An increase in the debt ratio will generally have no effect on which of these items?

Question 1
1.

Which of the following statements is correct?

Answer

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One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.

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One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.

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Stock repurchases can be used by a firm that wants to increase its debt ratio.

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Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities.

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One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

Question 2
1.

Which of the following statements is correct?

Answer

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If a company has a 2-for-1 stock split, its stock price should roughly double.

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Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases.

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Very often, a company’s stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen.

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Stock repurchases increase the number of outstanding shares.

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The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.

Question 3
1.

Which of the following statements is correct?

Answer

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If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

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An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.

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Stock repurchases tend to reduce financial leverage.

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If a company declares a 2-for-1 stock split, its stock price should roughly double.

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One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller’s dividend clientele theory.

Question 4
1.

Which of the following statements is correct?

Answer

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Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.

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One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends.

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Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities.

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If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.

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Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities.

Question 5
1.

Which of the following should not
influence a firm’s dividend policy decision?

Answer

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The firm’s ability to accelerate or delay investment projects.

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A strong preference by most shareholders for current cash income versus capital gains.

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Constraints imposed by the firm’s bond indenture.

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The fact that much of the firm’s equipment has been leased rather than bought and owned.

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The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains.

Question 6
1.

Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

Answer

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investors are indifferent between dividends and capital gains.

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investors require that the dividend yield and capital gains yield equal a constant.

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capital gains are taxed at a higher rate than dividends.

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investors view dividends as being less risky than potential future capital gains.

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investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.

Question 7
1.

Trenton Publishing follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase
in the firm’s dividend per share?

Answer

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The firm’s net income increases.

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The company increases the percentage of equity in its target capital structure.

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The number of profitable potential projects increases.

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Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.

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Earnings are unchanged, but the firm issues new shares of common stock.

Question 8
1.

Which of the following statements is correct?

Answer

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One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

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If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not
follow the strict residual dividend policy.

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If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm’s investment opportunities improve.

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If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios.

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Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees.

Question 9
1.

Which of the following statements is CORRECT?

Answer

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When firms are deciding on the size of stock splits—say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.

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Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today.

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Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits.

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When a company declares a stock split, the price of the stock typically declines—by about 50% after a 2-for-1 split—and this necessarily reduces the total market value of the equity.

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If a firm’s stock price is quite high relative to most stocks—say $500 per share—then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low—say $2 per share—then it can declare a “reverse split” of say 1-for-25 so as to bring the price up to somewhere around $50 per share.

Question 10
1.

You own 100 shares of Troll Brothers’ stock, which currently sells for $120 a share. The company is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be after such a split takes place?

Answer

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You will have 200 shares of stock, and the stock will trade at or near $120 a share.

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You will have 200 shares of stock, and the stock will trade at or near $60 a share.

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You will have 100 shares of stock, and the stock will trade at or near $60 a share.

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You will have 50 shares of stock, and the stock will trade at or near $120 a share.

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You will have 50 shares of stock, and the stock will trade at or near $60 a share.

Question 11
1.

Which of the following actions will best enable a company to raise additional equity capital?

Answer

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Refund long-term debt with lower cost short-term debt.

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Declare a stock split.

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Begin an open-market purchase dividend reinvestment plan.

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Initiate a stock repurchase program.

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Begin a new-stock dividend reinvestment plan.

Question 12
1.

If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay

Answer

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no dividends except out of past retained earnings.

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no dividends to common stockholders.

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dividends only out of funds raised by the sale of new common stock.

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dividends only out of funds raised by borrowing money (i.e., issue debt).

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dividends only out of funds raised by selling off fixed assets.

Question 13
1.

Firm M is a mature firm in a mature industry. Its annual net income and net cash flows are both consistently high and stable. However, M’s growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new firm in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is correct?

Answer

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Firm M probably has a lower debt ratio than Firm N.

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Firm M probably has a higher dividend payout ratio than Firm N.

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If the corporate tax rate increases, the debt ratio of both firms is likely to decline.

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The two firms are equally likely to pay high dividends.

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Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income.

Question 14
1.

Which of the following statements about dividend policies is correct?

Answer

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Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the “bird-in-the hand” effect.

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One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases.

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One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.

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One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.

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The clientele effect suggests that companies should follow a stable dividend policy.

Question 15
1.

Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio?

Answer

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Its earnings become more stable.

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Its access to the capital markets increases.

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Its R&D efforts pay off, and it now has more high-return investment opportunities.

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Its accounts receivable decrease due to a change in its credit policy.

