Unit 8: Financing Decisions - Practice Quiz

1 What does a firm's capital structure describe?

2 Which financing source normally requires fixed interest payments?

3 According to capital structure theories, a firm's value is generally maximized when its overall cost of capital is:

4 Which measure represents the combined average cost of debt and equity financing?

5 Under the Net Income Approach, increasing the proportion of cheaper debt is expected to:

6 What happens to the value of a firm as leverage increases under the Net Income Approach?

7 Under the Net Operating Income Approach, the overall capitalization rate is assumed to be:

8 Under the Net Operating Income Approach, why does cheaper debt not change the total value of the firm?

9 According to the Traditional Approach, moderate use of debt initially causes WACC to:

10 What happens when debt exceeds the optimal level under the Traditional Approach?

11 Under the Modigliani-Miller Model without taxes, capital structure is considered:

12 In the Modigliani-Miller Model with corporate taxes, debt can increase firm value because of the:

13 Which assumption is associated with the basic Modigliani-Miller Model?

14 An optimal capital structure generally seeks to:

15 Which factor is most directly considered when finding an optimal debt level?

16 Why is financial flexibility considered in a capital structure decision?

17 Which issue should managers examine before adding more debt?

18 Which of the following is a direct cost of bankruptcy?

19 Which of the following is an indirect cost of financial distress?

20 Financial distress occurs when a firm has difficulty:

21 A company is comparing an all-equity plan with 100,000 shares to a debt-equity plan with 60,000 shares and annual interest of $40,000. Ignoring taxes, what is the EBIT–EPS indifference point?

22 A firm's total capital is $2 million, consisting of 35% debt and 65% equity by market value. What is the market value of its debt?

23 Which statement correctly contrasts the predictions of the Net Income and Net Operating Income approaches?

24 A firm has EBIT of $180,000, debt of $600,000 carrying 7% interest, and an equity capitalization rate of 11.5%. Under the Net Income approach, what is the total value of the firm?

25 Under the Net Income approach, both the cost of debt and cost of equity remain constant, with debt costing less than equity. What happens as the debt proportion increases?

26 A firm generates perpetual NOI of $150,000 and has an overall capitalization rate of 10%. Under the Net Operating Income approach, what is the firm's total value after it increases debt?

27 Under the NOI approach, a firm has an overall cost of capital of 10%, debt cost of 6%, and a debt-to-equity ratio of 0.5. What is its cost of equity?

28 According to the Traditional approach, how does moderate use of debt initially affect WACC?

29 A firm continues adding debt after reaching the minimum point on its traditional U-shaped WACC curve. What is the most likely result?

30 Two firms have identical operating assets and cash flows, but one is levered and the other is unlevered. Under MM Proposition I without taxes and with perfect markets, how should their values compare?

31 An unlevered firm is worth $3 million. It permanently issues $800,000 of debt, and the corporate tax rate is 25%. Under the MM model with corporate taxes, what is the levered firm's value?

32 Under MM Proposition II without taxes, the unlevered cost of capital is 9%, debt costs 5%, and . What is the levered cost of equity?

33 A firm estimates WACCs of 10.2%, 9.4%, 8.9%, and 9.3% at debt ratios of 10%, 30%, 40%, and 50%, respectively. Which debt ratio is optimal if expected operating cash flows are unchanged?

34 A proposed capital structure uses 40% debt costing 6% before tax and 60% equity costing 12%. If the corporate tax rate is 30%, what is the WACC?

35 A company operates in a highly cyclical industry and already has volatile operating earnings. Which financing choice is generally most consistent with a prudent capital structure checklist?

36 Founders want to finance an expansion without diluting voting control, but the company can safely meet fixed payments. Which financing choice best addresses their control concern?

37 Which item is an indirect cost of financial distress rather than a direct bankruptcy cost?

38 A financing plan creates an 8% probability of financial distress next year, with an estimated loss of $500,000 if distress occurs. Ignoring discounting, what is the expected distress cost?

39 An additional block of debt provides an expected tax benefit of $55,000 but increases expected financial distress costs by $40,000. What is the net expected contribution to firm value, ignoring other effects?

