I without taxes?
A. Levered firms have greater value than unlevered firms.
B. The interest tax shield increases the value of a firm.
C. A firm's cost of equity is directly related to the firm's debt-equity ratio.
D. The capital structure of a firm is totally irrelevant.
27. Which one of the following is an implication of M&M Proposition II, without taxes?
A. The risk of equity depends on both the degree of financial leverage and the riskiness of the firm's operations.
B. A firm's optimal capital structure is 100% debt.
C. WACC decreases as the debt-equity ratio increases.
D. WACC is unaffected by the capital structure of a firm.
28. Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship?
A. Static theory of interest rates
B. Interest tax shield
C. Homemade leverage
D. Financial risk
29. Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases?
A. Static theory of capital structure
B. M&M Proposition I without taxes
C. M&M Proposition II without taxes
D. M&M Proposition I with taxes
30. Which one of the following represents the present value of the interest tax shield?
A. Tc x D
B. D/(1− Tc)
C. D / Tc
D. D x (1− Tc)
31. Which of the following will increase the value of a levered firm according to M&M Proposition I with taxes?
I. Decrease in the amount of the debt
II. Increase in the value of the unlevered firm
III. Decrease in the tax rate
IV. Increase in the interest rate on the debt
A. II and III only
B. II only
C. I and IV only
D. II and IV only
32. Which of the following statements correctly relate to M&M Proposition I with taxes?
I. Debt decreases the value of a firm.
II. The levered value of a firm exceeds the firm's unlevered value.
III. The weighted average cost of capital (WACC) is constant.
IV. The optimal capital structure is zero debt.
A. II only
B. I, III and IV only
C. I and IV only
D. II and III only
33. Stone House Cafe has a 30% tax rate and total taxes of $35 280. What is the value of the interest tax shield if the interest expense is $16 700?
A. $5010
B. $6023
C. $5395
D. $5708
34. Kelner's Nursery has 8000 bonds outstanding with a face value of $1000 each. The coupon rate is 6.5% and the tax rate is 34%. What is the present value of the interest tax shield?
A. $3.09 million
B. $3.26 million
C. $2.83 million
D. $2.72 million
35. Southern Fried Foods has a $12 million bond issue outstanding with a coupon rate of 6.75% and a yield-to-maturity of 7.27%. What is the present value of the tax shield if the tax rate is 35%?
A. $4 200 000
B. $305 340
C. $3 560 000
D. $283 500
36. Kline Construction is an all-equity firm that has projected perpetual earnings before interest and taxes of $879 000. The current cost of equity is 18.3% and the tax rate is 34%. The company is in the process of issuing $6.2 million of 8.5% annual coupon bonds at par. What is the levered value of the firm?
A. $6 422 225
B. $7 385 695
C. $6 713 185
D. $5 278 164
37. Which one of the following is the theory that a firm should borrow up to the point where the additional tax benefit from an extra dollar of debt equals the additional costs associated with financial distress from that additional debt?
A. M&M Proposition I, without taxes
B. Static theory of capital structure
C. M&M Proposition II, with taxes
D. Homemade leverage proposition
38. The static theory of capital structure assumes a firm:
A. has an all-equity structure.
B. is operating at the point where financial distress costs are eliminated.
C. is fixed in terms of its assets.
D. maintains a constant debt-equity ratio.
39. Which one of the following conditions exists at the point where a firm maximises its value?
A. The debt-equity ratio is 1.0.
B. WACC is minimised
C. Financial distress costs are equal to zero.
D. The tax benefit from an additional dollar of debt is zero.
40. Which one of the following statements related to the static theory of capital structure is correct?
A. The linear function of a firm's value has a constant positive slope.
B. The actual value of a firm continually rises in direct proportion to the increased use of debt.
C. A firm's value is maximised when a firm operates at its optimal debt level.
D. The value of a firm will automatically decrease whenever the debt-equity ratio is decreased.
41. Which one of the following is correct, based on the static theory of capital structure?
A. A firm receives the greatest benefit from debt financing when its tax rate is relatively low.
B. A debt-equity ratio of one is considered to be the optimal capital structure.
C. The costs of financial distress decrease the value of a firm.
D. At the optimal level of debt a firm also optimises its tax shield on debt.
42. Assume both corporate taxes and financial distress costs apply to a firm. Given this, the static theory of capital structure illustrates that:
