Quiz no.

3 – Capital Structure and Leverage/ Distribution to Shareholders

Name:________________________________________ Date:_______________

1. A firm's business risk is largely determined by the financial characteristics of its industry, especially by the
amount of debt the average firm in the industry uses.

2. Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with
their risk if the firm had used no debt.

3. A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only
operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other
purposes.

4. If a firm borrows money, it is using financial leverage.

5. Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk
as measured by its beta coefficient.

6. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more
peaked than the distribution if the firm used no leverage, other things held constant.

7. Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while
financial leverage affects both EPS and EBIT.

8. The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of
debt financing.

9. Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will
probably not get back the full amount of funds that they loaned. Therefore, lenders charge higher rates to
borrowers judged to be more likely to go bankrupt.

10. Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

11. Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has
no effect on a firm's value.

12. Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and
that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

13. It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have
more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B.

14. As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable
risk components.

15. If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected
EPS, then they must have the same amount of business risk.

16. In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its
value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the
firm's value rises as it uses more and more debt, other things held constant.

17. According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is
approximately 100% debt financing.

18. According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital
structure calls for approximately 100% debt financing.

19. According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no
effect on the firm's value.

20. Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has
no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM
then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's
value would be maximized if it used (almost) 100% debt.

21. Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the
conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100%
debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to
the assumption of an optimal capital structure where the debt ratio is less than 100%.

22. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds
personal taxes.

23. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds
personal taxes.

24. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the
development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter
of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset
the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.

25. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that
were assumed away in their original article. Once they took account of all these assumptions, they concluded
that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to
determine his or her firm's optimal debt ratio.

26. Some people--including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)--
have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt
forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private
plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms.

27. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders
have the same information about a firm's future prospects as its managers. That was called "symmetric
information," and it is questionable. The introduction of "asymmetric information" led to the development of the
"signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because
investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions
give off different signals, and the end result is that capital structure is affected by managers' perceptions about
how their financing decisions will affect investors' views of the firm and thus its value.

28. According to the signaling theory of capital structure, firms first use common equity for their capital, then
use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt
financing signals to investors that the firm's managers think that the future does not look good.

29. Other things held constant, firms with more stable and predictable sales tend to use more debt than firms
with less stable sales.

30. Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt
than firms whose assets are harder to sell (like those engaged in research and development).

31 The optimal distribution policy strikes that balance between current dividends and capital gains that
maximizes the firm's stock price.

32 Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should
be.

33 Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in
dividends has no effect on either its cost of capital or its stock price.

34 Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in
dividends has no effect on its cost of capital, but it does affect its stock price.

35 If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price
should set a low payout ratio.

36 A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's
stock price.
37 A "reverse split" reduces the number of shares outstanding.

38 The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the
price of the firm's stock, other things held constant.

39 The federal government sometimes taxes dividends and capital gains at different rates. Other things held
constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to an
increase in dividend payout ratios.
40 The federal government sometimes taxes dividends and capital gains at different rates. Other things held
constant, if the tax rate on dividends is high relative to that on capital gains, then individuals with low taxable
incomes should favor stocks with low payouts and high-income individuals should favor high-payout
companies.

41It has been argued that investors prefer high-payout companies because dividends are more certain (less risky)
than the capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that
this argument is incorrect, and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief
that most dividends are reinvested in stocks, hence are exposed to the same risks as reinvested earnings.

42 Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the
value of the firm is determined only by its basic earning power and its business risk.

43. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must
be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other
things held constant.

44. If a retired individual lives on his or her investment income, then it would make sense for this person to
prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of
selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends
received to prefer a low-payout company because that would save him or her taxes and brokerage costs.

45. Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while
others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to
establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy.

46. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout,
announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people
would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would
agree with this argument.

47. If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can
have an important effect on its stock price and cost of equity.

48. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual
after providing for the equity required to fund the capital budget. Under this model, the better the firm's
investment opportunities, the lower its payout ratio will be, other things held constant.

49. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual
after providing for the equity required to fund the capital budget. Under this model, the higher the firm's debt
ratio, the lower its payout ratio will be, other things held constant.

50. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is
correct, then it must adhere to the residual dividend policy.

511. If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, then
the price of the stock should drop by approximately $1.50 on January 31.

52. If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, to
holders of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15,
which is the ex-dividend date.

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

54. There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that
would have been paid as dividends to buy stock on the open market. Under the other type, the company issues
new stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who
choose to reinvest their dividends.

55. If a firm pays out all of its earnings as dividends and its stockholders then elect to have all of their dividends
reinvested, the company should reconsider its dividend policy and possibly move to a lower dividend payout
ratio.

56. If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split
price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price
could be due to signaling effects investors believe that management split the stock because they think the firm is
going to do better in the future. The higher price could also be because investors like lower-priced shares.

57. Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and
stock prices decline. Your firm's earnings, investment opportunities, and capital structure do not change. If the
firm follows the residual dividend model, then its dividend payout ratio would increase.

58. Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its debt ratio on the
horizontal axis. Then you plotted a similar curve for Firm V. The curve for firm U resembled a shallow "U,"
while that for Firm V resembled a sharp "V." Both firms have debt ratios that cause their WACCs to be
minimized. Other things held constant, it would be easier for Firm V than for Firm U to maintain a steady
dividend in the face of varying investment opportunities and earnings from year to year.

59. Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

60. A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are
needed, even in "bad times." This is called "financial flexibility," and the lower the firm's debt ratio, the greater
its financial flexibility, other things held constant.

61. If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a
decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will
be.