Chapter 16 Comprehension

The following costs are included in the term "financial distress costs"

- Direct Bankruptcy costs - Indirect Bankruptcy costs - Direct costs related to being financially distressed, but not bankrupt - Indirect cost related to being financially distressed, but not bankrupt

Related to Financial Risk

- Financial risk is the risk associated with the use of debt financing - As financial risk increases so too does the cost of equity (increases the risk borne by stockholders) -Financial risk is wholly dependent upon the financial policy of a firm

A firm may file for CH 11 bankruptcy:

- in an attempt to gain a competitive advantage - using a prepack - while allowing the current management to continue running them

Relates to M&M Proposition 2: (with no tax)

- the required return on assets is equal to the WACC - Financial risk is determined by the debt-equity ratio.

Correct statements according to pecking-order theory:

-Firm's stockpile internally generated cash -There is an inverse relationship between a firm's profit level and it's debt level -A firm's capital structure is dictated by the need for external financing

The interest tax shield has no value when a firm has a:

-tax rate of zero - zero debt -zero leverage (debt)

M&M Proposition 1 with tax supports the theory that:

A firm's WACC decreases as the firm's debt-equity ratio increases - more debt firm uses, lower the WACC

M&M Proposition 2 is the proposition that:

A firm's cost of equity is a linear function with a slope equal to (RA-RD)

Correct statement regarding the levered and an unlevered capital structure?

At the break-even point, there is no advantage to debt.

The equity risk that is most related to the daily operations of a firm

Business Risk

The explicit costs such as legal and administrative expenses, associated with corporate default are classified as ...

Direct Bankruptcy costs

The equity risk related to a firm's capital structure policy

Financial risk

The costs incurred by a business in an effort to avoid bankruptcy are classified as .....

Indirect Bankruptcy costs

Butter and Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which if the following terms is used to describe this tax savings?

Interest tax shield

Which form of financing do firms prefer to use first according to the pecking-order?

Internal Funds -selling securities is expensive so they try to avoid at all costs

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

Low probabilities of financial distress

States that the value of a firm is unrelated to the firm's capital structure?

M&M Proposition 1

The concept of homemade leverage is most associated with

M&M Proposition 1 - states that the value of the firm is independent of the firm's capital structure -homemade leverage an individual can alter their leverage

States that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure

M&M Proposition 2

AA Tours is comparing two capital structures: first option consists of all equity financing, second based on a debt equity ratio of 0.45. What should AA Tours do if the expected EBIT are less than the Break-even level?

Select the unlevered option since the expected EBIT is less than the break-even level - EBIT is only profitable when it is above the break-even level

Jessica invested in Quantro stock when the firma was unlevered (no debt) Since then the Quantro has changed its capital structure and now has a debt-equity ratio of 0.30 To unlever her position, Jessica needs to ....

Sell some shares of Quantro stock and loan out the sale proceeds -Refers to Homemade leverage which is the use of personal borrowing to alter the degree of financial leverage -shareholders can adjust the amount of financial leverage by borrowing and lending on their own

The present value of the interest tax shield is expressed as:

Tc x D

The value of the firm is maximized when ....

The WACC is minimized

Homemade Leverage is ....

The borrowing or lending of money by individual shareholders as a means for adjusting their level of financial leverage

You have computed the break-even point between a levered and unlevered capital structure. At the break even level ....

The firm is just earning enough to pay for the cost of debt.

The Static theory of Capital Structure

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs.

Bankruptcy

Transfers value from shareholders to bondholders

Which one of the following statements related to CH 7 bankruptcy is correct?

a trustee will assume control of the firm's assets until those assets can be liquidated.

The Unlevered cost of capital refers to the cost of capital for a(n):

all-equity firm (no debt)

The optimal capital structure has been achieved when the

debt-equity ratio results in the lowest possible WACC

Based on M&M Proposition 2 with taxes, the WACC:

decreases as the debt-equity ratio increases

The static theory of capital structure advocates that the optimal capital structure for a firm:

equates the tax savings from an additional dollar of debt to the increased bankruptcy costs

The business risk of a firm

has a positive relationship with the firm's cost of equity -equity risk that comes from the nature of the firm's operating activities.

M&M Proposition 2 with taxes:

has the same general implications as M&M Proposition 2 w/o taxes.

Which one of the following makes the capital structure of a firm irrelevant?

homemade leverage

A firm is technically insolvent when:

it is unable to meet its financial obligations.

A firm should select the capital structure that....

maximizing the value of the firm

The capital structure that maximizes the value of a firm also:

minimizes the cost of capital.

Which one of the following is a direct bankruptcy cost?

paying an outside accountant fees to prepare bankruptcy reports?

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

payment of employee wages

The Bankruptcy Abuse Prevention and Consumer Act of 2005:

permits key employee retention plans only if an employee has another job offer

M&M Proposition 1 with no tax supports the argument that:

the debt-equity ratio of a firm is completely irrelevant

The interest tax shield is a key reason why:

the net cost of debt to a firm is generally less than the cost of equity.

M&M Proposition 1 with taxes is based on the concept that:

the value of a firm increases as the firm's debt increases because of the interest tax shield.

Corporation's in the U.S. tend to

underutilize debt

If a firm has the optimal amount of debt, then the....

value of the levered firm (with debt) will exceed the value of the firm if it were unlevered.

In general, the capital structures used by U.S firms:

vary significantly across industries

The optimal capital structure

will vary over time as taxes and market conditions change