Fin 323 Ch 16

Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings? A. interest tax shield B. interest credit C. financing shield D. current tax yield E. tax-loss interest

A. interest tax shield

The explicit costs, such as legal and administrative expenses, associated with corporate default are classified as _____ costs. A. flotation B. issue C. direct bankruptcy D. indirect bankruptcy E. unlevered

C. direct bankruptcy

Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm? A. exceptionally high depreciation expenses B. very low marginal tax rate C. substantial tax shields from other sources D. low probabilities of financial distress E. minimal taxable income

D. low probabilities of financial distress

Edwards Farm Products was unable to meet its financial obligations and was forced into using legal proceedings to restructure itself so that it could continue as a viable business. The process this firm underwent is known as a: A. merger. B. repurchase program. C. liquidation. D. reorganization. E. divestiture.

D. reorganization.

M&M Proposition I with tax supports the theory that: A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases. B. the value of a firm is inversely related to the amount of leverage used by the firm. C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. E. a firm's cost of equity increases as the debt-equity ratio of the firm decreases.

A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio increases.

The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M&M Proposition I. C. M&M Proposition II. D. the capital asset pricing model. E. the open markets theorem.

A. the static theory of capital structure.

The unlevered cost of capital refers to the cost of capital for a(n): A. private entity. B. all-equity firm. C. governmental entity. D. private individual. E. corporate shareholder.

B. all-equity firm

Which one of the following is the legal proceeding under which an insolvent firm can be reorganized? A. restructure process B. bankruptcy C. forced merger D. legal takeover E. rights offer

B. bankruptcy

A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity.

B. maximizes the value of the firm.

The basic lesson of M&M Theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. size of the stockholders' claims.

B. the total cash flow of the firm.

Bankruptcy: A. creates value for a firm. B. transfers value from shareholders to bondholders. C. technically occurs when total equity equals total debt. D. costs are limited to legal and administrative fees. E. is an inexpensive means of reorganizing a firm.

B. transfers value from shareholders to bondholders.

M&M Proposition II is the proposition that: A. the capital structure of a firm has no effect on the firm's value. B. the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C. a firm's cost of equity is a linear function with a slope equal to (RA - RD). D. the cost of equity is equivalent to the required rate of return on a firm's assets. E. the size of the pie does not depend on how the pie is sliced.

C. a firm's cost of equity is a linear function with a slope equal to (RA - RD).

A firm is technically insolvent when: A. it has a negative book value. B. total debt exceeds total equity. C. it is unable to meet its financial obligations. D. it files for bankruptcy protection. E. the market value of its stock is less than its book value.

C. it is unable to meet its financial obligations.

A business firm ceases to exist as a going concern as a result of which one of the following? A. divestiture B. share repurchase C. liquidation D. reorganization E. capital restructuring

C. liquidation

M&M Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. the cost of equity rises as leverage rises. C. the debt-equity ratio of a firm is completely irrelevant. D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the increased probability of financial distress. E. homemade leverage is irrelevant.

C. the debt-equity ratio of a firm is completely irrelevant.

Which of the following are correct according to pecking-order theory? I. Firms stockpile internally-generated cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms avoid external debt at all costs. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV

D. I, II, and IV only

Based on M&M Proposition II with taxes, the weighted average cost of capital: A. is equal to the aftertax cost of debt. B. has a linear relationship with the cost of equity capital. C. is unaffected by the tax rate. D. decreases as the debt-equity ratio increases. E. is equal to RU × (1 - TC).

D. decreases as the debt-equity ratio increases.

The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital.

E. debt-equity ratio results in the lowest possible weighted average cost of capital.

The static theory of capital structure advocates that the optimal capital structure for a firm: A. is dependent on a constant debt-equity ratio over time. B. remains fixed over time. C. is independent of the firm's tax rate. D. is independent of the firm's weighted average cost of capital. E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

E. equates the tax savings from an additional dollar of debt to the increased bankruptcy costs related to that additional dollar of debt.

Which form of financing do firms prefer to use first according to the pecking-order theory? A. regular debt B. convertible debt C. common stock D. preferred stock E. internal funds

E. internal funds

Which one of the following is a direct bankruptcy cost? A. company CEO's time spent in bankruptcy court B. maintaining cash reserves C. maintaining a debt-equity ratio that is lower than the optimal ratio D. losing a key company employee E. paying an outside accountant fees to prepare bankruptcy reports

E. paying an outside accountant fees to prepare bankruptcy reports