Chapter 18

14) MM's Proposition I corrected for the inclusion of corporate income taxes is expressed as A) VL = VU. B) VL = VU + D(1 − TC). C) VL = VU + (TC)(D). D) VU = VL + (TC)(D).

C) VL = VU + (TC)(D).

48) What signal is sent to the market when a firm decides to issue new stock to raise capital? A) Bond markets are overpriced. B) Bond markets are underpriced. C) Stock price is too low. D) Stock price is too high.

D) Stock price is too high.

19) For every dollar of operating income paid out as interest, the bondholder realizes A) (1 - Tp). B) (1 − TpE) (1 − TC). C) (1 − TC). D) 1/(1 − TC).

A) (1 - Tp).

5) In order to calculate the tax shields provided by debt, the tax rate used is the A) average corporate tax rate. B) marginal corporate tax rate. C) average of shareholders' equity tax rates. D) average of bondholders' personal tax rates.

B) marginal corporate tax rate.

3) If a firm borrows $50 million for one year at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate. A) $0.95 million B) $1.50 million C) $1.00 million D) $4.55 million

A) $0.95 million PV of interest tax shield = ((0.21)(50)(0.1))/1.1 = $0.9545.

24) Suppose that your firm's current unlevered value, V*, is $800,000, and its marginal corporate tax rate is 21 percent. Also, you model the firm's PV of financial distress as a function of its debt level according to the relation: PV of financial distress = 800,000 × (D/V*)2. What is the firm's levered value if it issues $200,000 of perpetual debt to buy back stock? A) $792,000. B) $869,555. C) $920,000. D) $350,000.

A) $792,000. Value of firm = value of unlevered firm + PV(tax shield) − PV(cost of financial distress); Value of firm (in 000s) = 800 + (0.21 × 200) − 800 × [(200/800)^2] = 792K.

18) What is the relative tax advantage of debt? Assume that personal and corporate taxes are given by: TC = (corporate tax rate) = 21 percent; TpE = personal tax rate on equity income = 15 percent; and Tp = personal tax rate on interest income = 37 percent. A) 0.94 B) 1.16 C) 1.35 D) 0.86

A) 0.94 Relative advantage = (1 − 0.37)/[(1 − 0.15)(1 − 0.21)] = 0.94.

27) Which of the following entities likely has the highest cost of financial distress? A) A pharmaceuticals development company B) A downtown bayfront hotel C) A yacht leasing company D) A real estate investment trust

A) A pharmaceuticals development company The more tangible the assets available to liquidate, the lower the cost to exercise bankruptcy.

26) Firm A and Firm B are identical except that A is incorporated while B is an unlimited liability partnership. Both have assets worth $500,000 ($500K) funded with a debt ratio of 40 percent. Suppose that the assets suddenly become worthless, what is the maximum possible loss to the equityholders of each company? A) Firm A: $300K; Firm B: $500K B) Firm A: $200K; Firm B: $300K C) Firm A: $500K; Firm B: $200K D) Firm A: $500K; Firm B: $500K

A) Firm A: $300K; Firm B: $500K Firm A's equityholders can declare bankruptcy, resulting in a maximum loss of their original $300K of equity. Firm B's equityholders cannot escape their debt position. Their equity position has deteriorated from $300K to −$200K, a loss of $500K.

11) Given corporate taxes, why does adding debt to the capital structure increase firm value? I) Extra cash flow goes to the firm's investors rather than the tax authorities. II) Earnings before interest and taxes are fully taxed at the corporate rate. III) Personal tax rates are the same as marginal corporate tax rates. A) I only B) II only C) III only D) II and III only

A) I only

29) Although the use of debt provides tax benefits to the firm, debt also puts pressure on the firm to: I) meet interest and principal payments, which if not met can put the company into financial distress; II) make dividend payments, which if not met can put the company into financial distress; III) meet both interest and dividend payments, which when met increase the firm cash flow; IV) meet increased tax payments, thereby increasing firm value A) I only B) II only C) II and III only D) III and IV only

A) I only

10) Why does MM Proposition I not hold in the presence of corporate taxes? A) Levered firms pay lower taxes when compared with identical unlevered firms. B) Bondholders require higher rates of return compared with stockholders. C) Earnings per share are no longer relevant with taxes. D) Dividends are no longer relevant with taxes.

A) Levered firms pay lower taxes when compared with identical unlevered firms.

