Capital Structure

Which of the following are true? 1. There should be no dilution problem for a company issuing additional stock at prices below book value per share, if investors know that the company can earn an adequate rate of return on the new money.

1. True - While book value per share may decline, as long as the firm can earn its required rate of return, market value per share should not decline.

2. If a company goes out of business, the claim of the preferred stock is junior to that of any debt, but senior to that of common stock.

2. True

3. When corporations make investments in other corporations, buying preferred or common stocks has an advantage over purchasing bonds in terms of how the income from those instruments is taxed.

3. True - Preferred dividends qualify for the 70% exclusions for inter corporate dividends.

Adverse selection:

A seller with private information is likely to sell you worse-than- average goods.

Which of the following statements about corporate financing is true? Possible Answers A In times of rapid inflation, it is normal in the manufacturing sector to see increasing ratios of debt to book asset value.

A. True - Book value will understate the true asset value and the firm will be able to support more debt relative to book value.

B Firms sell forward contracts primarily to raise money for new capital investment.

B. False - Selling a forward involves delivery and receipt of funds in the future. It does not raise money for new investment but is used as a hedge instead.

Managers tend to issue more debt after a rise in their stock's price.

C. False - Managers favor equity rather than debt financing after an abnormal price rise although this is not necessarily rational.

Credibility principle:

Claims in one's self- interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue.

The most important source of finance is debt.

D. False - Equity is a larger proportion of total capitalization.

Dividends are paid with pre-tax income.

E. False - Dividends to shareholder must be paid with after tax income, while interest can be paid with pre-tax income.

Leverage Ratchet Effect

Explains that once existing debt is in place: • Equity holders may have an incentive to take on more debt even if it reduced the firm value. • Equity holders will not have an incentive to decrease leverage by buying back debt even if it will increase the firm value. [A levered firm is reluctant to reduce leverage even if this will increase the firm's value. This is because only the debt holders, not the equity holders, may benefit from the recapitalization.]

Agency costs are larger for short-term debt than for long-term debt.

False Agency costs are smallest for short-term debt.

3. The amount of fixed production charges does NOT affect the beta of the capital project.

False - Fixed costs (operating leverage), have a direct effect on asset betas, which in turn have an effect on market betas.

Which of the following statements about equity and debt securities are true? • United States law allows corporations to issue different classes of common stock with different voting rights.

I is true.

According to the "pecking order theory", firms prefer internal financing to external financing.

I is true. If internal funds (i.e. retained earnings) available, there's no need to seek external financing.

Which statements are true about issuance of securities: I. A primary offering refers to the shares a company sells to the public, and secondary offering refers to the shares this company sells to private investors such as institutional and corporate investors.

I. False. Both refer to shares sold to the public (including institutional and corporate investors). A primary offering is newly issued shares sold by the company to raise additional capital; secondary offering is existing shares sold by current shareholders to reduce their investment in the company.

Which of the following reduce the attractiveness of corporate borrowing? I. The existence of capital gains tax preference

I. True - Capital gains preference means that equity income which is primarily capital gains is tax advantaged relative to interest income for individuals which reduces some of the corporate level tax advantage for debt.

Which of the following statements are true with respect to tax arguments and capital structure? I. Corporate taxes tend to favor debt financing

I. True - due to the deductibility of interest

II. The lead underwriter is usually the primary banking or investment firm that leads the underwriting syndicate in issuing security.

II True. Sometimes a single firm will not have the capacity manage a large issue. , An underwriting syndicate, which is led by the lead underwriter, will be formed for the issue. Another reason to form a syndicate is to increase geographical or other diversity of potential investors.

• The par value of a company's common stock (as entered in the company's books) is generally equal to the amount of money the company receives when first selling the shares to the public.

II is false because in general, the par value of common stock is set very low, often at $1 .

An increased likelihood of bankruptcy tends to raise the cost of capital for a firm.

II is true. An increased likelihood of bankruptcy increases the risk of the investment thus increasing the required return for a potential investor.

II. Personal taxes tend to favor debt financing

II. False - due to the fact that it is assumed that interest is taxed more highly than equity returns

II The fact that the firm is not currently profitable

II. True - Any deductions will have to be carried forward declining in present value

• A bond that is both senior and secured does not pose much risk to the investor.

III is false because the risk is a function of the riskiness of the issuing firm's assets. A bond secured by risky assets is still risky.

The more senior the claim in a reorganization, the more likely the claimant is to prefer liquidation.

III is true. Under a liquidation, the senior claimants are likely to receive full recovery of their claims. Under a reorganization, full recovery will be dependent on the future financial success of the reorganized company.

