1.The evidence indicates that, on average, a company’s stock price declines when it announces a new issue of equity.
True
2.Debt financing results in lower after-tax earnings relative to equity financing.
True
3.The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value.
False
4.In some instances, additional debt financing can encourage managers to act more in the interests of owners.
True
5.If the maturity of a company’s liabilities is less than that of its assets, the company incurs a refinancing risk.
True
6.When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.
True
7.Financial leverage:
I. increases expected ROE but does not affect its variability.
II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved.
III. is a fundamental financial variable affecting sustainable growth.
IV. increases expected return and risk to owners.
II, III, and IV only
8.The best financing choice is the one that:
A. sets the debt-to-assets ratio equal to 1.
B. trades off the tax disadvantage of debt against the signaling effects of equity.
C. maximizes expected cash flows.
D. ignores the false comfort of financial flexibility.
E. results in the lowest possible financial distress costs.
9.Homemade leverage is:
A. the incurrence of debt by a corporation in order to pay dividends to shareholders.
B. the exclusive use of debt to fund a corporate expansion project.
C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
D. best defined as an increase in a firm’s debt-equity ratio.
E. the term used to describe the capital structure of a levered firm.
F. None of the above.
10.The basic lesson of the M&M theory is that the value of a firm is dependent upon:
A. the firm’s capital structure.
B. the total cash flow of the firm.
C. minimizing the marketed claims.
D. the amount of marketed claims to that firm.
E. the size of the stockholders’ claims.
F. None of the above.
11.The term “financial distress costs” includes which of the following?
I. Direct bankruptcy costs
II. Indirect bankruptcy costs
III. Direct costs related to being financially distressed, but not bankrupt
IV. Indirect costs related to being financially distressed, but not bankrupt
I, II, III, and IV
12.Which of the following is/are helpful for evaluating the effect of leverage on a company’s risk and potential returns?
I. Estimated pro forma coverage ratios
II. The recognition that financing decisions do not affect firm or shareholder value
III. A range of earnings chart and proximity of expected EBIT to the breakeven value
IV. A conservative debt policy that obviates the need to evaluate risk
I and III only
13.In general, the capital structures used by non-financial U.S. firms:
A. typically result in debt-to-asset ratios between 60 and 80 percent.
B. tend to converge to the same proportions of debt and equity.
C. tend to be those that maximize the use of the firm’s available tax shelters.
D. vary significantly across industries.
E. None of the above.
14.Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Tax benefits
IV. Financial flexibility
I and III only
15.Which of the following factors favor the issuance of equity in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility
II and IV only
16.Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility
I and III only
17.Which of the following is NOT a likely financing policy for a rapidly growing business?
A. Adopt a modest dividend payout policy that enables the company to finance most of its growth externally.
B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort.
C. Maintain a conservative leverage ratio to ensure continuous access to financial markets.
D. If external financing is necessary, use debt to the point it does not affect financial flexibility.
E. None of the above.
18.According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct?
I. For financing needs, firms prefer to first tap internal sources such as retained profits and excess cash.
II. There is an inverse relationship between a firm’s profit level and its debt level.
III. Firms prefer to issue new equity rather than source external debt.
IV. A firm’s capital structure is dictated by its need for external financing.
I, II, and IV only
19.Which of the following is NOT an implication of the pecking order theory of capital structure?
A. On average, a firm’s stock price drops when it announces an equity issue.
B. Firms may want to maintain a reserve of cash or unused borrowing capacity.
C. More-profitable firms (all else equal) should have higher debt ratios.
D. Firms may fail to undertake positive-NPV projects if they would have to be financed with a new issue of equity.
20.Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt, but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance?
A. $560,000
B. $1,400,000
C. $8,000,000
D. $20,000,000
21.Which of the following statements regarding interest tax shields is correct?
A. Taxes are reduced by the amount of a firm’s interest-bearing debt.
B. Taxable income is reduced by the amount of a firm’s interest-bearing debt.
C. Taxes are reduced by the amount of the interest on a firm’s debt.
D. Taxable income is reduced by the amount of the interest on a firm’s debt.
22.Which of the following would not be considered a cost of financial distress?
A. Lack of interest tax shields
B. Bankruptcy costs
C. Excessive risk-taking by shareholders
D. Loss of customers or suppliers.
23.When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)?
A. ABC’s cash flows from operations are less volatile than XYZ’s.
B. ABC is a computer software firm, and XYZ is an electric utility.
C. ABC operates in a more competitive industry than XYZ.
D. ABC’s assets have lower resale values than XYZ’s assets.
24.According to the pecking order theory of capital structure, why do firms avoid issuing equity?
A. Because fees associated with issuing new equity are so high
B. Because they want to avoid dilution of earnings per share
C. Because they don’t want to commit to paying dividends on the new equity
D. Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall
25.Under the simplifying assumptions of Modigliani and Miller, an increase in a firm’s financial leverage will:
A. increase the variability in earnings per share.
B. reduce the operating risk of the firm.
C. increase the value of the firm.
D. decrease the value of the firm.
26.The interest tax shield has no value when a firm has:
I. no taxable income.
II. debt-equity ratio of 1.
III. zero debt.
IV. no leverage.
I, III, and IV only
27.Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish’s times-burden-covered ratio if Squamish sells 2 million new shares at $20 a share.
