Capital Structure Exercises and Principles of Finance

This document presents a set of multiple-choice questions and true/false statements related to capital structure in finance. The questions cover various aspects, including the Modigliani and Miller theorem, the impact of leverage on risk and return, the weighted average cost of capital (WACC), and the pecking order theory. The assignment explores the relationship between debt and equity financing, the tax implications of debt, and the concept of optimal capital structure. It also examines the factors that influence a firm's financing decisions, such as the cost of capital, risk, and the priority of claims. The solutions provided offer insights into the key concepts and principles of capital structure, helping students understand how firms make financing decisions to maximize value. The assignment addresses topics such as leverage, cost of capital, and how debt and equity interact in a firm's financial structure.

Capital structure exercises
1) Which of the following statements is FALSE?
A) Modigliani and Miller's conclusion verified the common view, which stated that even with
perfect capital markets, leverage would affect a firm's value.
B) We can evaluate the relationship between risk and return more formally by computing the
sensitivity of each security's return to the systematic risk of the economy.
C) Investors in levered equity require a higher expected return to compensate for its increased
risk.
D) Leverage increases the risk of equity even when there is no risk that the firm will default.
2) Which of the following statements is FALSE?
A) Leverage decreases the risk of the equity of a firm.
B) Because the cash flows of the debt and equity sum to the cash flows of the project, by the
Law of One Price the combined values of debt and equity must be equal to the cash flows of
the project.
C) Franco Modigliani and Merton Miller argued that with perfect capital markets, the total
value of a firm should not depend on its capital structure.
D) It is inappropriate to discount the cash flows of levered equity at the same discount rate
that we use for unlevered equity.
3) Which of the following is NOT one of Modigliani and Miller's set of conditions
referred to as perfect capital markets?
A) All investors hold the efficient portfolio of assets.
B) There are no taxes, transaction costs, or issuance costs associated with security trading.
C) A firm's financing decisions do not change the cash flows generated by its investments,
nor do they reveal new information about them.
D) Investors and firms can trade the same set of securities at competitive market prices equal
to the present value of their future cash flows.
4) Which of the following statements is FALSE?
A) With no debt, the WACC is equal to the unlevered equity cost of capital.
B) With perfect capital markets, a firm's WACC is dependent of its capital structure and is
equal to its equity cost of capital only the firm it is unlevered.
C) As the firm borrows at the low cost of capital for debt, its equity cost of capital rises, but
the net effect is that the firm's WACC is unchanged.
D) Although debt has a lower cost of capital than equity, leverage does not lower a firm's
WACC.
5) Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%.
Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase
existing shares of stock. Assume perfect capital markets. If Taggart borrows until they
achieved a debt -to-equity ratio of 50%, then Rearden's levered cost of equity would be
closest to:
A) 10.0%
B) 12.0%
C) 15.0%
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D) 16.0%
6) Generally, increases in leverage result in ________ return and ________ risk.
A) decreased; increased
B) decreased; decreased
C) increased; increased
D) increased; decreased
7) A firm's capital structure is the mix of short-term liabilities and long-term debt.
A) TRUE
B) FALSE
8) Poor capital structure decisions can result in a high cost of capital, thereby making
some unacceptable investments acceptable.
A) TRUE
B) FALSE
9) The relative inexpensiveness of debt capital is due to the fact that the lenders take the
least risk among the long-term contributors of capital.
A) TRUE
B) FALSE
10) Debt capital is less risky than equity capital because a firm is legally obligated to
pay interest to bondholders but they are not legally obligated to pay dividends to
preferred or common stockholders.
A) TRUE
B) FALSE
11) Effective capital structure decisions can lower the cost of capital, resulting in higher
NPVs and more acceptable projects, thereby increasing the value of a firm.
A) TRUE
B) FALSE
12) Pecking order is a hierarchy of financing beginning with retained earnings, followed
by debt financing, and finally external equity financing.
A) TRUE
B) FALSE
13) The pecking order explanation of capital structure states that a hierarchy of
financing exists for firms, in which new external debt financing is employed first,
followed by retained earnings and finally by external equity financing.
A) TRUE
B) FALSE
14) The lower risk nature of long-term debt in a firm's capital structure is due to the
fact that ________.
A) the debt holders are the true owners of the firm
B) equity capital has a fixed return
C) creditors have a higher position in the priority of claims
D) dividend payments are tax-deductible
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15) A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm
has a 40 percent tax rate. The yearly, after-tax cost of this debt is ________.
A) $40,000
B) $60,000
C) $100,000
D) $166,667
16) Optimal capital structure is the capital structure at which the weighted average cost
of capital is minimized, thereby maximizing a firm's value.
A) TRUE
B) FALSE
17) Beginning with a zero-leverage company, as debt is substituted for equity in the
capital structure ________.
A) the overall cost of capital first rises, reaches a maximum, and then declines
B) the overall cost of capital declines
C) the overall cost of capital first declines, reaches a minimum, and then rises
D) the overall cost of capital rises
18) Which of the following is a reason why equity capital is considered riskier than debt
capital?
A) Equity capital has a higher priority claim against assets and earnings.
B) Equity capital requires regular periodic payments in the form of dividends.
C) Equity capital expects dividend payments which are not tax-deductible.
D) Equity capital remains invested in a firm indefinitely.
19) As debt is substituted for equity in the capital structure and the debt ratio increases,
the behavior of the overall cost of capital is partially explained by ________.
A) the tax-deductibility of interest payments
B) the increase in the number of common shares outstanding
C) the reduction in risk as perceived by the common shareholders
D) the decrease in the cost of equity
20) Which of the following is the correct order in which corporations generally raise
funds to enhance the wealth of stockholders and to send positive signals to the market?
A) retained earnings, equity, debt
B) retained earnings, debt, equity
C) debt, retained earnings, equity
D) equity, retained earnings, debt
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