Chapter 16 - Financial Leverage and Capital Structure Policy
Chapter 16
Financial Leverage and Capital Structure Policy
Multiple Choice Questions
1. Homemade leverage is:
A. the incurrence of debt by a corporation in order to pay dividends to shareholders.
B. the exclusive use of debt to fund a corporate expansion project.
C. the borrowing or lending of money by individual shareholders as a means of adjusting their
level of financial leverage.
D. best defined as an increase in a firm's debt-equity ratio.
E. the term used to describe the capital structure of a levered firm.
2. Which one of the following states that the value of a firm is unrelated to the firm's capital
structure?
A. Capital Asset Pricing Model
B. M&M Proposition I
C. M&M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
3. Which one of the following states that a firm's cost of equity capital is directly and
proportionally related to the firm's capital structure?
A. Capital Asset Pricing Model
B. M&M Proposition I
C. M&M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
4. Which one of the following is the equity risk that is most related to the daily operations of a
firm?
A. market risk
B. systematic risk
C. extrinsic risk
D. business risk
E. financial risk
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,Chapter 16 - Financial Leverage and Capital Structure Policy
5. Which one of the following is the equity risk related to a firm's capital structure policy?
A. market
B. systematic
C. extrinsic
D. business
E. financial
6. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by
$1,000. Which of the following terms is used to describe this tax savings?
A. interest tax shield
B. interest credit
C. financing shield
D. current tax yield
E. tax-loss interest
7. The unlevered cost of capital refers to the cost of capital for a(n):
A. private entity.
B. all-equity firm.
C. governmental entity.
D. private individual.
E. corporate shareholder.
8. The explicit costs, such as legal and administrative expenses, associated with corporate
default are classified as _____ costs.
A. flotation
B. issue
C. direct bankruptcy
D. indirect bankruptcy
E. unlevered
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,Chapter 16 - Financial Leverage and Capital Structure Policy
9. The costs incurred by a business in an effort to avoid bankruptcy are classified as _____
costs.
A. flotation
B. direct bankruptcy
C. indirect bankruptcy
D. financial solvency
E. capital structure
10. By definition, which of the following costs are included in the term "financial distress
costs"?
I. direct bankruptcy costs
II. indirect bankruptcy costs
III. direct costs related to being financially distressed, but not bankrupt
IV. indirect costs related to being financially distressed, but not bankrupt
A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV
11. The proposition that a firm borrows up to the point where the marginal benefit of the
interest tax shield derived from increased debt is just equal to the marginal expense of the
resulting increase in financial distress costs is called:
A. the static theory of capital structure.
B. M&M Proposition I.
C. M&M Proposition II.
D. the capital asset pricing model.
E. the open markets theorem.
12. Which one of the following is the legal proceeding under which an insolvent firm can be
reorganized?
A. restructure process
B. bankruptcy
C. forced merger
D. legal takeover
E. rights offer
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, Chapter 16 - Financial Leverage and Capital Structure Policy
13. A business firm ceases to exist as a going concern as a result of which one of the
following?
A. divestiture
B. share repurchase
C. liquidation
D. reorganization
E. capital restructuring
14. Edwards Farm Products was unable to meet its financial obligations and was forced into
using legal proceedings to restructure itself so that it could continue as a viable business. The
process this firm underwent is known as a:
A. merger.
B. repurchase program.
C. liquidation.
D. reorganization.
E. divestiture.
15. The absolute priority rule determines:
A. when a firm must be declared officially bankrupt.
B. how a distressed firm is reorganized.
C. which judge is assigned to a particular bankruptcy case.
D. how long a reorganized firm is allowed to remain under bankruptcy protection.
E. which parties receive payment first in a bankruptcy proceeding.
16. 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.
E. equates the value of debt with the value of equity.
16-4
Chapter 16
Financial Leverage and Capital Structure Policy
Multiple Choice Questions
1. Homemade leverage is:
A. the incurrence of debt by a corporation in order to pay dividends to shareholders.
B. the exclusive use of debt to fund a corporate expansion project.
C. the borrowing or lending of money by individual shareholders as a means of adjusting their
level of financial leverage.
D. best defined as an increase in a firm's debt-equity ratio.
E. the term used to describe the capital structure of a levered firm.
2. Which one of the following states that the value of a firm is unrelated to the firm's capital
structure?
A. Capital Asset Pricing Model
B. M&M Proposition I
C. M&M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
3. Which one of the following states that a firm's cost of equity capital is directly and
proportionally related to the firm's capital structure?
A. Capital Asset Pricing Model
B. M&M Proposition I
C. M&M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis
4. Which one of the following is the equity risk that is most related to the daily operations of a
firm?
A. market risk
B. systematic risk
C. extrinsic risk
D. business risk
E. financial risk
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,Chapter 16 - Financial Leverage and Capital Structure Policy
5. Which one of the following is the equity risk related to a firm's capital structure policy?
A. market
B. systematic
C. extrinsic
D. business
E. financial
6. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by
$1,000. Which of the following terms is used to describe this tax savings?
A. interest tax shield
B. interest credit
C. financing shield
D. current tax yield
E. tax-loss interest
7. The unlevered cost of capital refers to the cost of capital for a(n):
A. private entity.
B. all-equity firm.
C. governmental entity.
D. private individual.
E. corporate shareholder.
8. The explicit costs, such as legal and administrative expenses, associated with corporate
default are classified as _____ costs.
A. flotation
B. issue
C. direct bankruptcy
D. indirect bankruptcy
E. unlevered
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,Chapter 16 - Financial Leverage and Capital Structure Policy
9. The costs incurred by a business in an effort to avoid bankruptcy are classified as _____
costs.
A. flotation
B. direct bankruptcy
C. indirect bankruptcy
D. financial solvency
E. capital structure
10. By definition, which of the following costs are included in the term "financial distress
costs"?
I. direct bankruptcy costs
II. indirect bankruptcy costs
III. direct costs related to being financially distressed, but not bankrupt
IV. indirect costs related to being financially distressed, but not bankrupt
A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV
11. The proposition that a firm borrows up to the point where the marginal benefit of the
interest tax shield derived from increased debt is just equal to the marginal expense of the
resulting increase in financial distress costs is called:
A. the static theory of capital structure.
B. M&M Proposition I.
C. M&M Proposition II.
D. the capital asset pricing model.
E. the open markets theorem.
12. Which one of the following is the legal proceeding under which an insolvent firm can be
reorganized?
A. restructure process
B. bankruptcy
C. forced merger
D. legal takeover
E. rights offer
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, Chapter 16 - Financial Leverage and Capital Structure Policy
13. A business firm ceases to exist as a going concern as a result of which one of the
following?
A. divestiture
B. share repurchase
C. liquidation
D. reorganization
E. capital restructuring
14. Edwards Farm Products was unable to meet its financial obligations and was forced into
using legal proceedings to restructure itself so that it could continue as a viable business. The
process this firm underwent is known as a:
A. merger.
B. repurchase program.
C. liquidation.
D. reorganization.
E. divestiture.
15. The absolute priority rule determines:
A. when a firm must be declared officially bankrupt.
B. how a distressed firm is reorganized.
C. which judge is assigned to a particular bankruptcy case.
D. how long a reorganized firm is allowed to remain under bankruptcy protection.
E. which parties receive payment first in a bankruptcy proceeding.
16. 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.
E. equates the value of debt with the value of equity.
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