Test bank Chapter 16

TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.
1) When there are no taxes and capital markets function well, the market value of a company
does not depend on its capital structure.
⊚ true
⊚ false

2) When asked about key factors of debt policy, financial managers commonly mention the tax
advantage of debt and the importance of maintaining their credit rating.
⊚ true
⊚ false

3) Loan covenants can ensure that companies will accept all positive-NPV investments and
reject negative ones.
⊚ true
⊚ false

4) Debt finance does not affect the operating risk but it does add financial risk.
⊚ true
⊚ false

5) Debt financing affects neither the business risk nor the financial risk of the firm.
⊚ true
⊚ false

6) As long as investors can borrow or lend on their own account on the same terms as the firm,
they will not pay extra for firm leverage.
⊚ true
⊚ false

7) Once you recognize the fact that debt also increases financial risk and causes shareholders to
demand a higher return on their investment, debt is no cheaper than equity.
⊚ true
⊚ false

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8) At moderate debt levels the probability of financial distress is trivial and therefore the tax
advantages of debt dominate.
⊚ true
⊚ false

9) Debt financing affects neither the operating risk nor the business risk of the firm.
⊚ true
⊚ false

10) Financial leverage describes debt financing's amplification of the effects of changes in
operating income on the returns to stockholders.
⊚ true
⊚ false

11) Financial risk is the risk to shareholders that results from debt financing.
⊚ true
⊚ false

12) MM's proposition I, or the debt-irrelevance proposition, states that the value of a firm is
unaffected by its capital structure.
⊚ true
⊚ false

13) According to MM, debt restructuring will not change the firm’s overall value.
⊚ true
⊚ false

14) According to MM’s proposition II the expected return on equity is equal to the expected
return on assets for a levered firm.
⊚ true
⊚ false

15) MM's proposition II states that the expected return on assets increases as the debt-equity ratio
increases.
⊚ true
⊚ false

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16) MM's proposition II states that the required return on equity increases as the firm's debt-
equity ratio increases.
⊚ true
⊚ false

17) The benefit of an interest tax shield is captured by the equity holders.
⊚ true
⊚ false

18) The risk of tax shields can be reasonably assumed to be the same as that of the interest
payments generating them.
⊚ true
⊚ false

19) Even after relaxing the MM assumption of no taxes, restructuring should not affect the value
of the firm.
⊚ true
⊚ false

20) Costs of financial distress are costs arising from bankruptcy or distorted business decisions
before bankruptcy.
⊚ true
⊚ false

21) The "trade-off theory" of capital structure suggests that firms have an optimal level of debt.
⊚ true
⊚ false

22) At some debt-equity ratio, the costs of financial distress are expected to overcome the value
of the extra interest tax shield for a firm.
⊚ true
⊚ false

23) Studies suggest that the indirect costs of bankruptcy are typically of a significant magnitude.
⊚ true
⊚ false

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24) The pecking-order theory of capital structure states that firms prefer internal financing to
avoid sending out adverse signals that may lower the stock price.
⊚ true
⊚ false

25) Management's perceived signals to investors form an important component of pecking-order

theory.
⊚ true
⊚ false

26) Financial slack means having ready access to cash or debt financing.
⊚ true
⊚ false

27) When additional borrowing causes the probability of financial distress to increase rapidly, the
potential costs of distress begin to take a substantial bite out of firm value.
⊚ true
⊚ false

28) A necessary assumption in the MM's proposition I, or the debt-irrelevance proposition, is that
the company and individual borrowing rates are the same.
⊚ true
⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or
answers the question.
29) A firm is expected to generate $1.5 million in operating income and pay $250,000 in interest.
Ignoring taxes, this will generate $12.50 earnings per share. What will happen to EPS if
operating income increases by 33.3% to $2.0 million?
A) EPS increases by 25% to $15.63.
B) EPS increases by 33.3% to $16.67.
C) EPS increases by 40% to $17.50.
D) EPS increases by 60% to $20.00.

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30) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and
an equal amount of debt. The firm is expected to generate $1.5 million in operating income
and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm
repurchases $2,500,000 of shares and substitutes an equal amount of additional debt?
A) EPS decreases by 33.3% to $10.00.
B) EPS decreases by 6.7% to $11.67.
C) EPS increases by 20% to $15.00.
D) EPS increases by 80% to $22.50.

