Valuation Ch 16/17

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

A) agency costs to bondholders.

Assume that for the next two weeks, the bondholders of Western Markets have the option of exchanging their bonds for common shares of the firm's stock. As a result of these exchanges, you should expect the firm's debt-equity ratio to: A) decline and the stock's price to also decline. B) increase and the stock's price to remain constant. C) decline and the stock's price to increase. D) increase and the stock's price to increase. E) decline and the stock's price to remain constant.

A) decline and the stock's price to also decline.

Below the break-even EBIT, increased financial leverage will _______ EPS, all else the same. Assume there are no taxes. A) decrease B) not affect C) either increase or decrease D) increase EBIT but decrease

A) decrease

All else the same, the financial leverage of a frim will: A) decrease as the firm's retained earnings account grows B) increase by the amount of equity it issues in a given year C) decrease if the firm has negative net income D) decrease as the firm uses debt to fund expansion projects

A) decrease as the firm's retained earnings account grows

Which of the following statements regarding leverage is false? A) if things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS) B) as a firm levers up, shareholders are exposed to greater risk C) the benefits of leverage will not be as great in a firm with substantial accumulated losses or other types of tax shields compared to a firm with substantial accumulated losses or other types of tax shields compared to a firm without many tax shields D) beyond a certain point, the costs of financial distress outweigh the benefits of leverage

A) if things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS)

A key underlying assumption of MM Proposition I without taxes is that: A) individuals and corporations borrow at the same rate. B) managers always act to maximize the value of the firm. C) individuals can borrow at lower rates than corporations. D) financial leverage increases risk. E) corporations are all-equity financed.

A) individuals and corporations borrow at the same rate.

The option of keeping a financially distressed firm as an operating concern is called a(n): A) reorganization B) acquisition C) merger D) technical solvency

A) reorganization

A firm has debt of $7,000, equity of $12,000, a cost of debt of 7 percent, a cost of equity of 14 percent, and a tax rate of 21 percent. What is the firm's weighted average cost of capital? A) 9.9% B) 10.88% C) 12.5% D) 8.45% E) 11.27%

B) 10.88%

The optimal capital structure is the mixture of debt and equity which: I. Maximizes the value of the firm II. Minimizes the firm's WACC III. Maximizes the market price of the firm's bonds A) I only B) I and II only C) I and III only D) I, II, and III

B) I and II only

All else the same, which of the following claims on the cash flows of the firm will tend to increase with decreases in the debt/equity ratio? I. Taxes II. Bankruptcy costs III. Stockholder claims IV. Bondholder claims A) I and IV only B) II and IV only C) I, II, and III only D) I and III only

D) I and III only

Assume there are no personal or corporate income taxes and that the firm's WACC is unaffected by its capital structure. Which of the following is true? I. A firm's cost of equity depends on the firm's business and financial risks. II. The value of the firm is dependent on its capital structure. III. The cost of equity increases as the firm's leverage decreases. A) II only B) III only C) I and III only D) I only

D) I only

_____________ implies that the firm should issue as much debt as possible. A) M&M Proposition I without taxes B) the static theory of capital structure C) M&M proposition II without taxes D) M&M Proposition I with taxes

D) M&M Proposition I with taxes

According to __________, the value of the firm is independent of its capital structure. A) M&M Proposition I with taxes B) the static theory of capital structure C) M&M Proposition II without taxes D) M&M Proposition I without taxes

D) M&M Proposition I without taxes

The procedure for liquidating a corporation is outlined in: A) The BNA act B) The Canadian Constitution C) Chapter 11 D) The Bankruptcy and Insolvency Act

D) The Bankruptcy and Insolvency Act

The absolute priority rule establishes the order in which: A) firm are liquidated by the bankruptcy costs B) reorganization events must occur C) bankruptcy cases are heard by the courts D) claims are paid in a bankruptcy proceeding

D) claims are paid in a bankruptcy proceeding

Why does the possibility of bankruptcy have a negative effect on a firm?

The bankruptcy risk is not what lowers value, but instead the costs associated with bankruptcy, which the stockholders have to bear

What are financial distress indirect costs?

impaired ability to run business (lost sales)

What are financial distress direct costs?

legal and administrative

A capital restructuring occurs when a firm: A) Changes its debt-equity ratio without changing its total assets B) Reduces both its debt and its equity while maintaining a constant debt-equity ratio C) Changes its level of debt without changing its total equity D) Refinances its debt at a lower rate of interest

A) Changes its debt-equity ratio without changing its total assets

According to M&M Proposition II without taxes, a firm's cost of equity is a function of which of the following factors? I. The required rate of return on the firm's assets II. The firm's debt/equity ratio III. The firm's cost of debt A) II only B) I and II only C) I and III only D) I, II, and III

A) II only

The weighted average cost of capital can also be defined as the: A) Market weighted cost of equity financing B) Rate of return based on net book value C) Required return on a firm's overall assets D) Basis of M&M Proposition I

A) Market weighted cost of equity financing

Reasons for financial distress?

