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M&M Proposition II, without taxes, states that the:


A) capital structure of a firm is highly relevant.
B) weighted average cost of capital decreases as the debt-equity ratio decreases.
C) cost of equity increases as a firm increases its debt-equity ratio.
D) return on equity is equal to the return on assets multiplied by the debt-equity ratio.
E) return on equity remains constant as the debt-equity ratio increases.

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

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Cross Town Cookies is an all-equity firm with a total market value of $4,187,100.The firm has 127,500 shares of stock outstanding.Management is considering issuing $300,000 of debt at an interest rate of 6 percent and using the proceeds to repurchase shares.The projected earnings before interest and taxes are $215,600.What are the anticipated earnings per share if the debt is issued? Ignore taxes.(Round the number of shares repurchased down to the nearest whole share.)


A) $1.59
B) $1.76
C) $1.38
D) $1.67
E) $1.47

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

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Which one of the following statements concerning financial leverage is correct?


A) The benefits of leverage are unaffected by the amount of a firm's earnings.
B) The use of leverage will always increase a firm's earnings per share.
C) The shareholders of a firm are exposed to less risk anytime a firm uses financial leverage.
D) Changes in the capital structure of a firm will generally change the firm's earnings per share.
E) Financial leverage is beneficial to a firm only when the firm has negative earnings.

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

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Which one of the following statements is correct regarding bankruptcies post-2005?


A) All Chapter 7 bankruptcy filings must include a "workout" agreement.
B) Firms must remain in bankruptcy for at least 18 months.
C) Key employee retention plans are no longer permitted under any circumstances.
D) Labor contracts cannot be modified through the bankruptcy process.
E) Section 363 speeds up the bankruptcy process via a bidding process.

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

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Debbie's Cookies has a return on assets of 12.6 percent and a cost of equity of 14.8 percent.What is the pretax cost of debt if the debt-equity ratio is .38? Ignore taxes.


A) 5.87 percent
B) 95.29 percent
C) 9.04 percent
D) 7.31 percent
E) 6.81 percent

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

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Northwestern Lumber Products currently has 12,400 shares of stock outstanding and no debt.Patricia, the financial manager, is considering issuing $160,000 of debt at an interest rate of 6.95 percent and using the proceeds to repurchase shares.Given this, how many shares of stock will be outstanding once the debt is issued if the break-even level of EBIT between these two capital structure options is $48,000? Ignore taxes.


A) 2,873 shares
B) 3,051 shares
C) 3,025 shares
D) 2,558 shares
E) 2,667 shares

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

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Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming the absolute priority rule is followed?


A) Claims by unsecured creditors
B) Employee wages
C) Government tax claims
D) Contributions to employee retirement plans
E) Bankruptcy administrative expenses

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

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An all-equity firm has a return on assets of 21 percent.The firm is considering converting to a debt-equity ratio of .48.The pretax cost of debt is 6.9 percent.Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?


A) 28.22 percent
B) 27.49 percent
C) 28.81 percent
D) 29.24 percent
E) 27.77 percent

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

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Great Lakes Shipping is an all-equity firm with anticipated earnings before interest and taxes of $386,000 annually forever.The present cost of equity is 17.1 percent.Currently, the firm has no debt but is considering borrowing $1.48 million at 8.5 percent interest.The tax rate is 35 percent.What is the value of the levered firm?


A) $1,985,251
B) $2,006,519
C) $1,888,47
D) $1,666,667
E) $2,018,181

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

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Shoe Box Stores is currently an all-equity firm with 25,000 shares of stock outstanding.Management is considering changing the capital structure to 35 percent debt.The interest rate on the debt would be 8 percent.Ignore taxes.Jamie owns 600 shares of Shoe Box Stores stock that is priced at $22 a share.What should Jamie do if she prefers the all-equity structure but Shoe Box Stores adopts the new capital structure?


