6. Which statement best describes mergers?

a. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing
another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash
rarely undertake mergers.
b. The smaller the synergistic benefits of a particular merger, the greater the scope for
striking a bargain in negotiations, and the higher the probability that the merger will be
completed.
c. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a
greater debt capacity are rarely relevant considerations when considering a merger.
d. Managers who purchase other firms often assert that the new combined firm will enjoy
benefits from diversification, including more stable earnings. However, since shareholders
are free to diversify their own holdings, and at whats probably a lower cost,
diversification benefits are generally not a valid motive for a publicly held firm.
ANS: D PTS: 1 DIF: MEDIUM REF: 696698 | 706707
OBJ: (24.1 and 24.8) Merger motivation and setting the bid price
BLM: Higher Order
14. Which statement best describes mergers?
a. The purchase of Red Lobster Restaurants initiated by Remax Realty is an example of
conglomerate mergers.
b. A merger can be blocked either by a firms customers or its suppliers, not the government.
c. The existence of golden parachutes is a reason that the management of a target company
tries to block a takeover.
d. In a hostile takeover, the target companys management makes a tender offer asking its
shareholders to sell their shares to the acquiring company.
ANS: A PTS: 1 DIF: MEDIUM REF: 698701
OBJ: (Comp. 24.2, 24.4) Aspects of mergers BLM: Higher Order
19. Kelly Tubes is considering a merger with Reilly Tires. Reillys market-determined value is $3.75 million,
and Kellys market value as a stand-alone company is $4.50 million. Both firms are all equity-financed.
Kelly acquires Reilly for $4.25 million because it believes the combined firm value will increase to $9.25
million. What will the synergy from this merger be?
a. $0.50 million
b. $1.00 million
c. $4.75 million
d. $5.00 million
ANS: B
Given combined firm value VK + R = $9.25m, stand-alone values of VK = $4.5m and VR = $3.75m, synergy
= V = 9.25 (4.5 + 3.73) = $1 million.

PTS: 1 DIF: MEDIUM REF: 696 OBJ: (24.1) Synergy

BLM: Higher Order
20. 20 Firms A and B, both all-equity financed, are merging. Prior to merge, Firm A, having 100 shares
outstanding, is worth $15,000, while Firm B has 50 shares outstanding worth $10,000. The combined
firm will be worth $30,000. Firm A pays $11,500 in cash for Firm B. What is the net benefit of the
merger to Firm A?

ANS: A
 The net benefit of a merger to the acquirer is synergy minus premium paid for the target. With premium =
$11,500 $10,000 = $1,500, and synergy = $30,000 $15,000 $10,000 = $5,000, merger benefit
(NPV) = $5,000 $1,500 = $3,500.

PTS: 1 DIF: MEDIUM REF: 696 | 706707

OBJ: (24.1 and 24.8) Merger benefit and pricing BLM: Higher Order

22. Brau Auto, a national auto parts chain, is considering purchasing a smaller chain, South Georgia Parts
(SGP). Braus analysts project that the merger will result in the following incremental free cash flows, tax
shields, and horizon values:
Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate
of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current
$15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would
remain the same. SGPs pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free
rate is 8% and the market risk premium is 4%. What is the value of SGP to Brau?
a. $53.40 million
b. $61.96 million
c. $64.59 million
d. $76.96 million
ANS: C
rsL = rRF + b(RPM) = 8% + 2.0(4%) = 16%
WACC = wdrd (1 T) + wsrs = 0.30(10%)(1 34%) + 0.70(16%) = 13.18%

Since all of the cash flows are to be discounted at the same rate, we dont need to separately calculate the
values of the tax shield and unlevered value of operations. We can simply add the tax shields and free
cash flows together each year to input in the financial calculator:

Financial calculator solution (in millions):

Inputs: CF0 = 0; CF1 = 2; CF2 = 4; CF3 = 5; CF4 = 117; I/YR = 13.2
Output: NPV = $79.59 million = Value of operations

Value of equity = Value of operations Value of debt = $79.59 15 = $64.59 million

Some students will calculate separately the value of the tax shield and the unlevered value of
operations and add them together. In that case, the separate calculations are:

Unlevered value of operations:

Inputs: CF0 = 0; CF1 = 1; CF2 = 3; CF3 = 3; CF4 = 75 + 7 = 82; I/YR = 13.2
Output: NPV = $55.23 million = Unlevered value of operations

Value of tax shields:

Inputs: CF0 = 0; CF1 = 1; CF2 = 1; CF3 = 2; CF4 = 3 + 32 = 35; I/YR = 13.2
 Output: NPV = $24.36 million = Value of tax shields

Value of operations = Value of tax shields + Unlevered value of operations = $55.23 + $24.36 =
$79.59 million.

