Reference no: EM1314905

Objective type questions on cost of capital and WACC

1. Which of the following statements is most correct?

a)    Since debt financing raises the firm\'s financial risk, raising a company debt ratio will always increase the company WACC.

b)   Since debt financing is cheaper than equity financing, raising a company debt ratio will always reduce the company WACC.

c)    Increasing a company debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company WACC.

d)   Statements a and c are correct.

e)    None of the statements above is correct.

2. Ridgefield Enterprises has total assets of $300 million. The company currently has no debt in its capital structure. The company basic earning power is 15 percent. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain the same. Which of the following will occur as a result of the recapitalization?

a)    The company's ROA will decline.

b)   The company's ROE will increase.

c)    The company's basic earning power will decline.

d)   Answers a and b are correct.

e)    All of the above answers are correct.

3. Which of the following events is likely to encourage a company to raise its target debt ratio?

a)    An increase in the corporate tax rate.

b)   An increase in the personal tax rate.

c)    An increase in the company operating leverage.

d)   Statements a and c are correct.

e)    All of the statements above are correct.

4. Which of the following statements is false? As a firm increases its operating leverage for a given quantity of output, this

a)    changes its operating cost structure.

b)   increases its business risk.

c)    increases the standard deviation of its EBIT.

d)   increases the variability in earnings per share.

e)    decreases its financial leverage.

5. Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (rd). Which of the following statements is most correct?

a)    Company A has a higher return on assets (ROA) than Company B.

b)   Company A has a higher times interest earned (TIE) ratio than Company B.

c)    Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than CompanyB .

d)   Statements b and c are correct.

e)    All of the statements above are correct.

6. The major contribution of the Miller model is that it demonstrates that

a)    personal taxes increase the value of corporate debt.

b)   personal taxes decrease the value of corporate debt.

c)    financial distress and agency costs reduce the value of corporate debt.

d)   equity costs increase with financial leverage.

e)    debt costs increase with financial leverage.

7. Which of the following statements concerning capital structure theory is false?

a)    The major contribution of Miller theory is that it demonstrates that personal taxes decrease the value of corporate debt.

b)   Under MM with zero taxes, financial leverage has no effect on firm value.

c)    Under MM with corporate taxes, the value of the levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.

d)   Under MM with corporate taxes, rs increases with leverage, and this increase is just sufficient to offset the tax benefits of debt financing.

e)    Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.

8. Which of the following statements concerning the MM extension with growth is false?

a)    The tax shields should be discounted at the cost of debt.

b)   The value of a growing tax shield is greater than the value of a constant tax shield.

c)    For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM's original (with tax) assumptions.

d)   For a given D/S, the WACC is greater than the WACC under MM's original (with tax) assumptions.

e)    The total value of the firm increases with the amount of debt