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Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

Question 16
1.

Business risk is affected by a firm's operations. Which of the following is NOT associated with (or does not contribute to) business risk?

Answer

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Demand variability.

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Sales price variability.

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The extent to which operating costs are fixed.

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The extent to which interest rates on the firm's debt fluctuate.

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Input price variability.

Question 17
1.

The firm’s target capital structure should be consistent with which of the following statements?

Answer

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Maximize the earnings per share (EPS).

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Minimize the cost of debt (rd).

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Obtain the highest possible bond rating.

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Minimize the cost of equity (rs).

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Minimize the weighted average cost of capital (WACC).

Question 18
1.

Which of the following statements is CORRECT?

Answer

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The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

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The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.

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The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.

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Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, this still may raise the company’s WACC.

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If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.

Question 19
1.

Which of the following statements is CORRECT?

Answer

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If corporate tax rates were decreased while other things were held constant, and if the Modigliani-Miller tax-adjusted tradeoff theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

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A change in the personal tax rate should not affect firms’ capital structure decisions.

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“Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.

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The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WACC, and (3) maximizes its EPS.

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If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.

Question 20
1.

Which of the following statements is CORRECT?

Answer

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Since debt financing raises the firm's financial risk, increasing a company’s debt ratio will always increase its WACC.

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Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.

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Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing. However, this action still may raise the company’s WACC.

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Increasing a company’s debt ratio will typically increase the marginal cost of both debt and equity financing. However, this action still may lower the company’s WACC.

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Since a firm's beta coefficient it not affected by its use of financial leverage, leverage does not affect the cost of equity.

Question 21
1.

Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L’s debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?

Answer

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The two companies have the same times interest earned (TIE) ratio.

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Firm L has a lower ROA than Firm U.

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Firm L has a lower ROE than Firm U.

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Firm L has the higher times interest earned (TIE) ratio.

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Firm L has a higher EBIT than Firm U.

Question 22
1.

If debt financing is used, which of the following is CORRECT?

Answer

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The percentage change in net operating income will be greater than a given percentage change in net income.

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The percentage change in net operating income will be equal to a given percentage change in net income.

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The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.

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The percentage change in net income will be greater than the percentage change in net operating income.

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The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income.

Question 23
1.

An increase in the debt ratio will generally have no effect on which of these items?

Answer

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Business risk.

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Total risk.

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Financial risk.

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Market risk.

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The firm's beta.

Question 24
1.

Which of the following statements is CORRECT?

Answer

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As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.

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The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.

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The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.

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The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.

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The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.

Question 25
1.

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure?

Answer

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Its sales become less stable over time.

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The costs that would be incurred in the event of bankruptcy increase.

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Management believes that the firm’s stock has become overvalued.

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Its degree of operating leverage increases.

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The corporate tax rate increases.

Question 26
1.

Volga Publishing is considering a proposed increase in its debt ratio, which would also increase the company’s interest expense. The plan would involve issuing new bonds and using the proceeds to buy back shares of its common stock. The company’s CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO’s estimates are correct, which of the following statements is CORRECT?

Answer

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Since the proposed plan increases Volga’s financial risk, the company’s stock price still might fall even if EPS increases.

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If the plan reduces the WACC, the stock price is also likely to decline.

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Since the plan is expected to increase EPS, this implies that net income is also expected to increase.

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If the plan does increase the EPS, the stock price will automatically increase at the same rate.

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Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

Question 27
1.

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant?

Answer

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An increase in costs incurred when filing for bankruptcy.

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An increase in the corporate tax rate.

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An increase in the personal tax rate.

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The Federal Reserve tightens interest rates in an effort to fight inflation.

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The company's stock price hits a new low.

Question 28
1.

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this will

Answer

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normally lead to an increase in its fixed assets turnover ratio.

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normally lead to a decrease in its business risk.

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normally lead to a decrease in the standard deviation of its expected EBIT.

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normally lead to a decrease in the variability of its expected EPS.

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normally lead to a reduction in its fixed assets turnover ratio.

Question 29
1.

Which of the following statements is CORRECT?

Answer

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Increasing financial leverage is one way to increase a firm’s basic earning power (BEP).

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If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage.

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The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price.

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If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company’s operating income.)

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If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.

Question 30
1.

Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT?

Answer

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Company HD has a higher net income than Company LD.

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Company HD has a lower ROA than Company LD.

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Company HD has a lower ROE than Company LD.

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The two companies have the same ROA.

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The two companies have the same ROE.