FIN 365 TEST 1 COMPLETE EXAM QUSTIONS WITH DETAILED VERIFIED ANSWERS
/ALREADY GRADED A+
Capital structure - (answer)Mix of debt and equity financing, and stock prices.
Capital structure policy involves trade off of? - (answer)risk and return
More debt raises? - (answer)riskiness of the firm's earning stream and the risk borne by
stockholders
Higher _______ generally leads to higher expected rate of return - (answer)debt ratio
Target capital structure - (answer)Mix of debt, preferred stock, and common equity a
firm uses to raise capital
A firm's target capital structure is generally set equal to _________. - (answer)the
estimated optimal capital structure
Optimal capital structure - (answer)structure that strikes the optimal balance between
risk and return and maximizes firm's stock price
7 primary factors that influence capital structure decisions? - (answer)-Business risk
-major reason for using debt is that interest is tax deductible, which lowers the effective
cost of debt
-The higher a firm's tax rate, the more advantageous debt is to the firm
-Financial flexibility
-greater the probable future need for capital, the worse the consequences of a capital
shortage, the stronger the balance sheet should be.
-managerial conservatism (aggressiveness)
-firms with more growth options cannot support as much debt and require greater
financial flexibility than firms whose value is comprised mostly of assets in place
business risk - (answer)the riskiness inherent in the firm's operations if no debt is used.
as it goes up, optimal debt ratio goes down
Financial flexibility, - (answer)ability to raise capital on reasonable terms under adverse
conditions. Potential future availability of funds and the consequences of a funds
shortage influence the target capital structure
managerial conservatism/aggressiveness - (answer)influences the target capital
structures firms extablisth
_________ can cause the actual capital structure to vary from the target -
(answer)operating conditions
,___________________ in the stand-alone sense is a function of the uncertainty
inherent in projections of a firm's return on invested capital (ROIC) - (answer)Business
risk
ROIC - (answer)net operating profit after taxes divided by the firms capital
ROIC Calculation - (answer)NOPAT/Capital or (Net income to common stockholders +
after tax interest payments)/capital
At zero debt ROIC = ? - (answer)ROE
Business risk of a leverage-free firm can be measured by? - (answer)Standard deviation
of its ROIC
7 most important factors that change business risk? Are they controllable? - (answer)-
demand variability
- sales price variability
- input cost variability
-ability to adjust output prices for changes in input costs
-ability to develop new products in a timely, cost-effective manner
-foreign risk exposure
- extent to which costs are fixed: operating leverage
*Some are controllable to some extent by management*
What is the technique companies use to reduce business risk? - (answer)Hedging
Operating leverage? - (answer)The extent to which a firm uses fixed costs in its
operations
High operating leverage means that a small change in sales results in a ________
change in operating income - (answer)large
Higher a firm's degree of operating leverage, the ______ its operating breakeven point -
(answer)higher
Operating breakeven point - (answer)Output quantity at which ROE = 0, hense when
EBIT = 0
calculating breakeven point - (answer)fixed costs divided by the different in sales price
and variable costs per unit F/(P-V)
The higher a firm's operating leverage, the __________ its business risk, all else equal -
(answer)higher
How is business risk measured? - (answer)variability of EBIT and roe
,Higher degree of operating leverage, the ________ the firm's business risk -
(answer)higher
Financial leverage refers to? - (answer)firm's use of fixed-income securities such as
debt and preferred stock in the firm's capital structure
Financial risk is - (answer)the additional risk placed on the common stockholders as a
result of the decision to finance with debt
the degree to which a firm employs financial leverage will affect - - (answer)its expected
earnings per share and riskiness of those earnings
Financial leverage causes - (answer)earnings per share to rise, however, the degree of
risk associated with the firm will also increase as leverage increases
MM's Irrelevance result - (answer)VL = VU
Where the value of a levered firm and value of an otherwise identical but unlevered firm
are equal
