Chapter 17 - Does Debt Policy Matter?

Chapter 17 Does Debt Policy Matter? Answer Key

Multiple Choice Questions

1. When a firm has no debt, then such a firm is known as:

I) an unlevered firm
II) a levered firm
III) an all-equity firm
A. I only
B. II only
C. III only
D. I and III only

Type: Easy

2. Capital structure of the firm can be defined as:

I) the firm's debt-equity ratio
II) the firm's mix of different securities used to finance assets
III) the market imperfection that the firm's manager can exploit
A. I only
B. II only
C. III only
D. I, II, and III

Type: Easy

3. The total market value (V) of the securities of a firm with both debt (D) and equity (E) is:
A. V = D - E
B. V = E - D
C. V = D * E
D. V = D + E

Type: Easy

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Chapter 17 - Does Debt Policy Matter?

4. If a firm is financed with both debt and equity, the firm's equity is known as:
A. unlevered equity
B. levered equity
C. preferred equity
D. none of the above

Type: Easy

5. Under what conditions would a policy of maximizing the value of the firm not the same as
a policy of maximizing shareholders' wealth?
A. If the issue of debt increases the probability of bankruptcy
B. If the firm issues debt for the first time
C. If the beta of equity is positive
D. If an issue of debt affects the market value of existing debt

Type: Difficult

6. A policy of maximizing the value of the firm is the same as a policy of maximizing the
shareholders' wealth rests on two important assumptions. They are:
I) the firm can ignore dividend policy
II) the debt equity ratio of the firm does not change
III) an issue of new debt does not affect the market value of existing debt
A. I only
B. II only
C. III only
D. I and III only

Type: Difficult

7. Modigliani and Miller's Proposition I states that:

A. The market value of any firm is independent of its capital structure
B. The market value of a firm's debt is independent of its capital structure
C. The market value of a firm's common stock is independent of its capital structure
D. None of the above

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

8. An investor can create the effect of leverage on his/her account by:

I) buying equity of an unlevered firm
II) by investing in risk-free debt like T-bills
III) by borrowing on his/her own account
A. I only
B. II only
C. III only
D. I and III only

Type: Medium

9. If firm U is unlevered and firm L is levered, then which of the following is true:
I) VU = EU
II) VL = EL + DL
III) VL = EU + DL
A. I only
B. I and II only
C. I, II, and III
D. III only

Type: Medium

10. If an investor buys "a" proportion of an unlevered firm's (firm U) equity then his/her
payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Type: Easy

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Chapter 17 - Does Debt Policy Matter?

11. If an investor buys "a" proportion of an both debt and equity of a levered firm (firm L)
then his/her payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Type: Medium

12. If an investor buys "a" proportion of the equity of a levered firm (firm L) then his/her
payoff is:
A. (a) * (profits)
B. (a) * (interest)
C. (a) * (profits - interest)
D. none of the above

Type: Medium

13. The law of conservation of value implies that:

A. The value of a firm's common stock is unchanged when debt is added to its capital
structure
B. The value of any asset is preserved regardless of the nature of the claims against it
C. The value of a firm's debt is unchanged when common stock is added to its capital
structure
D. None of the above

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

14. An investor can undo the effect of leverage on his/her own account by:
I) investing in the equity of a levered firm
II) by borrowing on his/her own account
III) by investing in risk-free debt like T-bills
A. I only
B. II only
C. III only
D. I and III above

Type: Medium

15. If an individual wanted to borrow with limited liability he/she should:

A. Invest in the equity of an unlevered firm
B. Borrow on his/her own account
C. Invest in the equity of a levered firm
D. Invest in a risk-free asset like T-bills

Type: Difficult

16. "Value additivity" works for:

I) combining assets
II) splitting up of assets
III) mix of debt securities issued by the firm
A. I only
B. II only
C. I and II only
D. I, II, and III

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

17. The law of conservation of value implies that:

I) the mix of senior and subordinated debt does not affect the value of the firm
II) the mix of convertible and non-convertible debt does not affect the value of the firm
III) the mix of common stock and preferred stock does not affect the value of the firm
A. I only
B. II only
C. III only
D. I, II, and III

Type: Medium

18. The law of conservation of value implies that:

I) the mix of common stock and preferred stock does not affect the value of the firm
II) the mix of long-term and short-term debt does not affect the value of the firm
III) the mix of secured and unsecured debt does not affect the value of the firm
A. I only
B. II only
C. III only
D. I, II, and III

Type: Medium

19. Capital structure is irrelevant if:

A. the capital markets are perfect
B. each investor holds a fully diversified portfolio
C. each investor holds the same proportion of debt and equity of the firm
D. all of the above