31) A firm issues 100,000 shares of common stock with a total market value of $5,000,000 and
an equal amount of debt. The firm is expected to generate $1.5 million in operating income
and pay $250,000 in interest. If the firm does not pay tax, what will happen to EPS if the firm
repurchases $3,750,000 of shares and substitutes an equal amount of debt?
A) EPS decreases by 33.3% to $10.00.
B) EPS stays at $12.50.
C) EPS increases by 140% to $30.00.
D) EPS increases by 240% to $42.50.

32) Which one of these is not an underlying assumption of MM Proposition I?

A) Capital markets function well.
B) Investors can borrow or lend on the same terms as firms.
C) Taxes remain at their current non-zero levels.
D) Securities are fairly priced.

33) Fluctuations in a firm's operating income represent:

A) financial leverage.
B) the weighted-average cost of capital.
C) capital structure.
D) business risk.

34) An increase in a firm's financial leverage will:

A) increase the variability in earnings per share.
B) always reduce the operating risk of the firm.
C) increase the value of the firm in an MM world.
D) increase the WACC.

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35) Financial risk refers to the:
A) risk of owning equity securities.
B) risk faced by equity holders of firms with debt.
C) general business risk of the firm.
D) possibility that interest rates will increase.

36) If MM's proposition II without taxes is true, what is the return to investors who invest $20 in
a stock, borrow another $20 to buy a share of stock and pay 6% on the borrowed money if
the EPS is $1.50?
A) 6.0%
B) 9.0%
C) 12.0%
D) 15.0%

37) What is the proportion of debt financing for a firm that expects a 24% return on equity, a
16% return on assets, and a 12% return on debt? Ignore taxes.
A) 54.0%
B) 60.0%
C) 66.7%
D) 75.0%

38) Assume a firm is financed with 30% debt on which it pays interest of 9%. What is the
expected return on equity if the expected return on assets is 14%? Ignore taxes.
A) 16.14%
B) 17.86%
C) 14.92%
D) 15.50%

39) Assume a firm is financed with 60% debt on which it pays interest of 7%. What is the
expected return on equity if the expected return on assets is 12%? Ignore taxes.
A) 16.14%
B) 20.30%
C) 19.50%
D) 21.67%

40) According to MM Proposition II, as a firm's debt-equity ratio decreases:

A) its financial risk increases.
B) its operating risk increases.
C) the required rate of return on equity increases.
D) the required rate of return on equity decreases.

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41) An implicit cost of adding debt to the capital structure is that it:
A) adds interest expense to the operating statement.
B) increases the required return on equity.
C) reduces the expected return on assets.
D) decreases the firm's beta.

42) When debt is risky:

A) bondholders shift some of the firm risk to equity holders.
B) equity holders shift some of the firm risk to bondholders.
C) the value of the interest tax shield is at its highest.
D) there is more overall risk in the firm.

43) What is the amount of the annual interest tax shield for a firm with $3 million in debt that
pays 12% interest if the firm is in the 21% tax bracket?
A) $75,600
B) $234,000
C) $260,000
D) $550,000

44) A firm has perpetual debt of $10 million at an interest rate of 7%. What is the present value
of the interest tax shield if the tax rate is 21%?
A) $245,000
B) $700,000
C) $2,100,000
D) $10,000,000

45) If MM's proposition II without taxes is true and no bankruptcy risk exists, how much debt
will a company prefer if their cost of debt is 6%, cost of equity is 10% and the corporate tax
rate is 21%?
A) 0%
B) 21%
C) 35%
D) 100%

46) When taxes are considered, the value of a levered firm equals the value of the:
A) unlevered firm.
B) unlevered firm plus the value of the debt.
C) unlevered firm plus the present value of the tax shield.
D) unlevered firm plus the value of the debt plus the value of the tax shield.

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47) Assume an unlevered firm changes its capital structure to include $1 million in permanent
debt at a 7% interest rate. The tax rate is 21%. According to MM I with taxes, the value of
the firm will increase by ____ due to this change in its capital structure.
A) $35,000
B) $70,000
C) $210,000
D) $700,000

48) In a world with corporate taxes but no possibility of financial distress, the value of the firm is
maximized when the:
A) firm uses no debt in its capital structure.
B) firm uses the maximum amount of debt in its capital structure.
C) firm uses a debt-equity ratio of 1.0.
D) corporate tax rate approaches 100%.

