Chapter 17 | Capital Structure

Free cash flow hypothesis

- an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities - argues that an increase in debt will reduce the ability of managers to pursue wasteful activities more effectively than dividend increases.

Given agency conflicts between shareholders and bondholders, which type of firm is likely to experience distortions in an investment policy?

A levered Firm

Which type of firm is more susceptible to selfish shareholder strategies? A firm not listed on a stock exchange A levered firm facing financial distress An all-equity firm A financially healthy firm

A levered firm facing financial distress

Who are the main claimants of a firm's cash flows? Board of directors Bondholders Stockholders Government

Bondholders Stockholders Government

How do bankruptcy costs affect bondholders and shareholders in the context of the distribution of firm value?

Both bondholders and shareholders are adversely affected

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations? Customers may not buy, fearing future service problems. The government may increase taxes on future sales. Suppliers may not supply inventory, fearing nonpayment. 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. Banks may place restrictions on the firm's financial activities.

Why do we start with internal funds first?

It's the cheapest, going to an outside source requires financing which includes fees

What are some examples of indirect financial distress costs? Lost sales Lost dividends Legal expenses Lost reputation

Lost sales, Lost reputation

What are soft costs associated with financial distress?

Management begins to focus on cost cutting measures rather than selling their business and then other firms continue to improve while the financially distressed business spirals harder

Compared to the pharmaceutical industry, the utilities industry is likely to use more debt because operating income tends to be Blank______. more volatile more stable unpredictable less stable

More stable

Tax act of 2018

Puts a limit on how much interest expenses can be taxed; why? Because it was incentivizing companies to borrow more more more of debt which pretax was all being tax deducted. Now there is a cap to how much will count toward tax deduction and more pretax will know be taxed.

Which of the following factors affect the establishment of a target debt-equity ratio? Taxes Uncertainty of operating income Type of assets, tangible or intangible Advertising budget forecasts

Taxes Uncertainty of operating income Type of assets, tangible or intangible

Which of the following is true after an LBO? The ownership pattern changes. The company is generally owned by more investors than it was previously. The company is owned by a few investors. The firm is debt-free.

The company is owned by a few investors. The ownership pattern changes.

If a firm is in financial distress, who will get paid first?

The lawyers

Who owns most of the firm after an LBO? The government The bondholders The managers The regulators

The managers

What is the difference in the limits on the payments to shareholders and bondholders? There is no difference in the limits on the payments to each group. There is no limit on the payments to bondholders; there is a fixed upper limit on the payments to shareholders. There is no limit on the payments to shareholders; there is a fixed upper limit on the payments to bondholders. The payments to shareholders cannot be more than twice the quoted interest rate on bonds.

There is no limit on the payments to shareholders; there is a fixed upper limit on the payments to bondholders.

What is the upper limit on a payment to common stockholders?

There is no upper limit

How do companies determine capital structure?

They ask questions like: Do we want to grow slowly? Do we want to grow quickly? We need to know the strategy so that we can sell the story. Includes optimistic, likely, and downside scenarios. Consider the required amount of cushion and slack

Stockholders bear the costs of bankruptcy

True

When a company needs to convince investors to invest, is there a point where offering a higher coupon rate on the money to be invested where investors don't want to invest.

Yes there is, they get spooked and eventually the company will have to fund a project using equity.

The ___ costs of equity reduces the value of the firm.

agency

In bankruptcy cases, the claims of lawyers are ___ the claims of senior bondholders.

given priority over

In a leveraged buyout (LBO), current shareholders are bought out at a price that is ___.

higher than the current market price

As debt ___, bankruptcy costs ___.

increase, increase decrease, decrease

Different creditors fighting with each other ___ bankruptcy costs.

increases

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

Protective covenants typically ___ interest rates.

lower

Profitable firms will tend to have Blank______ debt than unprofitable firms.

more

In order to understand the effect of taxes on capital structure decisions, we need to consider both corporate and ___ taxes.

personal

A ___ covenant is an agreement between bondholders and stockholders.

protective

Highly profitable firms are likely to have higher debt ratios because they can deduct interest for ___ purposes.

tax