Chapter 13 Capital Structure

Rank each of the following in order of priority of payment.

1. bankruptcy administrative expenses 2. wages, salaries, and commissions 3. consumer claims 4. payment to common shareholders

Based on M&M Proposition I with corporate taxes, the optimal capital structure is

100% debt

Which costs of financial distress are easier to measure?

Direct costs are easy to measure.

True or false: Based on M&M Proposition I, even including taxes, capital structure does not matter to the firm.

False

True or false: Direct costs are very difficult to measure and, thus, are often estimated,

False

True or false: Holding eguity in an unlevered firm has no risk.

False

True or false: Holding equity in an unlevered firm has no risk.

False

True or false: Stockholders care most about the dividend maximization of the firm.

False

True or false: The legal process of bankruptcy is typically quick and inexpensive.

False

True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.

False

True or false: When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency.

False

Which of the two types of costs of bankruptcy are more difficult to quantify?

Indirect costs are difficult to quantify.

Which of the following assumptions is necessary for M&M Proposition I to hold?

Individuals can borrow on their own at an interest rate equal to that of the firm.

Which of the following is true of the impact of financial leverage?

It magnifies gains and losses.

The present value of the interest tax shield equals what?

TC x D

How does the level of debt affect the weighted average cost of capital (WACC)?

The WACC initially falls and then rises as debt increases.

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?

The rate of return on assets is unaffected by leverage.

True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.

True

True or false: Firm value is maximized when the WACC is minimized.

True

True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

True

True or false: M&M demonstrated that debt financing is neither better nor worse than equity financing.

True

What is the expression for the value of a levered firm in the presence of corporate taxes?

Value of levered firm = Value of unlevered firm + Tax benefit of debt

The costs of financial distress depend mostly on how easily the ownership of the firm's _____ can be transferred.

assets

The fact that failure to meet debt obligations can result in bankruptcy is

bad for the firm

The equity risk that comes from the nature of a firm's operating activities is known as

business risk

Bankruptcy costs may exceed the tax shield benefits of

debt

The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of

debt

The cost of debt will begin to increase as the

degree of leverage increases

According to M&M Proposition I, a firm's capital structure choices

do not affect the value of the firm

The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs _____ the present value of the tax shield benefits.

equals

The weighted average cost of capital rises at higher levels of debt owing to

financial distress costs

An investor who buys the common stock of a levered firm is subject to more risk due to the addition of

financial risk

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as

financial risk

The tax deductibility of interest payments is

good for the firm

The value of a levered firm will be ______ than the value of an identical unlevered firm because the levered firm's taxes will be _____

greater; lower

Equity carries risk; thus, an investor should expect a _____ return than that on less risky debt.

higher

An individual can duplicate a levered firm through a strategy called _______ leverage where the investor uses his own funds plus borrowed funds to buy stocks.

homemade

With _________ an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock

homemade leverage

How is the optimal debt level determined?

in a subjective manner

If the degree of leverage increases, the cost of debt will

increase

Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of _____ costs of financial distress.

indirect

What is generally the most important component of direct bankruptcy costs?

legal costs

The risk of too much _____ is bankruptcy.

leverage

M&M Proposition I does not work with corporate taxes because

levered firms pay lower taxes than unlevered firms

The cost of debt is generally ____ than the cost of equity.

lower

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be

lower

The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.

negative

The value of a levered firm in M&M Proposition I with corporate taxes equals the value of an all equity firm

plus the tax rate times the value of debt

The expected return on equity is ________ to leverage.

positively related

Volatility or _____ increases for equity holders when leverage increases.

risk

The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the ____ theory of capital structure.

static

The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the _____ theory of capital structure.

static

It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because

the bankruptcy process can be long and expensive

M&M Proposition Il shows that

the cost of equity rises with leverage

A beneficial rule to follow is to set the firm's capital structure so that

the firm's value is maximized

Under M&M Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases

the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt

The Static Theory of Capital Structure suggests employing debt to the point that its cost equals the cost of

the increased probability of bankruptcy

The tax savings attained by a firm from the tax deductibility of interest expense is called

the interest tax shield

Under M&M Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because

the return on assets (RA) is unchanged

Which of the following industries tend to have a high leverage?

•Cable television •Airlines

Which of the following industries tend to have a low leverage?

•Computers •Drugs

Which of the following are examples of firms which filed for bankruptcy for strategic reasons?

•Johns Manville •Continental Airlines •Texaco •Dow Corning

According to M&M Proposition I, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?

•The asset to be financed is the same. •M&M demonstrated that debt financing is neither better nor worse than equity financing.

Which of the following will apply when a firm's debt levels are extremely high?

•The benefits of debt financing may be more than offset by the costs of financial distress. •The possibility of financial distress will become a chronic problem.

A corporation gains no value from an interest tax shield if which of the following are true?

•The corporation is an all-equity firm. •Corporate tax rates are zero. •The corporation has no debt.

Which of the following are generally true about the cost of equity and the cost of debt?

•The cost of debt increases with leverage. •The cost of equity may increase with leverage. •The cost of debt is generally lower than the cost of equity.

Which of the following are direct costs of financial distress?

•administrative expenses •legal fees

Financial distress can arise in the form of possible

•business failure •legal bankruptcy

Which two of the following are broad types of costs of financial distress?

•indirect costs •direct costs

Bankruptcy is very valuable because

•it can be used strategically to improve a firm's competitive position •payments to creditors cease pending the outcome of the bankruptcy process

What are some examples of indirect financial distress costs?

•lost sales •lost reputation

An optimal capital structure will

•maximize the value of the firm •minimize the cost of capital

The tax shield afforded by debt will be of the least use to firms with

•negative EBT •losses carried forward

M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then

•the value of the two firms is equal •how the firms are financed is irrelevant