A) Borrow money and buy an additional 180 shares
B) Borrow money and buy an additional 210 shares
C) Keep her shares but loan out all of the dividend income at 8 percent
D) Sell 210 shares and loan out the proceeds at 8 percent
E) Sell 180 shares and loan out the proceeds at 8 percent

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

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Cross Road Realty is an all-equity firm with 50,000 shares of stock outstanding and a total market value of $744,000.Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $126,560 if the economy is normal, $74,000 if the economy is in a recession, and $156,000 if the economy booms.Ignore taxes.Management is considering issuing $200,000 of debt at a coupon rate of 6.5 percent.If the firm issues the debt, the proceeds will be used to repurchase stock.What will the earnings per share be if the debt is issued and the economy is in a recession? (Round the number of shares repurchased down to the nearest whole share.)


A) $0.32
B) $1.67
C) $0.71
D) $0.23
E) $2.71

F) None of the above
G) C) and E)

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Assume you are comparing two firms that are identical in every aspect, except one is levered and one is unlevered.Which one of the following statements is correct regarding these two firms?


A) The levered firm has higher EPS (earnings per share) than the unlevered firm at the break-even point.
B) The levered firm will have higher EPS than the unlevered firm at all levels of EBIT.
C) The unlevered firm will have higher EPS than the levered firm at relatively high levels of EBIT.
D) The EPS for the unlevered firm will always exceed those of the levered firm.
E) The unlevered firm will have higher EPS at relatively low levels of EBIT.

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

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Burkhart and Mueller has no debt.Its current total value is $9.5 million.What will the company's value be if it sells $4 million in debt and has a tax rate of 21 percent? Assume all debt proceeds are used to repurchase equity.


A) $11.84 million
B) $13.59 million
C) $6.84 million
D) $8.59 million
E) $10.34 million

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

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Gulf Shores Inn is comparing two separate capital structures.The first structure consists of 64,000 shares of stock and no debt.The second structure consists of 50,000 shares of stock and $1.01 million of debt.What is the price per share of equity?


A) $75.50
B) $69.97
C) $72.14
D) $68.36
E) $74.00

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

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Which one of the following is minimized when the value of a firm is maximized?


A) Return on equity
B) WACC
C) Debt
D) Taxes
E) Bankruptcy costs

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

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Gabella's is an all-equity firm that has 36,000 shares of stock outstanding at a market price of $27 a share.The firm has earnings before interest and taxes of $57,600 and has a 100 percent dividend payout ratio.Ignore taxes.Gabella's has decided to issue $125,000 of debt at a rate of 9 percent and use the proceeds to repurchase shares.Terry owns 800 shares of Gabella's stock and has decided to continue holding those shares.How will Gabella's debt issue affect Terry's annual dividend income?


A) Decrease from $640 to $567
B) Increase from $2,160 to $1,890
C) Decrease from $640 to $591
D) Increase from $1,890 to $2,160
E) No change

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

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Uptown Construction is comparing two different capital structures.Plan I would result in 16,000 shares of stock and $160,000 in debt.Plan II would result in 18,000 shares of stock and $110,000 in debt.The interest rate on the debt is 9 percent.Ignoring taxes, EPS will be identical for Plans I and II when EBIT equals which one of the following?


A) $48,550
B) $50,400
C) $69,600
D) $53,700
E) $60,750

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

Correct Answer

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The Woodworker has a pretax cost of debt of 6.25 percent and a return on assets of 15.5 percent.The debt-equity ratio is .41.Ignore taxes.What is the cost of equity?


A) 18.46 percent
B) 18.78 percent
C) 19.43 percent
D) 18.94 percent
E) 19.29 percent

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

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Which one of the following statements related to the static theory of capital structure is correct?


A) A firm begins to lose value as soon as the first dollar of debt is incurred.
B) The actual value of a firm continually rises in direct proportion to the increased use of debt.
C) The linear function of a firm's value has a constant positive slope.
D) A firm's value is maximized when a firm operates at its optimal debt level.
E) The value of a firm will automatically decrease whenever the debt-equity ratio is decreased.

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

Correct Answer

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Which one of the following is a direct bankruptcy cost?


A) Loss of customer goodwill resulting from a bankruptcy filing
B) Legal and accounting fees related to a bankruptcy proceeding
C) Management time spent on a bankruptcy proceeding
D) Any financial distress cost
E) Costs a firm spends trying to avoid bankruptcy

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

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