Format:  True/False

Learning Objective:  LO 1
Level of Difficulty:  Easy
1. Increasing a firm's outstanding equity will increase firm leverage.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
2. Minimizing the cost of a firm's financing activities also maximizes the total
value of the firm.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
3. When calculating free cash flow, it is important to include interest and principal
payments.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
4. M&M Proposition 1 assumes that the mix of debt and equity that a firm chooses
does not affect real investment policy.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
5. The enterprise value of a firm is the value of equity minus the value of debt.
A) True
B) False
Ans: B

Page 1
 Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
6. A financial restructuring can change the value of a firm's real assets, such as
plant and equipment.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
7. M&M Proposition 2 states that the required rate of return on a firm's stock is
related to the debt-to-equity ratio.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Medium
8. M&M Proposition 1 states that the capital structure of a firm does not affect the
required rate of return on a firm's assets, while M&M Proposition 2 shows that
the required rate of return on firm's equity does change with capital structure
decisions.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
9. If a firm has debt and pays taxes, the present value of the tax shield is the
amount of debt outstanding times the tax rate.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Medium
10. Under the M&M assumptions with taxes, the value of the firm with debt is the

Page 2
 value of the firm without debt plus the present value of the interest tax shield.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 1
Level of Difficulty:  Easy
11. With no debt, the WACC is the cost of equity plus the required rate of return on
the firm's underlying assets.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
12. Issuing debt is less expensive than issuing stock.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
13. Bankruptcy and agency costs both act as limits on the amount of debt in the
capital structure.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
14. Direct-bankruptcy costs are considered transactions costs and occur when a firm
must navigate the bankruptcy process.
A) True
B) False
Ans: A

Page 3
 Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Medium
15. When a firm gets closer to financial distress causing expected bankruptcy costs
to increase, lenders will often charge the firm a lower interest rate in order to
reduce the chance of an actual bankruptcy occurring.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
16. Direct bankruptcy costs are considered small when compared to indirect costs.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
17. Indirect bankruptcy costs include changes in customer and supplier behavior
that negatively affect the firm.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
18. Unlike direct bankruptcy costs, indirect costs are not considered transactions
costs.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2

Page 4
 Level of Difficulty:  Easy
19. Indirect bankruptcy costs will often increase when a firm is in financial stress
and may even push the company into bankruptcy.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Medium
20. More debt in the capital structure provides managers with an incentive to
maximize cash flows, but also makes them want to take on negative NPV
projects.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Medium
21. Dividends reduce the value of lender claims, and this is why bondholders often
limit the firm's ability to distribute cash to equity holders.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
22. Borrowing money and paying out a special dividend to shareholders is an
example of the asset substitution problem.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Easy
23. When a firm is in financial distress, stockholders would like to overinvest in

Page 5
 positive NPV projects.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 2
Level of Difficulty:  Medium
24. Without debt in the capital structure, there are no asset substitution or
underinvestment problems.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 3
Level of Difficulty:  Easy
25. The trade-off theory of capital structure states that leverage is increased until the
marginal cost of debt is equal to the marginal benefit.
A) True
B) False
Ans: A

Format:  True/False
Learning Objective:  LO 3
Level of Difficulty:  Easy
26. Under the pecking order theory, debt is factually the cheapest source of funds
due to the interest tax shield.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 3
Level of Difficulty:  Medium
27. Firms have a difficult time selling equity when in financial distress.
A) True
B) False
Ans: A

Page 6
 Format:  True/False
Learning Objective:  LO 3
Level of Difficulty:  Easy
28. Industries with large amounts of tangible assets often use little debt.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 3
Level of Difficulty:  Easy
29. More profitable firms have less debt, which supports the trade-off theory.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO 4
Level of Difficulty:  Easy
30. Managers often focus on cash flows, but reported accounting earnings are a
better indicator of the firm's economic health.
A) True
B) False
Ans: B

Format:  True/False
Learning Objective:  LO for Appendix
Level of Difficulty:  Medium
31. An operating lease is treated like a purchase for accounting purposes.
A) True

B) False
Ans: B

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
32. A firm's capital structure is the mix of financial securities used to finance its
activities and can include all of the following except
A) stock.
B) bonds.

