FINC 3310 - CH 13

Roller Coaster's has a WACC of 11.6 percent, ignoring taxes. It has a target capital structure of 60 percent equity and 40 percent debt and a cost of equity of 14.27 percent. What is the cost of debt?

.1427 = .116 + (.116 − RD) × (.40/.60) RD = .0760, or 7.6%

Click and drag on elements in order Rank each of the following in order of priority of payment.

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

Based on M&M Proposition I with corporate taxes, the optimal capital structure is ______.

100% debt

Horizon Landscape currently has 62,000 shares of stock outstanding and no debt. The price per share is $18.50. The firm is considering borrowing funds at 7 percent interest and using the proceeds to repurchase 12,000 shares of stock. Ignore taxes. How much is the firm borrowing?

12,000 × $18.50 = $222,000

In the process of liquidation, some types of claims receive preference over other claims. Which one of the following determines which type of claim is paid first?

Absolute priority rule

2 Which one of the following is the equity risk arising from the daily operations of a firm?

Business risk

Select all that apply Which of the following industries tend to have a low leverage?

Computers Drugs

Which costs of financial distress are easier to measure?

Direct costs are easy to measure.

Select all that apply Which of the following are examples of firms which filed for bankruptcy for strategic reasons?

Dow Corning Continental Airlines Texaco Johns Manville

True or false: The legal process of bankruptcy is typically quick and inexpensive.

False

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

False Equity still carries risk; thus, an investor should expect a higher return than that on less risky debt.

True or false: Direct costs are very difficult to measure and, thus, are often estimated.

False Indirect costs are difficult to measure.

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

False It has reached accounting insolvency when book liabilities exceed the book value of total assets.

True or false: Based on M&M Proposition I, even including taxes, capital structure does not matter to the firm.

False Once taxes are included, capital structure matters.

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

False The optimal debt level is determined in a subjective manner. There is no precise equation.

Which one of the following is an example of a direct bankruptcy cost?

Incurring legal fees for the preparation of bankruptcy filings

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

Indirect costs are difficult to quantify.

Which of the following assumptions is necessary for M&M Proposition I to hold? Personal taxes must be lower than corporate taxes. Individuals can borrow on their own at an interest rate equal to that of the firm. Interest rates must be low. Managers must be acting to maximize the value of the firm.

Individuals can borrow on their own at an interest rate equal to that of the firm.

Green Tea House has a tax rate of 25 percent and an interest tax shield valued at $8,046 for the year. How much did the firm pay in annual interest?

Interest = $8,046/.25 = $32,184.00

Which of the following is true of the impact of financial leverage? It magnifies gains and losses. It protects gains but magnifies losses. It protects gains and minimizes losses. It magnifies gains but protects against losses.

It magnifies gains and losses.

Gulf Shores Inn is comparing two separate capital structures. The first structure consists of 64,000 shares of stock and no debt. The second structure consists of 50,000 shares of stock and $1.11 million of debt. What is the price per share of equity?

P = $1,110,000/(64,000 − 50,000) = $79.29

Southern Foods has a $13 million bond issue outstanding with a coupon rate of 7.15 percent and a yield to maturity of 7.39 percent. What is the present value of the tax shield if the tax rate is 24 percent?

PV of tax shield = .24 × $13,000,000 = $3,120,000

1 Gabe's Market is comparing two different capital structures. Plan I would result in 15,000 shares of stock and $210,000 in debt. Plan II would result in 13,000 shares of stock and $252,000 in debt. The interest rate on the debt is 8 percent. Ignoring taxes, compare both plans to an all-equity plan assuming that EBIT will be $52,000. The all-equity plan would result in 25,000 shares of stock outstanding. Of the three plans, the firm will have the highest EPS with _________blank and the lowest EPS with _________blank.

Plan II; the all-equity plan

The present value of the interest tax shield equals what?

TC × 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. The WACC always increases as debt increases. The WACC initially rises and then falls as debt increases. The WACC always falls as debt increaseS

The WACC initially falls and then rises as debt increases.

Select all that apply According to M&M 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?

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

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

The benefits of debt financing may be more than offset by the costs of financial distress. The possibility of financial distress will become a chronic problem.

True or false: According to the absolute priority rule, administrative expenses associated with the bankruptcy are paid first in the distribution of the proceeds of liquidation.

