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Greenwood Motels has filed a petition for bankruptcy but hopes to continue its operations both during and after the bankruptcy process. Which one of the following terms best applies to this situation?


A) Chapter 7 bankruptcy
B) Liquidation
C) Technical insolvency
D) Accounting insolvency
E) Reorganization

F) None of the above
G) A) and B)

Correct Answer

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Which one of the following states that a firm's cost of equity capital is a positive linear function of the firm's capital structure?


A) Static theory of capital structure
B) M&M Proposition I
C) M&M Proposition II
D) Homemade leverage theory
E) WACC

F) B) and D)
G) All of the above

Correct Answer

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You are comparing two possible capital structures for a firm. The first option is an all-equity firm. The second option involves the use of $3.8 million of debt. The break-even point between these two financing options occurs when the earnings before interest and taxes (EBIT) are $428,000. Given this, you know that leverage is beneficial to the firm:


A) whenever EBIT is less than $428,000.
B) only when EBIT is $428,000.
C) whenever EBIT exceeds $428,000.
D) only if the debt is decreased by $428,000.
E) only if the debt is increased by $428,000.

F) None of the above
G) A) and B)

Correct Answer

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Which one of the following statements related to the static theory of capital structure is correct?


A) A firm begins to lose value as soon as the first dollar of debt is incurred.
B) The actual value of a firm continually rises in direct proportion to the increased use of debt.
C) The linear function of a firm's value has a constant positive slope.
D) A firm's value is maximized when a firm operates at its optimal debt level.
E) The value of a firm will automatically decrease whenever the debt-equity ratio is decreased.

F) All of the above
G) C) and D)

Correct Answer

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A firm has a cost of debt of 7.5 percent and a cost of equity of 16.2 percent. The debt-equity ratio is 0.45. There are no taxes. What is the firm's weighted average cost of capital?


A) 11.75 percent
B) 12.29 percent
C) 13.50 percent
D) 14.47 percent
E) 16.20 percent

F) C) and D)
G) A) and E)

Correct Answer

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Stone House Cafe has a 30 percent tax rate and total taxes of $35,280. What is the value of the interest tax shield if the interest expense is $16,700?


A) $4,887
B) $5,010
C) $5,395
D) $5,708
E) $6,023

F) B) and E)
G) B) and D)

Correct Answer

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Bruno's is considering a change from its current capital structure. Bruno's currently has an all-equity capital structure and is considering a capital structure with 30 percent debt. There are currently 6,500 shares outstanding at a price per share of $46. EBIT is expected to remain constant at $43,000. The interest rate on new debt is 8.5 percent and there are no taxes. Tracie owns $20,700 worth of stock in the company. The firm has a 100 percent payout. What would Tracie's cash flow be under the new capital structure assuming that she keeps all of her shares?


A) $1,998
B) $2,227
C) $2,815
D) $3,027
E) $3,499

F) A) and B)
G) A) and C)

Correct Answer

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Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases?


A) M&M Proposition I, without taxes
B) M&M Proposition II, without taxes
C) M&M Proposition I, with taxes
D) Static theory of capital structure
E) No theory suggests this.

F) B) and E)
G) A) and B)

Correct Answer

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Which of the following statements correctly relate to M&M Proposition I, with taxes? I. Debt decreases the value of a firm. II. The levered value of a firm exceeds the firm's unlevered value. III. The weighted average cost of capital (WACC) is constant. IV. The optimal capital structure is zero debt.


A) I only
B) II only
C) II and III only
D) I and IV only
E) I, III, and IV only

F) A) and D)
G) A) and C)

Correct Answer

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Which one of the following best defines legal bankruptcy?


A) Negotiating new payment terms with a firm's creditors
B) A temporary technical insolvency A legal proceeding for liquidating or reorganizing a business
C) The internal process of revising the capital structure of a firm
D) The failure of a firm to meet its financial obligations in a timely manner

E) All of the above
F) B) and D)

Correct Answer

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Which one of the following terms refers to the termination of a firm as a going concern?


