Business Finance Ch 13

True or false: Stockholders care most about the dividend maximization of the firm.

False

True or false: The legal process of bankruptcy is typically quick and inexpensive.

False

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

The risk of too much _______ is bankruptcy.

leverage

A firm is considered bankrupt when the value of its equity is ____ .

zero

Which of the following are direct costs of financial distress?

- Administrative expenses - Legal fees

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

- Airlines - Cable television

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

- Computers - Drugs

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

- Direct costs - Indirect costs

Financial distress can arise in the form of possible:

- Legal bankruptcy - Business failure

Bankruptcy is very valuable because:

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

Which of the following are examples of firms which filed for bankruptcy for strategic reasons?

- Texaco - Johns Manville - Continental Airlines - Dow Corning

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.

Which of the following are generally true about the cost of equity and the cost of debt?

- The cost of debt increases with leverage. - The cost of debt is generally lower than the cost of equity. - The cost of equity may increase with leverage.

A capital restructuring may include

- issuing more equity - issuing debt and repurchasing equity - issuing more debt

The tax shield afforded by debt will be of the least use to firms with ______ .

- losses carried forward - negative EBT

Rank each of the following in order of priority of payment.

1. bankruptcy administrative expenses 2. wages, salaries, and commissions 3. consumer claims 4. payment to common stakeholders

Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.

100% debt

Which costs of financial distress are easier to measure?

Direct costs

True or false: Based on MM Proposition I, even including taxes, capital structure does not matter to the firm.

False

True or false: Direct costs are very difficult to measure and, thus, are often estimated.

False

True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.

False

True or false: When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency.

False

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

Financial leverage

How is the optimal debt level is determined?

In a subjective manner

Which of the two types of costs of bankruptcy are more difficult to quantify?

Indirect costs

Which of the following is true of the impact of financial leverage?

It magnifies gains and losses

What is generally the most important component of direct bankruptcy costs?

Legal costs

How does the level of debt affect the weighted average cost of capital (WACC)?

The WACC initially falls and then rises as debt increases.

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?

The rate of return on assets is unaffected by leverage.

True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.

True

True or false: Firm value is maximized when the WACC is minimized.

True

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

True

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

assets

The fact that failure to meet debt obligations can result in bankruptcy is ______.

bad for the firm

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

bondholders

Bankruptcy costs may exceed the tax shield benefits of _________

debt

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:

debt

The cost of debt will begin to increase as the:

degree of leverage increases

The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs _____ the present value of the tax shield benefits.

equals

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

financial distress costs

The tax deductibility of interest payments is?

good for the firm

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

greater; lower

An individual can duplicate a levered firm through a strategy called ______ leverage where the investor uses his own funds plus borrowed funds to buy stocks.

homemade

With ______ ______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.

homemade leverage

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

increase

Capital structure decisions are made ______ investment decisions.

independent of

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

indirect

The cost of debt is generally ________ than the cost of equity.

lower

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

The possibility of bankruptcy costs has a(n) ______ effect on the value of the firm.

negative

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

The expected return on equity is _____ to leverage.

positively related

Volatility or ______ increases for equity holders when leverage increases.

risk

The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the _________ theory of capital structure.

static

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

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

the firm's value is maximized

The Static Theory of Capital Structure suggests employing debt to the point that its cost equals the cost of ____________________.

the increased probability of bankruptcy

The tax savings attained by a firm from the tax deductibility of interest expense is called

the interest tax shield

What are some examples of indirect financial distress costs?

- lost reputation - lost sales

An optimal capital structure will

- maximize the value of the firm - minimize the cost of capital