Capital Structure Theory CH 17+18

Coffee Roaster's International takes out a loan from its bank in the amount of $30,000. The interest rate on the loan is 8%. Coffee Roaster's tax rate is 35%. What is the interest payment on the loan?

$2,400 Reason: 0.08 x $30,000 = $2,400

Tea Haus International takes out a loan from its bank in the amount of $40,000. The interest rate on the loan is 8%. Tea Haus tax rate is 35%. What is the interest payment on the loan?

$3,200 Reason: 0.08 x $40,000 = $3,200

Suppose that a firm that is all equity financed is valued at $400 million. The present value of its tax shield is $30 million. According to the principles of MM, what is the value of the firm?

$430 million Reason: $400 million + $30 million = $430 million

If a firm is in financial distress, how much will the bondholders receive under the following scenario: expected cash available =$140; claims of bondholders =$120; claims of bankruptcy lawyers = $80?

$60 Reason: $140 - 80 = $60

Why do firms prefer debt over equity as a source of external financing?

-Equity has more risk than debt. -Debt is less likely to be mispriced

Debt ratios of individual companies seem to depend on which of the following factors?

-Profitability -Size -Tangible Assets -Market to Book ratios

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

-Suppliers may not supply inventory, fearing nonpayment. -Customers may not buy, fearing future service problems. -Banks may place restrictions on the firm's financial activities.

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

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

The costs of financial distress depend on which of the following:

-probability of distress -magnitude of costs if distress occurs

Susie is trying to determine the discount rate for her firm's interest tax shields. The tax shields come from debt that is paid with 6% interest. The risk-free rate is 4%, and the market risk premium is 3%. What should Susie use as the discount rate for the interest tax shields?

6% Reason: It is common to assume that the risk of the tax shields is that same as the interest paid on the debt; in this case 6%

How could the theoretical assumptions lead to all-debt financing by firms?

A world with corporate taxes but no financial distress costs

What theoretical assumptions will lead to all-debt financing by firms?

A world with corporate taxes but no financial distress costs

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

Debt

MM's proposition 2 states that if a company receives a tax shield on their interest payments then the after-tax WACC capital does which of the following?

Declines as debt increases.

Which costs of financial distress are easier to measure?

Direct costs

True or false: Managing a bankrupt firm is easy.

False

True or false: Stockholders and bondholders are the only claimants to the cash flows of the firm.

False

True or false: Changes in capital structure always benefits stockholders even if the value of the firm decreases.

False Reason: Changes in capital structure benefit stockholders only if the value of the firm increases.

True or false: The most profitable companies display evidence that the trade-off theory of capital structure works.

False Reason: In practice, the trade-off theory often fails. Many of the world's most profitable companies borrow the least.

What is the most important benefit of debt?

It provides a tax benefit.

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

Legal costs

Given asymmetric information, who is assumed to have more information about the companies' prospects, risks, and values?

Managers

Why do firms prefer not to issue equity?

Share prices tend to drop when equity is issued.

What are shareholders liable for if the firm is in financial distress and can pay only 75% of the payment due to the bondholders?

Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.

What are shareholders liable for if the firm is in financial distress and can pay only 80% of the payment due to the bondholders?

Since shareholders have limited liability, they are not personally responsible for the debt obligations of the firm.

Two firms have the same amount of earnings, but the firm with debt pays lower total taxes than the firm without debt. This is the value of the interest ______ shield.

Tax

What is the upper limit on payments to bondholders by the corporation regardless of the level of profits?

The obligation due in terms of interest and principal

Which of the following is likely to be true when a bankruptcy ruling is issued?

The ownership of assets is transferred from the shareholders to the bondholders.

Which capital structure theory suggests that profitable firms will use less debt?

The pecking order theory

True or false: According to MM with corporate taxes the value of the firm is equal to its value if all-equity financed plus the present value of the tax shield.

True

True or false: According to Modigliani and Miller, in a perfect market any combination of securities is as good as another.

True

True or false: The most profitable companies often borrow the least.

True

Which company illustrates the trade-off theory of capital structure by having a high debt ratio?

United Airlines Reason: United Airlines has more tangible assets and therefore a much higher debt ratio.

Stockholders and bondholders:

are not the only claimants to the cash flows of the firm

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

bondholders

Financial distress occurs when promises to _________ are broken or honored with difficulty.

creditors

According to MM with corporate taxes firms should prefer to raise capital via

debt Reason: According to MM with corporate taxes firms should prefer to raise capital via debt because of the tax shield.

If a firm issues ______, shareholders will assume the firm's common stock is undervalued, but if a firm issues ______, shareholders will assume the firm's common stock is overvalued.

debt; equity

The cost of debt will begin to increase as the:

degree of leverage increases

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

direct and indirect

The cost of equity is generally ______ ______ the cost of debt.

higher than

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

increase

Customers refusing to buy cars after GM filed for Chapter 11 (fearing the inability to service them in the future) is an example of ______ costs of financial distress.

indirect

In addition to the direct costs in the case of bankruptcy, such as legal cost, there are also ______________.

indirect costs

According to the pecking order theory, where does a firm look to first for financing?

internal funds

Which of the following is the correct order of financing supporting the pecking order theory?

internal funds, new issues of debt, new issues of equity

The trade-off theory implies that there is an optimal level of debt, but the pecking-order theory suggests that each firm chooses its leverage ratio based on ____.

its financing needs

Stockholders in corporations automatically get ___________.

limited liability

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

overvalued

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

plus the present value of the corporate tax shield

One of the important reasons why firms choose to raise capital by issuing debt is because of the ______ benefits of debt.

tax

The trade-off theory of capital structure states that a firm's debt-to-equity ratio is optimal when:

tax savings due to further borrowing are just offset by increases in the costs of financial distress

The extra after-tax income that results from the tax-deductibility of interest is called the:

tax shield

When a US corporation takes on debt, the interest that it pays on that debt is:

tax-deductible

Which types of companies illustrate the trade-off theory of capital structure by having low debt ratios?

technology companies

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

the change will increase the value of the firm

One important benefit of debt financing for corporations is:

the interest it pays on debt is tax-deductible

A common assumption made is that interest tax shields hold the same amount of risk as:

the interest payment on the debt generating the tax shield

The ____ theory is the dominant theory of capital structure.

trade-off

The ________________ states that a firm's debt-to-equity ratio is optimal when tax savings due to further borrowing are just offset by increases in the costs of financial distress.

trade-off theory of capital structure

The value of a levered firm equals the ____________.

value if all-equity-financed + PV(tax shield)