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Chapter 16
Capital Structure: Basic Concepts
Multiple Choice Questions
1. The u of personal borrowing to change the overall amount of financial leverage to which an
individual is expod is called:
A. homemade leverage.
B. dividend recapture.
C. the weighted average cost of capital.
D. private debt placement.
E. personal offt.
2. The proposition that the value of the firm is independent of its capital structure is called:
A. the capital ast pricing model.
B. MM Proposition I.
C. MM Proposition II.
D. the law of one price.
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E. the efficient markets hypothesis.
3. The proposition that the cost of equity is a positive linear function of capital structure is
called:
A. the capital ast pricing model.
B. MM Proposition I.
C. MM Proposition II.
D. the law of one price.
E. the efficient markets hypothesis.
4. The tax savings of the firm derived from the deductibility of interest expen is called the:
A. interest tax shield.
B. depreciable basis.
C. financing umbrella.boulevard of broken dreams
D. current yield.
E. tax-loss carry forward savings.
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5. The unlevered cost of capital is:
A. the cost of capital for a firm with no equity in its capital structure.
B. the cost of capital for a firm with no debt in its capital structure.
C. the interest tax shield times pretax net income.
D. the cost of preferred stock for a firm with equal parts debt and common stock in its capital
structure.
E. equal to the profit margin for a firm with some debt in its capital structure.
6. The cost of capital for a firm, rWACC, in a zero tax environment is:
A. equal to the expected earnings divided by market value of the unlevered firm.
B. equal to the rate of return for that business risk class.
C. equal to the overall rate of return required on the levered firm.
D. is constant regardless of the amount of leverage.
E. All of the above.
7. The difference between a market value balance sheet and a book value balance sheet is that a
market value balance sheet:
A. places asts on the right hand side.
B. places liabilities on the left hand side.
C. does not equate the right hand with the left hand side.
D. lists items in terms of market values, not historical costs.
E. us the market rate of return.
8. The firm's capital structure refers to:
A. the way a firm invests its asts.
B. the amount of capital in the firm.
C. the amount of dividends a firm pays.
D. the mix of debt and equity ud to finance the firm's asts.
E. how much cash the firm holds.
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9. A general rule for managers to follow is to t the firm's capital structure such that:
A. the firm's value is minimized.
B. the firm's value is maximized.
C. the firm's bondholders are made well off.
D. the firms suppliers of raw materials are satisfied.
E. the firms dividend payout is maximized.
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10. A levered firm is a company that has:
A. Accounts Payable as the only liability on the balance sheet.
B. some debt in the capital structure.
C. all equity in the capital structure.
D. All of the above.
E. None of the above.
11. A manager should attempt to maximize the value of the firm by:
A. changing the capital structure if and only if the value of the firm increas.
B. changing the capital structure if and only if the value of the firm increas to the benefit of
inside management.
C. changing the capital structure if and only if the value of the firm increas only to the
benefits of the debtholders.
jiaodongD. changing the capital structure if and only if the value of the firm increas although it
decreas the stockholders' value.
E. changing the capital structure if and only if the value of the firm increas and stockholder
wealth is constant.
12. The effect of financial leverage depends on the operating earnings of the company. Which
of the following is not true?
A. Below the indifference or break-even point in EBIT the non-levered structure is superior.
B. Financial leverage increas the slope of the EPS line.
C. Above the indifference or break-even point the increa in EPS for all equity structures is
less than debt-equity structures.
D. Above the indifference or break-even point the increa in EPS for all equity structures is
greater than debt-equity structures.
E. The rate of return on operating asts is unaffected by leverage.
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13. The Modigliani-Miller Proposition I without taxes states:
A. a firm cannot change the total value of its outstanding curities by changing its capital
structure proportions.
B. when new projects are added to the firm the firm value is the sum of the old value plus the
new.
C. managers can make correct corporate decisions that will satisfy all shareholders if they lect
projects that maximize value.
D. the determination of value must consider the timing and risk of the cash flows.
E. None of the above.
14. MM Proposition I without taxes is ud to illustrate:
A. the value of an unlevered firm equals that of a levered firm.
B. that one capital structure is as good as another.
C. leverage does not affect the value of the firm.
D. capital structure changes have no effect on stockholders' welfare.
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E. All of the above.
15. A key assumption of MM's Proposition I without taxes is:
A. that financial leverage increas risk.
B. that individuals can borrow on their own account at rates less than the firm.
C. that individuals must be able to borrow on their own account at rates equal to the firm.
D. managers are acting to maximize the value of the firm.
E. All of the above.
16. In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray.
The debt ray has a lower intercept becau:
A. more shares are outstanding for the same level of EBI.
johnny hallydayB. the break-even point is higher with debt.
C. a fixed interest charge must be paid even at low earnings.
D. the amount of interest per share has only a positive effect on the intercept.
E. the higher the interest rate the greater the slope.
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17. In an EPS-EBI graphical relationship, the debt ray and equity ray cross. At this point the
equity and debt are:
A. equivalent with respect to EPS but above and below this point equity is always superior.
B. at breakeven in EPS but above this point debt increas EPS via leverage and decreas EPS
below this point.
C. equal but away from breakeven equity is better as fewer shares are outstanding.
D. at breakeven and MM Proposition II states that debt is the better choice.
E. at breakeven and debt is the better choice below breakeven becau small payments can be
made.
18. When comparing levered vs. unlevered capital structures, leverage works to increa EPS
for high levels of EBIT becau:
A. interest payments on the debt vary with EBIT levels.
ndfB. interest payments on the debt stay fixed, leaving less income to be distributed over less
shares.
C. interest payments on the debt stay fixed, leaving more income to be distributed over less
shares.
D. interest payments on the debt stay fixed, leaving less income to be distributed over more
shares.
E. interest payments on the debt stay fixed, leaving more income to be distributed over more
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19. Financial leverage impacts the performance of the firm by:
A. maintaining the same level of volatility of the firm's EBIT.
B. decreasing the volatility of the firm's EBIT.
C. decreasing the volatility of the firm's net income.
D. increasing the volatility of the firm's net income.
E. None of the above.
20. The increa in risk to equityholders when financial leverage is introduced is evidenced by:
A. higher EPS as EBIT increas.
B. a higher variability of EPS with debt than all equity.
openyoureyesC. incread u of homemade leverage.
D. equivalence value between levered and unlevered firms in the prence of taxes.
E. None of the above.
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21. The reason that MM Proposition I does not hold in the prence of corporate taxation is
becau:
A. levered firms pay less taxes compared with identical unlevered firms.
B. bondholders require higher rates of return compared with stockholders.
C. earnings per share are no longer relevant with taxes.
D. dividends are no longer relevant with taxes.
E. All of the above.
