Finance Ch 15 - Capital Structure
If a firm has an annual debt obligation of $40 and generates cash flow of $30, how much will shareholders receive?
0
Which of the following will increase the value of stocks and bonds?
1) A reduction in the claims of lawyers 2) A reduction in government taxes
Which of the following are examples of signaling by a firm?
1) An increase in dividends 2) An increase in the target debt ratio
Who pays to gain the privilege of receiving cash flows in the future?
1) Bondholders 2) Shareholders
Nonmarketable claims include claims of the ________.
1) Lawyers 2) Government
What type of covenants may restrict shareholders from pursuing high-risk investments during financial distress?
1) Minimum interest coverage restrictions 2) Minimum net worth restrictions
Who are the main claimants of a firm's cash flows?
1) Stockholders 2) Government 3) Bondholders
What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?
1) Suppliers may not supply inventory, fearing nonpayment. 2) Customers may not buy, fearing future service problems. 3) Banks may place restrictions on the firm's financial activities.
What are some possible consequences of raising debt to fool the market about a firm's value?
1) When the market discovers the truth, share prices will drop 2) The probability and expected costs of financial distress will increase if debt rises above the optimal level.
Why would bondholders want to put restrictions on additional borrowing by the firm?
An increase in borrowing will dilute the claims of existing bondholders.
From a tax shield perspective, what is the expected relationship between a firm's profitability and its level of debt?
As profitability increases, a firm will increase the level of debt.
When is the present value of distress costs likely to exceed the present value of the tax shield from debt?
At high levels of debt.
From a tax shield perspective, why would a firm with low profits not borrow much?
Because the firm needs only a small interest deduction to offset pretax profits.
True or False: It is easy to measure indirect costs of financial distress?
False
MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.
False.
True or False: Corporate managers can consistently manipulate and fool the market.
False.
Why do bond covenants restrict high risk investments by shareholders during financial distress?
High risk projects tend to transfer wealth from the bondholders to the shareholders.
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. even though it is not insolvent.
I, II, III and IV
When is a rational firm likely to increase the level of debt so as to capture the tax shield benefit of debt?
If profits are expected to be high.
What is the impact on the present value of distress costs as more debt is added?
It increases.
What is management's attitude towards nonmarketed claims?
Management tries to reduce the value of nonmarketed claims.
Managers will try to _______ the value of marketed claims.
Maximize
Cash dividends always ______ free cash flow.
Reduce
Firm value initially increases when the proportion of debt in the capital structure increases due to the _______.
Tax shield.
How does the level of debt affect the weighted average cost of capital (WACC)?
The WACC initially falls and then rises as debt increases.
Who owns most of the firm after an LBO?
The managers
Why are managers likely to work harder after an LBO?
The managers have greater ownership interest.
What do Modigilani and Miller assert about the relationship between leverage and firm value in the presence of corporate taxes?
The value of the firm increases with leverage.
What are marketable claims?
These are claims that can be bought and sold in the market.
What claims would be paid first in a bankruptcy liquidation if the court adheres to the absolute priority rule?
Wages, salaries and commissions
Conflicts of interest between stockholders and bondholders are known as
agency costs
The legal proceeding for liquidating or reorganizing a firm operating in default is called a _________.
bankruptcy
The two broad types of costs of financial distress are ____ costs.
direct and indirect.
The explicit costs, such as the legal expenses, associated with corporate default are classified as ________ costs.
direct bankruptcy
In bankruptcy cases, the claims of lawyers are ______ the claims of senior bondholders.
given priority over
In a leveraged buyout (LBO), current shareholders are bought out at a price that is ______.
higher than the current market price.
Bankruptcy costs are likely to be ______ if there are fewer groups of lenders.
lower
The optimal capital structure will tend to include more debt for firms with
lower probability of financial distress
The pecking order theory states that when external funds are required, a firm should:
only issue equity securities after the firm's debt capacity is reached.
Bonds with _______ will be issued at relatively low interest rates.
protective covenants
Agency costs ____ the value of a levered firm.
reduce
A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a
reorganization.
The value of a firm depends on the value of its _______.
stocks and bonds
One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt.
tax
In general, the capital structures of U.S. firms:
vary significantly across industries.