Page 7
C) equity options.
D) preferred stock.
Ans: C

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
33. The optimal capital structure of a firm
A) minimizes the cost of financing a firm's projects.
B) minimizes interest payments to creditors.
C) maximizes firm value.
D) both a and c.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
34. M&M Proposition 1 assumes all of the following except that
A) there are no taxes.
B) there are no costs to acquiring information.
C) there are no transactions costs.
D) the real investment policy of the firm is affected by its capital structure decisions.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
35. A firm's enterprise value is given by
A) the value of equity plus the value of debt.
B) the value of equity minus the value of debt.
C) the value of equity minus the value of debt plus the value of future projects.
D) none of the above.
Ans: A

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
36. A financial restructuring
A) will not change the value of a firm's real assets under M&M Proposition 1.
B) includes financial transactions that change the capital structure of the firm.

Page 8
C) means that a firm has issued equity to retire debt.
D) both a and b.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
37. The weighted average cost of capital (WACC) includes
A) the required return on equity and required return on underlying firm assets.
B) the cost of any debt and the cost of equity.
C) the cost of any debt and required return on underlying firm assets.
D) none of the above.
Ans: B

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
38. M&M Proposition 2 states that the cost of a firm's common stock is related to
A) the debt-to-equity ratio.
B) the required rate of return on the firm's underlying assets.
C) the return of the market index.
D) a and b.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
39. According to M&M Proposition 2, the cost of a firm's equity
A) increases with the debt-to-equity ratio.
B) decreases with the debt-to-equity ratio.
C) increases and then falls with the debt-to-equity ratio.
D) decreases and then increases with the debt-to-equity ratio.
Ans: A

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
40. Financial risk
A) refers to the effect that a firm's financing decisions has on the riskiness to cash
flows that investors will receive.

Page 9
B) increases a firm's business risk.
C) decreases a firm's business risk.
D) is related to how debt affects the business decisions of a firm.
Ans: A

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Easy
41. Which of the following is a reason financial policy might matter?
A) Firms must pay corporate income taxes.
B) Capital structure choices can affect investment decisions, such as R&D and
PP&E.
C) Issuing equity is expensive.
D) All of the above.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
42. The interest tax shield
A) does not affect the WACC.
B) makes it less costly to distribute cash to the security holder through interest
payments than through dividends.
C) is given by D × (1 – t).
D) b and c.
Ans: B

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Easy
43. In order to calculate the present value of debt tax savings, the _______ is used
as the discount rate.
A) WACC
B) risk-free rate
C) required rate of return on debt
D) none of the above
Ans: C

Format:  Multiple Choice
Learning Objective:  LO 2

Page 10
 Level of Difficulty:  Easy
44. Academic studies have estimated that the tax benefit of debt realized by firms is
approximately
A) 10% of firm value.
B) a 10% reduction in WACC.
C) a 10% reduction in the cost of debt
D) 10% of debt value.
Ans: A

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Easy
45. The use of debt financing
A) may cause a manager to take on riskier projects in order to make interest
payments.
B) is more expensive than issuing equity due to the use of covenants.
C) allows managers to make discretionary interest payments.
D) limits the ability of managers to waste stockholder money.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
46. Which of these statements about direct bankruptcy costs is not true?
A) Direct bankruptcy costs include the hiring of additional accountants, lawyers, and
consultants.
B) Direct bankruptcy costs are less than indirect costs.
C) Suppliers requiring cash on delivery is part of a firm's direct bankruptcy costs.
D) Negotiating with lenders may help a firm reduce direct bankruptcy costs.
Ans: C

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
47. Which of these is not an example of indirect bankruptcy costs?
A) A firm's customers become concerned about whether or not warranties will be
honored.
B) Employees begin to leave the firm.
C) New accountants are brought in to help with the bankruptcy process.
D) A bankruptcy judge orders new projects to be halted.
Ans: C

Page 11
 Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
48. The use of debt financing
A) reduces agency costs between the stockholders and management by increasing
the amount of risk the managers take.
B) increases agency costs between the stockholders and management by limiting the
amount of risk the managers take.
C) increases agency costs since managers prefer to keep more retained earnings
rather than pay a dividend.
D) b and c.
Ans: D

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
49. The asset substitution problem occurs when
A) managers substitute riskier assets for less risky ones to the detriment of
bondholders.
B) managers substitute less risky assets for riskier ones to the detriment of
bondholders.
C) managers substitute riskier assets for less risky ones to the detriment of equity
holders.
D) managers substitute less risky assets for riskier ones to the detriment of equity
holders.
Ans: A

