Financial Management & Policy - Ch 16

If the current share price of an all-equity firm is $25, going to a capital structure with 50% debt and 50% equity will result in a new share price of _____ when ignoring the impact of taxes?

$25

If ABC Co. has EBIT of $2 million with debt of $5 million, what is the total cash flow to bondholders and stockholders if the interest rate is 10% and the tax rate is 21%?

**$1,685,000 >>EBIT - interest = EBT ~2,000,000 - (5,000,000*0.10) = 1,500,000 >>EBT - taxes = NI ~1,500,000 - (1,500,000*0.21) = 1,185,000 >>NI + Interest Tax Shield ~1,185,000 + (D*T) ~1,185,000 + (5,000,000*0.10*0.21) = WRONG -$1,500,000 -$975,000 -$1,975,000

Care Corp. has issued both debt and equity. it has an annual debt obligation of $30 toward interest and principal. Care corporation is forecasting a cash flow of either $25 (scenario 1) or $50 (scenario 2) in the coming year. What will be the payment to bondholders in the two scenarios?

**$25 in scenario 1 and $30 in scenario 2 -$25 in scenario 1 and $50 in scenario 2 -$25 in both scenarios -$30 in both scenarios

In a world without bankruptcy costs or taxes, the value of the firm (the pie) is divided among which of the following?

**bondholders **stockholders -the government -lawyers

Bankruptcy is very valuable because:

**payments to creditors cease pending the outcome of the bankruptcy process **it can be used strategically to improve a firm's competitive position -it makes capital structure policy irrelevant in terms of firm valuation

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 -minus the tax rate times the value of debt -times the tax rate times the value of debt -times the tax rate plus the value of debt

Omega Corp. has $20 million in perpetual debt outstanding with a coupon rate of 8%. The tax rate is 21%. What is the present value of the tax shield?

**$4.2 million >>PV = D*T = 20*0.21 = 4.2 -$50 million -%1.6 million -$0

Solid Rock is an unlevered firm with an EBIT of $10 million and an unlevered cost of capital of 12%. If the tax rate is 21%, what is the value of the firm?

**$65.83 million >>Vu=EBIT*(1-T)/Ru >>Vu=10,000,000*(1-0.21)/0.12 = 665,833,333.33 -$22 million -$83.33 million -$6 million

In 2019, the net interest deduction is limited to what percent of EBITDA?

**30 -0 -50 -100

Which costs of financial distress are easier to measure?

**direct costs -both costs are easy to measure -indirect costs -both costs are impossible to measure

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 -minimizes -maximizes

True or false: Holding equity in an unlevered firm has no risk.

**false

True or false: There is a precise mathematical equation for determining the optimal level of debt for any firm.

**false

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

**financial leverage -shareholder equity -long-term liability -opportunity costs

Financial distress can arise in the form of possible:

**legal bankruptcy **business failure -technical solvency -accounting exactitude

What is generally the most important components of direct costs?

**legal costs -lost sales -penalties on leases -unpaid taxes

Which of the following are nonmarketed claims to the firms cash flows?

**legal fees **taxes -dividend payments -interest payments

The risk of too much _____ is bankruptcy.

**leverage -equity -success -publicity

Based on the static theory, what should manager attempt to maximize and minimize while developing capital structure policy?

**maximize the tax shield benefit of debt and minimize the financial distress costs -maximize debt and minimize equity -maximize equity and minimize debt -minimize the tax shield benefit of debt and maximize the financial distress costs

The value of the firm is maximized when the WACC is:

**minimized -higher than the industry average -increasing at a decreasing rate -maximized

If a firm issues new equity, investors will infer that the firm's outstanding stock must be _____.

**overvalued -priced correctly -undervalued

How do predictions for leverage by profitable firms differ under the pecking order theory and the static theory?

