FIN 362 - CH 16

What are the advantages of using internal financing? It may be cheaper than debt or equity issues. Firms are required to use internal financing before exploring external sources. It prevents the adverse market reaction that tends to accompany a stock issue. The use of internal financing increases free cash flow.

- It may be cheaper than debt or equity issues. - It prevents the adverse market reaction that tends to accompany a stock issue.

Which of the following are generally true about the cost of equity and the cost of debt? The cost of debt is generally lower than the cost of equity. The cost of debt increases with leverage. The cost of equity is generally lower than the cost of debt. The cost of equity may increase with leverage.

- 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.

Rank each of the following in order of priority of payment starting with the highest priority item to lowest priority item. Wages, salaries, and commissions Bankruptcy administrative expenses Payment to common shareholders Consumer claims

1. Bankruptcy administrative expenses 2. Wages, salaries, and commissions 3. Consumer claims 4. Payment to common shareholders

What is the preferred source of financing for firms according to the pecking-order theory? common stock Retained earnings debt

1. Retained earnings 2. debt 3. common stock

According to the Tax Cuts and Jobs Act of 2017, after 2021, the net interest deduction drops to what percent of EBIT?

30

In 2019, the net interest deduction is limited to what percent of EBITDA?

50

Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step. Divide by the cost of equity for an all-equity firm. Multiply EBIT by 1 minus the corporate tax rate. Add the present value of the debt tax shield. Calculate EBIT.

Calculate EBIT. Multiply EBIT by 1 minus the corporate tax rate. Divide by the cost of equity for an all-equity firm. Add the present value of the debt tax shield.

A corporation gains no value from an interest tax shield if which of the following are true? The debt-equity ratio is 1. Corporate tax rates are zero. The corporation has no debt. The corporation is an all-equity firm.

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

Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer?

Debt

______ is the term that describes the capital structure when debt is used to finance assets.

Financial leverage

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

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

What is financial slack?

It is excess cash accumulated by the firm.

What is the most important benefit of debt?

It provides a tax benefit.

Financial distress can arise in the form of possible: Legal bankruptcy Technical solvency Accounting exactitude Business failure

Legal bankruptcy Business failure

Bankruptcy is very valuable due to which of the following? Payments to creditors cease pending the outcome of the bankruptcy process. It can be used strategically to improve a firm's competitive position. It makes capital structure policy irrelevant in terms of firm valuation.

Payments to creditors cease pending the outcome of the bankruptcy process. It can be used strategically to improve a firm's competitive position.

How do predictions for leverage by profitable firms differ under the pecking order theory and the static theory?

Pecking order theory predicts that profitable firms will use less leverage.

According to the pecking order theory, what is the preferred source for firms seeking to raise capital?

Retained earnings

Why do firms prefer not to issue equity?

Share prices tend to drop when equity is issued.

Which capital structure theory suggests that profitable firms will use less debt?

The pecking order theory

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

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require:

a higher expected return.

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

business

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

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

do not affect the value of the firm

Financial leverage affects the performance of a firm because the range of possible values for ___.

earnings per share is wider

Voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties. This may involve _____.

extension or composition

An unlevered firm ____.

has an all-equity capital structure

Financial slack helps firms avoid ___.

having to rely on external financing

The cost of equity is generally ______ ______ the cost of debt.

higher than

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

homemade leverage

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

homemade leverage

In the presence of corporate taxes, the tax shield effect of debt will ____ the value of the firm.

increase

The manager of a firm should change the capital structure if and only if ___.

it increases the value of the firm

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

levered firms pay lower taxes than unlevered firms

Under the pecking order theory, profitable firms will tend to have ______ levels of debt.

lower

A company should select the capital structure that _____.

maximizes the company's value

The value of the firm is maximized when the weighted average cost of capital (WACC) is _____.

minimized

If a firm issues new equity, investors will infer that the firm's outstanding stock must be ___.

overvalued

The expected return on equity is _____ to leverage.

positively related

Volatility or ______ increases for equity holders when leverage increases.

risk

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because _____.

shareholders capture the interest tax shield

Financial ___ is the term used to describe when a firm stockpiles internally generated cash in order to avoid selling new equity.

slack

The ___ theory is the dominant theory of capital structure.

static

One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt.

tax

A firm's capital structure refers to ___.

the firm's mix of debt and equity

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

the firm's value is maximized

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? Drugs Airlines Cable television Computers

Airlines Cable television