PTS: 1 DIF: MEDIUM REF: 703706

OBJ: (24.7) Value of an acquisition BLM: Higher Order
26.Blazer Inc. is thinking of acquiring Laker Company. Blazer expects Lakers NOPAT to be $9 million the first
year, with no net new investment in operating capital and no interest expense. For the second year, Laker
is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year
only, Laker will need $10 million of net new investment in operating capital. Lakers marginal tax rate is
40%. After the second year, the free cash flows and the tax shields from Laker to Blazer will both grow at
a constant rate of 4%. Blazer has determined that Lakers cost of equity is 17.5%, and Laker currently has
no debt outstanding. Assuming that all cash flows occur at the end of the year, Blazer must pay $45
million to acquire Laker. What it the NPV of the proposed acquisition? Note that you must first calculate
the value to Blazer of Lakers equity.
a. $ 45.0 million
b. $ 68.2 million
c. $ 94.1. million
d. $139.1 million
ANS: C
The unlevered cost of equity is 17.5%. All cash flows are discounted at this rate:

FCFE: Year 1 = $9 million, Year 2 = $25 $10 $5(1 40%) = $12 million, HV = [$25 $5(1
40%)](1 + 4%) / (17.5% 4%) = $169.48 million

Vops = $9/(1.175) + ($12 + $169.48)/(1.175)2 = $139.11 = V equity since there is no debt.

The NPV is $139.11 $45 = $94.11 million

PTS: 1 DIF: HARD REF: 705706 OBJ: (24.7) Merger NPV

BLM: Higher Order

Scenario Maritime
TV Emporium, a national retailer of flat panel screens, is investigating an opportunity to purchase
Maritime TV and Sound Inc. An acquisition is expected to lower overhead costs, improve distribution
efficiencies, and improve ordering volumes from the major manufactures. If those improvements
(synergies) are implemented, TV Emporium financial staff estimates the following incremental net cash
flows to be $5 million, $5.6 million, and $6.9 million for the first three years. Cash flows would grow at
3% thereafter. Maritime TV and Sounds tax rate is 30%. Its cost of equity is 10%.

30. Refer to Scenario Maritime. What is the horizontal value of Maritimes operation as of year 3?
a. $101.53 million
b. $98.57 million
c. $86.66 million
d. $71.07 million
ANS: A
 .

PTS: 1 DIF: MEDIUM REF: 704

OBJ: (24.7) Horizontal value of operations BLM: Higher Order

31. Refer to Scenario Maritime.What is the highest price TV Emporium pays for Maritime?
a. $67.75 million
b. $76.28 million
c. $81.10 million
d. $90.64 million
ANS: D

PTS: 1 DIF: MEDIUM REF: 705707

OBJ: (24.7 and 24.8) Merger value and Bid price BLM: Higher Order

2. Which action does NOT always increase a companys market value?

a. increasing the expected growth rate of sales
b. increasing the expected operating profitability (nopat/sales)
c. decreasing the capital requirements (capital/sales)
d. decreasing the weighted average cost of capital
ANS: A
Only (a) is correct, because investors recognize that companies sometimes try to grow too fast, at the
expense of maintaining profit margins.

PTS: 1 DIF: MEDIUM REF: 675

OBJ: (23.3) Value-based management BLM: Higher Order

14.Based on the corporate valuation model, the value of a companys operations is $900 million. Its balance
sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term
investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes
payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings,
and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what
is the best estimate of the stocks price per share?
a. $23.00
b. $25.56
c. $28.40
d. $31.24
ANS: C
Value of operations: $900
Short-term investments: $30
Notes payable: $110
Long-term debt: $90
Preferred stock $20
 Shares outstanding: 25

Assuming that the book value of debt is close to its market value, the total market value of the company
is:

= +
= $900 + $30 = $930

Value of Equity = Total MV - Long- and Short-term debt and preferred = $710
Stock price = Value of Equity/Shares outstanding = $28.40

The book values of equity figures are irrelevant for this problem. Also, the working capital account
numbers are not relevant because they were netted out when the FCF was calculated.