A. the maximum value of a firm is obtained when a firm is financed solely with debt.
B. a firm's value and its weighted average cost of capital are inversely related.
C. the value of a firm rises as both the interest rate on debt and the tax rate rise.
D. the value of a firm rises as the interest rate on debt rises.
43. Which one of the following best defines legal liquidation?
A. A temporary technical insolvency
B. Negotiating new payment terms with a firm's creditors
C. A legal proceeding for liquidating or reorganising a business
D. The internal process of revising the capital structure of a firm
44. Which one of the following terms refers to the termination of a firm as a going concern?
A. Technical insolvency
B. Liquidation
C. Reorganisation
D. Legal bankruptcy
45. When is a firm insolvent from an accounting perspective?
A. When the firm's revenues cease
B. When the firm's debt exceeds the value of the firm's equity
C. When the market value of the firm's equity equals zero
D. When the firm has a negative net worth
46. Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming the absolute priority rule is followed?
A. Government tax claims
B. Claims by unsecured creditors
C. Bankruptcy administrative expenses
D. Employee wages
47. Barrier Reef Island Resorts has no debt. Its current total value is $58 million. What will the company's value be if it sells $21 million in debt securities and has a tax rate of 30%, assuming that the proceeds will be used to purchase equity?
A. $62 300 000
B. $51 700 000
C. $60 300 000
D. $64 300 000
48. Eastcoast Transport Ltd can borrow at 7.5%. The firm currently has no debt, and the cost of equity is 16%. The current value of the firm is $540 000. What will the value be if the firm borrows $160 000 and uses the proceeds to repurchase shares? The corporate tax rate is 34%.
A. $552 000
B. $571 000
C. $528 000
D. $594 400
49. Manly Manufacturing is comparing two different capital structures. Plan I would result in 23 000 shares and $320 000 in debt. Plan II would result in 17 000 shares and $260 000 in debt. The interest rate on the debt is 10%. Ignoring taxes, EPS will be identical for Plans I and II when EBIT equals which one of the following?
A. $9000
B. $8550
C. $9600
D. $10 750
50. Ettalong Electrical Company Ltd has 9000 shares outstanding and no debt. The new CFO is considering issuing $80 000 of debt and using the proceeds to retire 1500 shares. The coupon rate on the debt is 7.5%. What is the break-even level of earnings before interest and taxes between these two capital structure options if the tax rate is 30%?
A. $18 500
B. $36 000
C. $32 500
D. $24 000
51. Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure?
A. Static theory of capital structure
B. M&M Proposition I
C. M&M Proposition II
D. Homemade leverage theory
52. Which one of the following is a direct liquidation cost?
A. Loss of customer goodwill resulting from a liquidation filing
B. Legal and accounting fees related to a liquidation proceeding
C. Management time spent on a liquidation proceeding
D. Any financial distress cost
53. Which one of the following terms applies to the costs incurred by a firm that is trying to avoid filing for liquidation?
A. Indirect liquidation costs
B. Direct liquidation costs
C. Static theory cost
D. Optimal capital structure cost
54. Greenwood Motels has filed a petition for liquidation but hopes to continue its operations both during and after the liquidation process. Which one of the following terms best applies to this situation?
A. Legal bankruptcy
B. Liquidation
C. Technical insolvency
D. Reorganisation
55. In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first?
A. Technical insolvency definition
B. Absolute priority rule
C. Accounting insolvency definition
D. Australian prudential and regulatory authority
56. Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered. Which one of the following statements is correct regarding these two firms?
A. The levered firm has higher EPS (earnings per share) than the unlevered firm at the break-even point.
B. The levered firm will have higher EPS than the unlevered firm at all levels of EBIT.
C. The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT.
D. The unlevered firm will have higher EPS at relatively low levels of EBIT.
57. Which one of the following statements concerning financial leverage is correct?
A. Financial leverage increases profits and decreases losses.
B. Financial leverage has no effect on a firm's return on equity.
C. Financial leverage refers to the use of common stock.
D. Financial leverage magnifies both profits and losses.
58. Northern Wood Products is an all-equity firm with 16 000 shares of stock outstanding and a total market value of $352 000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $26 000 if the economy is normal, $3000 if the economy is in a recession and $33 000 if the economy booms. Ignore taxes. Management is considering issuing $88 000 of debt with a 6% coupon rate. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession?