16.1 Capital Structure Choices

Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)
Chapter 16 Capital Structure
16.1 Capital Structure Choices
1) Financial managers prefer to choose the same debt level no matter which industry they operate in.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
AACSB Objective: Analytic Skills
Author: KB
Question Status: Previous Edition
2) Even if two firms operate in the same industry, they may prefer different choices of debt-equity ratios.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) Equity in a firm with no debt is called unlevered equity.

Answer: TRUE
Diff: 1 Var: 1
Skill: Definition
Author: KB
4) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its
________.
A) capital structure
B) dividend expense
C) retained earnings
D) paid out capital
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
1
Copyright © 2019 Pearson Education, Ltd.
5) A firm's ________ ratio is the fraction of the firm's total value that corresponds to debt.
A) debt-to-equity
B) equity-to-debt
C) debt-to-value
D) liability
Answer: C
Diff: 1 Var: 1
Skill: Definition
Author: KB
6) Which of the following statements is FALSE?

A) The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its
capital structure.
B) The most common choices are financing through equity alone and financing through a combination of
debt and equity.
C) A project's net present value (NPV) represents the value to the new investors of a firm created by the
project.
D) When corporations raise funds from outside investors, they must choose which type of security to
issue.
Answer: C
Explanation: C) A project's NPV represents the value to the existing shareholders of a firm created by the
project.
Diff: 1 Var: 1
Skill: Conceptual
Author: JN
7) Equity in a firm with debt is called ________.

A) levered equity
B) risk-free equity
C) unlevered equity
D) preferred equity
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: JN
2
8) Equity in a firm with no debt is called ________.
A) levered equity
B) unlevered equity
C) risk-free equity
D) preferred equity
Answer: B
Diff: 1 Var: 1
Skill: Definition
Author: JN
9) Which of the following does a firm consider in the choice of securities issued?
A) the tax consequences of the chosen security
B) the transactions costs of the chosen security
C) whether the chosen security will have a fair price in the market
D) All of the above are considered.
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
10) What role do industries play in the capital structure choice for a firm?
Answer: Industries are found to have distinct patterns in their capital structures. For example, software
companies such as Microsoft are far less levered than are automobile manufacturers such as Ford Motor
Company.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
Question Status: Revised
11) What is the capital structure of a firm?

Answer: The relative proportion of debt and equity used by a firm is called its capital structure.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
12) What considerations should managers have while deciding on firms' capital structure?
Answer: Managers should first take a look at the industry norm for the firm. Subsequently, they should
consider if the securities issued will receive fair price in the market, have tax consequences, entail
transaction costs, or require a change to future investment opportunities.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
3
16.2 Capital Structure in Perfect Capital Markets
1) According to researchers Modigliani and Miller, with perfect capital markets, the total value of a firm
should not depend on its capital structure.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) With perfect capital markets, because different choices of capital structure offer a benefit to investors,
the capital structure affects the value of a firm.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
3) A financial manager makes a choice of the amount and source of capital based on how the choice will
impact the ________.
A) revenue
B) face value of bonds
C) depreciation
D) firm value
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) Investment cash flows are independent of financing choices in a ________.

A) market with frictions
B) perfect capital market
C) setting with frictions in investment returns
D) firm with leverage
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4
5) A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of
10%, what is the levered value of the firm with perfect capital markets?
A) $20,000
B) $16,000
C) $24,000
D) more information needed
Answer: A
Explanation: A) Compute the present value of the cash flow.
$22,000 / (1 + 0.1) = $20,000
Diff: 1 Var: 15
Skill: Analytical
Author: KB
6) A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of
A) $15,855.86
B) $19,819.82
C) $23,783.78
Answer: B
Explanation: B) Compute the present value of the cash flow.
$22,000 / (1 + 0.11) = $19,819.82
Diff: 1 Var: 30
Skill: Analytical
Author: KB
7) A firm will give a one-time cash flow of $24,000 after one year. If the project risk requires a return of
A) $17,454.55
B) $26,181.82
C) $21,818.18
Answer: C
Explanation: C) Compute the present value of the cash flow.
$24,000 / (1 + 0.1) = $21,818.18
Diff: 1 Var: 30
Skill: Analytical
Author: KB
5
8) MM Proposition I states that in a perfect capital market the total value of a firm is equal to the market
value of the ________ generated by its assets.
A) earnings after taxes
B) earnings after interest
C) cash flows after taxes
D) free cash flows
Answer: D
Diff: 1 Var: 1
Skill: Definition
Author: KB
9) It is not correct to discount the cash flows of a levered firm with the cost of equity of the unlevered firm
because ________.
A) leverage decreases the risk of equity of the firm
B) leverage changes the unlevered cost of equity
C) leverage increases the risk of the equity of the firm
D) cost of debt decreases in this setting
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
10) By adding leverage, the returns on a firm are split between debt holders and equity holders, but
equity holder risk increases because ________.
A) interest payments can be rolled over
B) dividends are paid first
C) debt and equity have equal priority
D) interest payments have first priority
Answer: D
Diff: 2 Var: 1
Skill: Conceptual
Author: KB
11) In a setting where there is no risk that a firm will default, leverage ________ the risk of equity.
A) increases
B) decreases
C) does not change
D) cannot say for sure
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
6
12) A firm requires an investment of $18,000 and will return $25,000 after one year. If the firm borrows
$10,000 at 6%, what is the return on levered equity?
A) 80%
B) 64%
C) 96%
D) 112%
Answer: A
Explanation: A) The firm will owe debt holders the amount borrowed times (1 + rate) after one year.
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
13) A firm requires an investment of $20,000 and will return $26,500 after one year. If the firm borrows
$6000 at 7%, what is the return on levered equity?
A) 35%
B) 52%
C) 43%
D) 61%
Answer: C
Explanation: C) The firm will owe debt holders the amount borrowed times (1+rate) after one year.
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
7
14) A firm requires an investment of $25,000 and will return $36,500 after 1 year. If the firm borrows
$20,000 at 7%, what is the return on levered equity?
A) 162%
B) 202%
C) 242%
D) 283%
Answer: B
Explanation: B) The firm will owe debt holders the amount borrowed times (1 + rate) after one year.
Diff: 2 Var: 50+