MM's first theory had the assumption that there were - (answer)no taxes
MM's second theory had the assumptions relaxed such that there were -
(answer)corporate taxes
MM demonstrated that if all other assumptions hold, the asymmetry of the tax
dedeductibility of interest versus the non-deductibility of dividend payments leads to..... -
(answer)100% debt financing VL = VU + TD (where T is the corporate tax rate)
_______ analyzed the effects of personal taxes (PERSON) - (answer)Merton Miller
An increase in ________ makes debt look better to corporations, and increase in
_______ encourages additional equity financing - (answer)Corporate tax
Personal tax
All income from bonds is generally _______, taxed as ________ - (answer)interest,
personal income
Income from stocks generally comes partly from ______ and partly from _______. -
(answer)income, capital gains
Long-term capital gains are taxed at a rate of __% - (answer)20
Capital gains tax is deferred until the stock is ______ - (answer)sold and the gain is
realized
, If stock is held and the owner dies capital gains tax (is paid or is not paid) - (answer)is
not paid
On balance, returns on common stocks are taxed at ________ effective rates than
returns on debt - (answer)Lower
The deductibility of interest favors the use of _______, but the more favorable tax
treatment of income from stocks lowers the required rate of return on stock and thus
favors _______ - (answer)Debt financing, equity financing
Millers result is VL = VU + [ 1 - {(1 - TC)(1-TS)/(1-TD)}]D
What are TC, TS, and TD? The term in brackets, multiplied by D, is? - (answer)TC =
corporate tax rate TS = personal tax rate on stock income TD = personal tax rate on
income from debt, *The gain from leverage*
If all taxes are ignored, the model (miller's) - (answer)reduces back to the original MM
model without taxes
If we ignore personal taxes, then the model (miller's) reduces - (answer)back to the MM
model with corporate taxes
Gain from leverage in the Miller Model depend on the values of Tc, Ts, Td, and _____ -
(answer)the amount of debt financing
Because taxes on capital gains are both lower than on ordinary income and can be
deferred, the effective tax rate on stock income is normally less than that on -
(answer)bond income
When Ts < Td, the bracketed term is less than Tc, and the value of financial leverage is
_____ than it would be in the absence of personal taxes - (answer)less
Millers model confirms the earlier MM conclusion that the use of corporate debt
_______ the value of a firm, but the advantage is clearly less than _____ -
(answer)increases, TD
Personal taxes _______ the benefits of corporate debt - (answer)reduce
FACT: Millers model still prescribes close to 100% debt as the value-maximizing capital
sructure - (answer)FACT
At equilibrium, the tax advantage of debt to the firm would be exactly offset by personal
taxation, and capital structure _________ - (answer)would have no effect on a firm's
value or its cost of capital
Bankruptcy-related problems are more likely to arise when a firm includes more ______
in its capital structure. - (answer)debt
/ALREADY GRADED A+
Capital structure - (answer)Mix of debt and equity financing, and stock prices.
Capital structure policy involves trade off of? - (answer)risk and return
More debt raises? - (answer)riskiness of the firm's earning stream and the risk borne by
stockholders
Higher _______ generally leads to higher expected rate of return - (answer)debt ratio
Target capital structure - (answer)Mix of debt, preferred stock, and common equity a
firm uses to raise capital
A firm's target capital structure is generally set equal to _________. - (answer)the
estimated optimal capital structure
Optimal capital structure - (answer)structure that strikes the optimal balance between
risk and return and maximizes firm's stock price
7 primary factors that influence capital structure decisions? - (answer)-Business risk
-major reason for using debt is that interest is tax deductible, which lowers the effective
cost of debt
-The higher a firm's tax rate, the more advantageous debt is to the firm
-Financial flexibility
-greater the probable future need for capital, the worse the consequences of a capital
shortage, the stronger the balance sheet should be.
-managerial conservatism (aggressiveness)
-firms with more growth options cannot support as much debt and require greater
financial flexibility than firms whose value is comprised mostly of assets in place
business risk - (answer)the riskiness inherent in the firm's operations if no debt is used.