PTS: 1 DIF: MEDIUM REF: 664670

OBJ: (23.2) Corporate valuation model, P0 BLM: Higher Order

16.Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of
capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as
from Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: 1 2 3
Free cash flow: $20 $42 $45

a. $586
b. $617
c. $648
d. $680
ANS: B
Year: 1 2 3
Free cash flow: $20 $42 $45

WACC: 13%
First, find the growth rate: g = $45/$42 1.0 = 7.14%

Second, find the horizon, or terminal, value, at Year 2

HV2 = FCF3/(WACC g) = $45/(0.13 0.0714) = $768

Now find the PV of the FCFs and the horizon value:

Value of operations = $20/(1.13) + ($42 + $768)/(1.13)2 = $617

PTS: 1 DIF: HARD REF: 667

OBJ: (23.2) Corporate valuation model, value of operations BLM: Higher Order

1. When warrants are exercised, what happens as a result of this?

a. The security associated with the warrant drops in value depending on the exercise price of
the warrant.
b. Funds are transferred from the retained earnings account to common shares account for the
market value of the shares.
 c. The number of common shares outstanding changes.
d. There is no new capital for the firm because the warrants are exchanged for the common
shares.
ANS: C PTS: 1 DIF: MEDIUM REF: 475476
OBJ: (16.1) Warrants BLM: Higher Order

2. Which factor will NOT affect the price paid on warrants?

a. the coupon rates of the security to which the warrant is issued
b. the expiration time of the warrant
c. the difference between the current share price and the exercise price on warrants
d. the amount of cash dividends paid on the common shares of the firm
ANS: A PTS: 1 DIF: MEDIUM REF: 476
OBJ: (16.1) Warrants BLM: Higher Order

3. Which of the following statements best describes convertibles?

a. One advantage of convertibles over warrants is that the issuer receives additional cash
when convertibles are converted.
b. Investors are willing to accept a lower interest rate on a convertible than on otherwise
similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertibles conversion (or exercise) price is generally set equal
to or below the underlying stocks price.
d. For equilibrium to exist, the expected return on a convertible bond must normally be
between the expected return on the firms otherwise similar straight debt and the expected
return on its common stock.
ANS: D
(d) is correct. From an investors standpoint, convertibles are normally more risky than straight debt but
less risky than common stock, hence the expected return on the convertible lies between that of the share
and that of the straight bond.

7. Who or what is (are) the legal asset owner(s) behind home mortgage securitization?
a. special purpose vehicles (SPV)
b. individual investors
c. banks that originate the mortgages
d. Canada Mortgage and Housing Corporation (CMHC)
ANS: A PTS: 1 DIF: MEDIUM REF: 485
OBJ: (16.5) Securitization BLM: Remember
13. Orient Airlines common stock currently sells for $33, and its 8% convertible debentures (issued at par, or
$1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time
before 2017. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
ANS: D
Stock price: $33.00 Coupon rate: 8.00%
Bond price: $850.00 Par value: $1,000.00
Conversion ratio: 25.00
 Conversion value = Conversion ratio Stock price = $825

PTS: 1 DIF: EASY REF: 479

OBJ: (16.2) Convertible features: straight-debt value BLM: Higher Order
15. ABC Bank enters a credit default swap of $10 million for 5 years with XYZ Insurance. How much does
ABC have to pay with a premium rate of 2.5% per year?
a. $100,000
b. $150,000
c. $250,000
d. $500,000
ANS: C
Swap premium = notional value premium rate = $10 million 2.5% = $250,000

PTS: 1 DIF: EASY REF: 486 OBJ: (16.6) Credit derivatives

BLM: Higher Order
16. Warren Corporations stock sells for $42 per share. The company wants to sell some 20-year, annual
interest $1,000 par value bonds. Each bond would have 75 warrants attached to it, each exercisable into
one share of stock at an exercise price of $47. The firms straight bonds yield 10%. Each warrant is
expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate
must the company set on the bonds in order to sell the bonds-with-warrants at par?
a. 7.83%
b. 8.24%
c. 8.65%
d. 9.08%
ANS: B
Stock price: $42.00 Bond par value: $1,000
Exercise price: $47.00 Bond maturity: 20
No. of warrants: 75 Straight-debt yield: 10.0%
Value of warrants: $2.00

Total value = Straight-debt value + Warrant value = $1,000 = Bond value + $150
VB = $1,000 $150 = $850