49) Under the trade-off theory, how will a government loan guarantee impact financing? A) Prefer to issue debt B) Prefer to issue stock C) Prefer internal money D) No impact occurs.

A) Prefer to issue debt

37) What does "risk shifting" imply? A) When faced with bankruptcy, managers tend to invest in high-risk, high-return projects. B) When faced with bankruptcy, managers do not invest more equity capital. C) When faced with bankruptcy, managers may make accounting changes to conceal the true extent of the problem. D) When faced with bankruptcy, managers invest in low risk projects to conserve capital.

A) When faced with bankruptcy, managers tend to invest in high-risk, high-return projects.

44) The pecking order theory of capital structure predicts that A) if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal. B) firms prefer equity to debt financing. C) firms prefer financing by debt versus internally generated cash. D) high-risk firms will end up borrowing more.

A) if two firms are equally profitable, the more rapidly growing firm will end up borrowing more, other things equal.

33) According to the trade-off theory of capital structure, A) optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress. B) optimal capital structure occurs when the stockholders' right to default is balanced by the bondholders' right to get interest and principal payments. C) optimal capital structure occurs when the benefits of limited liability is just offset by the value of the firm's lawyers' claims. D) None of these options are correct.

A) optimal capital structure occurs when the present value of tax savings on account of additional borrowing just offsets the increase in the present value of costs of distress.

16) Assume the marginal corporate tax rate is 21 percent. The firm has no debt in its capital structure. It is valued at $100 million. What would be the value of the firm if it issued $50 million in perpetual debt and repurchased the same amount of equity? A) $65 million B) $110.5 million C) $100 million D) $150 million

B) $110.5 million VU = 100; (TC)(B) = 0.21(50) = 10.5; VL = VU + TCB = 100 + 10.5 = $110.5.

20) For every dollar of operating income paid out as equity income, the shareholder realizes A) (1 − Tp). B) (1 − TpE) (1 − TC). C) (1 − Tc). D) 1/(1 − Tp).

B) (1 − TpE) (1 − TC).

17) What is the relative tax advantage of debt? (TC = corporate tax rate; TpE = personal tax rate on equity income; and Tp = personal tax rate on interest income.) A) (1-Tc)/((1-TpE)(1-Tp)) B) (1-Tp)/((1-TpE)(1-Tc)) C) (1-TpE)/((1-Tp)(1-Tc)) D) (1-TpE)/((1-Tp)(1+Tc))

B) (1-Tp)/((1-TpE)(1-Tc))

1) The main advantage of debt financing for a firm is: I) no SEC registration is required for bond issues; II) interest expenses are tax deductible; III) unlevered firms have higher value than levered firms A) I only B) II only C) III only D) I and III only

B) II only

41) When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these will result in: I) no action by debtholders since these are equityholder concerns; II) positive agency costs, as bondholders act on various restrictions and covenants, which will diminish firm value; III) investments of the same risk class that the firm is in A) I only B) II only C) III only D) I and III only

B) II only

8) In order to calculate the tax shield of interest payments for a corporation, always use the: I) average corporate tax rate; II) marginal corporate tax rate; III) marginal rate on personal income tax A) I only B) II only C) III only D) I and III only

B) II only

21) Suppose that a company can direct $1 to either debt interest or capital gains for equity investors. If there were no personal taxes on capital gains, which of the following investors would not care how the money was channeled? (The marginal corporate tax rate is 21 percent.) A) Investors paying personal tax of 17.5 percent B) Investors paying personal tax of 21 percent C) Investors paying personal tax of 53 percent D) Tax-exempt personal investors

B) Investors paying personal tax of 21 percent

25) Compared to a firm with unlimited liability, the limited liability feature of common equity results in a A) lower present value of the interest tax shield. B) higher value to equityholders. C) leveraged buyout mechanism. D) higher value to debtholders.

B) higher value to equityholders.

43) The trade-off theory of capital structure predicts that A) unprofitable firms should borrow more than profitable ones. B) safe firms should borrow more than risky ones. C) rapidly growing firms should borrow more than mature firms. D) increasing leverage increases firm value, especially at high debt ratios.

B) safe firms should borrow more than risky ones.

34) The indirect costs of bankruptcy are borne principally by A) bondholders. B) stockholders. C) managers. D) the federal government.

B) stockholders.

