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Morales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. If the risk-free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity?


A) 1.53%
B) 1.70%
C) 1.87%
D) 2.05%
E) 2.26%

F) C) and E)
G) A) and C)

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Anson Jackson Court Company (AJC) The Anson Jackson Court Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. -Refer to the data for the Anson Jackson Court Company (AJC) . The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be AJC's new WACC and total value?


A) 7.38%; $800,008
B) 7.38%; $813,008
C) 7.50%; $813,008
D) 7.50%; $790,008
E) 7.80%; $790,008

F) A) and E)
G) A) and C)

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Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

A) True
B) False

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Firms U and L both have a return on invested capital (ROIC) of 12% and each has the same amount of assets. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 4.8%. Both firms have positive net income. Which of the following statements is CORRECT?


A) Firm L has a lower ROA than Firm U.
B) Firm L has a lower ROE than Firm U.
C) Firm L has the higher times interest earned (TIE) ratio.
D) Firm L has a higher EBIT than Firm U.
E) The two companies have the same times interest earned (TIE) ratio.

F) C) and D)
G) A) and E)

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The firm's target capital structure should be consistent with which of the following statements?


A) Minimize the cost of debt (rd) .
B) Obtain the highest possible bond rating.
C) Minimize the cost of equity (rs) .
D) Minimize the weighted average cost of capital (WACC) .
E) Maximize the earnings per share (EPS) .

F) B) and E)
G) A) and B)

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The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

A) True
B) False

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Which of the following statements is CORRECT?


A) The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
B) The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio.
C) Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company's WACC.
D) If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.
E) The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC) .

F) A) and E)
G) B) and D)

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Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt⎯HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? Firms HD and LD are identical except for their level of debt and the interest rates they pay on debt⎯HD has more debt and pays a higher interest rate on that debt. Based on the data given below, what is the difference between the two firms' ROEs? A) 2.18% B) 2.29% C) 2.41% D) 2.54% E) 2.66%


A) 2.18%
B) 2.29%
C) 2.41%
D) 2.54%
E) 2.66%

F) A) and B)
G) None of the above

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Which of the following statements is CORRECT?


A) The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.
B) The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share.
C) If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
D) 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.
E) 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.

F) A) and E)
G) B) and C)

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If Miller and Modigliani had incorporated the costs of bankruptcy into their model, it is unlikely that they would have concluded that 100% debt financing is optimal.

A) True
B) False

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Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT.

A) True
B) False

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Laramie Trucking's CEO is considering a change to the company's capital structure, which currently consists of 25% debt and 75% equity. The CFO believes the firm should use more debt, but the CEO is reluctant to increase the debt ratio. The risk-free rate, rRF, is 5.0%, the market risk premium, RPM, is 6.0%, and the firm's tax rate is 40%. Currently, the cost of equity, rs, is 11.5% as determined by the CAPM. What would be the estimated cost of equity if the firm used 60% debt? (Hint: You must first find the current beta and then the unlevered beta to solve the problem.)


A) 10.95%
B) 11.91%
C) 12.94%
D) 14.07%
E) 15.29%

F) None of the above
G) B) and D)

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If debt financing is used, which of the following is CORRECT?


A) The percentage change in net operating income will be equal to a given percentage change in net income.
B) The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
C) The percentage change in net income will be greater than the percentage change in net operating income.
D) 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.
E) The percentage change in net operating income will be greater than a given percentage change in net income.

F) D) and E)
G) A) and B)

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Based on the information below for Benson Corporation, what is the optimal capital structure?


A) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
B) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
C) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
D) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
E) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.

F) A) and C)
G) B) and C)

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It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS.

A) True
B) False

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Eccles Inc. Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. -Refer to the data for Eccles Inc.Assume that the firm's gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?


A) 16.4%
B) 18.2%
C) 20.2%
D) 22.5%
E) 25.0%

F) C) and D)
G) A) and C)

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Which of the following statements concerning capital structure theory is NOT CORRECT?


A) Under MM with zero taxes, financial leverage has no effect on a firm's value.
B) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
C) Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
D) Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
E) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

F) All of the above
G) C) and D)

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Hernandez Corporation expects to have the following data during the coming year. What is Hernandez's expected ROE? Hernandez Corporation expects to have the following data during the coming year. What is Hernandez's expected ROE? A) 12.51% B) 13.14% C) 13.80% D) 14.49% E) 15.21%


A) 12.51%
B) 13.14%
C) 13.80%
D) 14.49%
E) 15.21%

F) B) and C)
G) A) and E)

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Blueline Publishers is considering a recapitalization plan. It is currently 100% equity financed but under the plan it would issue long-term debt with a yield of 9% and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets, nor would it affect the firm's basic earning power, which is currently 15%. The CFO believes that this recapitalization would reduce the WACC and increase stock price. Which of the following would also be likely to occur if the company goes ahead with the recapitalization plan?


A) The company's earnings per share would decline.
B) The company's cost of equity would increase.
C) The company's ROA would increase.
D) The company's ROE would decline.
E) The company's net income would increase.

F) A) and C)
G) B) and E)

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Merriwether Building has operating income of $20 million, a tax rate of 40%, and no debt. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40% debt and 60% equity (based on market values) , its investment bankers believe its weighted average cost of capital would be 10%. What would its stock price be if it changes to the new capital structure?


A) $40
B) $48
C) $52
D) $54
E) $60

F) All of the above
G) A) and D)

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