Ch. 16: Financial Leverage and Capital Structure Policy

T/F: In the extended pie model, bankruptcy costs are a claim on cash flows of the firm.

True

A beneficial rule to follow is to set the firm's capital structure so that ___. a. the firm's value is maximized b. dividends are maximized c. the firm's bondholders are satisfied d. the firm's value is minimized

a

According to critics of Modigliani and Miller (M&M), M&M capital structure theory ____. a. does not work when real-world issues are factored in b. is flawed because it factors in ten main real-world issues c. is overly concerned with only three real-world issues

a

According to the Tax Cuts and Jobs Act of 2017, after 2021, the net interest deduction drops to what percent of EBIT? a. 30 b. 0 c. 50 d. 100

a

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___. a. a higher expected return b. collateral assets c. guaranteed dividends. d. stock options

a

During bankruptcy, the ownership of the firm's assets is transferred from stockholders to ___. a. bondholders b. equity holders c. stakeholders d. federal agencies

a

If the degree of leverage increases, the cost of debt will ______. a. increase b. stagnate c. decrease

a

In 2019, the net interest deduction is limited to what percent of EBITDA? a. 30 b. 0 c. 50 d. 100

a

Stockholders and bondholders _____. a. are not the only claimants to the cash flows of the firm b. are the only claimants to the cash flows of the firm c. can take the entire pie regardless of capital structure d. should not worry about government claims to the cash flows of the firm

a

The absolute priority rule establishes priority _____. a. of claims in liquidation b. of manager election to the firm's board c. in share purchasing during an IPO d. which firm to use as a pure play when calculating WACC

a

The two broad types of costs of financial distress are ___ costs. a. direct and indirect b. potential and realized c. implied and inferred d. paid and unpaid

a

Which of the following industries tend to have low leverage? a. Drugs b. Airlines c. Cable television

a

Which of the following are nonmarketed claims to the firms cash flows? (select all that apply) a. Legal fees b. Taxes c. Interest payments d. Dividend payments

a, b

Bankruptcy is very valuable due to which of the following? a. Payments to creditors cease pending the outcome of the bankruptcy process. b. It makes capital structure policy irrelevant in terms of firm valuation. c. It can be used strategically to improve a firm's competitive position.

a, c

What are some examples of indirect financial distress costs? (select all that apply) a. Lost sales b. Legal expenses c. Lost reputation d. Lost dividends

a, c

A company should select the capital structure that _____. a. has the lowest leverage b. maximizes the company's value c. results in the lowest debt d. results in the lowest taxes

b

A firm's capital structure refers to ___. a. how the firm invests its capital b. the firm's mix of debt and equity c. the amount of capital in the firm d. the amount of cash in a firm

b

According to the pecking order theory, what is the preferred source for firms seeking to raise capital? a. An equity issue b. Retained earnings c. A debt issue d. The federal government

b

Financial slack helps firms avoid ___. a. the misuse of funds b. having to rely on external financing c. having to rely on internal financing d. free cash flow

b

In the presence of corporate taxes, the tax shield effect of debt will ____ the value of the firm. a. initially increase and then decrease b. increase c. decrease d. initially decrease and then increase

b

It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because _____. a. nobody wins in a bankruptcy proceeding b. the bankruptcy process can be long and expensive c. the financially distressed firm can take advantage of creditors more easily in a "workout" d. loan contracts can never be altered once they are put in place

b

The benefits of debt financing _____ the costs of financial distress. a. are typically equal to b. may be more than offset by c. are never offset by

b

Under M&M Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because ___. a. the return on assets (RA) is lower b. the return on assets (RA) is unchanged c. the return on debt (RD) declines d. taxes are invariant to debt

b

Under MM Proposition II, a firm's cost of equity capital is ______ related to the firm's debt-equity ratio provided the cost of capital for an all-equity firm exceeds the cost of debt. a. not b. positively c. indirectly d. negatively

b

What are the two components of the static theory? a. High equity and low equity b. The tax benefits of debt and the costs of financial distress c. High leverage and low leverage d. The tax benefits of financial distress and the cost of debt

b

Which of the following will apply when a firm's debt levels are extremely high? a. The costs of financial distress may be more than offset by the benefits of debt financing. b. The possibility of financial distress will become a chronic problem. c. The benefits of debt financing may be more than offset by the costs of financial distress. d. The value of the firm will grow exponentially as debt levels continue to increase.

b, c

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. a. unlikely b. direct c. indirect d. retributive

c

How do predictions for leverage by profitable firms differ under the pecking order theory and the static theory? a. Both theories predict equal leverage for profitable firms b. Pecking theory predicts no leverage while static theory predicts 100% leverage c. Pecking order theory predicts that profitable firms will use less leverage. d. Pecking order theory predicts that profitable firms will use more leverage.

c

One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt. a. stabilizing b. safety c. tax

c

The risk of too much _______ is bankruptcy. a. equity b. publicity c. leverage d. success

c

Volatility or ______ increases for equity holders when leverage increases. a. yield-to-maturity b. certainty c. risk d. inevitability

c

Voluntary arrangements to restructure a company's debt to avoid bankruptcy may be beneficial to all involved parties. This may involve _____. a. composition or drafting b. comparison or externalization c. extension or composition d. extension or capitalism

c

Which of the following assumptions is necessary for MM Proposition I to hold? a. Interest rates must be low. b. Managers must be acting to maximize the value of the firm. c. Individuals can borrow on their own at an interest rate equal to that of the firm. d. Personal taxes must be lower than corporate taxes.

c

Which of the following is not a reason that bankruptcy may be valuable to a company? a. Payments to creditors cease pending the outcome of the bankruptcy process. b. It can be used strategically to improve a firm's competitive position. c. It generally instills greater confidence among a firm's main customers.

c

Why is MM's assertion about the positive relationship between firm value and leverage not observed in the real world? a. MM did not consider dividend costs. b. MM did not consider the debt tax shield. c. MM did not consider bankruptcy costs.

c

T/F: MM's assertion of a positive relationship between firm value and leverage is widely observed in the business world.

