Corporate Finance Chapter 13

______ is the term that describes the capital structure when debt is used to finance assets.

Financial leverage

Firm value is maximized when the WACC is minimized

True

The tax savings attained by a firm from the tax deductibility of interest expense is called

the interest tax shield

Based on MM Proposition I with corporate taxes, the optimal capital structure is ________.

100% debt

Which two of the following are broad types of costs of financial distress?

Direct costs Indirect costs

Which of the following industries tend to have a low leverage?

Drugs Computers

Based on MM Proposition I, even including taxes, capital structure does not matter to the firm.

False

Holding equity in an unlevered firm has no risk.

False

There is a precise mathematical equation for determining the optimal level of debt for any firm

False

When total book liabilities exceed the book value of the total assets, a firm is said to have reached fallen angel insolvency

False

The tax deductibility of interest payments is?

Good for the firm

Which of the two types of costs of bankruptcy are more difficult to quantify?

Indirect costs

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.

Which of the following is true of the impact of financial leverage?

It magnifies gains and losses

According to MM Proposition I, the value of a firm is the same for debt financing as it is for equity financing because of which of the following?

MM demonstrated that debt financing is neither better nor worse than equity financing. The asset to be financed is the same.

The present value of the interest tax shield equals what?

TC x D

How does the level of debt affect the weighted average cost of capital (WACC)?

The WACC initially falls and then rises as debt increases.

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)?

The rate of return on assets is unaffected by leverage.

It is possible for the present value of distress costs to exceed the present value of tax savings.

True

MM demonstrated that debt financing is neither better nor worse than equity financing.

True

What is the expression for the value of a levered firm in the presence of corporate taxes?

Value of Levered Firm = Value of Unlevered Firm + Tax Benefit of Debt

A firm is considered bankrupt when the value of its equity is ____ .

Zero

An investor who invests in the stock of a levered firm rather than in an all-equity firm will require ___.

a higher expected return

The fact that failure to meet debt obligations can result in bankruptcy is ______.

bad for the firm

Bankruptcy costs may exceed the tax shield benefits of ________.

debt

The value of a levered firm is higher than the value of an unlevered firm in the presence of corporate taxes owing to the tax shield benefit of:

debt

The cost of debt will begin to increase as the:

degree of leverage increases

According to M&M Proposition I, a firm's capital structure choices:

do not affect the value of the firm

The optimal level of debt in the presence of corporate taxes and bankruptcy costs occurs at the point at which the present value of distress costs _____ the present value of the tax shield benefits.

equals

The weighted average cost of capital rises at higher levels of debt owing to:

financial distress costs

An investor who buys the common stock of a levered firm is subject to more risk due to the addition of

financial risk

The equity risk that comes from the financial policy or capital structure decisions of the firm is known as:

financial risk

Equity carries risk thus an investor should expect a ________, Correct Unavailable return than that on less risky debt.

higher

M&M Proposition I states if the assets and operations (left-hand side of the balance sheet) for two firms are the same, then ___________________

how the firms are financed is irrelevant the value of the two firms is equal

If the degree of leverage increases, the cost of debt will ______

increase

Capital structure decisions are made ______ investment decisions.

independent of

MM Proposition I does not work with corporate taxes because:

levered firms pay lower taxes than unlevered firms

A beneficial rule to follow is to set the firm's capital structure so that ___.

the firm's value is maximized

Under MM Proposition II, a firm's WACC remains unchanged regardless of changes in its capital structure because as the % of debt increases _______________

the increase in the cost of both debt and equity is exactly offset by the increase in the % of lower cost debt.

Under MM Proposition II with no taxes, the weighted average cost of capital is invariant to the debt level because:

the return on assets (RA) is unchanged

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 ______.

Lower

What are some examples of indirect financial distress costs?

Lost reputation Lost Sales

With ______ ______, an investor is able to replicate a corporation's capital structure by borrowing funds and using those funds along with their own money to buy the company's stock.

homemade leverage

The cost of debt is generally _______ than the cost of equity.

lower

An optimal capital structure will

maximize the value of the firm minimize the cost of capital

The value of a levered firm in MM Proposition I with corporate taxes equals the value of an all equity firm:

plus the tax rate times the value of debt

Volatility or ______ increases for equity holders when leverage increases

risk

t is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because:

the bankruptcy process can be long and expensive

An individual can duplicate a levered firm through a strategy called ______ leverage where the investor uses his own funds plus borrowed funds to buy stocks.

homemade

The idea that a firm borrows to the point that the tax benefit of debt is exactly equal to the increased probability of financial distress is called the _________ theory of capital structure.

trade-off