Ch 16
Care Corporation has issued both debt and equity. It has an annual debt obligation of $30 toward interest and principal. Care corporation is forecasting a cash flow of either $25 (scenario 1) or $50 (scenario 2) in the coming year. What will be the payment to bondholders in the two scenarios?
$25 in scenario 1 and $30 in scenario 2
If ABC Co. has earnings before interest and taxes of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders of the interest rate is 10 percent and the tax rate is 21 percent?
(.1 * $5mil) + [$2mil(.1 * $5mil)(1-.21) = $1,685,000
Under the MM proposition 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
What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?
-banks may place restrictions on the firm's financial activities -customers may not buy, fearing future service problems -suppliers may not supply inventory, fearing nonpayment
Which of the following industries tend to have a high leverage?
-cable television -airlines
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
What are the advantages of using internal financing?
-it may be cheaper than debt or equity issues -it prevents the adverse market reaction that tends to accompany a stock issue
Which of the following will apply when a firm's debts 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
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
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 are consequences of nonpayment of debt obligations?
-the firm will encounter some form of financial distress -a firm may be forced to file for bankruptcy
Omega Corp. has $20 mil in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 21%. What is the present value of the tax shield?
.21 * $20 mil = $4.2 mil
Rank in order of priority of payment starting with the highest priority to lowest priority.
1. Bankruptcy administrative expenses 2. Wages, salaries, and commissions 3. Consumer claims 4. Payment to common shareholders
Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12%. If the tax rate is 21%, what is the value of the firm?
65.83 million $10mil(1-.21)/.12 = 65.83 mil
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
Under pecking order theory, firms can choose between debt or financing for external financing, which will they prefer?
Debt
Which two of the following are broad types of costs of financial distress?
Direct and indirect
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
Which of the following assumptions is necessary for the MM Proposition to hold?
Individuals can borrow on their own at an interest rate equal to that of the firm
The manager of a firm should change the capital structure if and only if
It increases the value of the firm
What is generally the most important component of direct costs?
Legal Costs
which of the following are non marketed claims to the firms cash flows?
Legal fees and taxes
The risk of too much ____ is bankruptcy
Leverage
MM Proposition I does not work with corporate taxes because
Levered firms pay lower taxes than unlevered firms
What are some examples of indirect financial distress costs?
Lost sales and lost reputation
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
How does the level of debt affect the WACC?
The WACC initially falls and then rises as debt increases
It is often in everyone's best interest to decide a "workout" strategy that avoids bankruptcy because
The bankruptcy process can be long and expensive
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
An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ____
higher expected return
MM Proposition II shows that
the cost of equity rises with leverage
Place the steps needed to calculate the value of a levered firm with perpetual cash flows in order starting with the first step
1. Calculate EBIT 2. Multiply EBIT by 1 minus the corporate tax rate 3. Divide by the cost of equity for an all-equity firm 4. Add the present value of the debt tax shield
A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8 percent, and a cost of equity of 12%. What is the firm's WACC if there are no taxes?
11.05% (16000/21000)x12%+(5000/21000)x8%=11.05%
If the current share price of an all-equity firm is $25, going to a capital structure with 50% debt and 50% equity will result in a new share price of _____ when ignoring the impact of taxes
25
What is the preferred source of financing for firms according to the pecking-order theory?
1. Retained earnings 2. Debt 3. Common stock
An individual can duplicate a levered firm through a strategy called ____ where the investor uses his own funds plus borrowed funds to buy stocks
Homemade leverage
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
A company should select a capital structure that
Maximizes the company's value
The value of the firm is maximized when the weighted average cost of capital (WACC) is:
Minimized
The expected return on equity is ____ to leverage
Positively related
What is the effect of possible bankruptcy costs on the value of a firm?
They reduce the value of the firm
Which costs of financial distress are easier to measure?
Direct costs
The value of the firm is given by the following expression:
Firm value = value of equity + value of debt
An unlevered firm
Has an all-equity capital structure
The cost of equity is generally
Higher than the cost of debt
Which capital structure theory suggests that profitable firms will use less debt?
The pecking-order theory
What are the two components of the static theory?
The tax benefits of debt and the costs of financial distress
MM Proposition I (with taxes)
The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.
What do Modigliani and Miller assert about the relationship between leverage and firm value in the presence of corporate taxes?
The value of the firm increases with leverage
a beneficial rule to follow is to set the firms capital structure so that
the firm's value is maximized
In absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because
-MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes -the asset to be financed is the same
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?
-the rate of return on assets is unaffected by leverage -below the indifference or break-even point in EBIT, an unlevered capital structure is best -financial leverage increases the slope of the EPS line