III. The fact that the debt might default

III. False - Only if there are bankruptcy related costs will potential for default reduce the advantages of borrowing

III. According to Tim Loughran and Jay Ritter, between 1990 and 1998, the initial offer price was generally higher than the price that stock market investors were willing to pay. Therefore, underwriters typically demand high underwriting spreads to compensate the risk of loss.

III. False. According to Tim Loughran and Jay Ritter, the initial offer price was generally LOWER than the price that stock market investors were willing to pay. This was often reflected in a run up in stock price immediately after an IPO.

III. The possibility that losses may not be immediately deductible reduces the amount of debt that a firm should issue.

III. True - as the value of the interest deduction declines if it is not immediately deductible

Assume that Modigliani and Miller Propositions hold. A firm is financed with both stocks and bonds. If the firm settles some of its debts by issuing more stocks, then which of the following will increase as a result? Asset (unlevered) cost of capital Equity cost of capital Debt cost of capital Debt-to-value ratio Debt-to-equity ratio

None I. Asset (unlevered) cost of capital will remain unchanged according to MM Propositions. II. Equity cost of capital will decrease since the risk of default is reduced. III. Debt cost of capital will remain unchanged or decrease since the risk of default is reduced. IV. Debt-to-value ratio will decrease since the debt amount is reduced. V. Debt-to-equity ratio will decrease since the debt amount is reduced.

present value of the tax shields created by the depreciation at the after tax borrowing rate

Tax shields = Dollar deductions × Marginal tax rate After tax borrowing rate = Pre-tax borrowing rate × (1 − Marginal tax rate)

Post-money valuation of the firm for this funding round

The share price for this funding round is Total capital raised/Number of shares issued. The share price after this funding round is Post-money valuation/Number of outstanding shares.

When a levered firm issues new debt, existing debt holders will bear agency or bankruptcy costs.

True Once a firm has debt already in place, some of the agency or bankruptcy costs that result from taking on additional leverage will fall on existing debt holders.

Equity holders may have an incentive to increase financial leverage, even if doing so would decrease the value of the firm.

True Once existing debt is in place, (1) shareholders may have an incentive to increase leverage even if it decreases the value of the firm.

Determine which one of the following statements about the agency costs of leverage is FALSE: When a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm.

True When a firm faces financial distress, shareholders have an incentive to withdraw cash.

When an unlevered firm issues new debt, equity holders will bear any agency or bankruptcy costs via a discount in the price they receive for the new debt.

True When an unlevered firm issues new debt, equity holders will bear any anticipated agency or bankruptcy costs via a discount in the price they receive for that new debt.

Which of the following statements about beta are true? 1. When a company borrows money, it increases the beta of its stock.

True - The effect of leverage on beta has been both theoretically and empirically shown.

2. A company whose revenues and earnings are strongly dependent on the state of the business cycle would tend to have a high beta.

True - The firm that has cyclical revenue would tend to have a high asset beta.

Lemons principle

When managers have private information about the value of a firm, investors will discount the price they are willing to pay for new equity issue due to adverse selection.

expected earnings per share

equity * rE / number of shares

They may convert their preferred stock into corporate bonds with fixed coupons at a lower price.

false Corporate Finance by Berk and DeMarzo never mentions that preferred stock holders may convert their preferred stock into corporate bonds with fixed coupons at a lower price.

The company cost of capital is equivalent to the expected return on the company's common stock.

false A company's cost of capital is the market value weighted average of its sources of capital. The statement would be true for an all equity firm.

Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements.

true

How will preferred stock holders be protected if they offer to invest in a private firm? They may have a senior claim on the firm's asset in the event of acquisition or liquidation.

true

In general,debtholders bear much less risk than do equityholders.

true

The stock price tends to rise prior to the announcement of an equity issue.

true

They may convert their preferred stock into common stock at a lower price.

true

They may receive 1-3 times of their initial investment in the event of acquisition or liquidation.

true

They may receive common stock dividends.

true

Which of the following are implications of adverse selection according to Corporate Finance by Berk and DeMarzo? The stock price declines on the announcement of an equity issue.

true

If a company reduces debt, its debtholders are likely to be satisfied with a lower return.

true In most circumstances, a reduction in the amount of debt will reduce the chance of bankruptcy and therefore be beneficial to the remaining debtholders. its debtholders are likely to be satisfied with a lower return.

Adverse selection has several implications for equity issuance:

• The stock price declines on the announcement of an equity issue. • The stock price tends to rise prior to the announcement of an equity issue. • Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcement.

percentage ownership

• share price after this funding round = Post-money valuation/Number of outstanding shares • percentage ownership = Total value of her shares/Post-money valuation or Number of her shares/Number of outstanding shares