Skill: Analytical
Author: KB
15) When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, it
is referred to as ________.
A) outside debt
B) retained earnings
C) homemade leverage
D) payout ratio
Answer: C
Diff: 1 Var: 1
Skill: Definition
Author: KB
16) A firm requires an investment of $30,000 and borrows $15,000 at 7%. If the return on equity is 19%,
what is the firm's pretax WACC?
A) 13%
B) 6.5%
C) 15.6%
D) 18.2%
Answer: A
Explanation: A) Pretax WACC = rE + rD
Pretax WACC = 19 % × [$15,000 / ($15,000 + $15,000] + 7% × [$15,000 / ($15,000 + $15,000] = 13%

Diff: 2 Var: 27
Skill: Analytical
Author: KB
8
17) A firm requires an investment of $36,000 and borrows $12,000 at 9%. If the return on equity is 20%,
A) 8.2%
B) 19.6%
C) 16.3%
D) 22.9%
Answer: C
Explanation: C) Pretax WACC = rE + rD
Pretax WACC = 20% × [$24,000 / ($24,000 + $12,000)] + 9% ×[$12,000 / ($24,000 + $12,000)] = 16.3%
Diff: 2 Var: 48
Skill: Analytical
Author: KB
18) A firm requires an investment of $30,000 and borrows $7500 at 7%. If the return on equity is 18%,
A) 7.6%
B) 18.3%
C) 21.4%
D) 15.3%
Answer: D
Explanation: D) Pretax WACC = rE + rD
Pretax WACC = 18% × [$22,500 / ($22,500 + $7500)] + 7% × [$7500 / ($22,500 + $7500)] = 15.3%
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
19) A firm has a market value of equity of $30,000. It borrows $7500 at 8%. If the unlevered cost of equity
is 15%, what is the firm's cost of equity capital?
A) 16.75%
B) 6.70%
C) 20.10%
D) 23.45%
Answer: A
Explanation: A) Use MM Proposition II equation, rE = rU + ( rU - rD )
The firm's cost of equity capital = 15% + ($7500 / $30,000)(15% - 8%) = 16.75%
Diff: 2 Var: 48
Skill: Analytical
Author: KB
9
A) 9.0%
B) 18.0%
C) 21.6%
D) 25.2%
Answer: B
Explanation: B) Use MM Proposition II equation, rE = rU + ( rU - rD )
Diff: 2 Var: 48
Skill: Analytical
Author: KB
A) 8.9%
B) 21.4%
C) 17.8%
D) 24.9%
Answer: C
Explanation: C) Use MM Proposition II equation, rE = rU + ( rU - rD )
Diff: 2 Var: 50+
Skill: Analytical
Author: KB
22) Leverage can ________ a firm's expected earnings per share, but does not necessarily increase the
share price.
A) decrease
B) dilute
C) increase
D) never change
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
10
23) In general, issuing equity may not dilute the ownership of existing shareholders if ________.
A) the value of new shares is equal to the value of debt
B) the new shares are sold at a fair price
C) the firm has no debt financing
D) the firm uses debt conservatively
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
24) 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 neither 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 (PV) of their future cash flows.
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: JN