as it goes up, optimal debt ratio goes down
Financial flexibility, - (answer)ability to raise capital on reasonable terms under adverse
conditions. Potential future availability of funds and the consequences of a funds
shortage influence the target capital structure
managerial conservatism/aggressiveness - (answer)influences the target capital
structures firms extablisth
_________ can cause the actual capital structure to vary from the target -
(answer)operating conditions
,___________________ in the stand-alone sense is a function of the uncertainty
inherent in projections of a firm's return on invested capital (ROIC) - (answer)Business
risk
ROIC - (answer)net operating profit after taxes divided by the firms capital
ROIC Calculation - (answer)NOPAT/Capital or (Net income to common stockholders +
after tax interest payments)/capital
At zero debt ROIC = ? - (answer)ROE
Business risk of a leverage-free firm can be measured by? - (answer)Standard deviation
of its ROIC
7 most important factors that change business risk? Are they controllable? - (answer)-
demand variability
- sales price variability
- input cost variability
-ability to adjust output prices for changes in input costs
-ability to develop new products in a timely, cost-effective manner
-foreign risk exposure
- extent to which costs are fixed: operating leverage
*Some are controllable to some extent by management*
What is the technique companies use to reduce business risk? - (answer)Hedging
Operating leverage? - (answer)The extent to which a firm uses fixed costs in its
operations
High operating leverage means that a small change in sales results in a ________
change in operating income - (answer)large
Higher a firm's degree of operating leverage, the ______ its operating breakeven point -
(answer)higher
Operating breakeven point - (answer)Output quantity at which ROE = 0, hense when
EBIT = 0
calculating breakeven point - (answer)fixed costs divided by the different in sales price
and variable costs per unit F/(P-V)
The higher a firm's operating leverage, the __________ its business risk, all else equal -
(answer)higher
How is business risk measured? - (answer)variability of EBIT and roe
,Higher degree of operating leverage, the ________ the firm's business risk -
(answer)higher
Financial leverage refers to? - (answer)firm's use of fixed-income securities such as
debt and preferred stock in the firm's capital structure
Financial risk is - (answer)the additional risk placed on the common stockholders as a
result of the decision to finance with debt
the degree to which a firm employs financial leverage will affect - - (answer)its expected
earnings per share and riskiness of those earnings
Financial leverage causes - (answer)earnings per share to rise, however, the degree of
risk associated with the firm will also increase as leverage increases
MM's Irrelevance result - (answer)VL = VU
Where the value of a levered firm and value of an otherwise identical but unlevered firm
are equal
MM's first theory had the assumption that there were - (answer)no taxes
MM's second theory had the assumptions relaxed such that there were -
(answer)corporate taxes
MM demonstrated that if all other assumptions hold, the asymmetry of the tax
dedeductibility of interest versus the non-deductibility of dividend payments leads to..... -
(answer)100% debt financing VL = VU + TD (where T is the corporate tax rate)
_______ analyzed the effects of personal taxes (PERSON) - (answer)Merton Miller
An increase in ________ makes debt look better to corporations, and increase in
_______ encourages additional equity financing - (answer)Corporate tax
Personal tax
All income from bonds is generally _______, taxed as ________ - (answer)interest,
personal income
Income from stocks generally comes partly from ______ and partly from _______. -
(answer)income, capital gains
Long-term capital gains are taxed at a rate of __% - (answer)20
Capital gains tax is deferred until the stock is ______ - (answer)sold and the gain is
realized
, If stock is held and the owner dies capital gains tax (is paid or is not paid) - (answer)is
not paid
On balance, returns on common stocks are taxed at ________ effective rates than
returns on debt - (answer)Lower
The deductibility of interest favors the use of _______, but the more favorable tax
treatment of income from stocks lowers the required rate of return on stock and thus
favors _______ - (answer)Debt financing, equity financing
Millers result is VL = VU + [ 1 - {(1 - TC)(1-TS)/(1-TD)}]D
What are TC, TS, and TD? The term in brackets, multiplied by D, is? - (answer)TC =
corporate tax rate TS = personal tax rate on stock income TD = personal tax rate on
income from debt, *The gain from leverage*
If all taxes are ignored, the model (miller's) - (answer)reduces back to the original MM
model without taxes
If we ignore personal taxes, then the model (miller's) reduces - (answer)back to the MM
model with corporate taxes
Gain from leverage in the Miller Model depend on the values of Tc, Ts, Td, and _____ -
(answer)the amount of debt financing
Because taxes on capital gains are both lower than on ordinary income and can be
deferred, the effective tax rate on stock income is normally less than that on -
(answer)bond income
When Ts < Td, the bracketed term is less than Tc, and the value of financial leverage is
_____ than it would be in the absence of personal taxes - (answer)less
Millers model confirms the earlier MM conclusion that the use of corporate debt
_______ the value of a firm, but the advantage is clearly less than _____ -
(answer)increases, TD
Personal taxes _______ the benefits of corporate debt - (answer)reduce
FACT: Millers model still prescribes close to 100% debt as the value-maximizing capital
sructure - (answer)FACT
At equilibrium, the tax advantage of debt to the firm would be exactly offset by personal
taxation, and capital structure _________ - (answer)would have no effect on a firm's
value or its cost of capital
Bankruptcy-related problems are more likely to arise when a firm includes more ______
in its capital structure. - (answer)debt
