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Capital Structure Policy Questions

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Practice Questions for Capital Structure Policy
Reference: Chapter 16 - Financial Leverage and Capital Structure Policy, Fundamentals of
Corporate Finance, any edition, Ross, Westerfield and Jordan.
Group A: Multiple Choices
1.
Which one of the following is the equity risk related to a firm's capital structure policy?
A.
market
B.
systematic
C.
business
D.
2.
The unlevered cost of capital refers to the cost of capital for a(n):
A.
private entity.
B.
all-equity firm.
C.
private individual.
D.
corporate shareholder.
3.
A firm should select the capital structure that:
A.
produces the highest cost of capital.
B.
maximizes the value of the firm.
C.
minimizes taxes.
D.
is fully unlevered.
4.
M & M Proposition I with no tax supports the argument that:
A.
business risk determines the return on assets.
B.
the cost of equity rises as leverage rises.
C.
the debt-equity ratio of a firm is completely irrelevant.
D.
a firm should borrow money to the point where the tax benefit from debt is equal to the
cost of the increased probability of financial distress.
5.
M & M Proposition II is the proposition that:
A.
the capital structure of a firm has no effect on the firm's value.
B.
a firm's cost of equity is a linear function with a slope equal to (R
A
- R
D
).
C.
the cost of equity is equivalent to the required rate of return on a firm's assets.
D.
the size of the pie does not depend on how the pie is sliced.

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6.
The interest tax shield has no value when a firm has a:
I. tax rate of zero.
II. debt-equity ratio of 1.
III. zero debt.
IV. zero leverage.
A.
I and III only
B.
II and IV only
C.
I, III, and IV only
D.
II, III, and IV only
E.
I, II, and IV only
______________________________________________________________________________
Group B: Show-Your-Work Questions
1. RAK, Inc., has no debt outstanding and a total market value of $165,000. Earnings before
interest and taxes, EBIT, are projected to be $21,000 if economic conditions are normal. If
there is strong expansion in the economy, then EBIT will be 25% higher. If there is a
recession, then EBIT will be 35% lower. The company is considering a $60,000 debt issue
with an interest rate of 7%. The proceeds will be used to repurchase shares of stock. There
are currently 5,500 shares outstanding. Assume that the company has a tax rate of 35% and a
market-to-book ratio of 1.0.
a. Calculate earnings per share (EPS) and return on equity (ROE) under each of the three
economic scenarios before any debt is issues. Also calculate the percentage changes in
EPS and ROE when the economy expands or enters a recession.
b. Repeat part (a) assuming that the company goes through with recapitalization. What do
you observe?
Group B:
1. a.
Recession
Normal
Expansion
EBIT
$13,650
$21,000
$26,250
Interest
0
0
0
Taxes (35%)
4,778
7,350
9,188
NI
$ 8,873
$13,650
$17,063
EPS
$1.61
(8,873/5,500)
$2.48
(13,650/5,500)
$3.10
(17,063/5,500)
%EPS
35%
–––
+25%
ROE 5.38% 8.27% 10.34%

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Practice Questions for Capital Structure Policy Reference: Chapter 16 - Financial Leverage and Capital Structure Policy, Fundamentals of Corporate Finance, any edition, Ross, Westerfield and Jordan. Group A: Multiple Choices 1. Which one of the following is the equity risk related to a firm's capital structure policy? A. market B. systematic C. business D. financial 2. The unlevered cost of capital refers to the cost of capital for a(n): A. private entity. B. all-equity firm. C. private individual. D. corporate shareholder. 3. A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. 4. M & M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. 5. M & M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. a firm's cost of equity is a linear function with a slope equal to (RA - RD). C. the cost of equity is equivalent to the required rate of return on a firm's assets. D. the size of the pie does not depend on how the pie is sliced. 1 6. The interest tax shield has no value when a firm has a: I. tax rate ...
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