Business Risk and Financial Risk by jcb11704

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									Sample Midterm – Answers at end


                                  Sample Questions - CHAPTER 16
True-False
Bankruptcy costs
i.       Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge a higher rate of
         interest to compensate for the present value of bankruptcy costs.

         a.   True
         b.   False

Business risk
ii.      The firm's business risk is largely determined by the financial characteristics of its industry.

         a.   True
         b.   False

Financi al risk
iii.     Financial risk refers to the extra risk stockholders bear as a result of the use of debt as co mpared with the risk
         they would bear if no debt were used.

         a.   True
         b.   False

Financi al risk
iv.      The firm's financial risk may have both market risk and diversifiable risk components.

         a.   True
         b.   False

Financi al risk
v.       In a stand-alone risk context, financial risk can be measured as
         ROE(L) - ROE(U).

         a.   True
         b.   False

Financi al leverage
vi.      Whenever a firm goes into debt, it is using financial leverage.

         a.   True
         b.   False

Use of debt financing
vii.     If a firm utilizes debt financing, a decrease in earnings before interest and taxes (EBIT) will result in a more
         than proportionate decrease in earnings per share.

         a.   True
         b.   False




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Sample Midterm – Answers at end

Use of financial leverage
viii.   The graphical probability distribution of net income, when financial leverage is used, would tend to be more
        peaked than a distribution where no leverage is present, other things held constant.

        a.   True
        b.   False

Financi al leverage
ix.     Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial
        leverage. Therefore, the variability of both firms' expected EBITs could actually be identical.

        a.   True
        b.   False

Operating and financi al leverage
x.      Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT.

        a.   True
        b.   False

Trade-off theory
xi.     The trade-off theory tells us that the capital structure decision involves a tradeoff between the costs of debt
        financing and the benefits of debt financing.

        a.   True
        b.   False

Business risk
xii.    Two firms, although they operate in different industries, have the same expected earnings per share and the
        same standard deviation of expected EPS. Thus, the two firms must have the same business risk .

        a.   True
        b.   False

Operating and financi al leverage
xiii.   Two firms could have identical financial and operating leverage, yet have different degrees of risk as
        measured by the variability of EPS.

        a.   True
        b.   False

Bankruptcy costs
xiv.    If Miller and Modigliani had considered the cost of bankruptcy, it is unlikely that they would ha ve concluded
        that 100 percent debt financing is optimal for the firm.

        a.   True
        b.   False




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Sample Midterm – Answers at end

Multiple Choice: Conceptual


Capi tal structure and WACC
xv.      Which of the follo wing statements is most correct?

         a.   Since debt financing raises the firm's financia l risk, raising a co mpany’s debt ratio will always increase
              the company’s WACC.
         b.   Since debt financing is cheaper than equity financing, raising a co mpany’s debt ratio will always
              reduce the company’s WACC.
         c.   Increasing a company’s debt ratio will typically reduce the marg inal cost of both debt and equity
              financing; however, it still may raise the co mpany’s WACC.
         d.   Statements a and c are correct.
         e.   None of the statements above is correct.

Capi tal structure, ROA, and ROE
xvi.     Ridgefield Enterprises has total assets of $300 million. The co mpany currently has no debt in its capital
         structure. The co mpany’s basic earning power is 15 percent. The co mpany is contemplating a
         recapitalization where it will issue debt at 10 percent and use the proceeds to bu y back shares of the
         company’s common stock. If the co mpany proceeds with the recapitalization, its operating income, total
         assets, and tax rate will remain the same. Which of the fo llo wing will occur as a result of the
         recapitalization?

         a.   The company’s ROA will decline.
         b.   The company’s ROE will increase.
         c.   The company’s basic earning power will decline.
         d.   Answers a and b are correct.
         e.   All of the above answers are correct.

Target debt rati o
xvii.    Which of the follo wing events is likely to encourage a company to raise its target debt ratio?

         a.   An increase in the corporate tax rate.
         b.   An increase in the personal tax rate.
         c.   An increase in the company’s operating leverage.
         d.   Statements a and c are correct.
         e.   All of the statements above are correct.