A) The Law of One Price implies that leverage will affect the total value of a firm under perfect capital
market conditions.
B) In the absence of taxes or other transaction costs, the total cash flow paid out to all of a firm's security
holders is equal to the total cash flow generated by the firm's assets.
C) With perfect capital markets, leverage merely changes the allocation of cash flows between debt and
equity, without altering the total cash flows of a firm.
D) In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows
generated by its assets and is not affected by its choice of capital structure.
Answer: A
Explanation: A) The Law of One Price implies that leverage will not affect the total value of the firm
under perfect capital market conditions.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
11
A) As long as a firm's choice of securities does not change the cash flows generated by its assets, the
capital structure decision will not change the total value of the firm or the amount of capital it can raise.
B) If securities are fairly priced, then buying or selling securities has a net present value (NPV) of zero
and, therefore, should not change the value of a firm.
C) The future repayments that the firm must make on its debt are equal in value to the amount of the loan
it receives up front.
D) An investor who would like more leverage than the firm has chosen can lend and add leverage to his
or her own portfolio.
Answer: D
Explanation: D) An investor who would like more leverage than the firm has chosen can borrow and add
leverage to his or her own portfolio.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN

A) As long as investors can borrow or lend at the same interest rate as a firm, homemade leverage is a
perfect substitute for the use of leverage by the firm.
B) When investors use leverage in their own portfolios to adjust the leverage choice made by a firm, we
say that they are using homemade leverage.
C) The value of a firm is determined by the present value (PV) of the cash flows from its current and
future investments.
D) The investor can re-create the payoffs of unlevered equity by borrowing and using the proceeds to
purchase the equity of a firm.
Answer: D
Explanation: D) The investor can re-create the payoffs of levered equity by borrowing and using the
proceeds to purchase the equity of the firm.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN

A) When a firm borrows significant money to repurchase shares or pay a large cash dividend, the
transaction is called a leveraged recapitalization.
B) MM Proposition I applies to capital structure decisions made at any time during the life of a firm.
C) By choosing positive-NPV projects that are worth more than their initial investment, a firm can
enhance its value.
D) The choice of capital structure does not change the value of a firm if the cost of equity is higher than
the cost of debt.
Answer: D
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
12
A) Investors can alter the leverage choice of a firm to suit their personal tastes either by borrowing and
reducing leverage or by holding bonds and adding more leverage.
B) As per MM proposition II, the cost of capital of levered equity is equal to the cost of capital of
unlevered equity plus a premium that is proportional to the debt-equity ratio.
C) The MM propositions imply that the true role of a firm's financial policy is to deal with financial
market imperfections such as taxes and transaction costs.
D) In practice, we will find that capital structure can have an effect on a firm's value.
Answer: A
Explanation: A) Investors can alter the leverage choice of a firm to suit their personal tastes either by
borrowing and increasing leverage or by holding bonds and reducing leverage.
Diff: 2 Var: 1
Skill: Conceptual
AACSB Objective: Reflective Thinking Skills
Author: JN
Use the information for the question(s) below.
Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm
Y is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X
has 2 million shares outstanding and $12 million in debt at an interest rate of 5%.
30) According to MM Proposition I, the stock price for Firm X is closest to ________.
A) $8.00
B) $24.00
C) $6.00
D) $12.00
Answer: C
Explanation: C) Under MM I, the total value of Firm X and Firm Y must be the same.
Value(Firm Y) = 1,000,000 × $24 = $24 million = Value(Firm X)

Value(levered equity) = value(Firm X) - debt = $24 million - $12 million = $12 million
Price per share = = $6.00
Diff: 2 Var: 1
Skill: Analytical
Author: JN
13
31) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the
same 5% rate as Firm X. You have $5000 of your own money to invest and you plan on buying Firm Y
stock. Using homemade leverage, how much do you need to borrow in your margin account so that the
payoff of your margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X
stock?
A) $10,000
B) $5,000
C) $2,500
D) $0
Answer: B
Explanation: B) Under MM I, the total value of Firm X and Firm Y must be the same.
Value(Firm Y) = 1,000,000 × $24 = $24 million

So, the leverage ratio of Firm X is 50% equity to 50% debt. To duplicate this in homemade leverage we
need to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin
loan. So, $5,000 is our equity, and we need to match it with $5,000 in a margin loan.
Diff: 2 Var: 1
Skill: Analytical
Author: JN
same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm Y
stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your
margined purchase of Firm Y stock will be the same as a $5,000 investment in Firm X stock. The number
of shares of Firm Y stock you purchased is closest to ________.
A) 425
B) 1,650
C) 2,000
D) 825
Answer: B

Value(levered equity) = value(Firm Y) - debt = $24 million - $12 million = $12 million
Price = = $6.00
So, the leverage ratio of with is 50% equity to 50% debt. To duplicate this in homemade leverage we need
to have equal proportions in our portfolio, this means we need 50% equity and 50% from a margin loan.
So, $5,000 is our equity and we need to match it with $5,000 in a margin loan. So, the total invested is
$10,000 / $6 per share = 1,667 shares.
Diff: 2 Var: 1
Skill: Analytical
Author: JN
14
same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X
stock. Using homemade (un)leverage, how much do you need to invest at the risk-free rate so that the
payoff of your account will be the same as a $5,000 investment in Firm Y stock?
A) $5,000
B) $0
C) $2,500
D) $4,000
Answer: C
Explanation: C) Under MM I, the total value of Firm X and Firm Y must be the same.

