BF for Final
Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.
100% debt
Which costs of financial distress are easier to measure?
Direct costs
What can we say about the dividends paid to common and preferred stockholders?
Dividends to preferred stockholders are fixed. Dividends to common stockholders are not fixed.
True or false: Based on MM Proposition I, even including taxes, capital structure does not matter to the firm.
False
Which of the following are true?
Ideally, we should use market values in the WACC. The market value of debt and equity are not reliable in case of privately owned company.
How is the optimal debt level is determined?
In a subjective manner
Which of the two types of costs of bankruptcy are more difficult to quantify?
Indirect costs
Which of the following is true of the impact of financial leverage?
It magnifies gains and losses
What is generally the most important component of direct bankruptcy costs?
Legal costs
Which of the following are direct costs of financial distress?
Legal fees Administrative expenses
The formula of the SML is:
RE = Rf + Beta x (RM- Rf)
What is the equation for finding the cost of preferred stock?
RP=D/P0
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 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 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: MM demonstrated that debt financing is neither better nor worse than equity financing.
True
True or false: RP=D/P0
True
True or false: The return an investor in a security receives is equal to the cost of the security to the company that issued it.
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 discount rate for the firm's projects equals the cost of capital for the firm as a whole when:
all projects have the same risk as that of the firm overall
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
Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
better than no risk adjustment
The dividend growth model is applicable to companies that pay ____.
dividends
According to M&M Proposition I, a firm's capital structure choices:
do not affect the value of the firm
The return an investor in a security receives is ______ _____ the cost of the security to the company that issued it.
equal to
If the firm is all-equity, the discount rate is equal to the firm's cost of ______ capital.
equity
True or false: Conglomerates are companies that specialize only in projects similar to the project your firm is considering.
false
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
M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___________________ .
how the firms are financed is irrelevant the value of the two firms is equal
If the degree of leverage increases, the cost of debt will ______.
increase
Capital structure decisions are made ______ investment decisions.
independent of
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
The risk of too much _______ is bankruptcy.
leverage
Preferred stock ___.
pays a constant dividend pays dividends in perpetuity
The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all equity firm:
plus the tax rate times the value of debt
The rate used to discount project cash flows is known as the ___.
required return discount rate cost of capital
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
To estimate a firm's equity cost of capital using the CAPM, we need to know the ___.
stock's beta risk-free rate market risk premium
It is difficult to establish discount rate for individual projects, so firm's often adopt an approach that involves making _____ adjustments to the overall WACC.
subjective
The WACC is the minimum required return for _______:
the overall firm
If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ______ projects.
too many
Given V = E + D, if we divide both V and D by ____, we can calculate the capital structure weights.
v
The WACC is the overall rate of return the firm must earn on its existing assets to maintain the ____ of its stock.
value or price
What does WACC stand for?
weighted average cost of capital
For a firm with outstanding debt, the cost of debt will be the ________ on that debt..
yield to maturity
Which two of the following are broad types of costs of financial distress?
Indirect costs Direct costs
The formula for calculating the cost of equity capital that is based on the dividend discount model is:
RE = D1/P0 + g
If D is the market value of a firm's debt, E the market value of that same firm's equity, V the total value of the firm (E+D), RD the yield on the firm's debt, TC is the corporate tax rate, and RE the cost of equity, the weighted average cost of capital is:
[E/V] × RE + [D/V] × RD ×(1 - T c)
If a firm has multiple projects, each project should be discounted using ___.
a discount rate commensurate with the project's risk
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
If a firm issues no debt, its average cost of capital will equal ___.
its cost of equity
The most appropriate weights to use in the WACC are the ______ weights.
market value
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
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
Other companies that specialize only in projects similar to the project your firm is considering are called ___.
pure plays
Including preferred stock in the WACC formula adds which term if P is the market value of preferred stock and RP is the cost of preferred?
(P/V) × RP
True or false: According to the CAPM, if the market risk premium is zero, then the expected return on a stock is equal to the required return.
False
True or false: Projects should always be discounted at the firm's overall cost of capital.True or false: Projects should always be discounted at the firm's overall cost of capital.
False
True or false: Stockholders care most about the dividend maximization of the firm.
False
True or false: The discount rate is also known as the expected return.
False
True or false: The expected percentage is the overall rate of return the firm must earn on its existing assets to maintain the value of its stock.
False
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.
Which of the following is true about a firm's cost of debt?
Yields can be calculated from observable data It is easier to estimate than the cost of equity.
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
A capital restructuring may include
issuing more equity issuing more debt issuing debt and repurchasing equity
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.
According to MM 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?
MM demonstrated that debt financing is neither better nor worse than equity financing. The asset to be financed is the same.
Which of the following are examples of firms which filed for bankruptcy for strategic reasons?
Texaco Johns Manville Dow Corning Continental Airlines
Which of the following are generally true about the cost of equity and the cost of debt?
The cost of equity may increase with leverage. The cost of debt increases with leverage. The cost of debt is generally lower than the cost of equity.
During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___.
bondholders
Financial distress can arise in the form of possible:
Business failure Legal bankruptcy
True or false: Direct costs are very difficult to measure and, thus, are often estimated.
False
True or false: Finding the cost of equity is fairly straightforward.
False
True or false: Holding equity in an unlevered firm has no risk.
False
True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.
False
True or false: The legal process of bankruptcy is typically quick and inexpensive.
False
True or false: The primary disadvantage of the dividend growth model approach is its simplicity.
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
______ is the term that describes the capital structure when debt is used to finance assets.
Financial leverage
What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?
RE = D1/P0
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
The equity risk that comes from the nature of a firm's operating activities is known as:
business risk
Dividends paid to common stockholders ______ be deducted from the payer's taxable income for tax purposes.
cannot
The cost of debt will begin to increase as the:
degree of leverage increases
Equity carries risk thus an investor should expect a ____ return than that on less risky debt.
higher
MM Proposition I does not work with corporate taxes because:
levered firms pay lower taxes than unlevered firms
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
We should use ____ values in the WACC. Because ____ values are often similar to market values for debt, we often use book value for debt and market value for equity.
market; book
An optimal capital structure will
minimize the cost of capital maximize the value of the firm
SmartKids, a textbook publisher, is considering investing in a software company that collects and stores data. What beta should SmartKids use to assess the risk of the project?
the beta for software companies that collect and store data
MM Proposition II shows that ___.
the cost of equity rises with leverage.
What will happen over time if a firm uses its overall WACC to evaluate all projects, regardless of each project's risk level?
the firm overall will become riskier it will accept projects that it should have rejected It will reject projects that it should have accepted
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 ___.
the firm's value is maximized
The tax shield afforded by debt will be of the least use to firms with ______ .
losses carried forward negative EBT
What are some examples of indirect financial distress costs?
lost reputation lost sales
The cost of debt is generally ____ than the cost of equity.
lower
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
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
If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital even though the project's beta is less than the firm's overall beta, it is possible that the project might be:
rejected, when it should be accepted(If the project's beta is less than the firm's overall beta, its cost of capital will be less than the overall cost of capital, and if the overall cost of capital is used, the project's cash flows will be discounted too severely, and it will most likely be rejected.)