1. cumulative losses 2. cash flows 3. macro trends 4. high expenses low sales 5. debt management 6. insufficient accounting practices

How to overcome financial distress?

1. proper communication 2. don't break promises 3. chase debtors 4. take advice

Assume there are no corporate or personal taxes. According to M&M Proposition: A) I, the total value of the firm depends on how cash flows are divided up between stockholders and bondholders B) II, the cost of equity rises as the firm increases its use of debt financing C) II, the cost of equity depends on the firm's business risk but not its financial risk D) I and II, as debt increases, the increase in the cost of equity is more than offset by the lower cost of debt and the WACC falls

B) II, the cost of equity rises as the firm increases its use of debt financing

The cost of equity capital, based on M&M Proposition II, can be defined as: A) Re = Ra + (Ra - Rd) (D/E) B) Re = Ra + (Ra - Rd) (D/E) C) Re = Ra + (Rd - Ra) (E/D) D) Re = Rd - (Rd - Ra) (D/E)

B) Re = Ra + (Ra - Rd) (D/E)

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 the covenants. A) a slightly higher interest rate than B) a lower interest rate than C) an interest rate equal to that of D) a significantly higher interest rate than E) a variable interest rate rather than the fixed rate paid on

B) a lower interest rate than

When choosing a capital structure, the objective of the firm should be to: A) choose the one that maximized the current value of the firm's bonds B) choose the one that minimizes the firm's WACC C) chose the one that results in the largest interest tax shield D) choose any capital structure since it is always irrelevant

B) choose the one that minimizes the firm's WACC

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 static theory of capital structure states that firms borrow up to the point where the tax benefit of one additional dollar of debt is equal to the marginal cost of: A) sales B) financial distress C) leverage D) financial capital

B) financial distress

Studies have found that firms with large investments in tangible assets tend to have: A) the same capital structure as firms that specialize in intangible asset investments. B) higher target debt-equity ratios than firms that primarily invest in intangible assets. C) higher financial distress costs than firms with comparable investments in intangible assets. D) the highest financial distress costs of any firm per dollar of debt. E) zero debt.

B) higher target debt-equity ratios than firms that primarily invest in intangible assets.

In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of: A) the effects of leverage on the cost of equity. B) homemade leverage. C) the relationship between dividends and earnings per share. D) taxes. E) the interest tax shield.

B) homemade leverage.

The firm's capital structure refers to the: A) mix of current and fixed assets a firm holds. B) mix of debt and equity used to finance the firm's assets. C) amount of dividends a firm pays. D) amount of capital invested in the firm. E) amount of cash versus receivables the firm holds.

B) mix of debt and equity used to finance the firm's assets.

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

B) the firm's financing needs.

The cost of debt is generally lower than the cost of equity; however, according to __________, replacing equity with debt will not change the value of the firm because the savings attributable to the lower cost of debt financing will be offset by the higher required return on the remaining equity. a) M&M Proposition I without taxes B) the static theory of capital structure C) M&M Proposition II without taxes D) M&M Proposition II with taxes

B) the static theory of capital structure

Which of the following is true about the WACC? A) the WACC is the appropriate discount rate for all new projects of the firm B) the value of the firm will be maximized when the WACC is minimized C) the WACC is virtually impossible to calculate for a firm with multiple divisions D) since discount rates and firm value move in the same direction, minimizing WACC will minimize the value of the firm

B) the value of the firm will be maximized when the WACC is minimized

Mary owns 100 percent of a gift shop with an equity value of $150,000. If she keeps the shop open 5 days a week, EBIT is $75,000. If the shop remains open 6 days a week, EBIT increases to $92,000 annually. Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent. The principal amount would be repaid at the end of the fifth year. Ignore taxes. What will be the cash flow for this year to Mary if she issues debt, remains open 6 days a week, and distributes all the residual cash flow to the shareholders? A) $65,000 B) $46,125 C) $88,500 D) $81,500 E) $71,500

C) $88,500

Which of the following statements is/are true regarding corporate borrowing when EBIT is positive? I. Increasing financial leverage increases the sensitivity of EPS and ROE to changes in EBIT II. The effect of financial leverage depends on the company's EBIT, that is, leverage is unfavorable when EBIT is relatively high, and leverage is favorable when EBIT is relatively low III. High leverage decreases the returns to shareholders (as measured by ROE) A) II only B) III only C) I only D) I, II, and III

C) I only

The theory that a change in the capital structure weights is exactly offset by the change in the cost of equity is known as: A) Homemade leverage B) Financial leverage C) The targeted capital structure theory D) M&M Proposition II

C) The targeted capital structure theory

The fact that individual investors can alter the amount of financial leverage to which they are exposed is referred to as: A) Capital structure targeting B) Adjusting the business risk C) homemade leverage D) M&M Proposition II

