Chapter 18

The 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 value

B. Safe firms should borrow more than risky ones

When financial distress is a possibility, the value of a levered firm consists of: I) value of the firm if all-equity-financed II) present value of tax shield III) present value of costs of financial distress IV) present value of omitted dividend payments A. I only B. I + II C. I + II - III D. I + II - III - IV

C. I + II - III

What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business. A. I only B. II only C. III only D. I and II only

C. III only

For every dollar of operating income paid out as interest, the bondholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

A. (1 - Tp)

Inclusion of restrictions in the bond contract leads to: A. Higher agency costs B. Higher bankruptcy costs C. Higher interest costs D. None the above

A. Higher agency costs

Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) Meet interest and principal payments which if not met can put the company into financial distress II) Make dividend payments which if not met can put the company into financial distress III) Meet both interest and dividend payments which when met increase the firm cash flow IV) Meet increased tax payments thereby increasing firm value A. I only B. II only C. II and III only D. III and IV only

A. I only

The positive value to the firm by adding debt to the capital structure in the presence of corporate taxes is: I) Due to the extra cash flow going to the investors of the firm rather than the tax authorities II) Due to the earnings before interest and taxes being fully taxed at the corporate rate III) Because personal-tax rates are the same as corporate tax rates A. I only B. II only C. III only D. II and III only

A. I only

The pecking order theory of capital structure predicts that: A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal B. Firms prefer equity to debt financing C. Risky firms will end up borrowing less D. Risky firms will end up borrowing more

A. If two firms are equally profitable, the more rapidly growing firm will borrow more, other things equal

The reason that MM Proposition I does not hold good in the presence of corporate taxes is because: A. Levered firms pay lower taxes when compared with identical unlevered firms B. Bondholders require higher rates of return compared with stockholders C. Earnings per share are no longer relevant with taxes D. Dividends are no longer relevant with taxes

A. Levered firms pay lower taxes when compared with identical unlevered firms

Under the trade off theory, how will a government loan guarantee impact financing? A. Prefer to issue debt B. Prefer to issue stock C. Prefer internal money D. No impact

A. Prefer to issue debt

Risk shifting implies: A. When faced with bankruptcy, managers tend to invest in high risk, high return projects B. When faced with bankruptcy, managers do not invest more equity capital C.When faced with bankruptcy; managers may make accounting changes to conceal the true extent of the problem D. All of the above

A. When faced with bankruptcy, managers tend to invest in high risk, high return projects

According to the trade-off theory of capital structure: A. optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress. B. optimal capital structure is reached when stockholders' right to default is balanced by the the bondholders' right to get interest and principal payments. C.optimal capital structure is reached when the benefits of limited liability is just offset by the value of the lawyers' claim. D. none of the above

A. optimal capital structure is reached when the present value of tax savings on account of additional borrowing is just offset by increases in the present value of costs of distress.

In Miller's model, when Personal tax rate on income from bonds is equal to the personal tax rate on income from stocks: A. relative advantage of debt depends only on the corporate tax rate B. relative advantage of debt depends only on the personal tax rate on interest income C. relative advantage of debt depends only on the personal tax rate on income from equity D. none of the above

A. relative advantage of debt depends only on the corporate tax rate

For every dollar of operating income paid out as equity income, the shareholder realizes: A. (1 - Tp) B. (1 - TpE) (1 - TC) C. (1 - TC) D. None of the above

B. (1 - TpE) (1 - TC)

In order to calculate the tax shield effect of interest payment for a corporation, always use the: I) average corporate tax rate II) marginal corporate tax rate III) state mandated tax rate A. I only B. II only C. III only D. I and III only

B. II only

The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issue II) interest expense of a firm is tax deductible III) unlevered firms have higher value than levered firms A. I only B. II only C. III only D. I and III only

B. II only

When shareholders pursue selfish strategies such as taking large risks or paying excessive dividends, these will result in: I) no action by debtholders since these are equity holder concerns II) positive agency costs, as bondholders impose various restrictions and covenants, which will diminish firm value III) investments of the same risk class that the firm is in A. I only B. II only C. III only D. I and III only

B. II only

Indirect costs of bankruptcy are borne principally by: A. Bondholders B. Stockholders C. Managers D. The federal government

B. Stockholders

In order to calculate the tax shields provided by debt, the tax rate used is the: A. average corporate tax rate B. marginal corporate tax rate C. average of shareholders' tax rates D. average of bondholders' tax rates