49) Calculate the WACC for a firm that pays 10% on its debt, requires an 18% rate of return on
its equity, finances 45% of the market value of its assets with debt, and has a tax rate of 21%.
A) 13.46%
B) 14.00%
C) 14.40%
D) 18.20%

50) What is the after-tax cost of debt for a firm in the 21% tax bracket that pays 15% on its debt?
A) 9.25%
B) 11.85%
C) 12.17%
D) 14.25%

51) A firm has an expected return on equity of 15% and an after-tax cost of debt of 6%. What
debt-equity ratio produces a WACC of 12%?
A) 0.50
B) 0.75
C) 0.67
D) 0.33

52) Which of the following items will NOT change due to the cost of financial distress?
A) Cost of debt
B) Cost of equity
C) Cost of goods sold
D) Cost of legal fees

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53) If the present value of the interest tax shield on debt equals the present value of the costs of
financial distress, then the trade-off theory implies that the:
A) firm is using the optimal level of debt.
B) firm is paying too high an interest rate.
C) firm's market value equals its book value.
D) firm should increase its use of debt.

54) The present value of the costs of financial distress increases as the debt ratio increases
because the:
A) expected return on assets increases.
B) present value of the interest tax shield is greater.
C) equity tax shield is depleted.
D) probability of default is greater.

55) When financial disaster is looming, management may borrow to invest in projects having a
negative expected NPV because:
A) the firm's beta is now negative.
B) taxes are no longer a concern.
C) the interest tax shield will cover the loan costs.
D) the lender bears most of the risk.

56) Firms facing financial distress may pass up positive NPV projects rather than commit new
equity because:
A) they prefer to finance with debt.
B) the benefits are shared with the bondholders.
C) no cash is available for dividends.
D) there is no interest tax shield associated with equity.

57) The trade-off theory of capital structure suggests that firms:

A) add leverage whenever interest rates are low.
B) with higher risk should use less debt.
C) should use 50% debt and 50% equity.
D) should use debt to overcome high par values of stock.

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58) The trade-off theory of capital structure describes the optimal capital structure for any firm as
being the level of debt that:
A) minimizes the financial distress costs.
B) maximizes the present value of the interest tax shield.
C) equates the present values of the incremental interest tax shield and the incremental
financial distress costs.
D) maximizes the after-tax cash flows that are internally generated.

59) Firms are more likely to restrict borrowing if the:

A) return on the financed project is too high.
B) firm's asset base is largely intangible.
C) firm's asset beta is zero.
D) increased debt decreases the firm's WACC.

60) According to the pecking-order theory, managers will often choose to finance with:
A) new equity rather than debt, due to bankruptcy costs.
B) debt rather than new equity, to avoid a fall in the share price.
C) debt rather than retained earnings, to lower the WACC.
D) new equity rather than debt, to strengthen EPS.

61) A firm's capital structure is represented by its mix of:

A) assets.
B) liabilities and equity.
C) assets and liabilities.
D) assets, liabilities, and equity.

62) Restructuring a firm involves changing the:

A) mix of liabilities and equity.
B) dividend payout policy.
C) managerial personnel.
D) types of production equipment utilized.

63) MM Proposition I without taxes states that:

A) firms should be all-equity financed to maximize shareholder value.
B) shareholders are unaffected by the debt policy of the firm.
C) shareholders are indifferent to a firm's value.
D) shareholders prefer to invest in all-equity firms.

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64) What is the return on equity for a firm with a return on assets of 15%, a return on debt of
10%, and a 0.75 debt-equity ratio?
A) 18.75%
B) 20.00%
C) 23.75%
D) 26.25%

65) An all-equity firm has 1 million shares outstanding with a market value of $10 million. It
does not pay tax and has an operating income of $1.5 million. If $2 million of 10% debt is
issued and the proceeds used to repurchase shares of stock, then the firm's EPS:
A) increases by 20% to $1.80.
B) decreases by 40% to $0.9.
C) decreases by 20% to $1.20.
D) increases by 8.3% to $1.63.

66) A firm currently has operating income of $4 million, interest expense of $2 million, and EPS
of $2. How low can operating income drop before EPS are reduced by half, to $1? Ignore
taxes.
A) $3.5 million
B) $3.0 million
C) $2.5 million
D) $2.0 million

67) A firm increases its debt ratio from 50% to 60%. In the absence of taxes, an investor can
offset the change in capital structure by:
A) selling part of her holding and buying debt.
B) borrowing money and investing it in the firm’s equity.
C) holding a diversified portfolio.
D) switching her investment to convertible bonds.

