Chapter 16 - Corporate Finance

What are 2 ways we can maximize stockholder wealth?

1. Maximizing the value of the firm 2. Minimizing the WACC

When there are taxes but no bankruptcy costs, what is the optimal capital structure?

100% debt

By increasing its interest expense by $2,500 last year, Bishara Foods was able to reduce its taxes by $525. This $525 amount is called the: A) interest tax shield. B) interest credit. C) homemade leverage shield. D) current tax yield. E) tax-loss interest.

A

The capital structure that maximizes the value of a company also: A) minimizes financial distress costs. B) minimizes the cost of capital. C) maximizes the present value of the tax shield on debt. D) maximizes the value of the debt. E) maximizes the present value of the bankruptcy costs.

B

The value of a firm is equal to the sum of?

the firm's debt and equity (bonds and stocks)

In general, the capital structures of U.S. firms: A) tend to overweigh debt in relation to equity. B) generally result in debt-equity ratios between .45 and .55. C) are fairly standard for all SIC codes. D) tend to exceed a debt-equity ratio of .45. E) vary significantly across industries.

E

What does a company financial leverage depend on?

EBIT, when EBIT is high, leverage is beneficial

How can a firm increase leverage?

Issuing debt and repurchasing outstanding shares

When there are no taxes and no bankruptcy costs, what happens to firm value and WACC due to financial leverage?

firm value: no effect, cash flows don't change WACC: no effect, as you borrow more, equity becomes riskier

A firm should select the capital structure that: A) produces the highest cost of capital. B) maximizes the value of the firm C) minimizes taxes. D) is fully unlevered. E) equates the value of debt with the value of equity.

B

According to ________, the value of a company is unrelated to its capital structure. A) the homemade leverage principle B) M&M Proposition I, no tax C) M&M Proposition II, no tax D) the pecking-order theory E) the static theory of capital structure

B

Bankruptcy: A) occurs when total equity is negative. B) is a legal proceeding. C) occurs when a company cannot meet its financial obligations. D) refers to a loss of value for debt holders. E) is an inexpensive means of reorganizing a company.

B

Which one of the following statements related to Chapter 7 bankruptcy is correct? A) A company in Chapter 7 bankruptcy is reorganizing its operations such that it can return to being a viable concern. B) Under a Chapter 7 bankruptcy, a trustee will assume control of the company's assets until those assets can be liquidated. C) Chapter 7 bankruptcies are always involuntary on the part of the firm. D) Under a Chapter 7 bankruptcy, the claims of creditors are paid prior to the administrative costs of the bankruptcy. E) Chapter 7 bankruptcy allows a firm to restructure its equity such that new shares of stock can be issued.

B

A company is technically insolvent when: A) it has a negative book value. B) its total debt exceeds its total equity. C) it is unable to meet its financial obligations. D) it files for bankruptcy protection. E) the market value of its stock is less than its book value.

C

According to ________, the cost of equity capital is directly and proportionally related to capital structure. A) the static theory of capital structure B) M&M Proposition I C) M&M Proposition II D) the homemade leverage principle E) the pecking-order theory

C

In an effort to avoid bankruptcy, a firm may incur certain costs, called ________ costs. A) flotation B) direct bankruptcy C) indirect bankruptcy D) financial solvency E) capital structure

C

M&M Proposition I with no tax supports the argument that: A) business risk has no effect on the return on assets. B) the cost of equity rises as leverage rises. C) a company's debt-equity ratio is completely irrelevant. D) business risk is irrelevant. E) homemade leverage is irrelevant.

C

M&M Proposition II, without taxes, is the proposition that: A) the capital structure of a company has no effect on that company's value. B) the cost of equity depends on the return on debt, the debt-equity ratio, and the tax rate. C) a company's cost of equity is a linear function with a slope equal to (RA − RD). D) the cost of equity is equivalent to the required rate of return on assets. E) the size of the pie does not depend on how the pie is sliced.

C

M&M Proposition I with taxes is based on the concept that: A) the optimal capital structure is the one that is totally financed with equity. B) capital structure is irrelevant because investors and companies have differing tax rates. C) WACC is unaffected by a change in the company's capital structure. D) the value of a taxable company increases as the level of debt increases. E) the cost of equity increases as the debt-equity ratio increases.

D

________ risk is the type of equity risk that is most related to the daily operations of a firm. A) Extrinsic B) Market C) Systematic D) Business E) Financial

D

According to the pecking-order theory, firms prefer to use ________ before any other form of financing. A) regular debt B) convertible debt C) common stock D) preferred stock E) internal funds

E

The absolute priority rule determines: A) when a firm must be declared officially bankrupt. B) how a distressed firm is reorganized. C) which judge is assigned to a particular bankruptcy case. D) how long a reorganized firm is allowed to remain under bankruptcy protection. E) which parties receive payment first in a bankruptcy proceeding.

E

________ risk is the type of equity risk related to a firm's capital structure policy. A) Market B) Systematic C) Static D) Business E) Financial

E

What is the pecking-order theory?

Firms prefer to issue debt rather than equity if internal financing is insufficient

What is the relationship between EBIT and the break-even point?

If EBIT > break-even, leverage is beneficial to stockholders and vice versa

What is capital restructuring?

It involves changing the amount of leverage a firm has without changing the firm's assets

What does leverage do to equity?

It makes it more risky

When there are taxes and bankruptcy costs, what is the optimal capital structure?

Part debt and part equity, it occurs where the benefit from an additional dollar of debt is offset by the increase in expected bankruptcy costs

What is financial distress?

Significant problems in meeting debt obligations

When there are no taxes or bankruptcy costs, what is the optimal capital structure?

There is none

When there are corporate taxes and bankruptcy costs, what happens to firm value and WACC due to financial leverage?

firm value: Increases to a certain point, then decreases WACC: Decreases to a certain point, then increases

When there are corporate taxes and no bankruptcy costs, what happens to firm value and WACC due to financial leverage?

firm value: the more you borrow, higher the firm value since interest in tax deductible WACC: It decreases

How can a firm decrease leverage?

issuing new shares and retiring outstanding debt

Homemade leverage

the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed