Chapter 17

Which one of the following industries tends to have the highest leverage ratio? A. natural gas distribution B. computer C. television broadcasting stations D. educational services E. biological products

C. television broadcasting stations

Which one of the following is true? A. A firm with low anticipated profits will likely take on a high level of debt. B. A successful firm will probably be all-equity financed. C. Rational firms raise debt levels when profits are expected to decline. D. Rational investors are likely to infer a firm is more valuable when its debt level declines. E. Investors will generally view an increase in debt as a positive sign for the firm's value.

E. Investors will generally view an increase in debt as a positive sign for the firm's value.

The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pretax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio selected results in the lowest possible weighed average cost of capital.

E. debt-equity ratio selected results in the lowest possible weighed average cost of capital.

The introduction of personal taxes may reveal a disadvantage to the use of debt if the personal tax rate on: A. the distribution of income to stockholders is less than the personal tax rate on interest income. B. the distribution of income to stockholders is greater than the personal tax rate on interest income. C. the distribution of income to stockholders is equal to the personal tax rate on interest income. D. interest income is zero. E. dividends and interest are equal.

A. the distribution of income to stockholders is less than the personal tax rate on interest income.

Which one of the following is not empirically correct? A. Some firms use no debt. B. Most corporations have relatively low debt-asset ratios C. Capital structures are fairly constant across industries. D. Debt levels across industries vary widely. E. Debt ratios in most countries are considerably less than 100 percent.

C. Capital structures are fairly constant across industries.

Which one of these best exemplifies "milking the property"? A. a firm paying a premium to acquire a competitor B. a firm demanding a premium to be acquired without a proxy fight C. a firm with high financial distress paying additional dividends D. an all-equity firm repurchasing shares E. a firm with high financial distress using expected dividends to repay debt

C. a firm with high financial distress paying additional dividends

Which one of these parties holds a marketable claim on a firm's assets? A. customers B. employees C. bondholders D. Internal Revenue Service E. state tax authorities

C. bondholders

When [(1 - tC) × (1 - tS) = (1 - tB)], then the: A. firm should hold no debt. B. value of the levered firm is greater than the value of the unlevered firm. C. cash flow to stockholders equals the cash flow to bondholders. D. tax shield on debt is exactly offset by higher levels of dividends. E. tax shield on debt is exactly offset by higher capital gains.

C. cash flow to stockholders equals the cash flow to bondholders.

The value of a firm is maximized when the: A. cost of equity is maximized. B. tax rate is zero. C. levered cost of capital is maximized. D. weighted average cost of capital is minimized. E. debt-equity ratio is minimized.

D. weighted average cost of capital is minimized.

Indirect costs of financial distress: A. effectively limit the amount of equity a firm issues. B. serve as an incentive to increase the financial leverage of a firm. C. include costs such as legal and accounting fees. D. tend to increase as the debt-equity ratio decreases. E. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

E. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the: A. debt-equity ratio will be less than optimal. B. weighted average cost of capital will be maximized. C. firm will be all-equity financed. D. required return on assets will be at its maximum point. E. increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

E. increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

The pecking order states that firms should: A. use internal financing first. B. always issue debt then the market won't know when management thinks the security is overvalued. C. issue new equity first. D. issue debt first. E. always issue equity to avoid financial distress costs.

A. use internal financing first.

When firms issue more debt, the present value of the tax shield on debt _____ while the present value of financial distress costs: A. decreases; decreases. B. increases; increases. C. decreases; remains constant. D. decreases; increases. E. increases; remains constant.

B. increases; increases.

Indirect costs of bankruptcy are born principally by: A. bondholders. B. stockholders. C. managers. D. the federal government. E. the firm's suppliers.

B. stockholders.

One of the indirect costs of bankruptcy is the incentive toward underinvestment. Underinvestment generally would result in: A. the firm selecting all projects with positive NPVs. B. the firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. C. bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments. D. shareholders making decisions based on the best interests of the bondholders. E. the firm accepting more projects than it would if the probability of bankruptcy was ignored.

B. the firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed.

Corporations in the U.S. tend to: A. minimize taxes. B. underutilize debt. C. rely less on equity financing than they should. D. have extremely high debt-equity ratios. E. rely more heavily on bonds than stocks as the major source of financing.

B. underutilize debt.

When graphing firm value against debt levels, the debt level that maximizes the value of the firm is the level where: A. the increase in the present value of distress costs from an additional dollar of debt is greater than the increase in the present value of the debt tax shield. B. the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield. C. the increase in the present value of distress costs from an additional dollar of debt is less than the increase of the present value of the debt tax shield. D. distress costs as well as debt tax shields are zero. E. distress costs as well as debt tax shields are maximized.

B. the increase in the present value of distress costs from an additional dollar of debt is equal to the increase in the present value of the debt tax shield.

Studies have found that firms with large investments in tangible assets tend to have: A. the same capital structure as the average firm in the overall market. B. zero debt. C. high leverage. D. less debt. E. about the same debt-equity ratios and firms with small investments in tangible assets.

C. high leverage.

Issuing debt instead of new equity in a closely held firm is most apt to cause: A. the owner-manager to work less hard and shirk duties. B. the owner-manager to consume more perquisites because the cost is passed to the debtholders. C. both more shirking and perquisite consumption since the government provides a tax shield on debt. D. agency costs to fall as owner-managers do not need to worry about other shareholders. E. the owner-manager to reduce shirking and perquisite consumption.

