Chapter 16

Rank each of the following in order of priority of payment starting with the highest priority item to lowest priority item .

1. Bankruptcy administrative expenses 2. Wages , salaries , and commissions 3. Consumer claims 4. Payment to common shareholders

According to the Tax Cuts and Jobs Act of 2017 , after 2021 , the net interest deduction drops to what percent of EBIT ?

30

In 2019 , the net interest deduction is limited to what percent of EBITDA ?

30

Which of the following is not a possible cause of financial distress ?

Accounting regression

Which costs of financial distress are easier to measure ?

Direct costs

Which of the following assumptions is necessary for MM Proposition I to hold ?

Individuals can borrow on their own at an interest rate equal to that of the firm .

Which of the following is not a reason that bankruptcy may be valuable to a company ?

It generally instills greater confidence among a firm's main customers .

What is the most important benefit of debt ?

It provides a tax benefit .

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 ,

Based on the static theory , what should the managers attempt to maximize and minimize while developing capital structure policy ?

Maximize the tax shield benefit of debt and minimize financial distress costs

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

The firm's manager

Which of the following is likely to be true when a bankruptcy ruling is issued ?

The ownership of assets is transferred from the shareholders to the bondholders ..

Which capital structure theory suggests that profitable firms will use less debt ?

The pecking order theory

True or false : In the extended pie model , bankruptcy costs are a claim on cash flows of the firm .

True

True or false : Nonpayment of periodic interest on debt can lead to bankruptcy .

True

An investor who invests in the stock of a levered firm rather than in an all - equity firm will require :

a higher expected return .

Stockholders and bondholders

are not the only claimants to the cash flows of the firm

The costs of financial distress depend mostly on how easily the ownership of the firm's _____ can be transferred .

assets

During bankruptcy , the ownership of the firm's assets is transferred from stockholders to

bondholders

The equity risk that comes from the nature of a firm's operating activities is known as _____ risk .

business

The main difference between marketed and nonmarketed claims is that marketed claims _____ be bought and sold in financial markets and nonmarketed claims _____.

can ; cannot

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

debt plus equity

According to M & M Proposition I , a firm's capital structure choices

do not affect the value of the firm

According to critics of Modigliani and Miller ( M & M ) , M & M capital structure theory

does not work when real - world issues are factored in

Voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties . This may involve

extension or composition

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as _____ risk .

financial

The weighted average cost of capital rises at higher levels of debt owing to

financial distress costs

Financial slack helps firms avoid

having to rely on external financing

If the degree of leverage increases , the cost of debt will

increase

In the presence of corporate taxes , the tax shield effect of debt will _____ the value of the firm .

increase

According to critics of Modigliani and Miller ( M & M ) , M & M capital structure theory is

irrelevant

The manager of a firm should change the capital structure if and only if

it increases the value of the firm

The risk of too much _____ is bankruptcy .

leverage

The value of a levered firm will be greater than the value of an identical unlevered firm because the levered firm's taxes will be :

lower

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

lower

A company should select the capital structure that

maximizes the company's value

The benefits of debt financing _______ the costs of financial distress .

may be more than offset by

The value of the firm is maximized when the weighted average cost of capital ( WACC ) is

minimized

The absolute priority rule establishes priority

of claims in liquidation

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all - equity firm

plus the tax rate times the value of debt

Under MM Proposition II , a firm's cost of equity capital is ______ related to the firm's debt - equity ratio provided the cost of capital for an all - equity firm exceeds the cost of debt .

positively

The expected return on equity is ___ to leverage .

positively related

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the

static theory of capital structure

One of the important reasons why firms choose to raise capital by issuing debt is because of the _____ benefits of debt .

tax

It is often in everyone's best interest to devise a " workout " strategy that avoids bankruptcy because

the bankruptcy process can be long and expensive

A firm's capital structure refers to

the firm's mix of debt and equity

Which of the following are nonmarketed claims to the firms cash flows ?

•Legal fees •Taxes

What are some examples of indirect financial distress costs ?

•Lost sales •Lost reputation

In the absence of taxes , the value of a firm is the same with debt financing as it is with equity financing because

•the asset to be financed is the same •MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes

Under the MM propositions with no taxes , managers cannot change the value of the firm by repackaging its securities because

•the overall cost of capital cannot be reduced •as debt is added , the equity becomes more risky

Which of the following industries tend to have low leverage ?

Drugs

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

False

True or false : In determining the optimal capital structure , managers should keep in mind that lower effective tax rates lead to greater incentives to borrowing

False

______ is the term that describes the capital structure when debt is used to finance assets .

Financial leverage

Customers refusing to buy GM cars when it filed for Chapter 11 for fear of not being able to service the cars in the future is an example of _____ costs of financial distress

indirect

Volatility or _____ increases for equity holders when leverage increases .

risk

The _____ theory has dominated thinking about capital structure for a long time .

static

The _____ theory is the dominant theory of capital structure .

static

A beneficial rule to follow is to set the firm's capital structure so that

the firm's value is maximized .

Under M & M Proposition II with no taxes , the weighted average cost of capital is invariant to the debt level because

the return on assets ( RA ) is unchanged

Which of the following industries tend to have a high leverage ?

•Airlines •Cable television

Financial distress can arise in the form of possible :

•Business failure •Legal bankruptcy

A corporation gains no value from an interest tax shield if which of the following are true ?

•Corporate tax rates are zero •The corporation has no debt •The corporation is an all - equity firm

Which of the following will apply when a firm's debt levels are extremely high ?

•The benefits of debt financing may be more than offset by the costs of financial distress •The possibility of financial distress will become a chronic problem

Under the MM propositions with no taxes , managers cannot change the value of the firm by repackaging its securities because

•as debt is added , the equity becomes more risky •the overall cost of capital cannot be reduced

Bankruptcy is very valuable due to which of the following ?

•It can be used strategically to improve a firm's competitive position •Payments to creditors cease pending the outcome of the bankruptcy process