Chapter 16 Financial Leverage and Capital: part 2

85. Eastern Markets has no debt outstanding and a total market value of $154,000. Earnings before interest and taxes, EBIT, are projected to be $12,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 27 percent higher. If there is a recession, then EBIT will be 55 percent lower. The firm is considering a $20,000 debt issue with an interest rate of 6.5 percent. The proceeds will be used to repurchase shares of stock. There are currently 2,000 shares outstanding. Ignore taxes. What will be the percentage change in EPS if the economy enters a recessionary period? A. -62 percent B. -55 percent C. -58 percent D. -71 percent E. -46 percent

a

37. Bankruptcy: A. Occurs when total equity is negative. B. Is a legal proceeding. C. Occurs when a firm cannot meet its financial obligations. D. Refers to a loss of value for debt holders. E. Is an inexpensive means of reorganizing a firm.

b

39. If a firm has the optimal amount of debt, then the: A. Direct financial distress costs must equal the present value of the interest tax shield. B. Value of the levered firm will exceed the value of the firm if it were unlevered. C. Value of the firm is minimized. D. Value of the firm is equal to VL + TC D. E. Debt-equity ratio is equal to 1.

b

41. The capital structure that maximizes the value of a firm 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

47. Corporations in the U.S. tend to: A. Minimize taxes. B. Underutilize debt. C. Rely less on equity financing than they should. D. Have relatively similar debt-equity ratios across industry lines. E. Rely more heavily on debt than on equity as the major source of financing.

b

50. Which one of the following statements related to Chapter 7 bankruptcy is correct? A. A firm 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 firm'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 are generally issued prior to the firm coming out of bankruptcy.

b

56. Paradise Travels is an all-equity firm that has 6,000 shares of stock outstanding at a market price of $34 a share. The firm's management has decided to issue $40,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 7 percent. What are the earnings per share at the break-even level of earnings before interest and taxes? Ignore taxes. A. $2.46 B. $2.38 C. $1.67 D. $1.43 E. $1.94

b

35. The interest tax shield is a key reason why: A. The required rate of return on assets rises when debt is added to the capital structure. B. The value of an unlevered firm is equal to the value of a levered firm. C. The net cost of debt to a firm is generally less than the cost of equity. D. The cost of debt is equal to the cost of equity for a levered firm. E. Firms prefer equity financing over debt financing.

c

42. The optimal capital structure: A. Will be the same for all firms in the same industry. B. Will remain constant over time unless the firm changes its primary operations. C. Will vary over time as taxes and market conditions change. D. Places more emphasis on operations than on financing. E. Is unaffected by changes in the financial markets.

c

49. A firm is technically insolvent when: A. It has a negative book value. B. Total debt exceeds 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

92. KN&J expects its EBIT to be $138,000 every year forever. The firm can borrow at 10 percent. KN&J currently has no debt and its cost of equity is 17.2 percent. The tax rate is 35 percent. What will the value of KN&J be if the firm borrows $50,000 and uses the loan proceeds to repurchase shares? A. $571,512 B. $346,600 C. $539,012 D. $578,900 E. $381,588

c

40. Which one of the following has the greatest tendency to increase the percentage of debt included in the optimal capital structure of a firm? A. Exceptionally high depreciation expenses. B. Very low marginal tax rate. C. Substantial tax shields from other sources. D. Low probability of financial distress. E. Minimal taxable income.

d

46. Which one of the following is correct according to pecking-order theory? A. There is a direct relationship between a firm's profit and its debt levels. B. Firms avoid external debt except as a last resort. C. A firm's capital structure is independent of its need for external funding. D. Firms stockpile internally generated cash. E. There is an optimal capital structure for every firm.

d

52. Which one of these statements related to Chapter 11 bankruptcy is correct? A. Prepacks apply only to Chapter 7, not Chapter 11 bankruptcies. B. Senior management must be replaced prior to firm exiting Chapter 11. C. A firm can only file for Chapter 11 after it becomes totally insolvent. D. Firms may file for Chapter 11 in an attempt to gain a competitive advantage. E. Chapter 11 involves the total liquidation of a firm.

d

53. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: A. Permits creditors to file a prepack immediately after a firm files for bankruptcy protection. B. Prevents creditors from submitting any reorganization plans. C. Prevents firms from filing for bankruptcy protection more than once. D. Permits key employee retention plans only if an employee has another job offer. E. Allows firms to pay bonuses to all key employees to entice those employees to remain in the firm's employ.

d

34. The present value of the interest tax shield is expressed as: A. (TC D) / RA.. B. VU + (TC D). C. [EBIT (TC D)] / RU. D. [EBIT (TC D)] / RA. E. TC D.

e

38. Which one of the following is a direct cost of bankruptcy? A. Bypassing a positive NPV project to avoid additional debt. B. Firm investing in cash reserves. C. Maintaining a debt-equity ratio that is lower than the optimal ratio. D. Losing a key company employee. E. Paying an outside accountant to prepare bankruptcy reports.

e

43. The static theory of capital structure advocates that the optimal capital structure for a firm: A. Is highly dependent on a constant debt-equity ratio over time. B. Remains fixed over time. C. Is independent of the firm's tax rate. D. Is independent of the firm's debt-equity ratio. E. Equates the tax savings from an additional dollar of debt to the increased bankruptcy costs.

e

45. Which form of financing do firms prefer to use first according to the pecking-order theory? A. Regular debt B. Convertible debt C. Common stock D. Preferred stock E. Internal funds

e

48. In general, the capital structures used by U.S. firms: A. Tend to overweigh debt in relation to equity. B. Generally result in debt-equity ratios between .45 and .60. C. Are fairly standard for all SIC codes. D. Tend to be those that maximize the use of the firm's available tax shelters. E. Vary significantly across industries.

e

51. Which one of the following will generally have the highest priority when assets are distributed in a bankruptcy proceeding? A. Consumer claims. B. Dividend payment to preferred shareholders. C. Company contribution to the employees' retirement account. D. Payment to an unsecured creditor. E. Payment of employee wages.

e