E. the owner-manager to reduce shirking and perquisite consumption.

In general, the capital structures used by U.S. firms: A. tend to overweigh debt in relation to equity. B. are easily explained in terms of earnings volatility. C. are easily explained by analyzing the types of assets owned by the various firms. D. tend to be those which maximize the use of the firm's available tax shelters. E. vary significantly across industries.

E. vary significantly across industries.

If a firm issues debt and includes protective covenants in the indenture then the firm's debt will probably be issued at _____ similar debt without thecovenants. A. a variable interest rate rather than the fixed rate paid on B. a lower interest rate than C. a significantly higher interest rate than D. an interest rate equal to that of E. a slightly higher interest rate than

B. a lower interest rate than

Shareholders sometimes pursue selfish strategies such as taking large risks or paying excessive dividends. These actions generally result in: A. no action by debtholders since these are shareholder concerns. B. agency costs to bondholders. C. investments with risks similar to those of the current firm. D. undertaking scale-enhancing projects. E. lower agency costs, as shareholders have more control over the firm's assets.

B. agency costs to bondholders.

The MM theory with taxes implies that firms should issue maximum debt. In practice, this does not occur because: A. debt is more risky than equity. B. bankruptcy is a disadvantage to debt. C. the weighted average cost of capital is inversely related to the debt-equity ratio. D. the weighted average cost of capital is directly related to the debt-equity ratio. E. U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3 to .7.

B. bankruptcy is a disadvantage to debt.

The legal proceeding for liquidating or reorganizing a firm operating in default is called a: A. tender offer. B. bankruptcy. C. merger. D. takeover. E. proxy fight.

B. bankruptcy.

Covenants restricting additional borrowings primarily protect the: A. shareholders' residual interests in the firm. B. debtholders from the added risk of dilution of their claims. C. debtholders from changes in market interest rates. D. managers by avoiding agency costs. E. shareholders from agency costs.

B. debtholders from the added risk of dilution of their claims.

The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs. A. flotation B. beta conversion C. direct bankruptcy D. indirect bankruptcy E. unlevered

C. direct bankruptcy

Which one of these is most related to a positive covenant? A. limiting the amount of the firm's dividends B. avoiding a merger while a debt remains unpaid C. furnishing financial statements to the firm's lenders D. not issuing any additional long-term debt E. ot selling any major assets without lender approval

C. furnishing financial statements to the firm's lenders

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs. A. flotation B. direct bankruptcy C. indirect bankruptcy D. financial solvency E. capital structure

C. indirect bankruptcy

The optimal capital structure of a firm _____ the marketable claims and _____ the nonmarketable claims against the cash flows of the firm. A. minimizes; minimizes B. minimizes; maximizes C. maximizes; minimizes D. maximizes; maximizes E. equates; (leave blank)

C. maximizes; minimizes

The optimal capital structure: A. will be the same for all firms in the same industry. B. will remain constant over time unless the firm makes an acquisition. C. of a firm will vary over time as taxes and market conditions change. D. places more emphasis on the operations of a firm rather than the financing of a firm. E. is unaffected by changes in the financial markets.

C. of a firm will vary over time as taxes and market conditions change.

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy: A. the firm will rank all projects and select the project which results in the highest expected firm value. B. bondholders expropriate value from stockholders by selecting high-risk projects. C. stockholders expropriate value from bondholders by selecting high-risk projects. D. the firm will always select the lowest-risk project available. E. the firm will select only all-equity financed projects.

C. stockholders expropriate value from bondholders by selecting high-risk projects.

The free cash flow hypothesis states: A. that firms with greater free cash flow will pay more in dividends thereby reducing the risk of financial distress. B. that firms with greater free cash flow should issue new equity to help minimize the wasting of resources by managers. C. that issuing debt requires interest and principal payments to be paid thereby reducing the potential of management to waste resources. D. that firms will higher levels of free cash flow should reduce their debt levels. E. that firms with higher levels of free cash flow should reward their managers with bonuses.

C. that issuing debt requires interest and principal payments to be paid thereby reducing the potential of management to waste resources.

According to the pecking-order theory, a firm's leverage ratio is determined by: A. the value of the tax benefit of debt. B. equating the tax benefit of debt to the financial distress costs of debt. C. the firm's financing needs. D. the market rate of interest. E. the profitability of the firm.

C. the firm's financing needs.

Conflicts of interest between stockholders and bondholders are known as: A. trustee costs. B. financial distress costs. C. dealer costs. D. agency costs. E. underwriting costs.

D. agency costs.

The optimal capital structure will tend to include more debt for firms with: A. the highest depreciation deductions. B. the lowest marginal tax rate. C. substantial tax shields from other sources. D. lower probability of financial distress. E. less taxable income.

D. lower probability of financial distress.

Many firms base their capital structure decisions on which two factors? A. industry averages and tax rates B. interest and tax rates C. need for financial slack and current interest rates D. need for financial slack and industry averages E. types of assets held and current interest rates

D. need for financial slack and industry averages

Which three factors are generally considered to be the most important when determining a target debt-equity ratio? A. taxes, asset types, and inflation rate B. asset types, current operating income, and inflation rates C. taxes, current operating income, and future operating income D. taxes, asset types, and uncertainty of operating income E. interest rates, inflation rates, and tax rates

D. taxes, asset types, and uncertainty of operating income

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm. A. flotation B. default beta C. direct bankruptcy D. indirect bankruptcy E. financial distress

E. financial distress