Now set N = 20, I/YR = 10, PV = 850, FV = 1000 and solve for PMT: $82.38
To get this payment on a $1,000 bond, the coupon rate must be: 8.24%

PTS: 1 DIF: MEDIUM REF: 476 OBJ: (16.1) Bonds with warrants
BLM: Higher Order

18. Upstate Water Company just sold a bond with 50 warrants attached. The bonds have a 20-year maturity
and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar
straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
ANS: A
Bond par value: $1,000 No. of warrants: 50
 Bond maturity: 20 Convertible coupon: 12.0%
Straight-debt yield: 15.0%

Find the straight-debt value: N = 20, I/YR = 15, PMT = 120, and FV = 1000. PV = $812.22

Total value = Straight-debt value + Warrant value.

$1,000 = Straight-debt value + 50(Warrant value)
Warrant value = ($1,000 - Straight-debt value)/50 = $3.76

PTS: 1 DIF: MEDIUM REF: 476 OBJ: (16.1) Bonds with warrants
BLM: Higher Order
13
46.Pavlin Corp.s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity,
and its forecasted net income is $1,000,000. If the company follows a residual dividend policy, how much
will it pay in dividends or, alternatively, how much new stock must it issue?

Dividends Stock Issued

W. $514,425 $162,901
X. $541,500 $171,475
Y. $570,000 $180,500
Z. $0 $200,000

a. Choice W
b. Choice X
c. Choice Y
d. Choice Z
ANS: D
Capital budget $2,000,000
% Equity 60%
Net income (NI) $1,000,000
Dividends: or new stock:
Dividends paid = NI - [% Equity(Cap. Bud)], stock issued if dividends zero or neg $0 $200,000

PTS: 1 DIF: MEDIUM | HARD REF: 403

OBJ: (13.5) Residual modeldivs paid or stock issued BLM: Higher Order

44. Sheehan Corp. is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of
stock. Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per
share. It finances with debt and common equity, but it wants to avoid issuing any new common stock
during the coming year. Given these constraints, what percentage of the capital budget must be financed
with debt?
a. 32.15%
b. 33.84%
c. 35.63%
d. 37.50%
ANS: D
EPS $3.00
Shares outstanding 500,000
 DPS $2.00
Capital budget $800,000
Net income = EPS Shares outstanding = $1,500,000
Dividends paid = DPS Shares outstanding = $1,000,000
Retained earnings available $500,000
Capital budget - 2- Retained earnings = Debt needed $300,000
Debt needed/Capital budget = % Debt financing 37.5%

PTS: 1 DIF: MEDIUM | HARD REF: 403

OBJ: (13.5) Residual dividend modelreqd debt ratio BLM: Higher Order

43.Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If
the firms total market value increased by 5% as a result of increased liquidity caused by the split, what
was the stock price following the split?
a. $24.00
b. $30.00
c. $31.50
d. $33.50
ANS: C
New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%
Post-split stock price = (P0/New per old)(% Value increase) $31.50

PTS: 1 DIF: MEDIUM REF: 414

40. Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a
target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the
company follows the residual dividend policy, how much in dividends, if any, will it pay?
a. $42,869
b. $45,125
c. $47,500
d. $50,000
ANS: D
% Debt 30%
% Debt 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Cap Bud % Equity = $350,000
Dividends = NI - 2- Equity requirement = $50,000

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual dividend policy; dividend may be zero BLM: Higher Order

36. Brooks Corp.s projected capital budget is $2,000,000, its target capital structure is 60% debt and 40%
equity, and its forecasted net income is $600,000. If the company follows a residual dividend policy, what
total dividends, if any, will it pay out?
 a. $228,000
b. $216,600
c. $205,770
d. $0
ANS: D
Capital budget $2,000,000
% Equity 40%
Net income (NI) $600,000
Dividends paid = NI [% Equity(Capital Budget)] $0

PTS: 1 DIF: MEDIUM REF: 403

OBJ: (13.5) Residual modeldivs paid, divs are zero BLM: Higher Order

33. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $150 per
share. The firms total market value was unchanged by the split. Other things held constant, what is the
best estimate of the stocks post-split price?
a. $50.00
b. $52.50
c. $55.13
d. $57.88
ANS: A
Number of new shares 3
Number of old shares 1
Pre-split stock price $150
Post-split stock price: P0/New per old = $50.00

