13) The par value of a corporate bond indicates the level of interest payments that will be paid to investors.

Answer:
FALSE

14) Any unsecured long-term debt instrument is a debenture. Answer: TRUE

15) A conversion feature confers the option of redeeming a bond for the company's stock rather than cash. Answer:
TRUE

16) The debenture is the legal agreement between the firm issuing a bond and the bond trustee who represents the
bondholders. Answer: FALSE

17) The current yield is the average rate of interest a bond will from the time of purchase until it matures. Answer:
FALSE

18) If the issuing company becomes insolvent, the claims of the bondholders are honored before those of preferred
stockholders. Answer: TRUE

9.2 Valuing Corporate Debt

31) Miller Motorworks has a $1,000 par value, 8% annual coupon bond with interest payable semiannually with a
remaining term of 15 years. The annual market yield on similar bonds is 6%. This bond will at a discount from par.
Answer: FALSE

32) Lambda Co. has bonds outstanding that mature in 10 years. The bonds have $1,000 par value, pay interest
annually at a rate of 9%, and have a current selling price of $1,125. The yield to maturity on the bonds is less than
9%. Answer: TRUE

33) Generic, Inc. has bonds outstanding that mature in 20 years. The bonds have $1,000 par value, pay interest
annually at a rate of 10%, and have a current selling price of $875.25. The current yield on the bonds is 11.63%.
Answer: FALSE

34) A basis point is equal to one hundredth of a percentage point. Answer: TRUE

35) A bond's "spread" refers to the difference between it's Moody's rating and its Standard & Poors rating. Answer:
FALSE
36) A bond issued by Pomme Computers has a coupon rate of #5 paid semi-annually. If the market's required rate of
return on this bond is also 3%, the bond will sell at par value. Answer: TRUE

37) Dry Seal plans to issue bonds to expand operations. The bonds will have a par value of $1,000, a 10-year
maturity, and a coupon interest rate of 9%, paid semiannually. Current market conditions are such that the bonds
will be sold to net $937.79. The yield-to-maturity of these bonds is 10%. Answer: FALSE

38) You purchased Photon, Inc. bonds exactly one year ago today for $875. During the latest year, you received $65
in interest on the bonds. The current yield on these bonds is 6.5%. Answer: FALSE

39) A AAA rated bond's yield to maturity will be very close to it's expected yield. Answer: TRUE

40) The longer the time to maturity, the more sensitive a bond's price to changes in market interest rates. Answer:
TRUE

41) A bond's value equals the present value of interest and principal the owner will receive. Answer: TRUE

42) The higher the bond rating, the more default risk associated with the bond. Answer: FALSE

43) Bond ratings measure the interest rate risk of a given bond issue. Answer: FALSE

44) When referring to bonds, expected rate of return and yield to maturity are often used interchangeably. Answer:
TRUE

45) Investment grade bonds are rated BB or lower. Answer: FALSE

46) The current yield of a bond will equal its coupon rate when the bond is selling at par value. Answer: TRUE

47) The better the bond rating, the lower the rate of return demanded in the capital markets. Answer: TRUE

48) The sensitivity of a bond's value to changing interest rates depends on both the bond's time to maturity and its
pattern of cash flows. Answer: TRUE

15) Bonds cannot be worth less than their book value. Answer: FALSE

16) So long as a bond sells for an amount above its par value, the coupon interest rate and yield to maturity remain
equal. Answer: FALSE
17) As market interest rates increase, bond prices decrease. Answer: TRUE

18) Bonds that sell at a discount have a coupon rate lower than the market interest rate. Answer: TRUE

19) Bonds with a longer time to maturity have less interest rate risk. Answer: FALSE

20) As investors' required rate of return on a bond increases, the value of the bond increases also. Answer: FALSE

21) As the maturity date of a bond approaches, the bond's market value approaches its par value. Answer: TRUE

22) Shorter-term bonds have greater interest rate risk than do longerterm bonds. Answer: FALSE

6) Debentures are unsecured long-term debt. Answer: TRUE

7) Zero coupon bonds are disadvantageous to the issuing firm if interest rates fall. Answer: TRUE

8) Eurobonds are bonds issued in a country different from the one in whose currency the bond is denominated.
Answer: TRUE

