Chapter 16

Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.

At the break-even point, there is no advantage to debt.

Which of the following statements are correct in relation to M&M Proposition II with no taxes? I. The required return on assets is equal to the weighted average cost of capital. II. Financial risk is determined by the debt-equity ratio. III. Financial risk determines the return on assets. IV. The cost of equity declines when the amount of leverage used by a firm rises

I and II only

By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt

I, II, III, IV

A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. only after the firm becomes insolvent.

I, II, and III only

Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations.

I, II, and III only

Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing.

I, II, and IV only

The interest tax shield has no value when a firm has a: I. tax rate of zero. II. debt-equity ratio of 1. III. zero debt. IV. zero leverage.

I, III, and IV only

Which one of the following states that the value of a firm is unrelated to the firm's capital structure?

M&M Proposition I

The concept of homemade leverage is most associated with:

M&M Proposition I with no tax.

Which proposition states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?

M&M Proposition II

The present value of the interest tax shield is expressed as:

Tc × D

Which one of the following statements related to Chapter 7 bankruptcy is correct?

Under a Chapter 7 bankruptcy, a trustee will assume control of the firm's assets until those assets can be liquidated.

M&M Proposition I with tax supports the theory that:

a firm's WACC decreases as the firm's debt-equity ratio increases

M&M Proposition II is the proposition that:

a firm's cost of equity is a linear function with a slope equal to (RA - RD).

The unlevered cost of capital refers to the cost of capital for a(n):

all-equity firm

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized?

bankruptcy

Which one of the following is the equity risk that is most related to the daily operations of a firm?

business risk

The optimal capital structure has been achieved when the:

debt-equity ratio results in the lowest possible weighted average cost of capital

Based on M&M Proposition II with taxes, the weighted average cost of capital

decreases as the debt-equity ratio increases

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs.

direct bankruptcy

The static theory of capital structure advocates that the optimal capital structure for a firm:

equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt

Which one of the following is the equity risk related to a firm's capital structure policy?

financial

You have computed the break-even point between a levered and an unlevered capital structure. Assume there are no taxes. At the break-even level, the:

firm is just earning enough to pay for the cost of the debt.

The business risk of a firm:

has a positive relationship with the firm's cost of equity

M&M Proposition II with taxes:

has the same general implications as M&M Proposition II without taxes

Which one of the following makes the capital structure of a firm irrelevant? (taxes, interest tax shield, homemade leverage, or 100% dividend payout ratio?)

homemade leverage

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

indirect bankruptcy

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings?

interest tax shield

Which form of financing do firms prefer to use first according to the pecking-order theory?

internal funds

A firm is technically insolvent when:

it is unable to meet its financial obligations

A business firm ceases to exist as a going concern as a result of which one of the following?

liquidation

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm?

low probabilities of financial distress

A firm should select the capital structure that:

maximizes the value of the firm

The capital structure that maximizes the value of a firm also:

minimizes the cost of capital

Which one of the following is a direct bankruptcy cost?

paying an outside accountant fees to prepare bankruptcy reports

Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding?

payment of employee wages

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005:

permits key employee retention plans only if an employee has another job offer.

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a:

reorganization.

AA Tours is comparing two capital structures to determine how to best finance its operations. The first option consists of all equity financing. The second option is based on a debt-equity ratio of 0.45. What should AA Tours do if its expected earnings before interest and taxes (EBIT) are less than the break-even level? Assume there are no taxes.

select the unlevered option since the expected EBIT is less than the break-even level

Jessica invested in Quantro stock when the firm was unlevered. Since then, Quantro has changed its capital structure and now has a debt-equity ratio of 0.30. To unlever her position, Jessica needs to:

sell some shares of Quantro stock and loan out the sale proceeds

Homemade leverage is:

the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage

M&M Proposition I with no tax supports the argument that:

the debt-equity ratio of a firm is completely irrelevant.

The interest tax shield is a key reason why:

the net cost of debt to a firm is generally less than the cost of equity

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called:

the static theory of capital structure.

The basic lesson of M&M Theory is that the value of a firm is dependent upon:

the total cash flow of the firm

M&M Proposition I with taxes is based on the concept that:

the value of a firm increases as the firm's debt increases because of the interest tax shield.

Bankruptcy:

transfers value from shareholders to bondholders

Corporations in the U.S. tend to:

underutilize debt

If a firm has the optimal amount of debt, then the:

value of the levered firm will exceed the value of the firm if it were unlevered

In general, the capital structures used by U.S. firms:

vary significantly across industries

The value of a firm is maximized when the:

weighted average cost of capital is minimized

The absolute priority rule determines:

which parties receive payment first in a bankruptcy proceeding

The optimal capital structure:

will vary over time as taxes and market conditions change