C) homemade leverage

Which of the following is NOT accurate regarding financial leverage? A) whenever a firm's debt increases faster than its equity, financial leverage increases B) leverage is most beneficial when EBIT is relatively high C) increasing financial leverage will always increase the EPS for stockholders D) the level of financial leverage that produces the highest firm value is the one most beneficial to stockholders

C) increasing financial leverage will always increase the EPS for stockholders

The equity beta of a firm depends on which of the following? I. The firm's business risk. II. The firm's financial policy. III. The firm's advertising policy. A) III only B) I and III only C) II and III only D) I and II only

D) I and II only

Which of the following is true concerning the rate of return earned on shares of a levered firm in terms of the possible range of earnings? There are no taxes. A) the returns do not differ from those of an unlevered firm B) the returns are greater than for an unlevered firm on the upside and equal on the downside C) the returns are greater than for an unlevered firm on the upside and lower on the downside D) the returns are the same for an unlevered firm on the upside and greater on the downside

C) the returns are greater than for an unlevered firm on the upside and lower on the downside

The Dance Studio is currently an all-equity firm that has 22,000 shares of stock outstanding with a market price of $27 a share. The current cost of equity is 12 percent and the tax rate is 23 percent. The firm is considering adding $225,000 of debt with a coupon rate of 6.25 percent to its capital structure. The debt will sell at par. What will be the levered value of the equity? A) $594,000 B) $325,500 C) $472,750 D) $420,750 E) $521,250

D) $420,750

A firm has a debt-equity ratio of .64, a pretax cost of debt of 8.5 percent, and a required return on assets of 12.6 percent. What is the cost of equity if you ignore taxes? A) 11.12% B) 16.38% C) 8.55% D) 15.22% E) 8.06%

D) 15.22%

The extent to which a firm relies on debt is referred to as: A) Homemade leverage B) The target ratio C) Business leverage D) Financial leverage

D) Financial leverage

Suppose you work for the CFO of Danforth, Inc. He believes sales and operating income will be sharply higher each year for the foreseeable future. If he seeks to maximize earnings per share, he should __________. (Assume there are no taxes) A) increase the firm's debt to equity ratio B) increase the firm's debt to equity ratio if the firm's EBIT will remain below the break-even (comparing levered to unlevered) level of EBIT C) decrease the firm's debt to equity ratio D) decrease the firm's debt to equity ratio if the firm's EBIT will remain below the break-even (comparing levered to unlevered) level of EBIT

D) decrease the firm's debt to equity ratio if the firm's EBIT will remain below the break-even (comparing levered to unlevered) level of EBIT

A firm's systematic risk will ____________ as its debt/equity ratio __________. A) decrease; increases B) remain unchanged; decreases C) remain unchanged; increases D) increase; increases

D) increase; increases

MM Proposition I with taxes is based on the concept that the: A) cost of equity increases as the debt-equity ratio of a firm increases. B) firm is better off with debt based on the weighted average cost of capital. C) optimal capital structure is the one that is totally financed with equity. D) presence of taxes causes debt to be valuable to a firm. E) capital structure of the firm does not matter because investors can use homemade leverage.

D) presence of taxes causes debt to be valuable to a firm.

Which of the following statements is correct? A) decisions regarding a firm's debt and equity can be called capital budgeting decisions B) the asset beta is a measure of the unsystematic risk of a firm's assets C) in a purely capital restructuring, the composition of the assets of the firm will change D) the use of personal leverage by an investor to alter the degree of financial leverage of a firm is called homemade leverage

D) the use of personal leverage by an investor to alter the degree of financial leverage of a firm is called homemade leverage

MM Proposition I with taxes supports the theory that: A) the value of a firm is inversely related to the amount of leverage used by the firm B) a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. C) a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises. D) there is a positive linear relationship between the amount of debt in a levered firm and the firm's value. E) the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.

D) there is a positive linear relationship between the amount of debt in a levered firm and the firm's value.

A general rule for managers to follow is to set the firm's capital structure such that the firm's: A) suppliers of raw materials are satisfied. B) size is maximized. C) bondholders are secured. D) value is maximized. E) dividend payout is maximized.

D) value is maximized.

Allison's requires $180,000 to fund a new project next year. The firm expects to earn excess cash of $68,000 this year after all expenses, taxes, and dividends are paid. The firm can borrow up to $150,000 at 6.5 percent interest for up to ten years or, it can issue up to 25,000 new shares of stock that will have an estimated value of $35 a share at the end of this year. According to the pecking-order theory, how much will the firm raise in new equity capital to fund this project? A) $180,000 B) $90,000 C) $30,000 D) $112,000 E) $0

E) $0

A firm has a debt-equity ratio of 1, a cost of equity of 16 percent, and a cost of debt of 8 percent. If there are no taxes or other imperfections, what is its unlevered cost of equity? A) 10% B) 14% C) 8% D) 16% E) 12%

E) 12%

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

E) A firm with high financial distress paying additional dividends

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

E) maximizes; minimizes