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Medium
50. The underinvestment problem occurs in a financially distressed firm when
A) the value of investing in a positive-NPV project is likely to go to debt holders
instead of equity holders.
B) the value of investing in a positive-NPV project is likely to go to equity holders
instead of debt holders.
C) management invests in negative-NPV projects to reduce their own risk.
D) issuing equity becomes difficult due to increased risk.
Ans: A

Page 12
 Format:  Multiple Choice
Learning Objective:  LO 3
Level of Difficulty:  Medium
51. Which of the following supports the trade-off theory of capital structure?
A) Firms use cash on hand first, since issuing equity and debt is expensive.
B) A firm's capital structure is the result of past equity and debt issuance decisions.
C) Firms have a target capital structure.
D) a and b.
Ans: C

Use the following to answer questions 52-58:

Dynamo Corp. produces annual cash flows of $150 and is expected to exist forever. The
company is currently financed with 75 percent equity and 25 percent debt. Your analysis tells
you that the appropriate discount rates are 10 percent for the cash flows, and 7 percent for the
debt. You currently own 10 percent of the stock.

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
52. M&M Proposition 1: How much is Dynamo worth today?
A) $1,765
B) $1,500
C) $2,143
D) None of the above.
Ans: B
Feedback:
CF $150
V Firm  i  0.1  $1,500

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
53. M&M Proposition 1: How much are your cash flows today?
A) $12.38
B) $15
C) $4.50

Page 13
D) $150
Ans: A
Feedback:
Cash flows to = Cash flows – Interest payments
shareholders
= $150 – ($1,500) × (0.25) × (0.07) = $123.75
Therefore, your 10% share = $123.75 × 0.1 = $12.375

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
54. M&M Proposition 1: If Dynamo wishes to change its capital structure from 75
percent to 60 percent equity and use the debt proceeds to pay a special dividend to
shareholders, how much debt should they issue?
A) $321
B) $375
C) $600
D) $225
Ans: D
Feedback:
Debt today = 0.25 × $1,500 = $375
Debt after restructuring = 0.40 × $1,500 = $600
Total debt issuance = $600 – $375 = $225

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
55. M&M Proposition 1: How much does Dynamo currently pay in interest, and how
much will it have to pay after the restructuring in the prior problem, assuming that the
cost of debt is constant?
A) $42 and $26.25
B) $26.25 and $42
C) $160 and $37.50
D) $37.50 and $60
Ans: B
Feedback:
Debt today = 0.25 × $1500 = $375
Interest payment on debt before restructuring = $375 × 0.07 = $26.25
Total debt after restructuring =0 .4 × $1,500 = $600

Page 14
 Interest payment on debt after restructuring = 0.07 × $600 = $42

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
56. M&M Proposition 1: How much of the special dividend do you receive, and how
much do you receive in regular dividends per annum after the restructuring?
A) $15 and $60
B) $60 and $15
C) $10.80 and $22.50
D) $22.50 and $10.80
Ans: D
Feedback:
Portion of special dividend received = 0.10 × $225 = $22.50
Cash flows to you after restructuring = 0.10 × ($150 – $42) = $10.80
Note: $42 = Interest payment on debt after restructuring

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
57. M&M Proposition 1: According to M&M Proposition 1, what transaction do you
need to take in order to undo the restructuring?
A) Sell $22.50 of stock.
B) Sell $10.80 worth of stock.
C) Buy $22.50 worth of debt.
D) Buy $10.80 worth of debt.
Ans: C
Feedback:
M&M Proposition 1 says to take your portion of the special dividend ($22.50) and buy
that much of the new debt issuance.

Reference:  Ref 16-1
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
58. M&M Proposition 1: What are the interest payments that you receive after you undo
the restructuring, and what are your total cash flows?
A) $1.58 and $12.38

Page 15
B) $23.55 and $75
C) $1.125 and $12.38
D) None of the above.
Ans: A
Feedback:
Since you have purchased $22.50 worth of debt, then you will receive $22.50 × 0.07 =
$1.58 in interest payments. Since you will receive $10.80 in dividends after the
restructuring, your total cash flows are $1.58 + $10.80 = $12.38, the same as before the
restructuring!