need to have equal proportions in our portfolio, which means we need 50% equity and 50% in the risk-
free asset. So, $5,000 is our total portfolio and we need $2,500 in equity (Firm X stock) and $2,500 in the
risk-free asset.
Diff: 2 Var: 1
Skill: Analytical
Author: JN
15
same 5% rate as Firm X. You have $5,000 of your own money to invest and you plan on buying Firm X
stock. Using homemade (un)leverage you invest enough at the risk-free rate so that the payoff of your
account will be the same as a $5,000 investment in Firm Y stock. The number of shares of Firm X stock
you purchased is closest to ________.
A) 100
B) 417
C) 1,650
D) 825
Answer: B

Price per share = = $6.00
need to have equal proportions in our portfolio, which means we need 50% equity and 50% in the risk-
free asset. So $5,000 is our total portfolio and we need $2,500 in equity (Firm X stock) and $2,500 in the
risk-free asset.
= 417 shares
Diff: 2 Var: 1
Skill: Analytical
Author: JN
16
Use the information for the question(s) below.
Luther is a successful logistical services firm that currently has $5 billion in cash. Luther has decided to
use this cash to repurchase shares from its investors and has already announced the stock repurchase
plan. Currently Luther is an all-equity firm with 1.25 billion shares outstanding. Luther's shares are
currently trading at $20 per share.
35) The market value of Luther's non-cash assets is closest to ________.

A) $20 billion
B) $19 billion
C) $25 billion
D) $24 billion
Answer: A
Explanation: A) Non-cash assets = (1.25 billion × $20 per share) - $5 billion = $25 billion - $5 billion
Non-cash assets = $20 billion
Diff: 2 Var: 1
Skill: Analytical
Author: JN
36) After the repurchase, how many shares will Luther have outstanding?
A) 0.75 billion
B) 1.0 billion
C) 1.1 billion
D) 1.2 billion
Answer: B
Explanation: B) Shares repurchased = $5 billion / $20 Share = 0.250 billion
Shares outstanding = 1.25 billion - 0.25 billion = 1.0 billion
Diff: 2 Var: 1
Skill: Analytical
Author: JN
37) With perfect capital markets, what is the market value of Luther's equity after the share repurchase?
A) $15 billion
B) $10 billion
C) $25 billion
D) $20 billion
Answer: C
Explanation: C) The market value of Luther's equity will not change since it uses cash to purchase its
own stock.
Diff: 2 Var: 1
Skill: Analytical
Author: JN
17
38) With perfect capital markets, what is the market price per share of Luther's stock after the share
repurchase?
A) $20
B) $24
C) $15
D) $25
Answer: D
Explanation: D) Market price per share = (1.25 billion × $20 per share) / 1 billion shares
= $25 billion / 1 billion shares = $25
Diff: 2 Var: 1
Skill: Analytical
Author: JN
39) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to
employees valued at $2 billion. The market value of Luther's non-cash assets is closest to ________.
A) $22 billion
B) $20 billion
C) $25 billion
D) $18 billion
Answer: A
Explanation: A) Market value of non-cash assets = (1.25 billion × $20 per share) + $2 billion - $5 billion
cash = $25 billion + $2 billion options - $5 billion cash = $22 billion
Diff: 2 Var: 1
Skill: Analytical
Author: JN
40) Assume that in addition to 1.25 billion common shares outstanding, Luther has stock options given to
employees valued at $2 billion. After the repurchase how many shares will Luther have outstanding?
A) 1.15 billion
B) 1.2 billion
C) 0.75 billion
D) 1.1 billion
Answer: A
Explanation: A) $2 billion / $20 Share = 0.10 billion shares repurchased
Shares outstanding = 1.25 - 0.10 = 1.15 billion
Diff: 2 Var: 1
Skill: Analytical
Author: JN
18
Consider the following equation for the question(s) below.
E+D=U=A
41) The E in the equation above represents ________.

A) the value of the firm's equity
B) the value of the firm's debt
C) the value of the firm's unlevered equity
D) the market value of the firm's assets
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: JN
42) The U in the equation above represents ________.

A) the value of the firm's equity
B) the market value of the firm's assets
C) the value of the firm's unlevered equity
D) the value of the firm's debt
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: JN
43) The A in the equation above represents ________.