40 Under the trade-off view, when should a firm stop adding debt?

41 A firm is comparing an all-equity plan with 100,000 shares to a debt-financed plan with 60,000 shares and $1,000,000 of debt at 8% interest. The corporate tax rate is 30%. At what annual EBIT are the two plans' EPS values equal?

42 Under the Net Income Approach with no taxes, a firm has EBIT of $900,000, debt of $2,000,000 at 6%, and a constant equity capitalization rate of 12%. What are the total firm value and overall capitalization rate?

43 Under the Net Operating Income Approach with no taxes, a firm's EBIT is $1.2 million and its overall capitalization rate is 10%. After debt rises to $5 million at a constant 6% interest rate, what is the implied cost of equity?

44 A no-tax firm estimates the following market-value financing costs. At debt ratios of 0%, 20%, 40%, and 60%, its respective pairs are , , , and . Which debt ratio minimizes WACC?

45 In a no-tax MM setting, identical levered and unlevered firms are each worth $10 million. The levered firm has $4 million of perpetual debt at 5% and EBIT of $1.5 million. Which homemade-leverage strategy replicates a 2% holding in the levered firm's equity?

46 An unlevered firm is worth $20 million. It issues $8 million of permanent debt and uses all proceeds to repurchase shares. Assuming only corporate taxes at 25% and standard MM assumptions, what is the value of the levered firm?

47 Under MM Proposition II with corporate taxes, a firm has an unlevered cost of capital of 10%, a pre-tax debt cost of 6%, a debt-to-equity ratio of 1.5, and a tax rate of 25%. What is its cost of equity?

48 A firm has market values of $14 million in equity and $6 million in debt. Its equity cost is 13%, its pre-tax debt cost is 5%, and its corporate tax rate is 30%. What is its market-value WACC?

49 A firm worth $50 million before financing side effects evaluates permanent debt levels. For debt of $0, $10, $20, and $30 million, the respective present values of tax shields are $0, $3, $6, and $9 million, while expected distress costs are $0, $1, $3, and $8 million. Which debt level maximizes firm value?

50 A firm has valuable tax shields available from debt but also has volatile operating cash flows, few tangible assets, restrictive existing covenants, and a likely acquisition requiring rapid financing. Which conclusion best follows from a capital-structure checklist?

51 An additional borrowing would create a tax-shield present value of $4.8 million. It would also increase the probability of distress by 8 percentage points. Conditional on distress, direct and indirect costs have present values of $15 million and $40 million, respectively. What is the incremental net effect on firm value?

52 A firm has existing assets that will certainly pay $80 million next period and debt with a $90 million face value. A new project costs shareholders $12 million today and certainly pays $20 million next period. Ignoring discounting, how does debt overhang affect the decision?

53 A capital-structure theory predicts that as debt replaces equity, both and remain constant, total firm value rises, and WACC declines. Which theory is described?

54 In a Miller-style framework, the corporate tax rate is 25%, the personal tax rate on equity income is 20%, and the personal tax rate on debt income is 40%. Using the effective debt-tax advantage factor , what advantage does debt receive per dollar?

55 A highly profitable firm persistently uses little debt even though estimated distress costs are low. Which interpretation most directly reconciles this observation with financing theory?

56 At its current leverage, each additional $1 of debt is estimated to add $0.25 in present-value tax benefits, $0.18 in expected distress costs, and $0.05 in agency costs. What does a marginal trade-off analysis imply?

57 A company finances permanent assets with short-term floating-rate debt because the current rate is unusually low. Which capital-structure checklist concern is most directly violated?

58 A distressed firm's operations will produce $140 million with probability 60% and $40 million with probability 40%. Continuing incurs an $8 million restructuring cost. Immediate liquidation yields $85 million and incurs a $5 million liquidation cost. Assuming risk neutrality and no discounting, which choice maximizes total claim value?

59 Under the Traditional Approach, moderate leverage initially reduces WACC, but heavy leverage eventually raises it. Which mechanism best explains the resulting interior optimum?

60 Both the Net Operating Income Approach and the no-tax MM model conclude that leverage does not change total firm value. What most clearly distinguishes the MM model's basis for that conclusion?