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

20. For a levered firm,

A. As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS)
increases by the same percent
B. As EBIT increases, the EPS increases by a larger percent
C. As EBIT increases, the EPS decreases
D. None of the above

Type: Medium

21. For an all equity firm,

A. As earnings before interest and taxes (EBIT) increases, the earnings per share (EPS)
increases by the same percent
B. As EBIT increases, the EPS increases by a larger percent
C. As EBIT increases, the EPS decreases
D. None of the above

Type: Medium

22. An EPS-Operating Income graph shows the trade-off between financing plans and:
I) Greater risk associated with debt financing, which is evidenced by the greater slope
II) Their break-even point
III) The minimum earnings needed to pay the debt financing for a given level of debt
A. I only
B. II only
C. III only
D. I, II, and III only

Type: Medium

23. According to EPS-operating income graph, debt financing is preferred if the expected
operating income is:
A. less than the break-even income
B. greater then the break-even income
C. equal to the break-even income

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

24. When comparing levered vs. unlevered capital structures, leverage works to increase EPS
for high levels of operating income because:
A. Interest payments on the debt vary with EBIT levels
B. Interest payments on the debt stay fixed leaving less income to be distributed over fewer
shares
C. Interest payments on the debt stay fixed, leaving less income to be distributed over more
shares
D. Interest payments on the debt stay fixed, leaving more income to be distributed over less
number of shares

Type: Medium

25. In an EPS-Operating Income graphical relationship, the slope of the debt line is steeper
than the equity line. The debt line has a negative value for intercept because:
A. The break-even point is higher with debt
B. A fixed interest charge must be paid even at low earnings
C. The amount of interest per share has only a positive effect on the intercept
D. The higher the interest rate the greater the slope

Type: Difficult

26. The effect of financial leverage on the performance of the firm depends on:
A. The rate of return on equity
B. The firm's level of operating income
C. The current market value of the debt
D. The rate of dividend growth

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

27. Health and Wealth Company is financed entirely by common stock that is priced to offer a
15% expected return. If the company repurchases 25% of the common stock and substitutes
an equal value of debt yielding 6%, what is the expected return on the common stock after
refinancing? (Ignore taxes.)
A. 18%
B. 21%
C. 15%
D. None of the above
rE = rA + (D/E)(rA - rD) = 15 + (0.25/0.75)(15 - 6) = 18%

Type: Difficult

28. Learn and Earn Company is financed entirely by Common stock that is priced to offer a
20% expected return. If the company repurchases 50% of the stock and substitutes an equal
value of debt yielding 8%, what is the expected return on the common stock after
refinancing?
A. 32%
B. 28%
C. 20%
D. None of the above
RE = 0.2 + (0.5/0.5)[0.20 - 0.08] = 0.32 = 32%

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

29. Wealth and Health Company is financed entirely by common stock that is priced to offer a
15% expected return. The common stock price is $40/share. The earnings per share (EPS) is
expected to be $6. If the company repurchases 25% of the common stock and substitutes an
equal value of debt yielding 6%, what is the expected value of earnings per share after
refinancing? (Ignore taxes.)
A. $6.00
B. $7.52
C. $7.20
D. None of the above
I = (10)(0.06) = 0.60; new EPS = (6 - 0.60)/0.75 = $7.20/share

Type: Difficult

30. Learn and Earn Company is financed entirely by common stock that is priced to offer a
20% expected rate of return. The stock price is $60 and the earnings per share are $12. If the
company repurchases 50% of the stock and substitutes an equal value of debt yielding 8%,
what is the expected earnings per share value after refinancing?
A. $12.00
B. $19.20
C. $24.00
D. None of the above
I = 30 (0.08) = $2.40; EPS = [12 - 2.4]/0.5 = $19.20

Type: Difficult

31. MM Proposition II states that:

A. The expected return on equity is positively related to leverage
B. The required return on equity is a linear function of the firm's debt to equity ratio
C. The risk to equity increases with leverage
D. All of the above
E. None of the above

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

32. Learn and Earn Company is financed entirely by common stock that is priced to offer a
20% expected rate of return. The stock price is $60 and the earnings per share are $12. The
company wishes to repurchase 50% of the stock and substitutes an equal value of debt
yielding 8%. Suppose that before refinancing, an investor owned 100 shares of Learn and
Earn common stock. What should he do if he wishes to ensure that risk and expected return
on his investment are unaffected by refinancing?
A. Borrow $3,000 and buy 50 more shares
B. Continue to hold 100 shares
C. Sell 50 shares and purchase $3,000 debt (bonds)
D. None of the above