A) the value of the firm's debt
B) the market value of the firm's assets
C) the value of the firm's equity
D) the value of the firm's unlevered equity
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: JN
19
A) While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's
equity.
B) Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
C) We can use MM Proposition I to derive an explicit relationship between leverage and the equity cost of
capital.
D) The total market value of the firm's securities is equal to the market value of its assets, whether the
firm is unlevered or levered.
Answer: B
Explanation: B) Although debt has a lower cost of capital than equity, we can consider this cost in
isolation.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN

A) The levered equity return equals the unlevered return plus an extra "kick" due to leverage.
B) By holding a portfolio of a firm's equity and its debt, we can replicate the cash flows from holding its
levered equity.
C) The cost of capital of levered equity is equal to the cost of capital of unlevered equity plus a premium
that is proportional to the market value debt-equity ratio.
D) If a firm is unlevered, all of the free cash flows generated by its assets are available to be paid out to its
equity holders.
Answer: B
Explanation: B) By holding a portfolio of a firm's equity and its debt, we can replicate the cash flows from
holding its unlevered equity.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
20
A) If we can identify a comparison firm whose assets have the same risk as the project being evaluated,
and if the comparison firm is levered, then we can use its cost of debt as the cost of capital for the project.
B) We can calculate the cost of capital of a firm's assets by computing the weighted average of the firm's
equity and debt cost of capital, which we refer to as the firm's weighted average cost of capital.
C) The portfolio of a firm's equity and debt replicates the returns we would earn if the firm were
unlevered.
D) When evaluating any potential investment project, we must use a discount rate that is appropriate
given the risk of the project's free cash flow.
Answer: A
Explanation: A) If we can identify a comparison firm whose assets have the same risk as the project being
evaluated, and if the comparison firm is levered, then we can use its unlevered equity cost of capital as
the cost of capital for the project.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN

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 on its capital structure and is equal to its
equity cost of capital only if the firm 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) As debt has a lower cost of capital than equity, higher leverage lowers a firm's WACC.
Answer: B
Explanation: B) With perfect capital markets, a firm's WACC is independent of its capital structure and is
equal to its equity cost of capital only if the firm is unlevered.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
48) Which of the following statements is TRUE?

A) Holding cash has the opposite effect of leverage on risk and return.
B) We use the market value of a firm's net debt when computing its WACC and unlevered beta to
measure the cost of capital and market risk of the firm's business assets.
C) Since the WACC does not change with the use of leverage, the value of a firm's free cash flow
evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on
its financing choices.
D) Even if a firm's capital structure is more complex, the WACC is calculated by computing the weighted
average cost of only the firm's debt and equity.
Answer: A
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
21
49) Which of the following statements is FALSE assuming a perfect market?
A) The unlevered beta measures the market risk of a firm's business activities, ignoring any additional
risk due to leverage.
B) If a firm holds $1 in cash and has $1 of risk-free debt, then the interest earned on the cash will equal the
interest paid on the debt. The cash flows from each source cancel each other, just as if the firm held no
cash and no debt.
C) The unlevered beta measures the market risk of a firm without leverage, which is equivalent to the
beta of the firm's assets.
D) As the amount of debt decreases, the debt becomes riskier because there is a chance the firm will
default.
Answer: D
Explanation: D) As the amount of debt increases, the debt becomes riskier because there is a chance the
firm will default.
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
50) The following equation:

X= rE + rD
can be used to calculate all of the following EXCEPT ________.

A) the cost of capital for a firm's assets
B) the levered cost of preferred equity
C) the unlevered cost of equity
D) the weighted average cost of capital
Answer: B
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
51) Which of the following equations would NOT be appropriate to use in a firm with risky debt?
A) rE = rU + (D / E) × (rU - rD)
B) rU = rD + (D / E) × (rU - rD)
C) rE = rU + (D / E) × rU
D) rU = [E / (E + D)]rE +[D / (E + D)]rD
Answer: C
Diff: 2 Var: 1
Skill: Conceptual
Author: JN
22
Use next year's Cash Flow Forecast for Blank Company to answer the question(s) below.
Demand Cash Flow