Leverage and capi tal structure
xviii.   Which of the follo wing would increase the likelihood that a company would increase its debt ratio in its
         capital structure?

         a.   An increase in costs incurred when filing for bankruptcy.
         b.   An increase in the corporate tax rate.
         c.   An increase in the personal tax rate.
         d.   A decrease in the firm’s business risk.
         e.   Statements b and d are correct.




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Sample Midterm – Answers at end


i.     Bankruptcy costs                                     Answer: a   Diff: E

ii.    Business risk                                        Answer: b   Diff: E

iii.   Financial risk                                       Answer: a   Diff: E

iv.    Financial risk                                       Answer: a   Diff: E

v.     Financial risk                                       Answer: a   Diff: E

vi.    Financial leverage                                   Answer: a   Diff: E

vii.   Use of debt financing                                Answer: a   Diff: E

viii. Use of financial leverage                             Answer: b   Diff: E

ix.    Financial leverage                                   Answer: b   Diff: E

x.     Operating and financial leverage                     Answer: b   Diff: E

xi.    Trade-off theory                                     Answer: a   Diff: E

xii.   Business risk                                        Answer: b   Diff: M

xiii. Operating and financial leverage                      Answer: a   Diff: M

xiv.   Bankruptcy costs                                     Answer: a   Diff: M

xv.    Capital structure and WACC                           Answer: e   Diff: E

       Statement a is false; if you are to the left of the firm's optimal
       capital structure on the WACC curve, raising a company's debt ratio
       will actually decrease the firm's WACC.   Statement b is false; if you
       are to the right of the firm's optimal capital structure on the WACC
       curve, raising a company's debt ratio will actually increase the firm's
       WACC. Statement c is false; as you increase the firm's debt ratio the
       cost of debt will increase because you're using more debt.      Because
       you're using more debt the cost of equity increases because the firm's
       financial risk has increased. From statements a and b you can see that
       whether the WACC is increased depends on where you are on the WACC
       curve relative to the firm's optimal capital structure. Therefore, the
       correct answer is statement e.


xvi.   Capital structure, ROA, and ROE                      Answer: d   Diff: E

       Statements a and b are correct; therefore, statement d is the
       appropriate choice. ROA = NI/TA. If total assets remain the same, but
       NI decreases (because of the new interest payment), ROA will decrease.
       NI will fall, but not as much in comparison to the amount that common
       equity will fall, thus ROE = NI/CE will rise.       BEP will r emain the
       same. BEP = EBIT/TA, where TA and EBIT remain the same.




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Sample Midterm – Answers at end


xvii. Target debt ratio                                    Answer: a   Diff: E

      An increase in the tax rate would lower the after -tax cost of debt
      relative to equity; therefore, this would encourage a company to raise
      its target debt ratio.   An increase in the personal tax rate affects
      the firm's investors' interest (from debt) and dividend income (from
      equity). Since all of interest income is taxed but capital gains (from
      equity) receive preferential treatment (lower tax) this would cause the
      firm to lower its target debt ratio.       An increase in a company's
      operating leverage would actually cause a firm to decrease its target
      debt ratio. Therefore, the correct choice is statement a.

xviii.Leverage and capital structure                    Answer: e   Diff: E   N

      If the costs incurred when filing for bankruptcy increased, firms would
      be penalized more if they filed for bankruptcy and would be less
      willing to take that risk. Therefore, they would reduce debt levels to
      help avoid bankruptcy risk, so statement a is false. An increase in the
      corporate tax rate would mean that firms would get larger tax breaks
      for interest payments. Therefore, firms have an incentive to increase
      interest payments, in order to reduce taxes. Therefore, they will
      increase their debt ratios, so statement b is true. An increase in the
      personal tax rate decreases the after-tax return that investors will
      receive. Firms will have to issue debt at higher interest rates in
      order to provide investors with the same after -tax returns they used to
      receive. This will raise firms’ costs of debt, which will increase
      their WACCs, so firms will not increase their debt ratios. Therefore,
      statement c is false. If a firm’s business risk decreases, then this
      will tend to increase its debt ratio. Theref ore, statement d is false.
      Since both statements b and d are true, the correct choice is state -
      ment e.




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