9) Convertible bonds can be exchanged for the issuing firm's common stock at a price specified at the time of issue.
Answer: TRUE

9.5 Determinants of Interest

D 5) Pursuant to the Fisher Effect, the real interest rate is exactly equal to the nominal interest rate less the rate of
inflation. Answer: FALSE

6) When inflation rates go up, bond prices go up as well. Answer: FALSE

7) As the time to maturity increases, the maturity premium increases. Answer: TRUE
8) Maturity risk and liquidity risk are equivalent terms. Answer: FALSE

9) Maturity risk and liquidity risk are equivalent terms. Answer: FALSE

10) Long-term government bonds are not without maturity risk. TRUE

36) Common stockholders are essentially creditors of the firm. Answer: FALSE

37) Common stock represents a claim on residual income. Answer: TRUE

38) The growth rate of future earnings is determined by return on equity and the profit-retention rate. Answer:
TRUE

39) The stockholder's expected rate of return consists of a dividend yield and interest. Answer: FALSE

40) When bankruptcy occurs, the claims of the common shareholders may go unsatisfied. Answer: TRUE

41) Cumulative voting gives each share of stock a number of votes equal to the number of directors being elected to
the board. Answer: TRUE

42) The expected rate of return implied by a given market price equals the required rate of return for investors at
the margin. Answer: TRUE

43) Stock valuation is more precise than bond valuation as stock cash flows are more certain. Answer: FALSE

44) The stock valuation model D1/(Rc - g) requires Rc > G. Answer: TRUE

The P/E ratio is the market price of a share of stock divided by book equity per share. Answer: FALSE

12) The higher a firm's P/E ratio, the more optimistic investors feel about the firm's growth prospects. Answer: TRUE

13) P/E ratios found in published sources or on the internet are always computed by dividing the next period's
expected earnings into the current price of the stock. Answer: FALSE

14) The higher the investor's required rate of return, the higher the P/E ratio will be. Answer: FALSE
27) A company may issue multiple classes of preferred stock. Answer: TRUE

28) The cumulative dividend feature is necessary to protect the rights of preferred stockholders. Answer: TRUE

29) Preferred stock cannot be retired.

Answer: FALSE

30) To determine the value of a share of preferred stock, the discount rate used is the annual dividend percent.
Answer: FALSE

31) The value of preferred shares is affected by changes in interest rates. Answer: TRUE

12) The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of
capital. Answer: FALSE

13) The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a
firm uses to finance a project. Answer: FALSE

14) When investors increase their required rate of return, the cost of capital increases simultaneously. Answer:
TRUE

15) The firm should continue to invest in new projects up to the point where the marginal rate of return earned on a
new investment equals the marginal cost of new capital. Answer: TRUE

16) Business risk reflects the added variability in earnings available to a firm's shareholders. Answer: FALSE

17) The after-tax cost of capital is computed by multiplying the before tax cost of capital by 1 minus the tax rate.
Answer: FALSE

6) A firm's weighted marginal cost of capital increases when internal equity financing is exhausted but is unaffected
by an increase in the cost of other financing sources. Answer: FALSE

7) Capital structure represents the mix of equity and interest-bearing debt used by a firm. Answer: TRUE

8) When computing a firm's cost of capital, book values should be used be used because they are more objective.
Answer: FALSE
9) The percentage of debt in the firm's capital structure should be adjusted by multiplying by 1 minus the firm's
marginal tax rate. Answer: FALSE

10) The amount of debt in the firm's capital structure should include all interest-bearing debt, both long-term and
short-term. Answer: TRUE

The firm financed completely with equity capital has a cost of capital equal to the required return on common
stock. Answer: TRUE

41) A bond with a Moody's rating of Aaa and an S&P rating of AAA will have a higher required return than a bond
with a Moody's rating of Aa1 and an S&P rating of AA+. Answer: FALSE

42) If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax cost of debt is 5.94%.
Answer: TRUE

43) No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-
deductible.
Answer: TRUE

44) A firm can estimate its cost of debt by finding the yield on bonds issued by other firms with similar ratings and
maturities. Answer: TRUE

45) The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm's
outstanding debt. Answer: FALSE

46) Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm must earn at least
$20 before tax on every $100 invested. Answer: TRUE

47) The cost of common equity is already on an after-tax basis since dividends paid to common stockholders are not
tax-deductible. Answer: TRUE