A) Insolvency
B) Reorganization
C) Chapter 11 bankruptcy
D) Prepack
E) Liquidation

F) C) and E)
G) A) and E)

Correct Answer

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Clark's Cookies has a return on assets of 15.3 percent and a cost of equity of 17.6 percent. What is the pre-tax cost of debt if the debt-equity ratio is 0.54? Ignore taxes.


A) 8.87 percent
B) 9.29 percent
C) 9.64 percent
D) 10.31 percent
E) 11.04 percent

F) A) and E)
G) A) and D)

Correct Answer

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Ernst Electrical has 9,000 shares of stock outstanding and no debt. The new CFO is considering issuing $80,000 of debt and using the proceeds to retire 1,500 shares of stock. The coupon rate on the debt is 7.5 percent. What is the break-even level of earnings before interest and taxes between these two capital structure options?


A) $18,500
B) $21,000
C) $24,000
D) $32,500
E) $36,000

F) A) and B)
G) B) and E)

Correct Answer

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The Doll House has a pre-tax cost of debt of 7.9 percent and a return on assets of 11.7 percent. The debt-equity ratio 0.45. Ignore taxes. What is the cost of equity?


A) 11.87 percent
B) 12.03 percent
C) 12.47 percent
D) 12.98 percent
E) 13.41 percent

F) A) and B)
G) A) and C)

Correct Answer

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An all-equity firm has a return on assets of 15.3 percent. The firm is considering converting to a debt-equity ratio of 0.30. The pre-tax cost of debt is 8.1 percent. Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?


A) 15.57 percent
B) 16.28 percent
C) 16.67 percent
D) 17.46 percent
E) 18.19 percent

F) B) and D)
G) D) and E)

Correct Answer

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The Gift Mart is an all-equity firm with a current cost of equity of 19.6 percent. The estimated earnings before interest and taxes are $239,000 annually forever. Currently, the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest. The tax rate is 30 percent. What is the value of the unlevered firm?


A) $849,207
B) $853,571
C) $856,411
D) $919,307
E) $926,667

F) A) and D)
G) B) and C)

Correct Answer

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Which one of the following is an example of a direct bankruptcy cost?


A) Operating at a debt-equity ratio that is less than the optimal ratio
B) Reducing the dividend payout ratio as a means of increasing a firm's equity
C) Forgoing a positive net present value project to conserve current cash
D) Incurring legal fees for the preparation of bankruptcy filings
E) Losing a key customer due to concerns over a firm's financial viability

F) A) and E)
G) B) and E)

Correct Answer

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Northern Wood Products is an all-equity firm with 16,000 shares of stock outstanding and a total market value of $352,000. Based on its current capital structure, the firm is expected to have earnings before interest and taxes of $26,000 if the economy is normal, $3,000 if the economy is in a recession, and $33,000 if the economy booms. Ignore taxes. Management is considering issuing $88,000 of debt with a 6 percent coupon rate. If the firm issues the debt, the proceeds will be used to repurchase stock. What will the earnings per share be if the debt is issued and the economy is in a recession?


A) -$0.27
B) -$0.19
C) $0.03
D) $0.26
E) $0.31

F) A) and B)
G) C) and E)

Correct Answer

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Chick 'N Fish is considering two different capital structures. The first option consists of 25,000 shares of stock. The second option consists of 15,000 shares of stock plus $150,000 of debt at an interest rate of 7.5 percent. Ignore taxes. What is the break-even level of earnings before interest and taxes (EBIT) between these two options?


A) $2,813
B) $3,134
C) $16,410
D) $28,125
E) $31,338

F) A) and D)
G) A) and C)

Correct Answer

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Which one of the following terms applies to the costs incurred by a firm which is trying to avoid filing for bankruptcy?


A) Indirect bankruptcy costs
B) Direct bankruptcy costs
C) Static theory cost
D) Optimal capital structure cost
E) Reorganization costs

F) B) and D)
G) B) and C)

Correct Answer

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