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
59. M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40%
debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the
risk-free rate is 3%, what is the appropriate WACC?
A) 8.4%
B) 9.6%
C) 10.4%
D) 9.2%
Ans: C
Feedback:
WACC = xDebt kDebt + xEquity kEquity = (0.40 ×.08) + (0.60 × 0.12) = 0.104

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
60. M&M Proposition 2: Gangland Water Guns, Inc., has a debt-to-equity ratio of 0.5. If
the firm's cost of debt is 7% and its cost of equity is 13%, what is the appropriate
WACC?
A) 9%
B) 10%
C) 11%
D) None of the above.
Ans: C
Feedback:
Using the debt-to-equity ratio, you can solve for the percentage of the capital structure
that is debt and the percentage that is equity. If D/E = 0.5, then let's assume that D = 1
and E = 2. Therefore, D + E = 3. This gives a debt percentage of 33.33% and an equity
percentage of 66.66%. Then, WACC = xDebt kDebt + xEquity kEquity = (1/3) × 0.07 + (2/3) ×
0.13 = 0.11.

Page 16
 Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
61. M&M Proposition 2: Swirlpool, Inc., has a WACC of 11%, a cost of debt of 8%, and a
cost of equity of 12%. What must the debt-to-equity ratio be?
A) 1/2
B) 1/4
C) 1/6
D) None of the above.
Ans: D
Feedback:
WACC = xDebt kDebt + xEquity kEquity
= xDebt × 0.08 + xEquity × 0.12 = 11%
Also, D + E = 1 by definition. Therefore, substituting gives you:
xDebt × 0.8 + (1 – xDebt) × 0.12 = 0.11.
Solving for xDebt gives you 1/4, which means that xEquity must be 3/4. Therefore, the D/E
is 1/3.

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
62. M&M Proposition 2: Melba's Toast has a capital structure with 30% debt and 70%
equity. Its pretax cost of debt is 6%, and its cost of equity is 10%. The firm's marginal
corporate income tax rate is 35%. What is the appropriate WACC?
A) 8.17%
B) 6.35%
C) 8.80%
D) 7.44%
Ans: A
Feedback:
WACC with taxes= xDebt kDebt pretax (1 – t) + xEquity kEquity
= 0.30 ×.06×(1 – 0.35) + 0.70 × 0.10 = 0.0817

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
63. M&M Proposition 2: A firm has $300mm in outstanding debt and $900mm in
outstanding equity. Its cost of equity is 11%, and its cost of debt is 7%. What is the
appropriate WACC?
A) 6%

Page 17
B) 8%
C) 9%
D) 10%
Ans: D
Feedback:
WACC = xDebt kDebt + xEquity kEquity
= (300/1200) × 0.07 + (900/1200) × 0.11 = 0.10

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
64. M&M Proposition 2: A firm has a WACC of 8.5%, a pretax cost of debt of 5%, a cost
of equity of 12%, and a marginal corporate income tax rate of 35%. What percent of the
firm is financed with equity?
A) 50%
B) 60%
C) 70%
D) None of the above
Ans: B
Feedback:
WACC = 0.085 = (1 – xEquity)kDebt (1 – t) + xEquity kEquity
= (1 – xEquity) × 0.05 × (1 – 0.35) + xEquity × 0.12
Solving for xEquity gives you 0.60

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
65. M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12%
and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the
required rate of return on their equity?
A) 12.15%
B) 13.15%
C) 14.15%
D) None of the above
Ans: B
Feedback:
kcs = kAssets + (D/E)(kAssets – kDebt)
= 0.12 + (1/5)(0.12 – 0.0625) = 0.1315

Format:  Multiple Choice
Learning Objective:  LO 1

Page 18
 Level of Difficulty:  Medium
66. M&M Proposition 2: Using the information for Bellamee from Question 64, what is
its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases
the required rate of return on their debt to 7%?
A) 14%
B) 14.25%
C) 14.50%
D) 15%
Ans: A
Feedback:
kcs = kAssets + (D/E)(kAssets – kDebt)
= 0.12 + (2/5)(0.12 – .07) = 0.14

Use the following to answer questions 67-69:

Suppose that Banana Computers has $1,000 in revenue this year, along with COGS of $400 and
SG&A of $100. The required rate of return on its equity is 14%, and the risk-free rate is 5%.
Assume that the COGS only includes the marginal costs of selling a computer. Banana is
considering adding $700 worth of debt with a coupon rate of 5% and a YTM of 7.9% to its
capital structure.