Type: Difficult

33. A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is
considering a new capital structure with 60% debt. The interest rate on the debt would be 8%.
Assuming there are no taxes its cost of equity capital with the new capital structure would be:
A. 8%
B. 16%
C. 13%
D. 10%
E. None of the above
rE = 10 + (60/40)(10 - 8) = 10 + 3 = 13

Type: Medium

34. The cost of capital for a firm, rWACC, in a tax-free environment is:
A. Equal to the expected EBIT divided by market value of the unlevered firm
B. Equal to rA, the rate of return for that business risk class
C. Equal to the overall rate of return required on the levered firm
D. All of the above

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

35. A firm has a debt-to-equity ratio of 1.0. If it had no debt, its cost of equity would be 12%.
Its cost of debt is 9%. What is its cost of equity if there are no taxes?
A. 21%
B. 18%
C. 15%
D. 16%
rE = 12 + 1.0(12 - 9) = 15%

Type: Medium

36. A firm has a debt-to-equity ratio of 0.50. Its cost of debt is 10%. Its overall cost of capital
is 14%. What is its cost of equity if there are no taxes?
A. 13%
B. 16%
C. 15%
D. 18%
14 = [1/3](10) + (2/3)(X); 42 = 10 + 2X; X = 16%

Type: Medium

37. If a firm is unlevered and has a cost of equity capital 9%, what would the cost of equity be
if the firms became levered at a debt-equity ratio of 2? The expected cost of debt is 7%.
(Assume no taxes.)
A. 15.0%
B. 16.0%
C. 14.5%
D. 13%
rE = 9 + 2(9 - 7) = 13%

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

38. A firm has a debt-to-equity ratio of 1. Its (levered) cost of equity is 16%, and its cost of
debt is 8%. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio
were zero?
A. 8%
B. 10%
C. 12%
D. 14%
16 = rA + 1(rA - 8); 16 = 2rA - 8; 24 = 2rA; rA = 12%

Type: Medium

39. For a levered firm, beta of equity (bE) is equal to:

A. bE = bA
B. bE = bA + (D/E) * [bA - bD]
C. bE = bA + (D/(D + E)) * [bA - bD]
D. None of the above

Type: Difficult

40. For a levered firm, return on equity (rE) is equal to:

A. rE = rA
B. rE = rA + (D/E) * [rA - rB]
C. rE = rA + (D/(D + E)) * [rA - rB]
D. None of the above

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

41. The beta of an all equity firm is 1.2. If the firm changes its capital structure to 50% debt
and 50% equity using 8% debt financing, what will be the beta of the levered firm? The beta
of debt is 0.2. (Assume no taxes.)
A. 1.2
B. 2.2
C. 2.4
D. None of the above
E = 1.2 + (0.5/0.5)(1.2 - 0.2) = 2.2

Type: Medium

42. The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value
debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?
A. 1.2
B. 0.73
C. 0.2
D. None of the above
1.2 = A + (0.5)(A - 0.2); A = 0. 73

Type: Medium

43. The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is
0.5, what is the equity beta? (Assume no taxes.)
A. 1.5
B. 1.1
C. 0.3
D. None of the above
bE = 1.1 + 0.5(1.1 - 0.3) = 1.5

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

44. Generally, which of the following is true?

A. rD > rA > rE
B. rE > rD > rA
C. rE > rA > rD
D. None of the above is true

Type: Medium

45. Generally, which of the following is true? (b = beta)

A. bD < bA < bE
B. bE < bA < bD
C. bA < bE < bD
D. None of the above is true

Type: Medium

46. Generally, which of the following is true?

A. rE < rD < rA
B. rD < rA < rE
C. rE < rA < rD
D. None of the above is true

Type: Medium

47. Which of the following is true?

A. bD > bA > bE
B. bE > bA > bD
C. bA > bE > bD
D. None of the above is true

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

48. The M&M Company is financed by $4 million (market value) in debt and $6 million
(market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the
weighted average cost of capital. (Assume no taxes.)
A. 10%
B. 15%
C. 8%
D. None of the above
Weighted average cost of capital (WACC) = (4/10)(5) + (6/10)(10) = 2 + 6 = 8%

Type: Medium

49. The M & M Company is financed by $10 million in debt (market value) and $40 million
in equity (market value). The cost of debt is 10% and the cost of equity is 20%. Calculate the
weighted average cost of capital assuming no taxes.
A. 18%
B. 20%
C. 10%
D. None of the above
WACC = (1/5)(10) + (4/5)(20) = 2 + 16 = 18%

