FNAN401-Chapter 17: Capital Structure.

What is a negative covenant?

A covenant that limits or prohibits actions that the company may take.

Which type of firm is more susceptible to selfish shareholder strategies?

A levered firm facing financial distress

Who is more likely to indulge in wasteful behavior?

A manager with a small ownership interest in the firm

An example of an ---- cost is when a firm issues more equity and an entrepreneur increases leisure time.

Agency

The --- cost of equity reduces the value of the firm.

Agency

If a manager has more information than an investor about the firm, that information is referred to as Blank______ information.

Asymmetric

When is the present value of distress costs likely to exceed the present value of the tax shield from debt?

At high level of debt

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

Banks may place restrictions on the firm's financial activities. Customers may not buy, fearing future service problems. Suppliers may not supply inventory, fearing nonpayment.

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.

During times of financial distress, the selfish actions of shareholders may lead to the expropriation (snatching) of wealth from Blank______.

Bondholders

What are the differences in the claims of shareholders and bondholders during bankruptcy?

Bondholders' claims are settled first. Bondholders have a fixed claim while shareholders have a variable claim on all the residuals

The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of Blank______.

Debt

The value of a firm is equal to the value of its Blank______.

Debt plus equity

No exact formula exists to evaluate the optimal --- ratio

Debt-equity

The two broad types of costs of financial distress are Blank______ costs.

Direct and indirect

True or false: Bondholders cannot restrict a firm's future borrowing decisions.

False

The payment to lawyers become relevant in the context of capital structure decisions in the event of Blank______.

Financial distress

How does managerial ownership of equity affect the debt-equity ratio of real-world companies?

Firms in which managers have high equity ownership tend to have lower leverage.

An individual will work Blank______ if they own a Blank______ percentage of the company.

Harder, larger. less, smaller

What is the likely impact on the work ethic of an employee once he acquires shares in the firm where he works?

He is likely to work harder.

Firms in which managers have Blank______ equity ownership tend to have Blank______ leverage.

High, lower. Low, higher.

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

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.

The value of a firm will Blank______ when the firm first uses leverage if we assume that there are no bankruptcy costs.

Increase

Volatility in income Blank______ the probability of financial distress.

Increases

What are the advantages of using internal financing?

It prevents the adverse market reaction that tends to accompany a stock issue. It may be cheaper than debt or equity issues.

What are the benefits of having few lenders during bankruptcy?

It reduces the conflict among lenders. It makes it easier for the firm to negotiate with lenders.

What is generally the most important component of direct costs of financial distress?

Legal costs

What are some examples of indirect financial distress costs?

Lost sales and lost reputation.

Bankruptcy costs are likely to be Blank______ if there are fewer groups of lenders.

Lower

Protective covenants typically Blank______ interest rates.

Lower

Under the pecking-order theory, profitable firms will tend to have Blank______ levels of debt.

Lower

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world?

MM did not consider bankruptcy costs.

Modigliani and Miller suggest that there is a(n) Blank______ relationship between leverage and firm value in the presence of corporate taxes.

Positive

What are the two types of protective covenants?

Positive and negative covenants

In an agency relationship the Blank______.

Principal delegates decision making authority to an agent

A Blank______ covenant is an agreement between bondholders and stockholders.

Protective

The value of the firm is Blank______ by the agency costs of equity.

Reduced

According to the pecking order theory, what is the preferred source for firms seeking to raise capital?

Retained earnings

What is the preferred source of financing for firms according to the pecking-order theory?

Retained earnings.

How does the concept of limited liability apply to shareholders?

Shareholders cannot be held personally liable for the debts of the corporation.

In a financially distressed firm with shareholders and bondholders, who are the likely winners and losers if the firm invests in risky projects during a recession?

Shareholders win and bondholders lose.

Who are the main claimants of a firm's cash flows?

Stockholders. Bondholders. Government

Which of the following are examples of a negative covenant?

The firm is restricted from merging with another firm. The firm may not pay excessive dividends.

Who is likely to have the most information about a firm's future prospects?

The firm's managers.

Why is a manager with a small ownership interest in the firm more likely to indulge in wasteful behavior?

The manager bears only a small fraction of the costs but enjoys all the benefits.

What do Modigliani 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.

Why are shareholders more keen on investing in high-risk projects during times of financial distress?

They shareholders will lose no more than they have already lost. High risk projects offer the potential for a higher return for shareholders.

Most nonfinancial companies issue Blank______ debt.

Too little

True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

True

In 2019, the U.S. collected over $230 billion in corporate taxes. What do these figures suggest about the capital structure choices of U.S. firms?

U.S. firms do not use enough debt to capture all the tax shield benefits of debt.

Which of the following factors affect the establishment of a target debt-equity ratio?

Uncertainty of operating income AND Type of assets, tangible or intangible AND Taxes

What is the expression for the value of a levered firm in the presence of corporate taxes?

Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt

Sam owns 2 percent of the firm he manages. What things might Sam be tempted to do that would benefit himself but increase his firm's agency costs?

Would benefit himself but increase his firm's agency costs? Take on unprofitable projects. Increase his work-related perquisites. Increase his leisure time

Firm value initially increases when the proportion of debt in the capital structure increases due to the Blank______.

debt tax shield

Which of the following are differences between interest payments and dividend payments by the corporation?

dividend income is not fixed while interest income is generally fixed. dividend payments are not an obligation, but interest payments are an obligation. dividends are paid to stockholders while interest is paid to bondholders

The payment to lawyers become relevant in the context of capital structure decisions in the event of Blank______.

financial distress

The value of the firm is given by the following expression Blank______.

firm value = value of equity + value of debt

Firms with volatile operating income tend to have lower debt ratios because Blank______.

there is a higher probability of experiencing financial distress

Which two of the following are broad types of costs of financial distress?

Direct and indirect costs

U.S. firms Blank______ use enough debt to capture all the tax shield benefits of debt.

Do not

True or false. MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.

False

True or false: There is a precise mathematical equation that can be used to find the optimal debt-equity ratio for every firm.

False

What are shareholders liable for if the firm is in financial distress and can pay only 80 percent of the payment due to the bondholders?

Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.

Highly profitable firms are likely to have higher debt ratios because they can deduct interest for Blank______ purposes.

Tax

How can the selfish stockholder strategy of taking more risk during periods of financial distress lead to agency costs?

The bondholders may get paid less with a high-risk project relative to a low-risk project.

The empirical evidence on median debt-to-value ratios for countries around the world indicates that real-world companies Blank______.

do not issue enough debt to significantly reduce or eliminate corporate taxes

True or false: Protective covenants are classified as either direct or indirect covenants.

False