Reference:  Ref 16-2
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
67. M&M Proposition 2: What percent of the firm's costs are fixed, and what percent are
variable with the added debt?
A) 27.9% and 72.1%
B) 72.1% and 27.9%
C) 25.23 and 74.77%
D) 74.77% and 25.23%
Ans: C
Feedback:
With the debt, fixed cost percentage is
(SG&A + Interest payments)/(SG&A + Interest payments + CGS) =
($100 + ($700)(0.05)) / ($100 + ($700)(0.05) + $400) = 25.23%.
Therefore, variable costs are $400 / ($100 + ($200)(0.05) + $400) or 74.77%.

Reference:  Ref 16-2
Format:  Multiple Choice

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 Learning Objective:  LO 1
Level of Difficulty:  Medium
68. M&M Proposition 2: What is the net income of Banana without and with the debt?
A) $500 and $484.2
B) $484.2 and $500
C) $500 and $465
D) $490 and $500
Ans: C
Feedback:
Without debt, net income is
$1000 – $400 – $100 = $500
With debt, net income is
$1000 – $400 – $100 – $35 = $165

Reference:  Ref 16-2
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
69. M&M Proposition 2: Suppose revenues fall by $300. What is the percent change in
net income with and without the debt? Assume that the total variable productions costs
remain the same.
A) 64.5% and 60%
B) 60% and 64.5%
C) 59.2% and 40.8%
D) 40.8% and 59.2%
Ans: B
Feedback:
Without debt, the new net income is
$700 – $400 – $100 = $200
Therefore, the percent change is
($500 – $200) / $500 = 60%
With debt, the new net income is
$700 – $400 – $100 – $35 = $165
Therefore, the percent change is
($465 – $165) / $465 = 64.5%

Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
70. M&M Proposition 2: Suppose a firm has a cost of equity of 12%, a D/E or 1/6, and
the YTM on its bonds is 7.5%. The risk-free rate is currently 3%. What is the current

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 required rate of return on its assets and equity if the D/E is changed to 1/3?
A) 11.35% and 13.25%
B) 11.35% and 8.25%
C) 13.25% and 11.35%
D) None of the above.
Ans: D
Feedback:
kcs = kAssets + (D/E)(kAssets – kDebt)
12% = kAssets + (1/6)( kAssets – 7.5%)
Then, kAssets= 11.4%.
Note that if D/E changes, kAssets does not change.
The new cost of equity is then given by
kcs = 11.4% + (1/3)(11.4% – 7.5%) = 12.7%

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
71. The benefits of debt: Packman Corporation has a reported EBIT of $500, which is
expected to remain constant in perpetuity. If the firm borrows $2,000, its YTM will be
6.5% and its coupon rate will be 8%. If the company's marginal tax rate is 30% and its
average tax rate is 20%, what are its after-tax earnings?
A) $238
B) $272
C) $259
D) None of the above.
Ans: A
Feedback:
After-tax earnings = (Earnings – Interest payments)×(1 – t)
= ($500 – $160) × (1 –.3)
= $238

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
72. The benefits of debt: A firm plans to issue $1 million worth of debt at a YTM of 9%.
The debt is trading at par. The firm's marginal corporate tax rate is 25%, while its
average tax rate is 15%. By how much will this debt issuance reduce the firm's annual
tax liability?
A) $13,500
B) $22,500
C) $32,500
D) None of the above.

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Ans: B
Feedback:
Tax shield = D × kDebt × t
= $1,000,000 × 0.09 × 0.25
= $22,500

Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
73. The benefits of debt. A firm plans to issue $1 million worth of debt at a YTM of 9%.
The debt is trading at par. The firm's marginal corporate tax rate is 35%. What is the
present value of the tax savings in perpetuity?
A) $11,025
B) $20,475
C) $350,000
D) $227,500
Ans: C
Feedback:
VTax-savings debt = D × t = $1,000,000 × 0.35 = $350,000

Use the following to answer questions 74-75:

Millennium Motors has current pretax annual cash flows of $1,000 and is in the 35% tax bracket.
The appropriate discount rate for its cash flows is 12%. Suppose the firm issues a $1,500 bond
and uses these proceeds to pay a one-time special dividend to shareholders.

