Skip to content
Rob's e2700 Notes

✏️ Capital Structure Practice

Some warmup multiple choice practice questions.

✏️ Which of the following is NOT a characteristic of a perfect capital market?

  1. Investors can trade securities at competitive market prices equal to the present value of their future cash flows.
  2. Perfect information exists, so investors know that they will get an identical rate of return no matter what investment securities they choose.
  3. There are no tax consequences, transaction costs, or other issuance costs associated with financing decisions or security trading.
  4. A firm’s financing decisions do not change the cash flows generated by its investments.
✔ Click here to view answer

B.

✏️ Modigliani and Miller argued that:

  1. The cash flows of levered equity should be discounted at the same discount rate used for unlevered equity.
  2. Because leverage does not change the overall value of the firm, which is based on the present value of the cash flows the assets generate, equity should be considered a risk-free security.
  3. Because the cash flows to the firm are the same, shareholders will require the same rate of return whether or not leverage is use4.
  4. In a perfect capital market, the total value of a firm is equal to the market value of the free cash flows generated by its assets and is not affected by its choice of capital structure.
✔ Click here to view answer

D.

✏️ With perfect capital markets, as the amount of leverage increases

  1. the WACC remains constant.
  2. the WACC increases at an increasing rate.
  3. the WACC increases at a decreasing rate.
  4. the WACC falls.
✔ Click here to view answer

A.

✏️ Last year, Rossignol paid $3 million in interest payments. Rosignol is in the 30% tax bracket. Rosignol’s interest tax shield for the year was

  1. $630,000.
  2. $900,000.
  3. $1,200,000.
  4. $2,100,000.
✔ Click here to view answer

B.

✏️ In the presence of taxes, the total value of the levered firm:

  1. Equals the value of the firm without leverage.
  2. Exceeds the value of the firm without leverage due to the present value of the tax savings from debt.
  3. Is lower than the value of the firm without leverage due to the present value of the tax savings from debt.
  4. Is lower than the value of the firm without leverage due to the present value of the interest payments that must be made.
✔ Click here to view answer

B.
D. is a conceptual misunderstanding because the value of the firm is VL = D+E, and D is the PV of all of the debt payments. Thus, the PV of the interest payments is included in the value of the firm.

✏️ Trade-off theory

  1. measures the differences between the direct costs and indirect costs of financial distress.
  2. weighs the benefits of debt that result from shielding cash flows from taxes against the costs of financial distress associated with leverage.
  3. states that the total value of the levered firm is exactly equal to the total value of the unlevered firm.
  4. considers the costs of increased leverage but not the benefits of increased leverage.
✔ Click here to view answer

B.

✏️ Question

✔ Click here to view answer

✏️ Trident Technology just announced that it is selling 3 million new shares of stock. Which of the following would be the most reasonable for you to assume?

  1. Trident’s managers think that the company’s stock is currently overvalued.
  2. Trident’s managers think that the company’s stock is currently undervalued.
  3. Trident is signaling to the market that it has great projects because it is committing to large future debt payments.
  4. Agency problems must be significant for the firm for the managers to choose equity financing over debt financing.

A.

✏️ According to the pecking order hypothesis, managers will have a preference to fund investment using:

  1. Debt, followed by retained earnings, and finally new equity.
  2. Debt, followed by new equity, and finally retained earnings.
  3. New equity, followed by retained earnings, and finally debt.
  4. Retained earnings, followed by debt, and finally new equity.
✔ Click here to view answer

D.

✏️ Because bankruptcy is costly for managers, an increase in leverage is a signal that

  1. Agency costs are significant.
  2. Managers are willing to forego the interest tax shield in order to increase the risk and return of the company.
  3. Managers are confident in the firm’s ability to meet its debt obligations.
  4. Managers are concerned that the company will not be profitable in the near future.
✔ Click here to view answer

C.