Ch 13

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 shareholders

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

100% debt

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

the firm's value is maximized

Under MM Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases _______________ .

the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt.

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

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?

- Indirect costs - Direct costs

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

- Johns Manville - Continental Airlines - Dow Corning - Texaco

The cost of debt will begin to increase as the:

degree of leverage increases

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

do not affect the value of the firm

According to MM Proposition I, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?

- The asset to be financed is the same. - MM demonstrated that debt financing is neither better nor worse than equity financing.

Which costs of financial distress are easier to measure?

Direct costs

The present value of the interest tax shield equals what?

TC x D

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

business risk

The risk of too much _______ is bankruptcy.

leverage

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

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

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 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 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

True or false: MM demonstrated that debt financing is neither better nor worse than equity financing.

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

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

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 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

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

false

An investor who buys the common stock of a levered firm is subject to more risk due to the addition of

financial risk

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

financial risk

The tax deductibility of interest payments is?

good for the firm

Equity carries risk thus an investor should expect a _____ return than that on less risky debt.

higher

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

Under MM 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

Bankruptcy costs may exceed the tax shield benefits of _____.

debt

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

False

True or false: Holding equity in an unlevered firm has no risk.

False

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

Bankruptcy is very valuable because:

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

Financial distress can arise in the form of possible:

- Legal bankruptcy - Business failure

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

M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___________________ .

- how the firms are financed is irrelevant - the value of the two firms is equal

What are some examples of indirect financial distress costs?

- lost sales - lost reputation

An optimal capital structure will

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

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

- negative EBT - losses carried forward

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

False

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

false

MM Proposition I does not work with corporate taxes because:

levered firms pay lower taxes than unlevered firms

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

lower

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

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

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

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

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

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

financial distress costs

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