Weak $25,000
Expected $35,000
Strong $45,000
52) Suppose Blank Company has only one project, as forecast above, and an unlevered cost of equity of
8%. What is the value of the company if the demand is as expected?
A) $23,148.15
B) $32,407.40
C) $41,666.67
D) Cannot be determined with the information given.
Answer: B
Explanation: B) Expected cash flow is $35,000. Discounted for one period,
.
Diff: 1 Var: 1
Skill: Analytical
Author: JP
8%. If the company uses no leverage, what is expected return to equity holders?
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
Answer: A
Explanation: A) Unlevered cost of equity is given at 8%.
Diff: 1 Var: 1
Skill: Analytical
Author: JP
23
8%. If the company borrows $10,000 at 5% to make the investment, what is expected return to equity
holders? Assume the demand is as expected.
A) 8.0%
B) 11.6%
C) 9.33%
D) 30.0%
Answer: C
Explanation: C) Expected cash flow is $35,000. Equity costs $22,407.40 initially .
The firm must repay to debt holders, so cash flow to equity is
. Expected return to equity is .
Diff: 2 Var: 1
Skill: Analytical
Author: JP
8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if
demand is weak?
A) 8.0%
B) -37.5%
C) -58.6%
D) 10.28%
Answer: D
Explanation: D) In the weak demand scenario, cash flow is $25,000. Equity costs $13,148.15 initially
.
The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is
Diff: 2 Var: 1
Skill: Analytical
Author: JP
24
8%. If the company borrows $10,000 at 5% to make the investment, what is the return to equity holders if
demand is strong?
A) 8.0%
B) 8.95%
C) 28.6%
D) 38.0%
Answer: B
Explanation: B) In the strong demand scenario, cash flow is $45,000. Equity costs $31,666.67 initially
($45,000 / 1.08 - $10,000).
The firm must repay $10,500 ($10,000 × 1.05) to debt holders, so cash flow to equity is
Diff: 2 Var: 1
Skill: Analytical
Author: JP
16.3 Debt and Taxes
1) In general, the gain to investors from the tax deductibility of interest payments is referred to as the
interest rate tax shield.
Answer: TRUE
Diff: 1 Var: 1
Skill: Definition
Author: KB
2) Suppose a project financed via an issue of debt requires five annual interest payments of $12 million
each year. If the tax rate is 35% and the cost of debt is 5%, what is the value of the interest rate tax shield?
A) 14.55 million
B) $21.82 million
C) $36.37 million
D) $18.18 million
Answer: D
Explanation: D) Value of tax shield each year equals tax rate times the interest payment.
Compute the present value of annuity of payments calculated above.
Tax shield = 0.35 × 12 million = $4.2 million;
Diff: 1 Var: 18
Skill: Analytical
Author: KB
25
3) Suppose a project financed via an issue of debt requires six annual interest payments of $18 million
A) $23.30 million
B) $29.12 million
C) $34.95 million
D) $58.25 million
Answer: B
Explanation: B) Value of tax shield each year equals tax rate times the interest payment.
Tax shield = 0.35 × $18 million = $6.3 million;
Diff: 1 Var: 30
Skill: Analytical
Author: KB
4) Suppose a project financed via an issue of debt requires five annual interest payments of $18 million
A) $20.66 million
B) $31.00 million
C) $25.83 million
D) $51.66 million
Answer: C
Explanation: C) Value of tax shield each year equals tax rate times the interest payment.
Tax shield = 0.35 × $18 million = $6.3 million;
Diff: 1 Var: 30
Skill: Analytical
Author: KB
5) A firm requires an investment of $30,000 and borrows $20,000 at 9%. If the return on equity is 15% and
the tax rate is 30%, what is the firm's WACC?
A) 9.20%
B) 7.36%
C) 11.04%
D) 18.40%
Answer: A
Explanation: A) Use the WACC equation presented in this chapter.
rwacc = rE + rD (1 - TC)
rwacc = 15% × ($10,000 / $30,000) + 9% × (1 - 0.3) × ($20,000 / $30,000) = 9.20%

Diff: 1 Var: 36
Skill: Analytical
Author: KB
26
A) 11.1%
B) 13.9%
C) 16.7%
D) 27.9%
Answer: B
Explanation: B) Use the WACC equation presented in this chapter.
rwacc = 22% × ($30,000 / $60,000) + 9% × (1 - 0.35) × ($30,000 / $60,000) = 13.9%

Diff: 1 Var: 50+
Skill: Analytical
Author: KB
A) 11.2%
B) 9.0%
C) 13.4%
D) 22.4%
Answer: A
Explanation: A) Use the WACC equation presented in this chapter.
rwacc = 14% × ($40,000 / $60,000) + 8% × (1 - 0.3) × ($20,000 / $60,000) = 11.2%

Diff: 1 Var: 47
Skill: Analytical
Author: KB
8) What are some implications of market imperfections?

Answer: Market imperfections such as corporate taxes affect a firm's value and hence play a critical role
in the firm's choice of capital structure.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
27
9) How does the interest paid by a firm affect its value to investors?
Answer: The interest paid by a firm is tax-deductible and is referred to as interest tax shield. This is the
additional amount that a firm would have paid in taxes if it did not have any debt in its capital structure.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
10) What effect does debt have on a firm's weighted average cost of capital?
Answer: In a world with taxes, interest tax shield tends to reduce a firm's weighted average cost of
capital.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
16.4 The Costs of Bankruptcy and Financial Distress
1) A firm that does not have trouble meeting its debt obligations is said to be in financial distress.
Answer: FALSE
Diff: 1 Var: 1
Skill: Definition
Author: KB
2) The direct costs of bankruptcy are estimated to be far greater, as a percent of assets, than the indirect
costs of bankruptcy.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
3) A bankruptcy process is complex, time-consuming, and costly. The costs of bankruptcy include
________.
A) dividend payments
B) raw material costs
C) costs of hiring legal experts, appraisers, and auctioneers
D) taxes
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
28
4) Aside from direct costs of bankruptcy, a firm may also incur other indirect costs such as ________.
A) loss of customers and loss of suppliers
B) loss of interest receipts
C) loss of dividend receipts
D) increase in raw material costs
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
5) What are direct costs of financial distress?