True

True or false: Firm value is maximized when the WACC is minimized.

True

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

a higher expected return

Select all that apply Which of the following are direct costs of financial distress?

administrative expenses legal fees

The costs of financial distress depend mostly on how easily the ownership of the firm's Blank______ can be transferred.

assets

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

bad for the firm

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

bondholders

Select all that apply Financial distress can arise in the form of possible Blank______.

business failure legal bankruptcy

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

business risk

The cost of debt will begin to increase as the _____.

degree of leverage increases

Select all that apply Which two of the following are broad types of costs of financial distress?

direct costs indirect costs

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 Blank______ the present value of the tax shield benefits.

equals

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

The tax deductibility of interest payments is ______.

good for the firm

Equity carries risk; thus, an investor should expect a ____________ return than that on less risky debt.

higher

Capital structure decisions are made ______ investment decisions. taking into account in conjunction with independent of after

independent of

Customers refusing to buy GM cars when the company filed for Chapter 11 for fear of not being able to get service for the cars in the future is an example of ______ costs of financial distress.

indirect

A prepack:

is the joint filing of both a bankruptcy filing and a creditor-approved reorganization plan

Select all that apply A capital restructuring may include ______. issuing more equity borrowing on a line of credit issuing debt and repurchasing equity issuing more debt

issuing more equity issuing debt and repurchasing equity issuing more debt

The cost of debt is generally _____ than the cost of equity. (Enter only one word per blank.)

lower or less

Select all that apply An optimal capital structure will ______. minimize the cost of capital maximize the value of the firm maximize the earnings per share maximize the value of assets

minimize the cost of capital maximize the value of the firm

The possibility of bankruptcy costs has a(n) Blank______ effect on the value of the firm.

negative

Select all that apply The tax shield afforded by debt will be of the least use to firms with ______.

negative EBT losses carried forward

The value of a levered firm in M&M Proposition I with corporate taxes equals the value of an all equity firm ______.

plus the tax rate times the value of debt

The expected return on equity is ______ to leverage. negatively related unrelated positively related

positively related

Volatility or ______ increases for equity holders when leverage increases..

risk

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 Blank______ theory of capital structure.

static

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

the bankruptcy process can be long and expensive

M&M Proposition II shows that Blank______.

the cost of equity rises with leverage

A firm's capital structure refers to ______. how the firm invests its capital the amount of cash in a firm the firm's mix of debt and equity the amount of capital in the firm

the firm's mix of debt and equity

A beneficial rule to follow is to set the firm's capital structure so that _____. the firm's value is maximized the firm's value is minimized the firm's bondholders are satisfied dividends are maximized

the firm's value is maximized

The Bethlehem Inn is an all-equity firm with 9,000 shares outstanding at a value per share of $28.60. The firm is issuing $39,932 of debt and using the proceeds to reduce the number of outstanding shares. How many shares of stock will be outstanding once the debt is issued? Ignore taxes.

9,000 − ($39,932/$28.60) = 7,604 shares

Select all that apply Which of the following industries tend to have a high leverage?

Airlines Cable television

Which one of the following is correct based on the static theory of capital structure?

At the optimal level of debt a firm also optimizes its tax shield on debt.

The value of a levered firm will be __________ than the value of an identical unlevered firm because the levered firm's taxes will be __________ . (Enter only one word per blank.)

Blank 1: greater or higher Blank 2: lower or less

True or false: Stockholders care most about the dividend maximization of the firm.

False They care most about maximizing the overall value of the firm.

______ is the term that describes the capital structure when debt is used to finance assets. Financial leverage Opportunity costs Long-term liability Shareholder equity

Financial leverage

Which one of the following is the equity risk arising from the capital structure selected by a firm?

Financial risk

Which one of the following is a direct bankruptcy cost?

Legal and accounting fees related to a bankruptcy proceeding

An all-equity firm has a return on assets of 21 percent. The firm is considering converting to a debt-equity ratio of .48. The pretax cost of debt is 6.9 percent. Ignoring taxes, what will the cost of equity be if the firm switches to the levered capital structure?

RE = .21 + [(.21 − .069) × .48] RE = .2777, or 27.77%

Select all that apply A corporation gains no value from an interest tax shield if which of the following are true?

The corporation is an all-equity firm. The corporation has no debt. Corporate tax rates are zero.