**pecking order theory predicts that profitable firms will use less leverage -pecking order theory predicts that profitable firms will use more leverage -pecking theory predicts no leverage while static theory predicts 100% leverage -both theories predict equal leverage for profitable firms

Under MM Proposition II, a firm's cost of equity capital is _____ related to the firm's debt-equity ratio.

**positively -not -indirectly -negatively

Financial distress costs will _____ the value of the firm.

**reduce -muddy -enhance -increase

Volatility or _____ increases for equity holders when leverage increases.

**risk -yield-to-maturity -inevitability -certainty

An increase in the value of a previously all-equity firm occurs when debt is borrowed to repurchase stock because:

**shareholders capture the interest tax shield -shareholders prefer levered firms -debt has the same cost as equity -debt reduces the cost of equity

a beneficial rule to follow is to set the firms capital structure so that _____.

**the firm's value is maximized -the firm's bondholders are satisfied -dividends are maximized -the firm's value is minimized

Which of the following will apply when a firm's debt levels are extremely high?

**the possibility of financial distress will become a chronic problem **the benefits of debt financing may be more than offset by the costs of financial distress -the costs of financial distress may be more than offset by the benefits of debt financing -the value of the firm will grow exponentially as debt levels continue to increase

Rank each of the following in order of priority payment starting with the highest priority item to lowest priority item.

1. bankruptcy administrative expenses 2. wages, salaries, and commissions 3. consumer claims 4. payment to common shareholders

Calculate the cost of capital for an all-equity firm with equity of $12,500 and expected earnings of $1,900.

**15.2% >>1,900/12,500 = 0.152 -6.6% -16.5% -14.4%

What is financial slack?

**it is the excess cash accumulated by the firm -it is the difference between total equity and total debt -it is the deficit in long-term working capital requirements -it is the deficit in working capital requirements

Who is likely to have the most information about a firm's future prospects?

**the firm's manager -the SEC -the typical investor -the firm's debtholders

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

**airlines **cable television -drugs -computers

How does the level of debt affect the WACC?

**the WACC initially falls and then rises as debt increases -the WACC always falls as debt increases -the WACC initially rises and then falls as debt increases -the WACC always increases as debt increases

In the absence of taxes, the value of a firm is the same with debt financing as it is with equity financing because _____.

**the asset is to be financed is the same **MM demonstrated that debt financing is neither better nor worse than equity financing in the absence of taxes -debt financing is actually better than equity financing -equity financing is actually better than debt financing

It is often in everyone's best interest to devise a "workout" strategy that avoids bankruptcy because:

**the bankruptcy process can be long and expensive -loan contracts can never be altered once they are put in place -nobody wins in a bankruptcy proceeding -the financially distressed firm can take advantage of creditors more easily in a "workout"

A firm's capital structure refers to _____.

**the firm's mix of debt and equity -how the firm invests its capital -the amount of capital in the firm -the amount of cash in a firm

A company with a debt-to-equity ratio of 0.40 has a cost of debt of 7%. If the overall cost of capital is 10% and the tax rate is 21%, what is the company's cost of equity if there are not other imperfections?

**10.95% >>Re=Ru+(Ru-Rd)*(DE)*(1-T) -11.27% -12.41% -4.55%

The costs of financial distress depends mostly on how easily the ownership of the firms _____ can be transferred.

**assets -liabilities -debt -equity

The value of a firm is given by the following expression:

**firm value = value of equity + value of debt -firm value = value of equity -firm value = value of assets - value of debt -firm value = value of equity + value of assets

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

**homemade leverage -mortgaged property -homemade equity -unlevered leverage

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

**homemade leverage -personal principal -backyard bonding -bootleg debt

A firm has $5,000 of debt, $16,000 of equity, a cost of debt of 8% and a cost of equity of 12%. What is the firm's WACC if there are no taxes?