False

T/F: In determining the optimal capital structure, managers should keep in mind that lower effective tax rates lead to greater incentives to borrowing.

False (higher effective tax rates lead to greater incentive to borrowing)

Which capital structure theory suggests that profitable firms will use less debt? a. The pecking order theory b. The trade-off theory c. The debt capacity theory d. The theory of leverage

a

Which of the following is likely to be true when a bankruptcy ruling is issued? a. The ownership of assets is transferred from the shareholders to the bondholders. b. The ownership of assets is transferred from the bondholders to the shareholders. c. There is no change in the ownership of assets. d. The ownership of assets is transferred from the shareholders to the federal government.

a

Who is likely to have the most information about a firm's future prospects? a. The firm's manager b. The firm's debtholders c. The typical investor d. The SEC

a

A corporation gains no value from an interest tax shield if which of the following are true? (select all that apply) a. The corporation is an all-equity firm. b. Corporate tax rates are zero. c. The debt-equity ratio is 1. d. The corporation has no debt.

a, b, d

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because __. (select all that apply) a. the overall cost of capital cannot be reduced b. capital structures are fixed c. debt is not cheaper than equity d. as debt is added, the equity becomes more risky

a, d

The manager of a firm should change the capital structure if and only if ___. a. the value of the debt exceeds the value of the equity b. it increase the value of the firm c. it decrease the value of the firm d. it benefits management

b

The value of the firm is given by the following expression _____. a. firm value = value of equity + value of assets b. firm value = value of equity + value of debt c. firm value = value of equity d. firm value= value of assets - value of debt

b

The main difference between marketed and nonmarketed claims is that marketed claims ____________ (can/cannot) be bought and sold in financial markets and nonmarketed claims ___________ (can/cannot).

can; cannot

According to M&M Proposition I, a firm's capital structure choices _____. a. can only be considered in light of their affect on firm value b. result in less ambiguity c. change the value of the firm d. do not affect the value of the firm

d

According to critics of Modigliani and Miller (M&M), M&M capital structure theory is _____. a. object oriented b. highly relevant in the real world c. practical d. irrelevant

d

How does the level of debt affect the weighted average cost of capital (WACC)? a. The WACC always increases as debt increases. b. The WACC always falls as debt increases. c. The WACC initially rises and then falls as debt increases. d. The WACC initially falls and then rises as debt increases.

d

The costs of financial distress depend mostly on how easily the ownership of the firm's ________ can be transferred. a. liabilities b. debt c. equity d. assets

d

The equity risk that comes from the nature of a firm's operating activities is known as _____ risk. a. financial b. stand-alone c. portfolio d. business

d

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 ______. a. audited b. deferred c. higher d. lower

d

The value of the firm is maximized when the weighted average cost of capital (WACC) is ____________ (minimized/maximized)..

minimized

The ____________ theory is the dominant theory of capital structure.

static

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as _____ risk. a. stand-alone b. portfolio c. financial d. business

c

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all-equity firm ___. a. plus the tax rate times the value of debt b. times the tax rate plus the value of debt c. minus the tax rate times the value of debt d. times the tax rate times the value of debt

a

The value of the firm is maximized when the weighted average cost of capital (WACC) is _____. a. minimized b. increasing at a decreasing rate c. higher than the industry average d. maximized

a

______ is the term that describes the capital structure when debt is used to finance assets. a. Financial leverage b. Long-term liability c. Opportunity costs d. Shareholder equity

a

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as _____ risk. a. business b. financial c. stand-alone d. portfolio

b

The expected return on equity is _____ to leverage. a. negatively related b. positively related c. unrelated

b

What is the most important benefit of debt? a. It lowers financial distress costs. b. It provides a tax benefit. c. It reduces the probability of bankruptcy. d. It increases taxes.

b

Which of the following are consequences of nonpayment of debt obligations? a. Debt obligations will be repaid by the FDIC. b. A firm may be forced to file for bankruptcy. c. A firm may be taken over by the local government. d. The firm will encounter some form of financial distress

b, d

Based on the static theory, what should the managers attempt to maximize and minimize while developing capital structure policy? a. Maximize equity and minimize debt b. Maximize debt and minimize equity c. Minimize the tax shield benefit of debt and maximize financial distress costs d. Maximize the tax shield benefit of debt and minimize financial distress costs

d

The ______ theory has dominated thinking about capital structure for a long time. a. break-even b. leverage c. pecking order d. static

d

The weighted average cost of capital rises at higher levels of debt owing to _____. a. higher dividend costs b. excess free cash flow c. higher working capital d. financial distress costs

d

Which of the following is not a possible cause of financial distress? a. Technical insolvency b. Legal bankruptcy c. Business failure d. Accounting regression

d