Chapter 13 - BUS 361 Sample Test

1. The situation in which managers have different (presumably better) information about firms' prospects than do investors is called:
a. symmetric information.
b. asymmetric information.
c. signal information.
d. reserve borrowing capacity.

2. Jacob Industries is trying to determine its optimal capital structure. The company's CFO believes the optimal debt ratio is somewhere between 30 and 60%. His staff has developed the following projections for the company's EPS and stock price for various debt levels. Assuming that the firm uses only debt and common equity, at what debt ratio is the company's WACC minimized?
 

Debt Ratio    Projected EPS    Projected Stock Price

    30%                $4.35                        $44.32

    40%                $4.85                        $46.23

    50%                $5.55                        $46.01

    60%                $5.95                        $44.55

a. 30% debt ratio
b. 40% debt ratio
c. 50% debt ratio
d. 60% debt ratio

3. The ability to borrow money at a reasonable cost when good investment opportunities arise is called:
a. symmetric information.
b. asymmetric information.
c. capital structure.
d. reserve borrowing capacity.

4. Business risk is concerned with the operations of the firm. Which of the following is not associated with (or not a part of) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. Changes in required returns due to financing decisions.

5. Modigliani and Miller (MM) show that under a restrictive set of assumptions that a firm's value is unaffected by its capital structure. Which of the following are not assumptions used by MM?
a. no brokerage costs, no taxes, and no bankruptcy costs
b. investors borrow at the same rate as corporations
c. all investors have the same information as investors about the firm's future investment opportunities
d. EBIT is not affected by the use of debt
e. all of the above assumptions are used by MM

6. The target capital structure is affected by which of the following factors?
a. business risk
b. the firm's tax position
c. financial flexibility considerations
d. managerial attitudes (conservatism or aggressiveness)
e. all of the above

7. Smith Boating is trying to determine its optimal capital structure. The company's CFO believes the optimal debt ratio is somewhere between 20 and 50%. Her staff has developed the following projections for the company's EPS and stock price for various debt levels. Assuming that the firm uses only debt and common equity, what is Smith's optimal capital structure?
 

Debt Ratio    Projected EPS    Projected Stock Price

    20%                $4.35                        $44.32

    30%                $4.85                        $46.23

    40%                $5.55                        $46.01

    50%                $5.95                        $44.55

a. 20% debt ratio
b. 30% debt ratio
c. 40% debt ratio
d. 50% debt ratio

8. The Free Indeed Company manufactures ladies shoes that are sold through discount houses. The shoes are sold for $20 each pair; the fixed costs are $110,000 for up to 30,000 pairs of shoes; variable costs are $13 per pair of shoes. What is the firm's gain or loss at sales of 12,000 pairs of shoes?
a. -$26,000
b. $84,000
c. $130,000
d. $240,000
e. $300,000

9. The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.
a. True
b. False

10. Which of the following statements is most correct?
a. Increasing financial leverage is one way to increase a firm's revenues.
b. Firms with lower fixed costs tend to have greater operating leverage.
c. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.
d. Statements a and b are correct.

11. Which of the following does not affect a firm's business risk?
a. The level of uncertainty about future sales.
b. The degree of operating leverage.
c. The degree of financial leverage.
 

12. Which of the following is likely to encourage a company to use more debt in its capital structure?
a. A decrease in the variability of sales.
b. An increase in the liquidity of the firm's assets.
c. A decrease in the company's degree of operating leverage.
d. all of the above

13. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital is called the:
a. financial risk.
b. operating leverage.
c. business risk.
d. target capital structure.

14. Wiggins Motors has $50 million in assets that are financed entirely with equity. The firm's beta is currently 1.2. The CFO is suggesting that the firm recapitalize and use debt to finance 40% of its assets. Currently, the risk-free rate is 4%, and the market return is estimated to be 10%. The firm's tax rate is 40%. What would be the firm's estimated cost of equity if they recapitalize the firm? (Don't worry about this problem, it requires the Hamada equation)
a. 11.2%
b. 14.08%
c. 16.93%
d. 19.32%

15. Signaling theory suggests firms should in normal times maintain reserve borrowing capacity that can be used if an especially good investment opportunity comes along.
a. True
b. False