Chapter 13: Leverage and Capital Structure LearnSmart

Rank each of the following in order of priority of payment.

1. Bankruptcy 2. Wages 3. Consumer 4. Payment

What is generally the most important component of direct bankruptcy costs?

Legal costs

The cost of debt will begin to increase as the:

degree of leverage increases

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

do not affect the value of the firm

1. True or false: Stockholders care most about the dividend maximization of the firm.

1. False

7. True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

7. True

8. 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.

8. True

9. 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.

9. False

Financial distress can arise in the form of possible:

Business failure Legal bankruptcy

Which of the two types of costs of bankruptcy are more difficult to quantify?

Indirect costs

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.

Which of the following is true of the impact of financial leverage?

It magnifies gains and losses

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.

Which of the following are generally true about the cost of equity and the cost of debt?

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.

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 fact that failure to meet debt obligations can result in bankruptcy is ______.

bad for the firm

Bankruptcy costs may exceed the tax shield benefits of _______.

debt

Bankruptcy costs may exceed the tax shield benefits of ________ .

debt

Bankruptcy costs may exceed the tax shield benefits of________ .

debt

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

What are some examples of indirect financial distress costs?

lost sales lost reputation

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

lower

The tax shield afforded by debt will be of the least use to firms with ______ .

negative EBT losses carried forward

Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.

100% debt

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

MM Proposition II shows that ___.

the cost of equity rises with leverage

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

the firm's value is maximized

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

2. True or false: MM demonstrated that debt financing is neither better nor worse than equity financing.

2. True

3. True or false: Stockholders care most about the dividend maximization of the firm.

3. False

4. True or false: Based on MM Proposition I, even including taxes, capital structure does not matter to the firm.

4. False

6. True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

6. True

Which of the following are examples of firms which filed for bankruptcy for strategic reasons?

Johns Manville Dow Corning Continental Airlines Texaco

Which of the following are direct costs of financial distress?

Legal fees Administrative expenses

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 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.

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

business risk

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 expected return on equity is _____ to leverage.

positively related

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

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

Direct costs Indirect costs

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

assets

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

Volatility or ______ increases for equity holders when leverage increases.

risk

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