48) Because issuing common equity entails less risk to the firm, it is always less expensive than borrowing. Answer:
FALSE

49) It is not possible for a firm's after-tax cost of commmon equity to be lower than its after-tax cost of debt.
Answer: TRUE

The weighted cost of capital assumes that the company maintains a constant debt to equity ratio. Answer: TRUE
16) In most instances, as the amount of debt rises, the common stockholders will decrease their required rate of
return. Answer: FALSE

17) All things equal, as the tax rate increases, the incentive to use more debt financing increases. Answer: TRUE

18) As long as the firm issues no new debt, changes in interest rates will have no effect on the cost of capital.
Answer: FALSE
The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new
investments might be in a higher risk class. Answer: FALSE

12) The weighted average cost of capital is the minimum required return that must be earned on additional
investment if firm value is to remain unchanged. Answer: TRUE

13) Using separate cost of capital estimates for individual projects is not appropriate when the projects are relatively
few in number and large in scale. Answer: FALSE

14) Using a firm's overall cost of capital to evaluate individual projects creates an incentive for managers to avoid
high risk projects with potentially high returns. Answer: FALSE

15) Most large firms use individual costs of capital to evaluate all projects. Answer: FALSE

Flotation costs increase the amount of funds that must be raised to finance an investment. Answer: TRUE

11) Flotation costs are usually ignored when computing the NPV of projects financed with newly issued securities.
Answer: FALSE

12) All capital projects incur flotation costs, no matter how they are financed. Answer: FALSE

13) Flotation costs are higher for debt than for equity because debt creates more risk to the issuer. Answer: FALSE

14) A project with a positive NPV may have a negative NPV when flotation costs are considered. Answer: TRUE

Financial structure includes long-term and short-term sources of funds. Answer: TRUE
18) A firm's financial structure is defined by the Debt Ratio, while its capital structure is defined by the Debt to Value
ratio. Answer: TRUE

19) The Times Interest Earned Ratio measures a firm's ability to meet both interest payments and scheduled
principal repayments. Answer: FALSE

20) The debt ratio is usually computed using book values for both debt and equity. Answer: TRUE

21) Debt ratios and debt to enterprise value ratios differ widely from one industry to another. Answer: TRUE

Investors require a higher return on common stock investments if a firm uses less leverage. Answer: FALSE

32) Other things the same, the use of debt financing reduces the firm's total tax bill, resulting in a higher total market
value. Answer: TRUE

33) Given the existence of taxes and bankruptcy costs, the optimal capital structure is 100% debt. Answer: FALSE

34) The Modigliani and Miller Capital Structure Theorem suggests that the cost of equity decreases as financial
leverage increases. Answer: FALSE

35) The objective of capital structure management is to maximize the market value of the firm's equity. Answer:
TRUE

36) Agency costs occur when managers choose the easiest form of financing over the value maximizing capital
structure. Answer: TRUE

37) The pecking order theory of capital structure indicates that firms prefer to finance investment opportunities with
least expensive forms of financing first and the most expensive last. Answer: FALSE

38) The trade-off theory of capital structure recognizes the tax-shield benefit of debt financing, but also recognizes
that the benefit is offset by costs associated with debt financing. Answer: TRUE

39) The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal amount of
the debt and the firm's marginal tax rate. Answer: TRUE

U. S. companies differ very little in their capital structures. Answer: FALSE

7) Companies faced with higher tax burdens are likely to use more debt. Answer: TRUE
8) Conservative balance sheets may be advantageous for companies that have long-term relationships with their
customers. Answer: TRUE

9) Top management's desire to avoid the scrutiny that comes with higher levels of debt may influence the capital
structures of some firms. Answer: TRUE

The EBIT-EPS indifference point, sometimes called the break-even point, identifies the optimal range of financial
leverage regardless of the financing plan chosen by the financial manager. Answer: FALSE

27) Comparative leverage ratio analysis does not involve the use of industry norms. Answer: FALSE

28) High coverage ratios, compared with a standard, imply unused debt capacity. Answer: TRUE

29) Benchmarking the company's capital structure is popular because it is impossible to know exactly what the
company's optimal capital structure should be. Answer: TRUE

30) Rising bankruptcy costs should cause most firms to use less debt and more equity. Answer: TRUE