Answer: When a corporation becomes financially distressed, outside professionals, such as legal,
appraisers, auctioneers, and others with experience in distressed assets are generally hired. These are
direct costs of financial distress.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
6) What are indirect costs of financial distress?

Answer: Indirect costs of financial distress are difficult to measure and are often larger than the direct
costs. These costs arise from defaulting on the commitments of a firm with its various constituents.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
16.5 Optimal Capital Structure: The Tradeoff Theory
1) The presence of financial distress costs can explain why firms choose debt levels that are too low to
exploit the interest tax shield.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Differences in the magnitude of financial distress costs and volatility of cash flows across industries do
not impact the choice of leverage.
Answer: FALSE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
29
3) The tradeoff theory of optimal capital structure weighs the benefits of debt against the costs of
________.
A) financial distress
B) interest payments
C) dividend reinvestment
D) input factors
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
4) The Tradeoff Theory suggests that ________.

A) a firm should choose a debt level where the tax savings from increasing leverage are just offset by the
increased probability of incurring the costs of financial distress
B) with higher costs of financial distress, it is optimal for a firm to choose higher leverage
C) differences in the magnitude of financial distress costs and the volatility of cash flows cannot explain
the differences in the use of leverage across industries
D) there is no rational explanation for why firms choose debt levels that are too low to fully exploit the
debt tax shield
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
5) One of the factors that determine the present value (PV) of financial distress costs is ________.
A) costs of unpaid interest arrears
B) loss of dividend payments
C) probability of financial distress
D) employee compensation
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
30
6) Firms in industries such as real estate tend to have ________ distress costs because of a large
proportion of tangible assets.
A) high
B) low
C) unexpected
D) varying
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
7) The probability of financial distress depends on the ________.

A) likelihood that a firm will be unable to meet its debt commitments
B) chance that a firm's raw material costs will increase
C) likelihood of dividend payments
D) likelihood of asset growth
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
8) As the level of debt increases the tax benefits of debt increase until ________.
A) interest costs exceed dividend payments
B) tax shield benefit exceeds distress costs
C) raw material costs exceed dividend payments
D) employee costs exceed interest expense
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
9) What are the issues in determining the present value (PV) of financial distress?
Answer: Calculating the precise present value (PV) of financial distress costs is very difficult if not
impossible. However, there are two key qualitative factors that need to be considered: (1) the probability
of financial distress and (2) the magnitude of direct and indirect costs related to financial distress.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
31
10) What are the issues in determining the optimal leverage for a firm?
Answer: While interest tax shield tends to increase the value of a firm , the direct and indirect cost of
financial distress tend to increase with leverage. Thus, there is an optimal leverage where the costs and
benefits are optimized.
Diff: 1 Var: 1
Skill: Conceptual
Author: SS
16.6 Additional Consequences of Leverage: Agency Costs and Information
1) The presence of leverage can influence the behavior of the managers of a firm.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Equity-debt holder conflicts are more likely to arise if the risk of financial distress is high.
Answer: TRUE
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
Question Status: New
3) Agency costs arise when ________.

