Smartbook 16

If a firm that has an annual debt obligation of $40 generates a cash flow of $30, how much will the shareholders receive?

$0 the company must pay all of its remaining cash flow to debt holders. There will be none left over for equity holders

If ABC Co. has earnings before interest and taxes of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders if the interest rate is 10% and the tax rate is 21%?

$1,685,000 (.1 * 5 mil) + [2 mil - (.1 * 5 mil)](1 - .21) =

Omega Corp. has $20 million in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 21%. What is the present value of the tax shield?

$4.2 million .21 * $20 million =

Solid Rock is an unlevered firm with an EBIT of $10m and an unlevered cost of capital of 12%. If the tax rate is 21%, what is the value of the firm?

$65.83 million [$10 m (1 - .21)] / .12 =

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

- Below the indifference or break-even point in EBIT, an unlevered capital structure is best - The rate of return on assets is unaffected by leverage - Financial leverage increases the slope of the EPS line

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 equity may increase with leverage - The cost of debt increases with leverage

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

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

Financial distress can arise in the form of possible:

- business failure - legal bankruptcy

Rank each of the following in order of priority of payment starting with the highest priority item to lowest priority item

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

Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step

1. Calculate EBIT 2. Multiply EBIT by 1 minus the corporate tax rate 3. Divide by the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield

How do bankruptcy costs affect bondholders and shareholders in the context of the distribution of firm value

Both bondholders and shareholders are adversely affected

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

Debt

Which costs of financial distress are easier to measure?

Direct costs

What is generally the most important component of direct costs?

Legal costs

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because ___

MM demonstrated that the debt financing is neither better nor worse than equity financing in the absence of taxes the asset to be financed is the same

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

MM did not consider bankruptcy costs

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

Retained earnings

What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?

The obligation due in terms of interest and principal

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership of assets is transferred from the shareholders to the bondholders

Stockholders and bondholders

are not the only claimants to the cash flows of the firm

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

assets

The WACC is the cost of ___ times its weight in the capital structure plus the cost of ___ times its weight in the capital structure

debt equity

The value of a firm is equal to the value of its:

debt plus equity

The cost of debt will begin to increase as the:

degree of leverage increases

The value of the firm is given by the following expression:

firm value = value of equity + value of debt

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

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

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

it increases the value of the firm

The risk of too much ___ is bankruptcy

leverage

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 the value of the firm is maximized when WACC is minimized (since WACC is the denominator)

The expected return on equity is ___ to leverage

positively related

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the:

static theory of capital structure

In a world without bankruptcy costs or taxes, the value of the firm (the pie) is divided among which of the following?

stockholders bondholders

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

MM Proposition II shows that ___

the cost of equity rises with leverage

A beneficial rule to follow is to set the firms capital structure so that ___

the firm's value is maximized

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

- cable television - airlines

what are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

- customers may not buy, fearing future service problems - suppliers may not supply inventory, fearing nonpayment - banks may place restrictions on the firm's financial activities

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 is the preferred source of financing for firms according to the pecking-order theory?

1. Retained earnings 2. Debt 3. Common stock

A firm has $5,000 of debt $16,000 of equity Cost of debt of 8% Cost of equity of 12% What is the firm's WACC if there are no taxes?

11.05% ($16,000 / $21,000) * 12% + ($5,000 / $21,000) * 8% =

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

a higher expected return

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

Direct costs Indirect costs

During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___

bondholders

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

indirect

Which of the following are consequences of nonpayment of debt obligations?

- the firm will encounter some form of financial distress - a firm may be forced to file for bankruptcy

What are the advantages of using internal financing?

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

What are some examples of indirect financial distress costs?

- lost reputation - lost sales

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because ___

- as debt is added, the equity becomes more risky - the overall cost of capital cannot be reduced

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

- banks may place restrictions on the firm's financial activities - customers may not buy, fearing future service problems - suppliers may not supply inventory, fearing nonpayment

Which of the following are nonmarketed claims to the firms cash flows?

- taxes - legal fees

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

- the corporation is an all-equity firm - the corporation has no debt - corporate tax rates are zero

Alpha Co. has... debt-equity ratio of .6 pretax cost of debt of 7.5% unlevered cost of equity of 12% What is Alpha's cost of equity if you ignore taxes?

14.7% 12% + .6 (12% - 7.5) =

If the current share price of an all-equity firm is $25, going to the capital structure with 50% debt and 50% equity will result in a new share price of ___ when ignoring the impact of taxes

25