**11.05% >>WACC = (E/V)*Re + (D/v)*Rd ~E=16,000 ~D=5,000 ~V=21,000 >>WACC = (16,000/21,000)*0.12 + (5,000/21,000)*0.08 >>WACC = 0.0914286+0.0190476 = 0.1104762 -11.75% -9.85% -8.95%

According to critics of Modigliani and Miller (M&M), M&M capital structure theory is:

**irrelevant -practical -object oriented -highly relevant in the real world

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

**a higher expected return -collateral assets -stock options -guaranteed dividends

Why is MM's assertion about the positive relationship between the firm value and leverage not observed in the real world?

**MM did not consider bankruptcy costs -MM did not consider the debt tax shield -MM did not consider dividend costs

Which of the following are generally true about the cost of equity and the cost of debt?

**the cost of equity may increase with leverage **the cost of debt is generally lower than the cost of equity **the cost of debt increases with leverage -the cost of equity is generally lower than the cost of debt

MM Proposition II shows that _____.

**the cost of equity rises with leverage -equity is less expensive than debt -the market value of the firm is unaffected by its capital structure -there is no risk involved with leverage when there are no corporate taxes

Which of the following are consequences of nonpayment of debt obligations?

**a firm may be forced to file for bankruptcy **the firm will encounter some form of financial distress -debt obligations will be repaid by the FDIC -a firm may be taken over by the local government

Stockholders and bondholders:

**are not the only claimants to the cash flows of the firm -are the only claimants to the cash flows of the firm -can take the entire pie regardless of capital structure -should not worry about government claims to the cash flows of the firm

Under the MM propositions with no taxes, managers cannot change the value of the firm by repackaging its securities because _____.

**as debt is added, the equity becomes more risky **the overall cost of capital cannot be reduced -capital structures are fixed -debt is not cheaper than equity

What are some ways in which a bankruptcy filing might hinder a firm's normal business operations?

**banks may place restrictions on the firm's financial activities **supplies may not supply inventory, fearing nonpayment **customers may not buy, fearing future service problems -the government may increase taxes on future sales

During bankruptcy, the ownership of the firm's assets is transferred from stockholders to _____.

**bondholders -stakeholders -federal agencies -equity holders

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

**both bondholders and shareholders are adversely affected -only shareholders are adversely affected -only bondholders are adversely affected -neither bondholders nor shareholders are adversely affected

The equity risk that comes from the nature of a firm's operating activities is known as:

**business risk -portfolio risk -stand-alone risk -financial risk

Under pecking order theory firms can choose between debt or equity for external financing, which will they prefer?

**debt -equity

The two broad types of costs of financial distress are _____ costs.

**direct and indirect -implied and inferred -paid and unpaid -potential and realized

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

**financial leverage increases the slope of the EPS line **the rate of return on assets is unaffected by leverage **below the indifference or break-even point in EBIT, an unlevered capital structure is best -above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures

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 -retributive -direct -unlikely

Which of the following assumptions is necessary for MM Proposition 1 to hold?

**individuals can borrow on their own at an interest rate equal to that of the firm -personal taxes must be lower than corporate taxes -interest rates must be low -managers must be acting to maximize the value of the firm

The manager of a firm should change the capital structure if and only if _____

**it increases the value of the firm -the value of the debt exceeds the value of the equity -it benefits management -it decreases the value of the firm

What are the advantages of using internal financing?

**it prevents the adverse market reaction that tends to accompany a stock issue **it may be cheaper than debt or equity issues -firms are required to use internal financing before exploring external sources -the use of internal financing increases free cash flow

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 -deferred -higher -audited

The _____ theory has dominated thinking about capital structure for a long time.

**static -break-even -leverage -pecking order

The point at which the tax saving from an additional dollar in debt financing is exactly balanced by the increased costs of bankruptcy associated with additional borrowing is the essence of the:

**static theory of capital structure -signaling theory -dynamic theory of capital structure -hyperbolic theory of capital structure

What are the two components of the static theory?

**the tax benefits of debt and the costs of financial distress -high leverage and low leverage -the tax benefits of financial distress and the cost of debt -high equity and low equity