FINA 4315 - Chapter 6

In general, the capital structures used by non-financial U.S. firms

vary significantly across industries.

Under the simplifying assumptions of Modigliani and Miller, an increase in a firm's financial leverage will

increase the variability in earnings per share.

The best financing choice is the one that

maximizes expected cash flows.

Homemade leverage is

the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

The basic lesson of the M&M theory is that the value of a firm is dependent upon

the total cash flow of the firm.

In some instances, additional debt financing can encourage managers to act more in the interests of owners.

True

Inflation benefits borrowers only if the inflation is unexpected.

True

The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity.

True

When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.

True

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance?

$560,000

JKL Corporation has a projected times-interest-earned ratio of 4.0 for next year. What percentage could EBIT decline next year before JKL's times-interest-earned ratio would fall below 1.0?

75%

When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)?

ABC's cash flows from operations are less volatile than XYZ's.

According to the pecking order theory of capital structure, why do firms avoid issuing equity?

Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

Which of the following is NOT likely to be a prudent financing policy for a rapidly growing business?

Borrow funds rather than limit growth, thereby limiting growth only as a last resort.

If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk.

False

The M&M irrelevance proposition assures financial managers that their choice between equity and debt financing will ultimately have no impact on firm value.

False

The interest tax shield reduces a firm's taxes by the amount of interest on its debt.

False

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility

I and III only

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility

I and III only

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk

I and III only

The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed but not bankrupt IV. Indirect costs related to being financially distressed but not bankrupt

I, II, III, and IV

According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources, such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing.

I, II, and IV only

The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage

I, III, and IV only

Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility

II and IV only

Financial leverage I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners.

II, III, and IV only

Which of the following would NOT be considered a cost of financial distress?

Lack of interest tax shields

Which of the following is NOT an implication of the pecking order theory of capital structure?

More-profitable firms (all else equal) should have higher debt ratios.

Which of the following statements regarding interest tax shields is correct?

Taxable income is reduced by the amount of the interest on a firm's debt.

Debt financing results in lower after-tax earnings relative to equity financing.

True

If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk.

True

If the return on invested capital is greater than the after-tax interest rate, then a higher debt-to-equity ratio increases return on equity.

True