Week11_TutorialQuestions

SCHOOL OF BANKING AND FINANCE

FINS1613 BUSINESS FINANCE

Semester 2, 2009

TUTORIAL QUESTIONS

WEEK 11 – Capital Structure: Theory and Evidence

Multiple-choice Questions

1. The corporate tax rate is 37%. The MaPol Company has a 100 million dollars debenture issue outstanding with a coupon rate of 6.84% per annum. Face value of one debenture is $10 000 and investors require a 7% return on debentures with similar credit rating. What is the present value of the tax shield?

a. $6 840 000

b. $25 300 800

c. $37 000 000

d. $30 160 000

e. $7 000 000

2. Less Debt, Inc., just revised its capital structure such that the firm’s debt-equity ratio decreased from .80 to .40. Those individual investors who prefer the old capital structure:

a. should sell half of their equity holdings and invest in cash

b. should sell half of their equity holdings and loan out the net proceeds of the sale

c. should loan out funds equivalent to the amount invested in Less Debt

d. can replicate that structure by increasing their use of homemade leverage

e. can replicate that structure by reducing their debt and doubling their investment in the firm

3. Which of the following statements about capital structure theory is most correct?

a. Signaling theory suggests firms should at normal times maintain reserve borrowing

capacity that can be used if an especially good investment opportunity comes along.

b. In general, an increase in the corporate tax rate would cause firms to use less debt in their

capital structures.

c. According to the static trade-off theory, an increase in the costs of bankruptcy would lead

firms to reduce the amount of debt in their capital structures.

d. Statements a and c are correct.

e. All the statements above are correct.

4. The static (trade-off) theory of capital structure predicts that:

a. Unprofitable firms should borrow more than profitable ones.

b. Safe firms should borrow more than risky ones.

c. Rapidly growing firms should borrow more than mature firms.

d. Increasing leverage increases firm valu

e.

e. All of these answers.

5. The Signaling theory for capital structure implies that:

a. A company with poor future prospects should raise finance through equity issues.

b. A firm that raises debt will often experience a decrease in share price.

c. When equity is issued, the dilution effect is the only reason for any drop in the value of

shares.

d. All of these answers.

e. None of these answers.

Discussion Questions

RTBWJ Chapter 13 Critical Thinking and Concepts Review: 13.1, 13.3, 13.6.

Problem Questions

RTBWJ Chapter 13 Questions and Problems: 1, 8, 19