A) there are high labor costs
B) input costs are higher than interest costs
C) interest costs exceed dividend payments
D) conflicts of interest exist between stakeholders
Answer: D
Diff: 1 Var: 1
Skill: Definition
Author: KB
4) Managerial entrenchment means that managers ________ and run the firm for their own best interests.
A) may face little threat of being fired
B) are overseen by equity holders
C) are overseen by debt holders
D) are well compensated
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
32
5) When a firm's investment decisions have different consequences for the value of equity and the value
of debt, managers may take actions ________.
A) to increase debt values
B) to decrease costs of distress
C) that benefit shareholders at the expense of debt holders
D) to reduce fixed costs
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
6) The presence of a large amount of debt can encourage shareholders to take excessive risk because
________.
A) equity holders are risk seeking by nature
B) the costs of failure are borne largely by debt holders
C) debt holders are risk seeking
D) firm value increases with risk taking
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
7) To reduce agency costs, issuing debt instead of equity provides incentives for managers to run a firm
efficiently because ________.
A) debt increases the funds available to managers to run the firm
B) ownership of managers may remain more concentrated
C) managers may take actions that benefit shareholders but harm creditors and lower the value of the
firm
D) shareholders prefer to decline new projects to save cash, even if their NPVs are positive
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: JP
33
8) Under-investment problems refers to the problem that equity holders prefer not to invest in positive-
NPV projects in highly levered firms because ________.
A) future investments are contingent on debt financing
B) projects are contingent on equity financing
C) gains are evenly shared between all stakeholders
D) most of the gains from the investment accrue to debt holders
Answer: D
Diff: 2 Var: 1
Skill: Conceptual
Author: KB
9) The use of leverage as a way to signal ________ information to investors is known as the signaling
theory of debt.
A) good
B) bad
C) random
D) none of the above
Answer: A
Diff: 1 Var: 1
Skill: Definition
Author: KB
10) Asymmetric information implies that ________ may have better information about a firm's cash flows
than other stakeholders.
A) debt holders
B) suppliers
C) managers
D) creditors
Answer: C
Diff: 1 Var: 1
Skill: Definition
Author: KB
11) Market timing means that managers may sell ________ when they believe the stock is over-valued
and rely on ________ when the stock is undervalued.
A) debt, shares
B) debt, preferred stock
C) new shares, debt
D) debt, debt
Answer: C
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
34
12) The pecking order hypothesis states that managers will have a preference to fund investment by using
________, followed by ________, and will issue ________ as a last resort.
A) debt, equity, retained earnings
B) retained earnings, equity, debt
C) retained earnings, debt, equity
D) debt, retained earnings, equity
Answer: C
Diff: 1 Var: 1
Skill: Definition
Author: KB
16.7 Capital Structure: Putting It All Together
1) Managers should make use of the interest tax shield if a firm has ________.
A) consistent taxable income
B) volatility in taxable income
C) consistent dividend payments
D) low tax rates
Answer: A
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
2) Managers should consider ________ for external financing when agency costs are significant.
A) long-term debt
B) retained earnings
C) internal equity
D) short-term debt
Answer: D
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
35
3) Managers should not change the capital structure unless it departs significantly from the optimal level
because such a change would ________.
A) reduce dividends
B) incur transactions costs
C) increase fixed costs
D) change incentives of stakeholders
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
4) The optimal capital structure depends on ________ such as taxes, distress costs and agency costs.
A) capital market factors
B) market imperfections
C) firm specific risks
D) systematic risks
Answer: B
Diff: 1 Var: 1
Skill: Conceptual
Author: KB
36

16.1 Capital Structure Choices

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What are the main factors that influence a firm's capital structure choice?

What are the main factors that influence a firm's capital structure choice?

What are some of the costs associated with changing a firm's capital structure?

What are some of the costs associated with changing a firm's capital structure?

Fundamentals of Corporate Finance, 4e, GE (Berk/DeMarzo/Harford)

Chapter 16 Capital Structure

16.1 Capital Structure Choices

3) Equity in a firm with no debt is called unlevered equity.

6) Which of the following statements is FALSE?

7) Equity in a firm with debt is called ________.

11) What is the capital structure of a firm?

4) Investment cash flows are independent of financing choices in a ________.

Diff: 2 Var: 50+

Diff: 2 Var: 50+

Diff: 2 Var: 50+

Pretax WACC = 19 % × [$15,000 / ($15,000 + $15,000] + 7% × [$15,000 / ($15,000 + $15,000] = 13%

25) Which of the following statements is FALSE?

27) Which of the following statements is FALSE?

28) Which of the following statements is FALSE?

Use the information for the question(s) below.

Value(Firm Y) = 1,000,000 × $24 = $24 million = Value(Firm X)

Value(Firm Y) = 1,000,000 × $24 = $24 million

Value(Firm Y) = 1,000,000 × $24 = $24 million

Value(Firm Y) = 1,000,000 × $24 = $24 million

Value(Firm Y) = 1,000,000 × $24 = $24 million

35) The market value of Luther's non-cash assets is closest to ________.

41) The E in the equation above represents ________.

42) The U in the equation above represents ________.

43) The A in the equation above represents ________.

45) Which of the following statements is FALSE?

47) Which of the following statements is FALSE?

48) Which of the following statements is TRUE?

50) The following equation:

can be used to calculate all of the following EXCEPT ________.

Demand Cash Flow

16.3 Debt and Taxes

rwacc = 15% × ($10,000 / $30,000) + 9% × (1 - 0.3) × ($20,000 / $30,000) = 9.20%

rwacc = 22% × ($30,000 / $60,000) + 9% × (1 - 0.35) × ($30,000 / $60,000) = 13.9%

rwacc = 14% × ($40,000 / $60,000) + 8% × (1 - 0.3) × ($20,000 / $60,000) = 11.2%

8) What are some implications of market imperfections?

16.4 The Costs of Bankruptcy and Financial Distress

5) What are direct costs of financial distress?

6) What are indirect costs of financial distress?

16.5 Optimal Capital Structure: The Tradeoff Theory

4) The Tradeoff Theory suggests that ________.

7) The probability of financial distress depends on the ________.

16.6 Additional Consequences of Leverage: Agency Costs and Information

3) Agency costs arise when ________.

16.7 Capital Structure: Putting It All Together

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