Select all that apply Which of the following are generally true about the cost of equity and the cost of debt?

The cost of debt increases with leverage. The cost of debt is generally lower than the cost of equity. The cost of equity may increase with leverage.

True or false: It is possible for the present value of distress costs to exceed the present value of tax savings.

True

True or false: M&M demonstrated that debt financing is neither better nor worse than equity financing.

True

The Piano Movers can borrow at 7.8 percent. The firm currently has no debt, and the cost of equity is 15 percent. The current value of the firm is $680,000. What will the value be if the firm borrows $140,000 and uses the proceeds to repurchase shares? The corporate tax rate is 22 percent.

VL = $680,000 + (.22)($140,000) = $710,800

The Fruit Mart is an all-equity firm with a current cost of equity of 17.4 percent. The estimated earnings before interest and taxes are $169,500 annually forever. Currently, the firm has no debt but is in the process of borrowing $400,000 at 9.5 percent interest. The tax rate is 21 percent. What is the value of the unlevered firm?

VU = [$169,500 × (1 − .21)]/.174 = $769,569

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

Which one of the following conditions exists at the point where a firm maximizes its value?

WACC is minimized

M&M Proposition II, without taxes, states that the:

cost of equity increases as a firm increases its debt-equity ratio

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 weighted average cost of capital rises at higher levels of debt owing to ______. higher dividend costs higher working capital excess free cash flow financial distress costs

financial distress costs

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

Select all that apply 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 the firm funded by only equity will be worth more the firm funded with debt and equity will be worth more

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

How is the optimal debt level determined?

in a subjective manner

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

increase

Select all that apply 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

What is generally the most important component of direct bankruptcy costs?

legal costs

The risk of too much ______ is bankruptcy.

leverage

M&M Proposition I does not work with corporate taxes because ______.

levered firms pay lower taxes than unlevered firms

Select all that apply What are some examples of indirect financial distress costs?

lost reputation lost sales

Under M&M 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

The Static Theory of Capital Structure suggests employing debt to the point that its cost equals the cost of ____________________.

the increased probability of bankruptcy

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

the interest tax shield

Under M&M 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

According to M&M Proposition I with taxes, the value of a levered firm will increase when the:

value of the unlevered firm increases.

Peter's Tools recently defaulted on a bank loan. To avoid a bankruptcy proceeding, the bank agreed to a composition. This composition would do which one of the following?

Reduce the amount of the loan payments so Peter's can pay on time

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

A firm is considering two different capital structures. The first option is an all-equity firm with 75,000 shares of stock. The second option is 50,000 shares of stock plus some debt. Ignoring taxes, the break-even level of earnings before interest and taxes between these two options is $92,500. How much money is the firm considering borrowing if the interest rate is 8 percent?

EPSU = EPSL $95,000/75,000 = [$92,500 − (D × .08)]/50,000 D = $364,583

Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBIT)? Below the EBIT break-even point, the levered capital structure is best. The rate of return on assets is unaffected by leverage. Financial leverage decreases the slope of the EPS line. The slope of the EPS line is unaffected by financial leverage.

The rate of return on assets is unaffected by leverage.

Jericho Snacks is an all-equity firm with estimated earnings before interest and taxes of $624,000 annually forever. Currently, the firm has no debt but is considering borrowing $725,000 at 6.75 percent interest. The tax rate is 25 percent and the current cost of equity is 15.2 percent. What is the value of the levered firm?

VU = [$624,000 × (1 − .25)]/.152 = $3,078,947.37 VL = $3,078,947.37 + (.25 × $725,000) = $3,260,197

Alderanian's is an all-equity firm that has 200,000 shares of stock outstanding. Neal, the financial vice president, is considering borrowing $300,000 at 8.5 percent interest to repurchase 50,000 shares. Ignoring taxes, what is the current value of the firm?

Value per share = $300,000/50,000 = $6 Firm value = 200,000 × $6 = $1,200,000

Glass Growers has a cost of capital of 11.1 percent. The company is considering converting to a debt-equity ratio of .46. The interest rate on debt is 7.3 percent. What would be the company's new cost of equity? Ignore taxes.

WACC = .111 = (1/1.46)(RE) + (.46/1.46)(.073) RE = .1285, or 12.85%

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

financial distress costs

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

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. firm-specific personal homemade temporary

homemade

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

zero