Type: Medium

50. If beta of debt is zero, then the relationship between equity beta and asset beta is given
by:
A. equity beta = 1 + [(Beta of assets)/(debt-equity ratio)]
B. equity beta = (1 - Debt-equity ratio)(beta of assets)
C. equity beta = (1 + Debt-equity ratio)(beta of assets)
D. None of the above

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

51. Minimizing the weighted average cost of capital (WACC) is the same as:
A. Maximizing the market value of the firm
B. Maximizing the book value of the firm
C. Maximizing the profits of the firm
D. Maximizing the liquidating value of the firm

Type: Medium

52. The after-tax weighted average cost of capital (WACC) is given by: (Corporate tax rate =
TC )
A. WACC = (rD)(D/V) + (rE)(E/V)
B. WACC = (rD)(D/V) +[(rE )(E/V)/(1 - TC)]
C. WACC = [(rD)(D/V) + (rE)(E/V)]/(1 - TC)
D. WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)

Type: Medium

53. Given the following data for U&P Company: Debt (D) = $100 million;
Equity (E) = $300 Million; rD = 6%; rE = 12% and TC = 30%.
Calculate the after-tax weighted average cost of capital (WACC):
A. 10.5%
B. 15%
C. 10.05%
D. 9.45%
After-tax WACC = (1/4)(1 - 0.3)(6) + (3/4)(12) = 10.05%

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

54. According to the graph of WACC for Union Pacific, the following is (are) true:
I) cost of equity is an increasing function of the debt-equity ratio.
II) cost of debt is an increasing function of the debt-equity ratio.
III) weighted average cost of capital (WACC) is a decreasing function of the debt-equity
ratio.
A. I only
B. I and II only
C. III only
D. I, II and III

Type: Medium

55. A firm's return on assets is estimated to be 12% and the cost of the firm's debt is 7%.
Given a .7 debt to equity ratio, what is the levered cost of equity?
A. 7%
B. 12%
C. 13.6%
D. 15.5%
Re = .12 + (.12 - .07) .7 = .155

Type: Medium

56. A firm's equity beta is 1.2 and its debt is risk free. Given a .7 debt to equity ratio, what is
the firm's asset beta?
A. .7
B. 1.0
C. 1.2
D. 0
Ba = 1.2 (1/1.7) + 0 (.7/1.7) = .70

Type: Medium

True / False Questions

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Chapter 17 - Does Debt Policy Matter?

57. The firm's mix of long-term securities used to finance its assets is called the firm's capital
structure.
TRUE

Type: Medium

58. Value additivity does not hold good when assets are split up.
FALSE

Type: Difficult

59. The "law of conservation of value" is not applicable to the mix of debt securities.
FALSE

Type: Medium

60. Modigliani and Miller Proposition I states that the market value of any firm is independent
of its capital structure.
TRUE

Type: Medium

61. According to Modigliani and Miller Proposition II, the rate of return required by the debt
holders increases as the firm's debt-equity ratio increases.
FALSE

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

62. Modigliani and Miller Proposition II states that the rate of return required by the
shareholders increases, steadily, as the firm's debt-equity ratio increases.
TRUE

Type: Medium

63. According to Proposition II, the cost of equity increases as more debt is issued, but the
weighted average cost of capital remains unchanged.
TRUE

Type: Medium

64. Financial leverage increases the expected return and risk of the shareholder.
TRUE

Type: Medium

65. Investors require higher returns on levered equity than on equivalent unlevered equity.
TRUE

Type: Medium

66. Expected return on assets depends on several factors including the firm's capital structure.
FALSE

Type: Medium

67. The beta of the firm is equal to the weighted average of the betas on its debt and equity
under the assumption of no taxes.
TRUE

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

68. Since the expected rate of return on debt is less than the expected rate of return on equity,
the weighted average cost of capital declines as more debt is issued.
FALSE

Type: Medium

69. MM's proposition is violated when the firm, by imaginative design of its capital structure,
can offer some financial service that meets the need of such a clientele.
TRUE

Type: Medium

70. The firm's asset beta is usually higher than the firm's equity beta.
FALSE

Type: Medium

71. The firm's debt beta is usually approximately 1.0.

FALSE

Type: Medium

Short Answer Questions

72. Explain the concept of arbitrage.

In well functioning markets two investments that offer the same payoff must have the same
price. Otherwise, investors can buy an asset in one market and simultaneously sell an identical
asset in another market at a higher price and make a profit at no cost or risk.