Reference:  Ref 16-3
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
74. The cost of equity: What is its value without debt in the capital structure?
A) $350
B) $650
C) $2,917
D) $5,417
Ans: D
Feedback:
VFirm = [ CF × (1-t)] /i = [ $1,000 × (1 – 0.35) ] / 0.12 = $5,417

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 Reference:  Ref 16-3
Format:  Multiple Choice
Learning Objective:  LO 1
Level of Difficulty:  Medium
75. The cost of equity: What is Millennium's value after the debt issuance?
A) $5,417
B) $5,942
C) $6,392
D) None of the above.
Ans: B
Feedback:
PV of tax shield = $1,500 × 0.35 = $525
VFirm = VNo leverage+ PV of the tax shield = $5,417 + $525 = $5,942

Use the following to answer questions 76-79:

Suppose that UBM Corp has $100mm invested in 8% risk-free bonds that mature in one-year.
The firm also has $80mm in debt outstanding that will also mature in a year. UBM shareholders
are considering selling the $100mm in debt and investing in a project that has a 60% chance of
returning $200mm and a 40% chance of returning $2mm.

Reference:  Ref 16-4
Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
76. Agency costs: What will the equity value of UBM be in one-year without shareholders
taking on the project?
A) $100mm
B) $80mm
C) $20mm
D) $8mm
Ans: C
Feedback:
Value of risk-free debt owner – Value of bonds maturing = $20mm

Reference:  Ref 16-4
Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard

Page 23
 77. Agency costs: What is the expected value of the bonds to the lenders if the
stockholders sell the debt?
A) $100mm
B) $88.8mm
C) $48.8 mm
D) None of the above.
Ans: C
Feedback:
E[VBonds] = (0.60 × $80 mm) × + (0.40 × $2mm) = $48.8 mm

Reference:  Ref 16-4
Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
78. Agency costs: What is the expected value of the equity if the stockholders sell the
debt?
A) $175mm
B) $97.5mm
C) $51mm
D) None of the above.
Ans: D
Feedback:
E[VEquity] = ((0.60 × $200mm) – $80mm) + (0.40 × $0mm) = $40mm

Reference:  Ref 16-4
Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
79. Agency costs: Given the payoffs of the project, what does the percent chance of
success need to be in order for the expected value of equity with the project to be equal
to the expected value of equity without the project?
A) 1/3
B) 1/4
C) 1/5
D) 1/6
Ans: D
Feedback:
E[VEquity] = (PSuccess × 200mm – $80mm) + ((1 – PSuccess) × $0) = $20mm
(PSuccess × 200mm – $80mm) = $20mm
Therefore, PSuccess must be 1/6.

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 Format:  Multiple Choice
Learning Objective:  LO 2
Level of Difficulty:  Hard
80. Agency costs: Suppose that JMK, Inc., has debt with a face value of $100mm and
assets worth $70mm. Firm management has just identified a project that will require an
initial outlay of $10mm and will return a NPV of $16mm, risk-free. The firm currently
has no cash. What would be the net return to shareholders if they took on this project?
A) $–10mm
B) $0mm
C) $26mm
D) $70mm
Ans: A
Feedback:
If they take on the project, the firm will receive its $10mm back, along with the
$16mm. This gives them assets worth $96mm, which is still less than the value of
outstanding debt. Therefore, the shareholders would be out the $10mm of equity that
they had to sell in order to take on the project.

Format:  Multiple Choice
Learning Objective:  LO 3
Level of Difficulty:  Hard
81. The pecking order theory: A firm wishes to undertake a project that costs $150mm. It
currently has $10mm in cash on hand and believes that it can raise $75mm in debt and
$100mm in equity if needed. According to the pecking order theory of the capital
structure, what percent of the project will be financed by debt?
A) 0%
B) 26.67%
C) 50%
D) None of the above
Ans: C
Feedback:
According to the pecking order theory, the firm will first use its available cash, which is
$10mm. Next, the firm will turn to debt. Since the amount of debt it can raise plus the
amount of cash on hand is less than the project cost, their entire line of credit will be
used. Therefore, $75mm/$150mm = 50%.