6) If a firm permanently borrows $50 million at an interest rate of 10 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate. A) $50.0 million B) $25.0 million C) $10.5 million D) $1.5 million

C) $10.5 million PV of interest tax shield = (0.21)(50) = $10.5 million.

2) If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of the interest tax shield? (Assume that the marginal corporate tax rate is 21 percent.) A) $8.00 million B) $5.60 million C) $21.00 million D) $26.67 million

C) $21.00 million PV of interest tax shield = (0.21)(100) = $21 million.

32) When financial distress is a possibility, the value of a levered firm is a function of: I) value of the firm if all-equity-financed; II) present value of tax shield; III) present value of costs of financial distress; IV) present value of omitted dividend payments A) I only B) I + II C) I + II − III D) I + II - III − IV

C) I + II − III

9) If a corporation cannot use its interest payments as a tax shield for a particular year because it has suffered a loss, it is still possible to use the tax shield because: I) the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the amount of taxes paid in the previous two years; II) the carry-forward provision allows corporations to carry forward the loss and use it to shield income in subsequent years A) I only B) II only C) I and II D) the firm will lose the tax shield

C) I and II

46) According to Rajan and Zingales, debt ratios of individual companies depend on: I) size: large firms have higher debt ratios; II) tangible assets: firms with high ratios of fixed assets to total assets have higher debt ratios; III) profitability: more profitable firms have lower debt ratios; IV) market to book: firms with higher ratios of market-to-book value have lower debt ratios; V) market structure: firms with monopoly power have higher debt ratios A) I and II only B) I, II, and III only C) I, II, III, and IV only D) I, II, III, IV, and V

C) I, II, III, and IV only

35) Which of the following statements regarding financial distress is (are) true? I) Firms in financial distress always end up in bankruptcy. II) Firms can postpone bankruptcy for many years. III) Ultimately, the firm may recover from financial distress and avoid bankruptcy altogether. A) I only B) II only C) II and III only D) III only

C) II and III only

45) The pecking order theory of capital structure implies that: I) high-risk firms will end up borrowing more; II) firms prefer internal finance; III) firms prefer debt to equity when external financing is required A) I only B) II only C) II and III only D) III only

C) II and III only

36) What are some of the possible consequences of financial distress? I) Bondholders, who face the prospect of getting only part of their money back, will likely want the company to take additional risks. II) Equity investors would like the company to cut its dividend payments to conserve cash. III) Equity investors would like the firm to shift toward riskier lines of business. A) I only B) II only C) III only D) I and II only

C) III only

4) In order to find the present value of the tax shields provided by debt, the discount rate used is the A) cost of capital. B) cost of equity. C) cost of debt. D) T-bill rate.

C) cost of debt.

15) Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the A) managers of the firm. B) bondholders of the firm. C) stockholders of the firm. D) lawyers of the firm.

C) stockholders of the firm.

22) In Miller's model, when the quantity (1 − TC)(1 − TpE) = (1 − Tp), then A) the firm should hold no debt. B) the value of the levered firm is greater than the value of the unlevered firm. C) the tax shield on debt is exactly offset by higher personal taxes paid on interest income. D) the firm should be financed by 100 percent equity.

C) the tax shield on debt is exactly offset by higher personal taxes paid on interest income.

7) If a firm borrows $50 million for one year at an interest rate of 9 percent, what is the present value of the interest tax shield? Assume a 21 percent marginal corporate tax rate. A) $50.00 million B) $17.50 million C) $1.45 million D) $0.87 million

D) $0.87 million PV of interest tax shield = [(0.21)(50)(0.09)]/1.09 = $0.87 million.

31) Which of the following is not a potential result from financial distress? A) Suppliers refuse to extend terms to the firm. B) Key employees leave the firm, fearing the firm won't last. C) The firm has difficulty issuing additional bonds. D) Due to interest tax shields, the firm's effective tax rate is very low.

D) Due to interest tax shields, the firm's effective tax rate is very low.

