Fin 303 Final Ch. 18

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

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

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.

C.) III Only

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

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

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

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

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

) 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)

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% equity

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

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 firms effective tax rate is very low

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%. Which investor would not care how the money is channeled? (The marginal corporate tax rate is 21%.) A) Investors paying zero personal tax B) Investors paying a personal tax rate of 53% C) Investors paying a personal tax rate of 17.5% D) Investors paying a personal tax rate of 33%

D.) For an indifferent investor, (1 − TC)(1 − TpE) = (1 − Tp) (1 − 0.21) (1 − 0.15) = (1 − Tp) Tp = 32.85%.

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

D.) I and II

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

D.) I and III only

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

D.) I, II, III

Financial slack includes: I) cash; II) marketable securities; III) readily salable real assets; IV) ready access to debt markets or bank loans

D.) I, II, III, IV

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

D.) II and III only

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

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

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

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

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

(1 - TC)(1 - TpE) = (1 - Tp). Or, (1 - 0.35) (1 - 0.15) = (1 - Tp). Tp= 44.75%

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.)

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

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.) (T - Tp)

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%. 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'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.

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 onl

A.) I only

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. Answer: A

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

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

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

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

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

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.) the more tangible the assets available to liquidate, the lower the cost to exercise bankruptcy

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

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

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)

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 equity holders

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

B.) II Only

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

B.) II Only

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 corp tax rate

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

B.) Stockholders

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.

Assume the marginal corporate tax rate is 21%. 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

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