A. 1.03
B. 1.38
C. 1.60
D. 1.89
E. 2.10
F. None of the above.
28.Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish’s earnings per share if Squamish sells 2 million new shares at $20 a share.
A. 1.28
B. 1.39
C. 2.00
D. 2.22
E. 4.00
F. None of the above.
29.Please refer to the financial information for Squamish Equipment above. Calculate Squamish’s times-interest-earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent.
A. 2.00
B. 3.09
C. 3.66
D. 4.35
E. None of the above.
30.Please refer to the financial information for Squamish Equipment above. Calculate Squamish’s times-burden-covered ratio for the next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent and that annual sinking fund payments on the new debt will equal $8 million.
A. 1.01
B. 1.08
C. 1.38
D. 1.49
E. 1.95
F. None of the above.
31.Please refer to the financial information for Squamish Equipment above. Calculate Squamish’s earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent.
A. 1.28
B. 2.00
C. 2.12
D. 2.22
E. 3.06
F. None of the above.
32.The sustainable growth rate is the only growth rate in sales that is consistent with stable values of the profit margin, retention rate, asset turnover, and leverage
True
33.A company experiencing balanced growth does not generate cash surpluses or cash deficits.
True
34.In recent years, U.S. companies as a whole have repurchased more equity than they have issued.
True
35.Share repurchases usually decrease earnings per share.
False
36.One way to manage an actual growth rate below the sustainable growth rate is to repurchase
shares.
True
37.If a company seeks to maximize firm value, it should never grow at a rate above its sustainable growth rate.
False
38.The only way a company can grow at a rate above its current sustainable growth rate is by increasing leverage.
False
39.One way to manage an actual growth rate above the sustainable growth rate is to decrease prices.
False
40.which of the following will increase the sustainable rate of growth a corporation can achieve?
decrease in the dividend payout ratio
41.the retention ratio is
the percentage of net income available to the firm to fund future growth
42.Due to required cash investments in current assets, fast-growing and profitable companies can literally “grow broke”.
True
43.Rapid growth spurs increases in market share and profits and thus, is always a blessing.
False
44.The cash flows generated in a given time period are equal to the profits reported.
False
45.Profits provide assurance that cash flow will be sufficient to maintain solvency.
False
46.the sustainable growth rate of a firm is best described as the
maximum growth rate achievable, excluding any external equity financing while maintaining a constant debt-equity ratio
47.Which of the following is NOT a reason for why U.S. corporations haven’t issued more equity in recent years?
managers usually believe that their stock is overvalued
48.After issue, the market price of a fixed-rate bond can differ substantially from its par value
True
49.Bonds with call provisions will have lower coupon rates than otherwise identical bonds
False
50.common shareholders are the first investors to be repaid in bankruptcy liquidation
False
51.debt instruments offer residual claims to future cash payouts
False
52.bondholders enjoy a direct voice in company decisions
False
53.investment grade bonds are usually defined as bonds with a rating of b or higher
False
54.junk bonds are below investment grade
True
55.junk bonds typically offer lower yields to maturity than investment grade bonds
False
56.in case of bankruptcy, junk bonds have higher priority than preferred stock
True
57.junk bonds offer no coupon payments to investors
False
58.junk bonds are typically defined as bonds with default probabilities of 25% or higher
False
59.what would allow a corporation to issue a bond at a lower coupon rate, all else equal?
issuing at a lower market price
60.which of the following has a purely residual claim against a firms cash flows
common stockholders
61.equity securities offer fixed claims on future cash payouts
False
62. unlike bondholders, for their returns, shareholders rely entirely on price appreciation
False
63. in theory, common shareholders exercise very little control over company decisions
False
64.historically, common shareholders have earned a risk premium as compensation for risk borne in excess of government bonds
True
65.prefered stock differs from common stock in that
preferred stock dividends are fixed
66.general motors raises money by selling a new issue of equity. this transaction occurs in
the primary market
67.Which of the following is an advantage of using private placements for debt?
reduced costs from the elimination of the registration statement for the SEC, investment-banking underwriting fees and distribution costs
68.Cost of capital is true is the ultimate cost of raising funding to run or expand a business
True
69.Cost of capital determines the required return necessary to make a project worthwhile.
True
70.For bonds, cost of capital is always lower than the yield to maturity of the bond.
True
71.For equity, cost of equity is always higher than the required rate of return on common stock.
False
72.increased debt lowers the initial investment required by shareholders.
True
73.Increased debt amplifies the expected return.
True
74.Increased debt amplifies coverage ratios
False
75.Increased debt amplifies the risk faced by shareholders.
True
76.if the operating return on assets is greater than the interest rate on a debt, then a higher debt-to-equity ratio increases return on equity.
True
77.Usually, debt financing in associated with higher cost of capital relative to equity financing.
False
78.Retained earnings is the best source of capital because it has no cost.
False
79.Empirical evidence indicates that, on average, a company’s stock price increases when it announces a new issue of equity.
False
80.The pecking order theory suggests that only firms will outstanding profitability should consider issuing equity to obtain capital.
False
81.The fact that debt financing is generally cheaper than equity financing is only due to the impact of tax.
False
82.When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.
True
83.A company incurs costs of financial distress only after declaring bankruptcy.
False
84.According to the pecking order theory of capital structure, why do firms avoid issuing equity?
Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall
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