68) MM proposition I states that a firm's value is unaffected by its:

A) required rate of return on equity.
B) operating income, in the absence of taxes.
C) interest rate paid on debt.
D) mixture of debt and equity.

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69) A firm's business risk depends upon:
A) its use of debt in the capital structure.
B) the risk of the firm's assets and operations.
C) the types of debt financing utilized.
D) the costs of financial distress.

70) The reason that financial leverage increases shareholder risk is that there is:
A) more debt which increases the operating risk.
B) less equity to absorb the operating risk.
C) less business risk to be spread around.
D) more financial risk due to reduced business risk.

71) According to MM, leverage may increase expected earnings per share but still leave the share
price unchanged because:
A) the firm's operating risk decreases.
B) the number of shares is decreased.
C) the required return on equity increases.
D) the firm is less risky.

72) A firm has a WACC of 14%, an expected return on equity of 19%, and a debt-to-asset ratio
of 60%. If the firm does not pay tax, what is the interest rate on the debt?
A) 6.50%
B) 9.90%
C) 10.67%
D) 11.14%

73) In the absence of taxes, which one of the following would not be expected to change with
changes in the firm's capital structure?
A) Weighted-average cost of capital
B) Expected return on equity
C) Expected return on assets
D) Expected earnings per share

74) If a firm's expected return on equity equals its expected return on assets, then the:
A) expected return on debt exceeds the expected return on assets.
B) likelihood of financial distress is high.
C) firm has too much debt.
D) firm has no debt in its capital structure.

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75) MM's proposition II without taxes states that the:
A) expected return on equity increases as financial leverage increases.
B) expected return on assets decreases as expected return on debt decreases.
C) firm's capital structure is irrelevant to the firm's overall value.
D) greater the proportion of equity, the higher the expected return on debt.

76) As a firm's debt-equity ratio approaches zero, the firm's expected return on equity
approaches:
A) the expected return on debt.
B) the expected return on assets.
C) its maximum.
D) zero.

77) With risky debt and MM’s Proposition II, the expected return on assets ________ as the debt-
equity ratio ________.
A) increases; increases
B) decreases; increases
C) increases; decreases
D) remains constant; increases

78) When a firm pays tax, MM’s Proposition I no longer holds, and the capital structure of the
firm can be important due to the:
A) lower tax rates on dividends than on debt.
B) higher tax rates on retained earnings than on debt.
C) interest tax shield.
D) higher operating income from lower dividends.

79) The interest tax shield is equal to the:

A) difference between the interest expense and income taxes.
B) amount of interest paid in a given year.
C) product of the interest expense and the tax rate.
D) product of the debt principal and the interest rate on debt.

80) Any financial benefit derived from the interest tax shield accrues to the:
A) bondholders.
B) shareholders.
C) bondholders and shareholders equally.
D) shareholders and the federal government.

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81) The present value of a perpetual tax shield increases as the firm's tax rate ________ and as
the amount of the debt ________.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

82) How much debt is outstanding if the present value of a perpetual tax shield is $300,000, the
tax rate is 21% and the interest rate on the debt is 10%?
A) $300,000
B) $1,428,571
C) $3,000,000
D) $3,750,000

83) What is the expected rate of return to equity holders if the firm has a tax rate of 21%, the
interest rate on debt is 10%, WACC is 15%, and the debt-asset ratio is 60%?
A) 12.50%
B) 21.25%
C) 22.50%
D) 25.65%

84) When corporate taxes and the cost of financial distress are taken into consideration, the
market value of a firm is equal to the value of the all-equity firm ________ the PV of the tax
shield ________ the costs of financial distress.
A) plus; plus
B) minus; plus
C) plus; minus
D) minus; minus

85) According to the trade-off theory, if the PV of the tax shield generated by debt is equal to the
PV of the financial distress costs, then the:
A) tax shield has been calculated incorrectly.
B) firm is too heavily levered.
C) firm has reached its optimal debt level.
D) firm appears to have a low risk of financial distress.

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86) Which ranking of financing from most preferred to least preferred is predicted by the
pecking-order theory?
A) Debt issue, stock issue, internally generated funds
B) Internally generated funds, debt issue, stock issue
C) Stock issue, internally generated funds, debt issue
D) Internally generated funds, stock issue, debt issue

87) Debt may be the preferred form of external financing for many firms because:
A) most firms already have too much equity.
B) tax rates on equity are lower.
C) debt will not adversely affect the firm's financial ratios.
D) equity issuance is considered by investors to be a negative signal.