PTS: 1 DIF: EASY REF: 414

OBJ: (13.11) Stock splitssimple splits BLM: Higher Order

34. 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?
a. $904,875
b. $952,500
c. $1,000,125
d. $1,050,131
ANS: B
Capital budget $850,000
Equity ratio 65%
Dividends to be paid $400,000
Required net income = Dividends + (Capital budget % Equity) $952,500

PTS: 1 DIF: EASY | MEDIUM REF: 403

OBJ: (13.5) Residual dividend modelfind net income BLM: Higher Order
 32. Becker Financial recently completed a 7-for-2 stock split. Prior to the split, its stock sold for $90 per
share. If the total market value was unchanged by the split, what was the price of the stock following the
split?
a. $23.21
b. $24.43
c. $25.71
d. $27.00
ANS: C
Number of new shares 7
Number of old shares 2
Old (pre-split) price $90
New price = Old price (Old shrs/New shrs) $25.71

PTS: 1 DIF: EASY REF: 414

OBJ: (13.11) Stock splitsfractional splits BLM: Higher Order

30.Pate & Co. has a capital budget of $3,000,000. The company wants to maintain a target capital structure that
is 15% debt and 85% equity. The company forecasts that its net income this year will be $3,500,000. If
the company follows a residual dividend policy, what will be its total dividend payment?
a. $205,000
b. $500,000
c. $950,000
d. $2,550,000
ANS: C
The amount of new investment that must be financed with equity is
$3,000,000 85% = $2,550,000.

Since the firm has $3,500,000 of net income, $950,000 = $3,500,000 $2,550,000 will be left for
dividends.

PTS: 1 DIF: EASY REF: 403

OBJ: (13.5) Residual dividend policynonalgorithmic BLM: Higher Order

25. Which of the following statements is NOT true?

a. Stock repurchases can be used by a firm as part of a plan to change its capital structure.
b. After a 3-for-1 stock split, a companys price per share should fall, but the number of
shares outstanding will rise.
c. Investors can interpret a stock repurchase program as a signal that the firms managers
believe the stock is undervalued.
d. Stockholders pay no income tax on dividends if the dividends are used to purchase stock
through a dividend reinvestment plan.
ANS: D PTS: 1 DIF: MEDIUM REF: 410 | 414415
OBJ: (Comp: 13.8, 13.11, 13.12) Stock repurchases, stock splits, and DRIPs
BLM: Remember
8. Which statement about dividend policies is correct?
a. 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.
 b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid
paying taxes on the dividends that they choose to reinvest.
c. The key advantage of a residual dividend policy is that it enables a company to follow a
stable dividend policy.
d. The clientele effect suggests that companies should follow a stable dividend policy.
ANS: D PTS: 1 DIF: MEDIUM REF: 398 | 402 | 404 | 415
OBJ: (Comp. 13.1, 13.4, 13.5, 13.12) Dividend theories BLM: Remember
5. 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. What will your position be after such a split takes place?
a. You will have 200 shares of stock, and the stock will trade at or near $120 a share.
b. You will have 200 shares of stock, and the stock will trade at or near $60 a share.
c. You will have 50 shares of stock, and the stock will trade at or near $120 a share.
d. You will have 50 shares of stock, and the stock will trade at or near $60 a share.
ANS: B PTS: 1 DIF: EASY REF: 413414
OBJ: (13.11) Stock splits BLM: Higher Order
4. What is the chronology of a dividend payment?
a. declaration date, holder-of-record date, ex-dividend date, payment date
b. declaration date, ex-dividend date, holder-of-record date, payment date
c. declaration date, holder-of-record date, payment date, ex-dividend date
d. holder-of-record date, declaration date, ex-dividend date, payment date
ANS: B PTS: 1 DIF: EASY REF: 406
OBJ: (13.6) Dividend payment procedures BLM: Remember

Cap stru

29. Which of the following statements is correct?

a. If corporate tax rates were decreased while other things were held constant, and if the
ModiglianiMiller tax-adjusted trade-off theory of capital structure were correct, this
would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms capital structure decisions.
c. Business risk is differentiated from financial risk by the fact that financial risk reflects
only the use of debt, while business risk reflects both the use of debt and such factors as
sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the
firms stock, (2) minimizes its WACC, and (3) maximizes its EPS.
ANS: A PTS: 1 DIF: MEDIUM | HARD
REF: 383385 OBJ: (12.8) Miscellaneous capital structure concepts
BLM: Evaluate