B. marginal corporate tax rate

If a corporation cannot use its interest payments to get tax shield for a particular year because it has suffered a loss, it is still possible to get the tax shield because of the: I) carry back provision that allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years. II) carry forward provision that allows corporations to carry forward the loss and use it to shield income in subsequent years. A. I only B. II only C. I and II D. none of the above

C. I and II

According to Rajan and Zingales study, debt ratios of individual companies depend on: I) Size: Large firms have higher debt ratios. II) Tangible assets: Firms with high ratios of fixed assets to total assets have higher debt ratios. III) Profitability: More profitable firms have lower debt ratios. IV) Market to book: Firms with higher ratios of market-to-book value have lower debt ratios. V) Market structure: Firms with monopoly power have higher debt ratios. A. I and II only B. I, II and III only C. I, II, III and IV only D. I, II, III, IV and V

C. I, II, III and IV only

The pecking order theory of capital structure implies that: I) Risky firms will end up borrowing more II) Firms prefer internal finance III) Firms prefer debt to equity when external financing is required A. I only B. II only C. II and III only D. III only

C. II and III only

Which of the following statement(s) about financial distress is(are) true: I) always ends in bankruptcy II) firms can postpone bankruptcy for many years III) ultimately the firm may recover and avoid bankruptcy altogether A. I only B. II only C. II and III only D. III only

C. II and III only

The value of the firm in the presence of debt may risk financial distress. Bankruptcy, the most severe type of financial distress, has an impact on value by: I) the risk or probability that it may occur II) the level of risk aversion investors have to debt III) the total value of the firm being siphoned off to cover bankruptcy costs A. I only B. I and II only C. III only D. II only

C. III only

In Miller's model, when the quantity (1 - TC)(1 - TpE) = (1 - Tp), then: A. The firm should hold no debt B. The value of the levered firm is greater than the value of the unlevered firm C. The tax shield on debt is exactly offset by higher personal taxes paid on interest income D. None of the above

C. The tax shield on debt is exactly offset by higher personal taxes paid on interest income

MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as: A. VL = VU B. VL = VU + D(1 - TC) C. VL = VU + (TC)(D) D. VU = VL + (TC)(D)

C. VL = VU + (TC)(D)

In order to find the present value of the tax shields provided by debt, the discount rate used is the: A. cost of capital B. cost of equity C. cost of debt D. none of the above

C. cost of debt

Assuming that bonds are sold at a fair price, the benefits from the tax shield go to the: A. managers of the firm B. bondholders of the firm C. stockholders of the firm D. lawyers of the firm

C. stockholders of the firm

The costs of financial distress depend on the: I) probability of financial distress II) corporate and personal tax rates III) the magnitude of costs encountered if financial distress occurs A. I only B. I and II only C. I, II and III D. I and III only

D. I and III only

Financial slack includes: I) Cash II) Marketable securities III) Readily salable real assets IV) Ready access to debt markets or bank loans A. I only B. IV only C. III only D. I, II, III, and IV

D. I, II, III, and IV

MM Proposition I with corporate taxes states that: I) Capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield II) By raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value III) Firm value is maximized at an all debt capital structure A. I only B. II only C. III only D. I, II, and III

D. I, II, and III

One of the indirect costs to bankruptcy is the incentive toward under investment. Following this strategy may result in: I) the firm always choosing projects with the positive NPVs II) stockholders turning down low risk low return but positive NPV projects III) stockholders would declare and receive high cash dividends A. I only B. II only C. III only D. II and III only

D. II and III only

The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) Debt is more risky than equity II) Bankruptcy and its attendant costs is a disadvantage to debt III) The payment of personal taxes may offset the tax benefit of debt A. I only B. II only C. III only D. II and III only

D. II and III only

What signal is sent to the market when a firm decides to issue new stock to raise capital? A. Bond markets are overpriced B. Bond markets are underpriced C. Stock price is too low D. Stock price is too high

D. Stock price is too high

When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor high risk, high return projects even if they have negative NPV B. refuse to invest in low risk, low return projects with positive NPVs C. delay the onset of bankruptcy as long as they can D. all of the above

D. all of the above

When faced with financial distress; managers of firms acting on behalf of their shareholders' interests will: A. favor issuing large quantity of low quality debt to low quantity of high quality debt B. favor paying high dividends to the shareholders C. delay the onset of bankruptcy as long as they can D. all of the above

D. all of the above