Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs; hence they tend to use relatively little debt.
An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
An increase in the company's degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
2. Which of the following statements is CORRECT?
Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.
Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC.
Increasing a company's debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company's WACC.
Increasing a company's debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company's WACC.
Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.
3. Which of the following statements best describes the optimal capital structure?
The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS).
The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt.
The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.
4. If debt financing is used, which of the following is CORRECT?
The percentage change in net operating income will be greater than a given percentage change in net income.
The percentage change in net operating income will be equal to a given percentage change in net income.
The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
The percentage change in net income will be greater than the percentage change in net operating income.
The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.
5. Which of the following statements is CORRECT?
When firms are deciding on the size of stock splits-say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.
Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today.
Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits.
When a company declares a stock split, the price of the stock typically declines-by about 50% after a 2-for-1 split-and this necessarily reduces the total market value of the equity.
If a firm's stock price is quite high relative to most stocks-say $500 per share-then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low-say $2 per share-then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share.
6. Which of the following statements is CORRECT?
Under the tax laws as they existed in 2007, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.
One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends.
Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities.
If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.
Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities.
7. Ting Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and 65% equity, and it also wants to pay a dividend of $400,000. If the company follows a residual dividend policy, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance?
8. Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At current annual sales of 200,000 books, the publisher is just breaking even. It is estimated that if the authors' royalties are reduced, the variable cost per book will drop by $1. Assume authors' royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?
None of the above
9. Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also HD's basic earning power (BEP) exceeds its cost of debt (rd). Which of the following statements is CORRECT?
HD should have a higher return on assets (ROA) than LD.
HD should have a higher times interest earned (TIE) ratio than LD.
HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
Given that BEP > rd, HD's stock price must exceed that of LD.
Given that BEP > rd, LD's stock price must exceed that of HD.
10. Which of the following statements is CORRECT?
Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.
One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like.
An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM.
If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price.
Stock repurchases make the most sense at times when a company believes its stock is undervalued.
11. Which of the following statements about dividend policies is CORRECT?
Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.
One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases.
One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.
One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.
The clientele effect suggests that companies should follow a stable dividend policy.
12. Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? (
Its sales become less stable over time.
The costs that would be incurred in the event of bankruptcy increase.
Management believes that the firm's stock has become overvalued.
Its degree of operating leverage increases.
The corporate tax rate increases.
13. Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?
Sales price variability.
The extent to which operating costs are fixed.
The extent to which interest rates on the firm's debt fluctuate.
Input price variability.
14. Blease Inc. has a capital budget of $625,000, and it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio?
15. You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place?
You will have 200 shares of stock, and the stock will trade at or near $120 a share.
You will have 200 shares of stock, and the stock will trade at or near $60 a share.
You will have 100 shares of stock, and the stock will trade at or near $60 a share.
You will have 50 shares of stock, and the stock will trade at or near $120 a share.
You will have 50 shares of stock, and the stock will trade at or near $60 a share.
16. Which of the following statements is CORRECT?
A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.
17. Fauver Worldwide forecasts a capital budget of $650,000, and it wants to maintain a target capital structure of 40% debt and 60% equity. It also wants to pay a dividend of $225,000. If the company follows the residual dividend policy, how much net income must it earn to meet its capital requirements, pay the dividend, and keep the capital structure in balance?
18. Which of the following statements is CORRECT?
If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.
An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.
Stock repurchases tend to reduce financial leverage.
If a company declares a 2-for-1 stock split, its stock price should roughly double.
One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory.
19. Which of the following statements is CORRECT?
Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.
20. Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?
Company HD has a higher net income than CompanyLD.
Company HD has a lower ROA than Company LD.
Company HD has a lower ROE than Company LD.
The two companies have the same ROA.
The two companies have the same ROE.
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