30. Which of the following statements is correct?

a. Generally, debt-to-total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are
more volatile than those of firms in most other industries.
c. Prescription drug companies generally have high debt-to-equity ratios because their
earnings are very stable, and therefore they can cover the high interest costs associated
with high debt levels.
 d. 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.
ANS: D PTS: 1 DIF: HARD REF: 381383
OBJ: (12.7) Variations in capital structures BLM: Evaluate

2.Business risk is affected by a firms operations. Which of the following is NOT associated with (or does not
contribute to) business risk?
a. demand variability
b. input price variability
c. the extent to which operating costs are fixed
d. the extent to which interest rates on the firms debt fluctuate
D

27.Which of the following statements is correct?

a. In general, a firm with low operating leverage also has a small proportion of its total costs
in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms capital
structure decisions.
c. A firm with high business risk is more likely to increase its use of financial leverage than a
firm with low business risk, assuming all else is equal.
d. If a firms after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its
WACC by increasing its use of debt.
A

30. Which of the following statements is correct?

a. Generally, debt-to-total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are
more volatile than those of firms in most other industries.
c. Prescription drug companies generally have high debt-to-equity ratios because their
earnings are very stable, and therefore they can cover the high interest costs associated
with high debt levels.
d. 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.
D

31. 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?
a. $600,000
b. $466,667
c. $333,333
d. $200,000
ANS: D
$7(200,000) - $5(200,000) - F = 0; F = $400,000
$7(200,000) - $4(200,000) - F = 0; F = $600,000
 $600,000 - $400,000 = $200,000.
5. Which of the following statements best describes WACC?
a. Since debt financing raises the firms financial risk, increasing a companys debt ratio will
always increase its WACC.
b. Since debt financing is cheaper than equity financing, raising a companys debt ratio will
always reduce its WACC.
c. Increasing a companys debt ratio will typically reduce the marginal cost of both debt and
equity financing. However, this action still may raise the companys WACC.
d. Increasing a companys debt ratio will typically increase the marginal cost of both debt
and equity financing. However, this action still may lower the companys WACC.
ANS: D PTS: 1 DIF: EASY REF: 364366
OBJ: (12.2) Capital structure and WACC BLM: Understand
49. Vafeas Inc.s capital structure consists of 80% debt and 20% common equity, it has a beta of 1.60, and its
tax rate is 35%. However, the CFO thinks the company has too much debt, and he is considering moving
to a capital structure with 40% debt and 60% equity. The risk-free rate is 5.0% and the market risk
premium is 6.0%. By how much would the firms cost of equity change as a result of altering its capital
structure?
a. 5.20%
b. 5.78%
c. 6.36%
d. 6.99%
ANS: B
bL = 1.60
Current Debt% 80%
Target Debt% 40%
Current D/E = D%/(1 D%) 4.00
Target D/E = D%/(1 D%) 0.67
Tax rate = 35%
bU = bL/(1 + (D/E)(1 T)) 0.4444
new bL = bU (1 + (D/E) (1 T)) 0.6370
rRF = 5.00%
RPM 6.00%
rs 80% D = rRF + b80% D(RPM) = 14.60%
rs 40% D = rRF + b40% D (RPM) = 8.82%
Change in equity cost 5.78%
29.Which of the following statements is correct?
a. If corporate tax rates were decreased while other things were held constant, and if the
ModiglianiMiller tax-adjusted trade-off theory of capital structure were correct, this
would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms capital structure decisions.
c. Business risk is differentiated from financial risk by the fact that financial risk reflects
only the use of debt, while business risk reflects both the use of debt and such factors as
sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the
firms stock, (2) minimizes its WACC, and (3) maximizes its EPS.
ANS: A PTS: 1 DIF: MEDIUM | HARD
REF: 383385 OBJ: (12.8) Miscellaneous capital structure concepts
BLM: Evaluate
30. Which of the following statements is correct?
a. Generally, debt-to-total-assets ratios do not vary much among different industries,
although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are
more volatile than those of firms in most other industries.
c. Prescription drug companies generally have high debt-to-equity ratios because their
earnings are very stable, and therefore they can cover the high interest costs associated
with high debt levels.
d. 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.
ANS: D PTS: 1 DIF: HARD REF: 381383
OBJ: (12.7) Variations in capital structures BLM: Evaluate