88) Which one of the following statements is false according to MM's proposition I?
A) Firm value is unaffected by the firm's capital structure.
B) Proposition I is also called the debt-irrelevance proposition.
C) Shareholders should care about the firm's debt policy.
D) After restructuring, the firm's value should be the same as it was prior to
restructuring.

89) Debt usage will have an effect on:

A) business risk.
B) financial risk.
C) operating risk.
D) asset risk.

90) Leverage will ________ shareholders' expected return and ________ their risk.
A) increase; decrease
B) decrease; increase
C) increase; increase
D) increase; do nothing to

91) Calculate the firm's expected return on its assets if its expected return on debt is 10%, its
expected return on equity is 20%, and the company cost of capital is 14%.
A) 14%
B) 15%
C) 16%
D) 17%

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92) A firm with a debt-equity ratio of 0.5, a return on assets of 14%, and a return on debt of 8%,
will have a return on equity of:
A) 15.25%.
B) 16.00%.
C) 17.00%.
D) 17.33%.

93) As the debt-equity ratio decreases when debt is not risk free:
A) debtholders require a higher expected return.
B) debtholders require a lower expected return.
C) the expected return on equity increases.
D) the expected return on assets increases.

94) One advantage of debt financing over equity financing is the:

A) tax-deductible dividends.
B) tax-deductible interest.
C) tax-deductible principal repayment.
D) tax-free interest income.

95) Those who benefit from the interest tax shield are:
A) debtholders.
B) equityholders.
C) both debtholders and equityholders.
D) only the firm's customers.

96) When a corporation issues permanent debt, its value:

A) increases by the present value of the tax shield.
B) decreases by the present value of the tax shield.
C) increases by the annual interest tax shield.
D) decreases by the annual interest tax shield.

97) When corporate taxes are considered, how does leverage affect the WACC?
A) An increase in leverage will be offset by a decrease in equity financing, thus leaving
WACC unchanged.
B) Changes in leverage will affect the WACC only if the interest rate on debt changes.
C) Increased leverage will increase the WACC.
D) Increased leverage will decrease the WACC.

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98) According to the trade-off theory, optimal capital structure occurs when:
A) additional borrowing results in lower financial distress costs.
B) additional borrowing is offset by the interest tax shield.
C) the tax savings from additional leverage are offset by the increased costs of distress.
D) the present value of the tax shield exceeds the value of the all-equity-financed firm.

99) The possibility of bankruptcy will do all of the following except:

A) increase financial distress costs.
B) reduce the current market value of the firm.
C) reduce the interest rate on debt.
D) reduce the possible payoff to stockholders.

100) Costs of financial distress are greater when a firm increases its:
A) intangible assets as a percentage of total assets.
B) tangible assets as a percentage of total assets.
C) net working capital.
D) retained earnings.

101) Which one of the following statements is true regarding the trade-off theory?
A) Highly profitable firms should have low debt ratios.
B) All firms should have the same target debt-equity ratio.
C) Riskier firms should have high target debt ratios.
D) Less risky firms ought to have a greater amount of debt financing.

102) According to the trade-off theory, capital structure is a trade-off between:

A) tangible and intangible asset risk.
B) high and low target debt ratios.
C) tax savings and financial distress costs.
D) tax shields and equity financing.

103) The pecking-order theory suggests that less profitable firms borrow more because:
A) equity issues are more expensive.
B) leverage is preferred over raising funds internally.
C) debt issues are good omens.
D) they have insufficient internal funds.

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104) Financial slack:
A) is associated with high leverage
B) allows firms to take advantage of good investment opportunities
C) solves any agency costs when managers want to empire-build
D) is a term that describes a lazy CFO

105) Which one of these statements corresponds to MM proposition I without taxes?

A) Debt interest has no effect on either equity income or firm value.
B) Debt interest reduces equity income and increases firm value.
C) Debt interest reduces equity income but does not affect firm value.
D) The value of a firm increases as its debt-equity ratio increases.

106) Which one of these statements correctly applies to an unlevered firm that pays no taxes?
A) The return on equity exceeds the WACC.
B) The return on assets equals the return on equity and also equals WACC.
C) The return on assets equals the return on equity and exceeds WACC.
D) The return on equity equals WACC and exceeds the return on assets.

107) Which one of these is a disadvantage to tax-paying individual investors?