Format:  Multiple Choice
Learning Objective:  LO for Appendix
Level of Difficulty:  Medium
82. Which of the following should a company consider when deciding to buy or lease an asset?

Page 25
 A) Taxes
B) Information or transaction costs
C) If the choice would affect the real investment policy of the firm
D) All of the above
Ans: D

Format:  Multiple Choice
Learning Objective:  LO for Appendix
Level of Difficulty:  Medium
83. Which of the following arises because the lessee can have the incentive to use the asset more
than the lessor would prefer?
A) Operating lease conflict
B) Capital lease conflict
C) Intensity of use conflict
D) Maintenance conflict
Ans:C

Format:  Multiple Choice
Learning Objective:  LO for Appendix
Level of Difficulty:  Medium
84. Which of the following will limit the asset abuse problem for the lessor?
A) Track the total services obtained from the asset and charge the lessee based on usage
B) Bundle the lease contract with a service contract
C) Provide the lessee with the right to buy the asset when the lease expires
D) All of the above
Ans:D

Format:  Multiple Choice
Learning Objective:  LO for Appendix
Level of Difficulty:  Hard
8 LMNO Manufacturing needs a new laser and is comparing buying or leasing. Under either alternative,
5.  the company will only need the laser for 5 years. Assume LMNOs marginal tax rate is 30 percent.
Purchase Alternative: It would cost $50,000 to purchase the laser and the amount could be financed
with a five year balloon loan at 9%. The laser will be depreciated on straight line and have no salvage
value. Maintenance on the laser is expected to be $1,200 per year.
Lease alternative: The company that manufactures the laser offers a 5 year leasing option with annual
lease payments of $12,500.With this option the lessor will be responsible for maintenance of the laser
and will take it back after 5 years. The lease will be classified as an operating lease.
Which is the best option for LMNO Manufacturing?
A) Purchase, the company will be $4,416 better off.
B) Lease, the company will be $4,416 better off.
C) Purchase, the company is $10,496 better off
D) Lease, the company is $10,496 better off

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Ans:B

Feedback:
Purchase:
After tax annul interest expense = 50,000 x .09(1-.3) = <3,150>
Annual depreciation = 50,000/5 = 10,000, so annual tax savings = 10,000 x .3= 3,000
After tax annual maintenance cost = 1,200 x (1-.3) = <840>

So after tax cash flow years 1-4 = <3,150> + 3,000 + <840> = <990>
After tax cash flow year 5 = <50,000> loan repayment + <990> = <50,990>

NPV of total after tax cash flows at the after-tax cost of debt .09(1 - .3) = .063
= <$40,975.08>
Lease:
After tax annual lease payment = 12,500 x (1 - .3) = <8,750>
NPV of <8,750> for 5 years at 6.3% = <$36,559.31>

So, the total cost of Leasing is 40,975.08 – 36,559.31 = 4,415.77 less.

Format:  Essay
Learning Objective:  LO 1
86. One of the conditions that the M&M Propositions required was for there to be
no taxes. Briefly discuss whether the introduction of taxes decreases or
increases the value of the firm.
Ans: The relaxation of the no-tax assumptions actually increases the value of the firm
by an amount equal to the present value of the tax shield on the firm's debt
obligations. If we consider the debt to be infinitely outstanding, then we can
approximate the present value of the tax shield by multiplying the amount of the
debt by the tax rate.

Format:  Essay
Learning Objective:  LO 2
87. Briefly explain how an increase in the amount of debt that a firm has
outstanding may actually decrease the agency costs caused by the conflict
between managers and stockholders.
Ans: The manager-stockholder agency conflict is caused by a misalignment of interests
between the two parties. When a firm has excess cash available for managers to
waste—which is bad for stockholders—then an increase in debt, and
consequently the level of interest service required of that debt, will make less
cash available for the manager to waste. This has the effect of reducing manager-
stockholder agency cost.

Format:  Essay

Page 27
 Learning Objective:  LO 3
88. The pecking order theory of capital structure suggests that managers will choose
to utilize retained earnings before issuing additional debt when financing new
projects. Does that imply anything about the flotation costs of issuing new
securities?
Ans: The answer to the question is no. It implies that managers perceive there to be a
higher cost of issuing new debt versus stockholder's equity. It is a perception
because even after considering flotation costs, new debt is still much cheaper than
retained earnings, which belongs to stockholders.

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