12) MM Proposition I with corporate taxes states that: I) capital structure can affect firm value by an amount that is equal to the present value of the interest tax shield; II) by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total value; III) firm value is maximized by using an all-equity capital structure A) I only B) II only C) III only D) I and II

D) I and II

30) The costs of financial distress depend on the: I) probability of financial distress; II) corporate and personal tax rates; III) magnitude of costs encountered if financial distress occurs A) I only B) I and II only C) I, II, and III D) I and III only

D) I and III only

47) Financial slack includes: I) cash; II) marketable securities; III) readily salable real assets; IV) ready access to debt markets or bank loans A) I only B) IV only C) III only D) I, II, III, and IV

D) I, II, III, and IV

38) When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) favor high-risk, high-return projects even if they have negative NPV; II) refuse to invest in low-risk, low-return projects with positive NPVs; III) delay the onset of bankruptcy as long as they can A) I only B) II only C) III only D) I, II, and III

D) I, II, and III

39) When faced with financial distress, managers of firms acting on behalf of their shareholders' interests will tend to: I) issue large quantities of low-quality debt versus low quantities of high-quality debt; II) favor paying high dividends to shareholders; III) delay the onset of bankruptcy as long as they can A) I only B) II only C) III only D) I, II, and III

D) I, II, and III

28) The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because: I) debt is more risky than equity; II) bankruptcy and its attendant costs are a disadvantage to debt; III) the payment of personal taxes may offset the tax benefit of debt A) I only B) II only C) III only D) II and III only

D) II and III only

40) One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in: I) the firm always choosing projects with positive NPVs; II) stockholders turning down low-risk, low-return but positive NPV projects; III) the firm declaring and paying high cash dividends A) I only B) II only C) III only D) II and III only

D) II and III only

23) Suppose that a company can direct $1 to either debt interest or to capital gains for equity investors. The capital gains tax rate is 15 percent. Which investor would not care how the money is channeled? (The marginal corporate tax rate is 21 percent.) A) Investors paying zero personal tax B) Investors paying a personal tax rate of 53 percent C) Investors paying a personal tax rate of 17.5 percent D) Investors paying a personal tax rate of 33 percent

D) Investors paying a personal tax rate of 33 percent For an indifferent investor, it must be the case that (1 − TC)(1 − TpE) = (1 − Tp). Or(1 − 0.21) (1 − 0.15) = (1 − Tp). Tp = 32.85%.

42) Inclusion of restrictions in a bond contract leads to A) higher agency costs. B) higher bankruptcy costs. C) higher interest costs. D) lower agency costs.

D) lower agency costs.

13) Bombay Company's book and market value balance sheets are as follows: (NWC = net working capital; LTA = long term assets; D = debt; E = equity; V = firm value): Book Values. Market Values NWC 200. 500. D NWC 200. 500 D LTA. 2300 2000. E LTA. 2800. 2500 E 2500. 2500. V. 3000 3000 According to MM's Proposition I corrected for taxes, what will be the change in company value if Bombay issues $200 of equity and uses it to make a permanent reduction in the company's debt? Assume a 21 percent marginal corporate tax rate. A) +$140 B) +$70 C) $0 D) −$42

D) −$42 PV of tax shield = −$200 (0.21) = −$42.

50) The present value of the interest tax shield is the same regardless of whether the firm plans to borrow permanently or temporarily. (T/F)

False

51) Always use the average corporate tax rate to calculate the interest tax shields for firms. (T/F)

False

54) The existence of personal taxes on interest income and equity income will always increase the advantage of debt to a firm. (T/F)

False

59) Financial distress always results in bankruptcy. (T/F)

False

63) The existing tax code encourages a preference for equity over debt in corporate financing. (T/F)

False

52) MM's Proposition I corrected for corporate taxes states that Value of levered firm = Value of unlevered firm + PV tax shield. (T/F)

True

53) The value of a levered firm, given permanent debt level D, is Value of levered firm = Value of unlevered firm + (TC)(D). This assumes zero costs of financial distress. (T/F)

True

55) When (1 − Tp) = (1 − TpE)(1 − Tc), the impact of corporate and personal taxes makes the debt policy decision less significant. (T/F)

True

56) Financial distress occurs when promises to creditors are not honored or honored with great difficulty. (T/F)

True

57) When the costs of financial distress are included, the value of a levered firm is given by Value of levered firm = Value of unlevered firm + PV (tax shield) − PV (costs of financial distress). (T/F)

True

58) The right to default is valuable to shareholders. (T/F)

True

60) Risk shifting, refusing to contribute equity, and playing for time are some of the consequences of firms facing bankruptcy. (T/F)

True

61) According to the trade-off theory, more profitable firms should have more debt and thus higher debt ratios on average. (T/F)

True

62) The pecking order theory implies that firms prefer internal to external financing. (T/F)

True

64) A firm nearing bankruptcy has an incentive to issue more high risk debt. (T/F)

True