A) Receiving interest income rather than dividends
B) Receiving capital gains rather than dividends
C) Receiving capital gains rather than interest income
D) Receiving dividends rather than interest income

108) An increase in a corporation's tax rate will cause:

A) an increase in an unlevered firm's return on assets.
B) a decrease in a levered firm's WACC.
C) an increase in a levered firm's cost of debt.
D) a decrease in an unlevered firm's cost of equity.

SHORT ANSWER. Write the word or phrase that best completes each statement or
answers the question.
109) Which of the following pair of firms do you think should be more highly levered: A
retailing firm with prime downtown real estate, or a social media company whose major
assets are its unique software and client loyalty?

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110) Which of the following pair of firms do you think should be more highly levered: A
biotech firm which may need a large cash injection if its drug trials are successful, or a
company with a well-established market and large cash reserves?

111) Which of the following pair of firms do you think should be more highly levered: A
taxpaying company, or a company with large tax loss carry-forwards?

112) Which of the following pair of firms do you think should be more highly levered: A risky
company, or a safe company?

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Answer Key
Test name: Ch 16

1) TRUE
2) TRUE
3) FALSE
4) TRUE
5) FALSE
6) TRUE
7) TRUE
8) TRUE
9) TRUE
10) TRUE
11) TRUE
12) TRUE
13) TRUE
14) FALSE
15) FALSE
16) TRUE
17) TRUE
18) TRUE
19) FALSE
20) TRUE
21) TRUE
22) TRUE
23) TRUE
24) TRUE
25) TRUE
26) TRUE
27) TRUE
28) TRUE
29) C
30) D
31) D
32) C
33) D
34) A
35) B
36) B

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Return = [(1.50 × 2) − (20 × 0.06)] / 20 = 0.09 or 9.0%

37) C
0.24 = 0.16 + D / E(0.16 − 0.12); D / E = 2
Debt financing % = 2 / (2 + 1) = 0.667, or 66.7%

38) A
E( R) e = 0.14 + [0.30 / (1 − 0.30)](0.14 − 0.09) = 0.1614, or 16.14%

39) C
E( R) e = 0.12 + [0.60 / (1 − 0.60)](0.12 − 0.07) = 0.1950, or 19.50%

40)D
41)B
42)B
43)A
Annual interest tax shield = 0.12 × $3m × 0.21 = $75,600

44) C
PV tax shield = (0.07 × $10m × 0.21) / 0.07 = $2.1m

45) D
46) C
47) C
PV of interest tax shield = 0.21 × $1m = $210,000

48) B
49) A
WACC = (1 − 0.45)(0.18) + 0.45(0.10)(1 − 0.21) = 0.1346, or 13.46%

50) B
After-tax cost of debt = 0.15 × (1 − 0.21) = 0.1185, or 11.85%

51) A
0.12 = (0.15)(1 − x) + 0.06 x; x = 1 / 3 D/E = (1 / 3) / (1 − 1/3) = 1 / 2, or 0.50

52) C
53) A
54) D
55) D

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56) B
57) B
58) C
59) B
60) B
61) B
62) A
63) B
64) A
re = 0.15 + 0.75(0.15 − 0.10) = 0.1875, or 18.75%

65) D
Initially EPS = $1.5 million / 1 million = $1.5
After restructuring VE = $800,000; number of shares = 800,000; net income = $1.5 million −
0.10 × $2 million = $1.3 million; EPS = $1.3 million / 800,000 = $1.63

66) B
67) A
68) D
69) B
70) B
71) C
72) C
0.14 = (1 − 0.60)(0.19) + 0.60( Rd); Rd = 0.1067, or 10.67%

73)C
74)D
75)A
76)B
77)D
78)C
79)C
80)B
81)A
82)B
$300,000 = D × 0.21; D = $1,428,571

83) D
0.15 = (1 − 0.60) Re + 0.60(0.10)(1 − 0.21); Re = 0.2565, or 25.65%

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84)C
85)C
86)B
87)D
88)C
89)B
90)C
91)A
company cost of capital = expected return on assets = 14%

92) C
re = 0.14 + 0.5(0.14 − 0.08) = 0.17, or 17%

93) B
94) B
95) B
96) A
97) D
98) C
99) C
100) A
101) D
102) C
103) D
104) B
105) C
106) B
107) A
108) B
109) Short Answer
The retailing firm with readily saleable assets.

110) Short Answer

The company with a well-established market and large cash reserves.

111) Short Answer

The taxpaying company with income to shield.

112) Short Answer

The safe company.

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