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

73. State the law of conservation of value.

The law of conservation of value states that the value of an asset is preserved regardless of the
nature of claims against it.

Type: Medium

74. Explain the concept of "value additivity."

If we have two streams of cash flow, A and B, the present value of A + B is equal to the
present value of A plus the present value of B. The same idea holds good when assets are split
up also.

Type: Medium

75. Briefly discuss some of the applications of the law of conservation of value.
The law of conservation of value can be applied to the choice of various securities issued by a
firm. For example, we could apply the law of conservation of value to the choice between
issuing preferred stock, common stock, or some combination of the two. The law implies that
the choice is irrelevant assuming perfect capital markets and that the choice does not affect
the firm's investment, borrowing, and operating policies. The law also applies to the mix of
debt securities issued by the firm. The choices of long-term versus short-term, secured versus
unsecured, senior versus subordinated, and convertible and nonconvertible debt all should not
have any effect on the overall value of the firm.

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

76. Briefly explain how EPS-Operating Income analysis helps determine the capital structure
of a firm?
The plot of EPS - operating income at a specified amount of debt will provide the break-even
income. If the firm's income is above the break-even point debt financing is preferred and
below that equity financing is preferred. In this method expected level of operating income
will determine whether debt financing should be used or equity financing be used.

Type: Medium

77. State and explain MM's Proposition II.

The expected rate of return on the common stock of a levered firm increases in proportion to
the debt-equity ratio, stated in market values. rE = rA + (D/E) * (rA - rD). As the debt-equity
ratio increases the cost of equity increases; the cost of debt and the weighted average cost of
capital remain constant. This also implies that the beta of the firm's equity also increases in
the same manner.

Type: Medium

78. Briefly explain how changes in debt-equity ratio impacts on the beta of the firm's equity?
There is a linear relationship between the equity beta of a firm and its debt-equity ratio. It is
obtained by combining Modigliani-Miller proposition II with the capital asset pricing model
(CAPM). The relationship is given by: bE = bA + (D/E)(bA - bD). Many times bD (beta of debt)
is zero. Then the relationship is written as: bE = [1 + (D/E)](bA).

Type: Difficult

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Chapter 17 - Does Debt Policy Matter?

79. Briefly describe the traditional position on capital structure.

The traditional view of the debt policy states that moderate amounts of debt increase the
expected return on equity, but when the firm borrows too much the expected return on equity
declines. The weighted average cost of capital declines initially at low levels of debt and later
increases at higher levels of debt. Hence, there is an optimal capital structure for a firm.

Type: Medium

80. Under what circumstances would MM's proposition is violated? Briefly discuss.
MM's proposition I is violated when the firm, by imaginative design of its capital structure, is
able to offer some financial service that meets the needs of a particular clientele. Either the
service must be new and unique or the firm must find a way to provide some existing service
more cheaply than other firms or financial intermediaries is able to provide. Therefore, smart
financial managers look for an unsatisfied clientele, investors who need a particular type of
financial instrument but because of market imperfections are unable to get it or get it cheaply.

Type: Difficult

81. Discuss a successful example of corporations trying to add value through innovative
financing.
Citicorp was the first to issue floating rate notes whose interest payments changed with
changes in short term interest rates. The success of the issue suggests that Citicorp was able to
add value through financing, by meeting an unmet need of the investors.

Type: Medium

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Chapter 17 - Does Debt Policy Matter?

82. State the generalized version of Modigliani-Miller proposition I.

Modigliani-Miller proposition I states that changes in capital structure does not affect the
value of a firm. MM's proposition I is an extremely general result. Any change in the capital
structure of the firm can be duplicated or "undone" by the investors at no cost. The investors
need not pay extra for borrowing indirectly (by holding shares in a levered firm) when they
can borrow just as easily and cheaply on their own account. It applies equally to trade-offs of
any choice of financial instruments. For example, the choice between long-term debt and
short-term debt would also not affect the value of the firm. Generally, the choice between
issuing preferred stock, common stock, or some combination of the two should not have any
effect on the overall value of the firm. It also applies to the mix of debt securities issued by
the firm. The choices of long-term versus short-term, secured versus unsecured, senior versus
subordinated, and convertible and nonconvertible debt all should not have any effect on the
overall value of the firm.

Type: Medium

83. Explain why the cost of equity and the cost of debt are concave upward at high levels of
debt.
As firm's take on higher levels of debt, the risk of default increases. Default risk requires a
risk premium for investors. Since the risk of both debt and equity not getting paid increases,
the premium also increases. Thus, both issues require an ever increasing risk premium.

Type: Difficult

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